Monopolistic Competition and Oligopoly

1
Chapter 12

• Monopolistic Competition and Oligopoly

2
Monopolistic Competition

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

3
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
• Retail

4
Monopolistic Competition

• Two important characteristics
• Differentiated but highly substitutable products
  (cross-price elasticity of demand large)
• Free entry and exit (keeps profits down)

5
A Monopolistically CompetitiveFirm in the Short
and Long Run
/Q
/Q
Short Run
Long Run
Quantity
Quantity
6
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

7
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

8
Monopolistically and Perfectly Competitive
Equilibrium (LR)
Monopolistic Competition
Perfect Competition
/Q
/Q
Quantity
Quantity
9
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.

10
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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Excess Capacity

• The FIRMs output is inefficiently low less than
  minimum ATC
• Fewer total firms in the INDUSTRY would increase
  the FIRMs demand and allow them to take
  advantage of economies of scale and increase
  output

12
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.

13
Oligopoly Characteristics

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

14
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

18
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
• Market price depends on the total output of both
  firms
• 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
20
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
• Different MC different reaction functions

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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
23
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

24
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, the
  equilibrium resulting from collusion, and Cournot
  Equilibrium
• 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 Cournot

• 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
30
Oligopoly Example

• Profit Maximization with Collusion
• Collusion implies industry profits maximized

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Profit Maximization w/ Collusion

• Contract 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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Review How to solve Cournot

• Begin with Total Revenue function
• Create by calculating P times Q1 and P is from
  the demand function in terms of Q total
• Must substitute Q1 Q2 for Q
• Result TR function in terms of Q1 and Q2
• Identify Marginal Revenue and set equal to
  Marginal Cost
• Solve this equality in terms of Q1 fn. Of Q2

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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.

39
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

40
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.

41
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 and each firm will
  supply half the market

42
Price Competition Bertrand Model

• Nash equilibrium is competitive equilibrium
  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

43
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

44
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 choose the same price, what
  share of total sales will go to each one?
• Probably not exactly half

45
Competition Versus CollusionThe Prisoners
Dilemma

• Nash equilibrium is a noncooperative equilibrium
  each firm makes decision that gives greatest
  profit, given actions of competitors
• Although collusion is illegal, why dont firms
  cooperate without explicitly colluding?
• Why not set profit maximizing collusion price and
  hope others follow?

46
Competition Versus CollusionThe Prisoners
Dilemma

• Competitor is not likely to follow
• Competitor can do better by choosing a lower
  price, even if they know you will set the
  collusive level price
• We can use a payoff matrix to better understand
  the firms choices

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Payoff Matrix for Pricing Game
Firm 2
Charge 4
Charge 6
Charge 4
Firm 1
Charge 6
48
Competition Versus CollusionThe Prisoners
Dilemma

• We can now answer the question of why firm does
  not choose cooperative price
• Cooperating means both firms charging 6 instead
  of 4 and earning 16 instead of 12
• Each firm always makes more money by charging 4,
  no matter what its competitor does
• Unless enforceable agreement to charge 6, will
  be better off charging 4

49
Competition Versus CollusionThe Prisoners
Dilemma

• An example in game theory, called the Prisoners
  Dilemma, illustrates the problem oligopolistic
  firms face
• Two prisoners have been accused of collaborating
  in a crime
• They are in separate jail cells and cannot
  communicate
• Each has been asked to confess to the crime

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Payoff Matrix for Prisoners Dilemma
Prisoner B
Confess
Dont confess
Confess
Prisoner A
Would you choose to confess?
Dont confess
51
Oligopolistic Markets

• Conclusions
• Collusion will lead to greater profits
• Explicit and implicit collusion is possible
• Reputations
• Short-lived gains from cheating
• Face retaliation
• Once collusion exists, the profit motive to break
  and lower price is significant

52
Price Rigidity

• Firms have strong desire for stability
• Price rigidity characteristic of oligopolistic
  markets by which firms are reluctant to change
  prices even if costs or demands change
• Fear lower prices will send wrong message to
  competitors, leading to price war
• Higher prices may cause competitors to raise
  theirs

53
Price Rigidity

• Basis of kinked demand curve model of oligopoly
• Each firm faces a demand curve kinked at the
  current prevailing price, P
• Above P, demand is very elastic
• If P gt P, other firms will not follow
• Below P, demand is very inelastic
• If P lt P, other firms will follow suit

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The Kinked Demand Curve
/Q
Quantity
MR
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Price Rigidity

• With a kinked demand curve, marginal revenue
  curve is discontinuous
• Firms costs can change without resulting in a
  change in price
• Kinked demand curve does not really explain
  oligopolistic pricing
• Description of price rigidity rather than an
  explanation of it
• How was price chosen to begin with?

56
Price Signaling and Price Leadership

• Price Signaling
• Implicit collusion in which a firm announces a
  price increase in the hope that other firms will
  follow suit
• Price Leadership
• Pattern of pricing in which one firm regularly
  announces price changes that other firms then
  match

57
Cartels

• Producers in a cartel explicitly agree to
  cooperate in setting prices and output
• Typically only a subset of producers are part of
  the cartel and others benefit from the choices of
  the cartel
• If demand is sufficiently inelastic and cartel is
  enforceable, prices may be well above competitive
  levels
• Most fail to maintain high prices

58
Cartels

• Examples of successful cartels
• OPEC
• International Bauxite Association
• Mercurio Europeo

• Examples of unsuccessful cartels
• Copper
• Tin
• Coffee
• Tea
• Cocoa

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Cartels Conditions for Success

• Stable cartel organization must be formed price
  and quantity settled on and adhered to
• Members have different costs, assessments of
  demand and objectives
• Tempting to cheat by lowering price to capture
  larger market share

60
Cartels Conditions for Success

• Potential for monopoly power
• Even if cartel can succeed, there might be little
  room to raise prices if it faces highly elastic
  demand
• If potential gains from cooperation are large,
  cartel members will have more incentive to make
  the cartel work
• Low potential low incentive to work out
  organizational problems

61
Cartels

• To be successful
• Total demand must be fairly inelastic
• Either the cartel must control nearly all of the
  worlds supply or the supply of noncartel
  producers must also be inelastic

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The Cartelization of Intercollegiate Athletics

1. Large number of firms (colleges)
2. Large number of consumers (fans)
3. Very high profits

63
The Cartelization of Intercollegiate Athletics

• NCAA is the cartel
• Restricts competition
• Reduces bargaining power by athletes enforces
  rules regarding eligibility and terms of
  compensation
• Reduces competition by universities limits
  number of games played each season, number of
  teams per division, etc.
• Limits price competition sole negotiator for
  all football television contracts

64
The Cartelization of Intercollegiate Athletics

• Although members have occasionally broken rules
  and regulations, has been a successful cartel
• In 1984, Supreme Court ruled that the NCAAs
  monopolization of football TV contracts was
  illegal
• Competition led to drop in contract fees
• More college football on TV, but lower revenues
  to schools