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Chapter 12. Monopolistic Competition and Oligopoly. Topics to be Discussed. Monopolistic Competition Oligopoly Price Competition Competition Versus Collusion: The Prisoners’ Dilemma Implications of the Prisoners’ Dilemma for Oligopolistic Pricing Cartels. Monopolistic Competition.
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Chapter 12Monopolistic Competition and OligopolyTopics to be Discussed
  • Monopolistic Competition
  • Oligopoly
  • Price Competition
  • Competition Versus Collusion: The Prisoners’ Dilemma
  • Implications of the Prisoners’ Dilemma for Oligopolistic Pricing
  • Cartels
  • Chapter 12Monopolistic Competition
  • Characteristics
  • Many firms
  • Free entry and exit
  • Differentiated product
  • Chapter 12Monopolistic Competition
  • The amount of monopoly power depends on the degree of differentiation
  • Examples of this very common market structure include:
  • Toothpaste
  • Soap
  • Cold remedies
  • Chapter 12Monopolistic 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
  • Chapter 12Monopolistic Competition
  • Two important characteristics
  • Differentiated but highly substitutable products
  • Free entry and exit
  • Chapter 12MCMCACACPSRPLRDSRDLRMRSRMRLRQSRQLRA Monopolistically CompetitiveFirm in the Short and Long Run$/Q$/QShort RunLong RunQuantityQuantityA Monopolistically CompetitiveFirm in the Short and Long Run
  • Short run
  • Downward sloping demand – differentiated product
  • Demand is relatively elastic – good substitutes
  • MR < P
  • Profits are maximized when MR = MC
  • This firm is making economic profits
  • Chapter 12A Monopolistically CompetitiveFirm in the Short and Long Run
  • Long run
  • Profits will attract new firms to the industry (no barriers to entry)
  • The old firm’s demand will decrease to DLR
  • Firm’s output and price will fall
  • Industry output will rise
  • No economic profit (P = AC)
  • P > MC  some monopoly power
  • Chapter 12Deadweight lossMCACMCACPPCD = MRDLRMRLRQCQMCMonopolistically and Perfectly Competitive Equilibrium (LR)Monopolistic CompetitionPerfect Competition$/Q$/QQuantityQuantityMonopolistic 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.
  • Chapter 12Monopolistic 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
  • Inefficiencies would make consumers worse off
  • Chapter 12Monopolistic 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.
  • Chapter 12The 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?
  • Chapter 12Elasticities of Demand forBrands of Colas and CoffeeChapter 12The 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
  • Chapter 12Oligopoly – Characteristics
  • Small number of firms
  • Product differentiation may or may not exist
  • Barriers to entry
  • Scale economies
  • Patents
  • Technology
  • Name recognition
  • Strategic action
  • Chapter 12Oligopoly
  • Examples
  • Automobiles
  • Steel
  • Aluminum
  • Petrochemicals
  • Electrical equipment
  • Chapter 12Oligopoly
  • 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
  • Chapter 12Oligopoly – 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
  • Chapter 12Oligopoly – 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
  • Chapter 12Oligopoly
  • 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
  • Chapter 12Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing.D1(0)If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MR1(0)D1(75)MR1(75)MC1MR1(50)D1(50)12.52550Firm 1’s Output DecisionP1Q1Chapter 12Oligopoly
  • The Reaction Curve
  • The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce
  • A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2
  • Chapter 12Firm 2’s ReactionCurve Q*2(Q1)Firm 1’s ReactionCurve Q*1(Q2)Reaction Curves and Cournot EquilibriumQ1Firm 1’s reaction curve shows how much itwill produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous model.10075Firm 2’s reaction curve shows how much itwill produce as a function of how much it thinks Firm 1 will produce. 50xx25xxQ2255075100Chapter 12Firm 2’s ReactionCurve Q*2(Q1)CournotEquilibriumFirm 1’s ReactionCurve Q*1(Q2)Reaction Curves and Cournot EquilibriumQ1100In Cournot equilibrium, eachfirm correctly assumes howmuch its competitors willproduce and therebymaximizes its own profits.7550xx25xxQ2255075100Chapter 12Cournot Equilibrium
