Monopolistic Competition and Oligopoly

1
Chapter 12

• Monopolistic Competition and Oligopoly

2
Topics to be Discussed

• Monopolistic Competition
• Oligopoly
• Price Competition

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Monopolistic Competition

• Characteristics
• Many firms
• Free entry and exit
• Differentiated product

4
Monopolistic Competition

• The amount of monopoly power depends on the
  degree of differentiation
• Examples of this very common market structure
  include
• Toothpaste
• Soap
• Cold remedies

5
Monopolistic Competition

• Toothpaste
• Crest and monopoly power
• Procter Gamble is the sole producer of Crest
• Consumers can have a preference for Crest
  taste, reputation, decay-preventing efficacy
• The greater the preference (differentiation) the
  higher the price

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Monopolistic Competition

• Two important characteristics
• Differentiated but highly substitutable products
• Free entry and exit

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A Monopolistically CompetitiveFirm in the Short
and Long Run
/Q
/Q
Short Run
Long Run
Quantity
Quantity
8
A Monopolistically CompetitiveFirm in the Short
and Long Run

• Short run
• Downward sloping demand differentiated product
• Demand is relatively elastic good substitutes
• MR lt P
• Profits are maximized when MR MC
• This firm is making economic profits

9
A Monopolistically CompetitiveFirm in the Short
and Long Run

• Long run
• Profits will attract new firms to the industry
  (no barriers to entry)
• The old firms demand will decrease to DLR
• Firms output and price will fall
• Industry output will rise
• No economic profit (P AC)
• P gt MC ? some monopoly power

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Monopolistically and Perfectly Competitive
Equilibrium (LR)
Monopolistic Competition
Perfect Competition
/Q
/Q
Quantity
Quantity
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Monopolistic Competition and Economic Efficiency

• The monopoly power yields a higher price than
  perfect competition. If price was lowered to the
  point where MC D, consumer surplus would
  increase by the yellow triangle deadweight
  loss.
• With no economic profits in the long run, the
  firm is still not producing at minimum AC and
  excess capacity exists.

12
Monopolistic Competition and Economic Efficiency

• Firm faces downward sloping demand so zero profit
  point is to the left of minimum average cost
• Excess capacity is inefficient because average
  cost would be lower with fewer firms

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Monopolistic Competition

• If inefficiency is bad for consumers, should
  monopolistic competition be regulated?
• Market power is relatively small. Usually there
  are enough firms to compete with enough
  substitutability between firms deadweight loss
  small.
• Inefficiency is balanced by benefit of increased
  product diversity may easily outweigh
  deadweight loss.

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The Market for Colas and Coffee

• Each market has much differentiation in products
  and tries to gain consumers through that
  differentiation
• Coke vs. Pepsi
• Maxwell House vs. Folgers
• How much monopoly power do each of these
  producers have?
• How elastic is demand for each brand?

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Elasticities of Demand forBrands of Colas and
Coffee
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The Market for Colas and Coffee

• The demand for Royal Crown is more price
  inelastic than for Coke
• There is significant monopoly power in these two
  markets
• The greater the elasticity, the less monopoly
  power and vice versa

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Oligopoly Characteristics

• Small number of firms
• Product differentiation may or may not exist
• Barriers to entry
• Scale economies
• Patents
• Technology
• Name recognition
• Strategic action

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Oligopoly

• Examples
• Automobiles
• Steel
• Aluminum
• Petrochemicals
• Electrical equipment

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Oligopoly

• Management Challenges
• Strategic actions to deter entry
• Threaten to decrease price against new
  competitors by keeping excess capacity
• Rival behavior
• Because only a few firms, each must consider how
  its actions will affect its rivals and in turn
  how their rivals will react

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Oligopoly Equilibrium

• If one firm decides to cut their price, they must
  consider what the other firms in the industry
  will do
• Could cut price some, the same amount, or more
  than firm
• Could lead to price war and drastic fall in
  profits for all
• Actions and reactions are dynamic, evolving over
  time

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Oligopoly Equilibrium

• Defining Equilibrium
• Firms are doing the best they can and have no
  incentive to change their output or price
• All firms assume competitors are taking rival
  decisions into account
• Nash Equilibrium
• Each firm is doing the best it can given what its
  competitors are doing
• We will focus on duopoly
• Markets in which two firms compete

22
Oligopoly

• The Cournot Model
• Oligopoly model in which firms produce a
  homogeneous good, each firm treats the output of
  its competitors as fixed, and all firms decide
  simultaneously how much to produce
• Firm will adjust its output based on what it
  thinks the other firm will produce

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Firm 1s Output Decision
P1
Q1
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Oligopoly

• The Reaction Curve
• The relationship between a firms
  profit-maximizing output and the amount it thinks
  its competitor will produce
• A firms profit-maximizing output is a decreasing
  schedule of the expected output of Firm 2

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Reaction Curves and Cournot Equilibrium
Q1
Firm 1s reaction curve shows how much it will
produce as a function of how much it thinks Firm
2 will produce. The xs correspond to the
previous model.
100
75
Firm 2s reaction curve shows how much it will
produce as a function of how much it thinks Firm
1 will produce.
50
x
x
25
x
x
Q2
25
50
75
100
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Reaction Curves and Cournot Equilibrium
Q1
100
In Cournot equilibrium, each firm correctly
assumes how much its competitors will produce and
thereby maximizes its own profits.
75
50
x
x
25
x
x
Q2
25
50
75
100
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Cournot Equilibrium

