chapter 12 monopolistic competition and oligopoly

Chapter 12

Monopolistic Competition and Oligopoly

Chapter 12 2©2005 Pearson Education, Inc.

Topics to be Discussed

Monopolistic CompetitionOligopolyPrice CompetitionCompetition Versus Collusion: The

Prisoners’ DilemmaImplications of the Prisoners’ Dilemma

for Oligopolistic PricingCartels


Monopolistic Competition

Characteristics1. Many firms

2. Free entry and exit

3. Differentiated product



The amount of monopoly power depends on the degree of differentiation

Examples of this very common market structure include: Toothpaste Soap Cold remedies



Toothpaste Crest and monopoly power

Procter & Gamble is the sole producer of CrestConsumers can have a preference for Crest –

taste, reputation, decay-preventing efficacyThe greater the preference (differentiation) the

higher the price



Two important characteristics Differentiated but highly substitutable

products Free entry and exit

A Monopolistically CompetitiveFirm in the Short and Long Run

Quantity

$/Q

Quantity

$/QMC

AC

MC

AC

DSR

MRSR

DLR

MRLR

QSR

PSR

QLR

PLR

Short Run 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



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

Deadweight lossMC AC

Monopolistically and Perfectly Competitive Equilibrium (LR)

$/Q

Quantity

$/Q

D = MR

QC

PC

MC AC

DLR

MRLR

QMC

P

Quantity

Perfect Competition Monopolistic Competition


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.


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 Inefficiencies would make consumers worse

off



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.


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?


Elasticities of Demand forBrands of Colas and Coffee


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


Oligopoly – Characteristics

Small number of firmsProduct differentiation may or may not

existBarriers to entry

Scale economies Patents Technology Name recognition Strategic action


Oligopoly

Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment


Oligopoly

Management Challenges Strategic actions to deter entry

Threaten to decrease price against new competitors by keeping excess capacity

Rival behaviorBecause only a few firms, each must consider

how its actions will affect its rivals and in turn how their rivals will react


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


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


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


MC1

50

MR1(75)

D1(75)

12.5

If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is

shifted to the left by this amount.

Firm 1’s Output Decision

Q1

P1

D1(0)

MR1(0)

Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing.

D1(50)MR1(50)

25

If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is

shifted to the left by this amount.


Oligopoly

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


Firm 2’s ReactionCurve Q*2(Q1)

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Reaction Curves and Cournot Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100


x

x

x

x

Firm 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.



Reaction Curves and Cournot Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100


x

x

x

x

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximizes its own profits.

CournotEquilibrium


Cournot 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


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


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


Oligopoly Example

Firm 1’s Reaction Curve MR = MC

111 )30( QQPQR :Revenue Total

122

11

1211

30

)(30

QQQQ

QQQQ


Oligopoly Example

An Example of the Cournot Equilibrium

12

21

11

21111

2115

2115

0

230

QQ

QQ

MCMR

QQQRMR

Curve Reaction s2' Firm

Curve Reaction s1' Firm


Oligopoly Example

An Example of the Cournot Equilibrium

1030

20

10)2115(2115

21

1

1

QP

QQQ

Q

QQ 2:mEquilibriu Cournot


Duopoly ExampleQ1

Q2

Firm 2’sReaction Curve

30

15


15

30

10

10

Cournot Equilibrium

The demand curve is P = 30 - Q andboth firms have 0 marginal cost.


Oligopoly Example

Profit Maximization with Collusion

MCMRMR

QQRMR

QQQQPQR

and 15 Q when 0

230

30)30( 2


Profit Maximization w/ Collusion

Contract Curve Q1 + Q2 = 15

Shows all pairs of output Q1 and Q2 that

maximize total profits

Q1 = Q2 = 7.5Less output and higher profits than the Cournot

equilibrium




Duopoly ExampleQ1

Q2

30

30

10

10

Cournot Equilibrium

CollusionCurve

7.5

7.5

Collusive Equilibrium

For the firm, collusion is the bestoutcome followed by the Cournot

Equilibrium and then the competitive equilibrium

15

15

Competitive Equilibrium (P = MC; Profit = 0)


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 1’s output



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)



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 .

1221111 30

0

Q - Q - QQ PQ R

MCMR



Using Firm 2’s Reaction Curve for Q2:

5.7 and 15:0

15

21

1111

QQMR

QQRMR

211

112

111

2115

)2115(30

QQ

QQQQR



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.


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


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.



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



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



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


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


Price 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



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



Firms set prices at the same time

202-12

20)212(

20$ :1 Firm

212

11

211

111

PPPP

PPP

QP



If P2 is fixed:

12

21

2111

413

413

0412

'

PP

PP

PPP

curve reaction s2' Firm

curve reaction s1' Firm

price maximizing profit s1 Firm


Nash 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


Firm 1’s Reaction Curve


P1

P2

Firm 2’s Reaction Curve

$4

$4

Nash Equilibrium

$6

$6

Collusive Equilibrium

Equilibrium at price of $4 and profits of $12



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


A 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



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)0.25

Where P, PU, PK are P&G’s, Unilever’s, and

Kao’s prices respectively



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


P&G’s Profit (in thousands of $ per month)


A 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


Competition 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?