  • Each firm’s 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
  • Chapter 12Oligopoly
  • 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
  • Chapter 12The 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
  • Chapter 12Oligopoly Example
  • Firm 1’s Reaction Curve  MR = MC
  • Chapter 12Oligopoly Example
  • An Example of the Cournot Equilibrium
  • Chapter 12Oligopoly Example
  • An Example of the Cournot Equilibrium
  • Chapter 1230Firm 2’sReaction CurveCournot Equilibrium1510Firm 1’sReaction Curve101530Duopoly ExampleQ1The demand curve is P = 30 - Q andboth firms have 0 marginal cost.Q2Chapter 12Oligopoly Example
  • Profit Maximization with Collusion
  • Chapter 12Profit 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
  • Chapter 12Firm 2’sReaction CurveCompetitive Equilibrium (P = MC; Profit = 0)15Cournot EquilibriumCollusive Equilibrium107.5Firm 1’sReaction CurveCollusionCurve7.51015Duopoly ExampleQ1For the firm, collusion is the bestoutcome followed by the CournotEquilibrium and then the competitive equilibrium30Q230Chapter 12First 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 1’s output
  • Chapter 12First Mover Advantage – The Stackelberg Model
  • Firm 1
  • Must consider the reaction of Firm 2
  • Firm 2
  • Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = 15 - ½(Q1)
  • Chapter 12First 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 2’s reaction curve as Q2 .
  • Chapter 12First Mover Advantage – The Stackelberg Model
  • Using Firm 2’s Reaction Curve for Q2:
  • Chapter 12First Mover Advantage – The Stackelberg Model
  • Conclusion
  • Going first gives Firm 1 the advantage
  • Firm 1’s output is twice as large as Firm 2’s
  • Firm 1’s profit is twice as large as Firm 2’s
  • 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.
  • Chapter 12Price 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
  • Chapter 12Price 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.
  • Chapter 12Price 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
  • Chapter 12Price 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
  • Chapter 12Price 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
  • Chapter 12Bertrand 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
  • Chapter 12Price Competition – Differentiated Products
  • Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product
  • In these markets, more likely to compete using price instead of quantity
  • Chapter 12Price Competition – Differentiated Products
  • Example
  • Duopoly with fixed costs of $20 but zero variable costs
  • Firms face the same demand curves
  • Firm 1’s demand: Q1 = 12 - 2P1 + P2
  • Firm 2’s 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
  • Chapter 12Price Competition – Differentiated Products
  • Firms set prices at the same time
  • Chapter 12Price Competition – Differentiated Products
  • If P2 is fixed:
  • Chapter 12Nash Equilibrium in Prices
  • What if both firms collude?
  • They both decide to charge the same price that maximizes both of their profits
  • Firms will charge $6 and will be better off colluding since they will earn a profit of $16
  • Chapter 12Firm 2’s Reaction CurveCollusive Equilibrium$6$4Firm 1’s Reaction CurveNash Equilibrium$4$6Nash Equilibrium in PricesP1Equilibrium at price of $4 and profits of $12P2Chapter 12Nash Equilibrium in Prices
  • If Firm 1 sets price first and then Firm 2 makes pricing decision:
  • Firm 1 would be at a distinct disadvantage by moving first
  • The firm that moves second has an opportunity to undercut slightly and capture a larger market share
  • Chapter 12A Pricing Problem: Procter & Gamble
  • Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd. were entering the market for Gypsy Moth Tape
  • All three would be choosing their prices at the same time
  • Each firm was using same technology so had same production costs
  • FC = $480,000/month & VC = $1/unit
  • Chapter 12A Pricing Problem: Procter & Gamble
  • Procter & Gamble had to consider competitors’ prices when setting their price
  • P&G’s demand curve was:
  • Q = 3,375P-3.5(PU)0.25(PK)0.25Where P, PU, PK are P&G’s, Unilever’s, and Kao’s prices respectivelyChapter 12A Pricing Problem: Procter & Gamble
  • What price should P&G choose and what is the expected profit?