• Each firms reaction curve tells it how much to
  produce given the output of its competitor
• Equilibrium in the Cournot model, in which each
  firm correctly assumes how much its competitor
  will produce and sets its own production level
  accordingly

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Oligopoly

• Cournot equilibrium is an example of a Nash
  equilibrium (Cournot-Nash Equilibrium)
• The Cournot equilibrium says nothing about the
  dynamics of the adjustment process
• Since both firms adjust their output, neither
  output would be fixed

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The Linear Demand Curve

• An Example of the Cournot Equilibrium
• Two firms face linear market demand curve
• We can compare competitive equilibrium and the
  equilibrium resulting from collusion
• Market demand is P 30 - Q
• Q is total production of both firms
• Q Q1 Q2
• Both firms have MC1 MC2 0

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Oligopoly Example

• Firm 1s Reaction Curve ? MR MC

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Oligopoly Example

• An Example of the Cournot Equilibrium

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Oligopoly Example

• An Example of the Cournot Equilibrium

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Duopoly Example
Q1
The demand curve is P 30 - Q and both firms
have 0 marginal cost.
Q2
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Oligopoly Example

• Profit Maximization with Collusion

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Profit Maximization w/ Collusion

• Collusion Curve
• Q1 Q2 15
• Shows all pairs of output Q1 and Q2 that maximize
  total profits
• Q1 Q2 7.5
• Less output and higher profits than the Cournot
  equilibrium

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Duopoly Example
Q1
For the firm, collusion is the best outcome
followed by the Cournot Equilibrium and then the
competitive equilibrium
30
Q2
30
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First Mover Advantage The Stackelberg Model

• Oligopoly model in which one firm sets its output
  before other firms do
• Assumptions
• One firm can set output first
• MC 0
• Market demand is P 30 - Q where Q is total
  output
• Firm 1 sets output first and Firm 2 then makes an
  output decision seeing Firm 1s output

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First Mover Advantage The Stackelberg Model

• Firm 1
• Must consider the reaction of Firm 2
• Firm 2
• Takes Firm 1s output as fixed and therefore
  determines output with the Cournot reaction
  curve Q2 15 - ½(Q1)

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First Mover Advantage The Stackelberg Model

• Firm 1
• Choose Q1 so that
• Firm 1 knows Firm 2 will choose output based on
  its reaction curve. We can use Firm 2s reaction
  curve as Q2 .

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First Mover Advantage The Stackelberg Model

• Using Firm 2s Reaction Curve for Q2

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First Mover Advantage The Stackelberg Model

• Conclusion
• Going first gives Firm 1 the advantage
• Firm 1s output is twice as large as Firm 2s
• Firm 1s profit is twice as large as Firm 2s
• Going first allows Firm 1 to produce a large
  quantity. Firm 2 must take that into account and
  produce less unless it wants to reduce profits
  for everyone.

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Price Competition

• Competition in an oligopolistic industry may
  occur with price instead of output
• The Bertrand Model is used
• Oligopoly model in which firms produce a
  homogeneous good, each firm treats the price of
  its competitors as fixed, and all firms decide
  simultaneously what price to charge

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Price Competition Bertrand Model

• Assumptions
• Homogenous good
• Market demand is P 30 - Q where
  Q Q1 Q2
• MC1 MC2 3
• Can show the Cournot equilibrium if Q1 Q2 9
  and market price is 12, giving each firm a
  profit of 81.

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Price Competition Bertrand Model

• Assume here that the firms compete with price,
  not quantity
• Since good is homogeneous, consumers will buy
  from lowest price seller
• If firms charge different prices, consumers buy
  from lowest priced firm only
• If firms charge same price, consumers are
  indifferent who they buy from

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Price Competition Bertrand Model

• Nash equilibrium is competitive output since have
  incentive to cut prices
• Both firms set price equal to MC
• P MC P1 P2 3
• Q 27 Q1 Q2 13.5
• Both firms earn zero profit

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Price Competition Bertrand Model

• Why not charge a different price?
• If charge more, sell nothing
• If charge less, lose money on each unit sold
• The Bertrand model demonstrates the importance of
  the strategic variable
• Price versus output

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Bertrand Model Criticisms

• When firms produce a homogenous good, it is more
  natural to compete by setting quantities rather
  than prices
• Even if the firms do set prices and choose the
  same price, what share of total sales will go to
  each one?
• It may not be equally divided
• Kreps and Scheinkman

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Price Competition Differentiated Products

• Market shares are now determined not just by
  prices, but by differences in the design,
  performance, and durability of each firms
  product
• In these markets, more likely to compete using
  price instead of quantity

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Price Competition Differentiated Products

• Example
• Duopoly with fixed costs of 20 but zero variable
  costs
• Firms face the same demand curves
• Firm 1s demand Q1 12 - 2P1 P2
• Firm 2s demand Q2 12 - 2P1 P2
• Quantity that each firm can sell decreases when
  it raises its own price but increases when its
  competitor charges a higher price

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Price Competition Differentiated Products

• Firms set prices at the same time

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Price Competition Differentiated Products

• If P2 is fixed