Competitor is not likely to followCompetitor 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



Assume:

16$ 6$ :Collusion

12$ 4$ :mEquilibriuNash

212 :demand s2' Firm

212 :demand s1' Firm

0$ and 20$

12

21

P

P

PPQ

PPQ

VCFC



Possible Pricing Outcomes:

4$204)6)(2(12)6(

20

20$206)4)(2(12)4(

20

4$ 6$

$16 6$ :2 Firm 6$ :1 Firm

111

222

QP

QP

PP

PP


Payoff Matrix for Pricing GameFirm 2

Firm 1

Charge $4 Charge $6

Charge $4

Charge $6

$12, $12 $20, $4

$16, $16$4, $20



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



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


-5, -5 -1, -10

-2, -2-10, -1

Payoff Matrix for Prisoners’ Dilemma

Prisoner A

Confess Don’t confess

Confess

Don’tconfess

Prisoner B

Would you choose to confess?


Oligopolistic Markets

Conclusions

1. Collusion will lead to greater profits

2. Explicit and implicit collusion is possible

3. Once collusion exists, the profit motive to break and lower price is significant


Charge $1.40 Charge $1.50

Charge$1.40

Unilever and Kao

Charge$1.50

P&G

$12, $12 $29, $11

$3, $21 $20, $20

Payoff Matrix for the P&G Pricing Problem

What price should P & G choose?


Observations of Oligopoly Behavior

1. In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur

2. In other oligopoly markets, the firms are very aggressive and collusion is not possible


Observations of Oligopoly Behavior

2. In other oligopoly markets, the firms are very aggressive and collusion is not possible

a. Firms are reluctant to change price because of the likely response of their competitors

b. In this case, prices tend to be relatively rigid


Price Rigidity

Firms have strong desire for stabilityPrice 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


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 > P*, other firms will not follow Below P*, demand is very inelastic

If P < P*, other firms will follow suit


Price 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


The Kinked Demand Curve$/Q

Quantity

MR

D

If the producer lowers price, thecompetitors will follow and the

demand will be inelastic.

If the producer raises price, thecompetitors will not and the

demand will be elastic.


The Kinked Demand Curve$/Q

D

P*

Q*

MC

MC’

So long as marginal cost is in the vertical region of the marginal

revenue curve, price and output will remain constant.

MR

Quantity


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


Price 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


The 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 where MRD and MCD cross

At P*, fringe firms sell QF and total quantity sold is QT = QD + QF


Price Setting by a Dominant FirmPrice

Quantity

D

DD

QD

P*

At this price, fringe firmssell QF, so that total

sales are QT.

P1

QF QT

P2

MCD

MRD

SF

The dominant firm’s demandcurve is the difference between

market demand (D) and the supplyof the fringe firms (SF).


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


Cartels

Examples of successful cartels OPEC International Bauxite

Association Mercurio Europeo

Examples of unsuccessful cartels Copper Tin Coffee Tea Cocoa


Cartels – Conditions for Success

1. 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


Cartels – Conditions for Success

2. 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


Analysis of Cartel Pricing

Members of cartel must take into account the actions of non-members when making pricing decisions

Cartel pricing can be analyzed using the dominant firm model OPEC oil cartel – successful CIPEC copper cartel – unsuccessful


The OPEC Oil CartelPrice

Quantity

MROPEC

DOPEC

TD SC

MCOPEC

TD is the total world demandcurve for oil, and SC is the

competitive supply. OPEC’s demand is the difference

between the two.

QOPEC

P*

OPEC’s profit maximizingquantity is found at the

intersection of its MR andMC curves. At this quantity

OPEC charges price P*.


Cartels

About OPEC Very low MC TD is inelastic Non-OPEC supply is inelastic DOPEC is relatively inelastic


The OPEC Oil Cartel

Price

Quantity

MROPEC

DOPEC

TD SC

MCOPEC

QOPEC

P*

The price without the cartel:•Competitive price (PC) where DOPEC = MCOPEC

QC QT

Pc


The CIPEC Copper Cartel

Price

Quantity

MRCIPEC

TD

DCIPEC

SC

MCCIPEC

QCIPEC

P*PC

QC QT

•TD and SC are relatively elastic•DCIPEC is elastic•CIPEC has little monopoly power•P* is closer to PC


Cartels

To be successful: Total demand must not be very price elastic Either the cartel must control nearly all of the

world’s supply or the supply of noncartel producers must not be price elastic


The Cartelization of Intercollegiate Athletics

1. Large number of firms (colleges)

2. Large number of consumers (fans)

3. Very high profits



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



Although members have occasionally broken rules and regulations, has been a successful cartel

In 1984, Supreme Court ruled that the NCAA’s monopolization of football TV contracts was illegal Competition led to drop in contract fees More college football on TV, but lower

revenues to schools

chapter 12 monopolistic competition and oligopoly

Documents

pearson education

price slide

oligopoly slide

monopoly power slide

coffee slide

time slide

differentiated product

market power