  • Can calculate profits by taking different possibilities of prices you and the other companies could charge
  • Nash equilibrium is at $1.40 – the point where competitors are doing the best they can as well
  • Chapter 12P&G’s Profit (in thousands of $ per month)Chapter 12A Pricing Problem for Procter & Gamble
  • Collusion with competitors will give larger profits
  • If all agree to charge $1.50, each earn profit of $20,000
  • Collusion agreements are hard to enforce
  • Chapter 12Competition Versus Collusion:The 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 don’t firms cooperate without explicitly colluding?
  • Why not set profit maximizing collusion price and hope others follow?
  • Chapter 12Competition Versus Collusion:The 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 example from before to better understand the firms’ choices
  • Chapter 12Competition Versus Collusion:The Prisoners’ Dilemma
  • Assume:
  • Chapter 12Competition Versus Collusion:The Prisoners’ Dilemma
  • Possible Pricing Outcomes:
  • Chapter 12$12, $12$20, $4$4, $20$16, $16Payoff Matrix for Pricing GameFirm 2Charge $4Charge $6Charge $4Firm 1Charge $6Chapter 12Competition Versus Collusion:The 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
  • Chapter 12Competition Versus Collusion:The 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
  • Chapter 12-5, -5-1, -10-10, -1-2, -2Payoff Matrix for Prisoners’ DilemmaPrisoner BConfessDon’t confessConfessPrisoner AWould you choose to confess?Don’tconfessChapter 12Oligopolistic MarketsConclusions
  • Collusion will lead to greater profits
  • Explicit and implicit collusion is possible
  • Once collusion exists, the profit motive to break and lower price is significant
  • Chapter 12$12, $12$29, $11$3, $21$20, $20Payoff Matrix for the P&G Pricing ProblemUnilever and KaoCharge $1.40Charge $1.50Charge$1.40P&GWhat price should P & G choose?Charge$1.50Chapter 12Observations of Oligopoly Behavior
  • In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur
  • In other oligopoly markets, the firms are very aggressive and collusion is not possible
  • Chapter 12Observations of Oligopoly Behavior
  • In other oligopoly markets, the firms are very aggressive and collusion is not possible
  • Firms are reluctant to change price because of the likely response of their competitors
  • In this case, prices tend to be relatively rigid
  • Chapter 12Price Rigidity
  • Firms have strong desire for stability
  • Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change
  • Fear lower prices will send wrong message to competitors, leading to price war
  • Higher prices may cause competitors to raise theirs
  • Chapter 12Price Rigidity
  • Basis of kinked demand curve model of oligopoly
  • Each firm faces a demand curve kinked at the current prevailing price, P*
  • Above P*, demand is very elastic
  • If P > P*, other firms will not follow
  • Below P*, demand is very inelastic
  • If P < P*, other firms will follow suit
  • Chapter 12Price Rigidity
  • With a kinked demand curve, marginal revenue curve is discontinuous
  • Firm’s costs can change without resulting in a change in price
  • Kinked demand curve does not really explain oligopolistic pricing
  • Description of price rigidity rather than an explanation of it
  • Chapter 12If the producer raises price, thecompetitors will not and the demand will be elastic.If the producer lowers price, thecompetitors will follow and the demand will be inelastic.DMRThe Kinked Demand Curve$/QQuantityChapter 12So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. MC’P*MCDQ*The Kinked Demand Curve$/QQuantityChapter 12MRPrice 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
  • Chapter 12Price Signaling and Price Leadership
  • The Dominant Firm Model
  • In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market
  • The large firm might then act as the dominant firm, setting a price that maximizes its own profits
  • Chapter 12The Dominant Firm Model
  • Dominant firm must determine its demand curve, DD
  • Difference between market demand and supply of fringe firms
  • To maximize profits, dominant firm produces QD whe
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