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Oligopolies and monopolistic competition

In between the two competition benchmarks


Today we finish examining the competition continuum we introduced last week

After today, you will know all four of the main models used to explain the different market structuresThe two extreme benchmarks (previous

weeks)The two “middle ground” models


Market power of firms

Perfect competition

Many firms with a homogeneous product

Oligopoly

A few producers with high market power

Monopoly

A single producer

Monopolistic competition

Many firms with differentiated products

The “competition continuum”


Importantly, the two cases we see today are in the middle of the competition continuum

They are more realistic that the extreme benchmarks of perfect competition and pure monopoly More “powerful” models in that they correspond

better to the real world Unfortunately, this means that they are also

more complex These models have required the development of

new tools


Oligopolies


Oligopolies

The oligopoly corresponds to the following market structure :

1. A few large producers2. Homogeneous products3. No entry of competing producers on the

market4. Perfect information5. Perfect mobility of inputs

Apart from the few producers instead of one, this is not much different from the monopoly

Oligopolies

Oligopolies are usually caused by the presence of barriers to entry which deter potential competitors.

Institutional or regulatory barriers (Example: defence industry or utilities)

The nature of the technology, which determines the existence of returns to scale and the minimal efficient scale of the firm (Example : Aeronautical industry)

Absolute cost differentials: Vertical integration, access to an efficient supply or distribution network (example: agribusiness)

Oligopolies

This is a common situation in many industries : Car industry, aeronautical industry Agribusiness (Nestlé, Danone, Kraft foods, Coca-

Cola Co) Electronics, computing Utilities, buildings, etc.

Compared to the monopoly case, each firm has an extra element to consider: The behaviour of its competitors (introduced last week) Because a firm’s output influences market

prices, competitors will react This will lead to strategic behaviour

Oligopolies

A simple solution for the market price and quantity is possible if the firms decide to cooperate. This cooperative equilibrium is called a cartel.

OPEC is a good example: an organisation of independent producers, producing the same goods, who decide to coordinate their strategies, so as to limit their output and increase prices. The good news: When firms do this (ie maximise

collective profit), they practise monopoly pricing and get monopoly profits. This means the simple monopoly model is enough

The “bad” news: This practise is illegal in most countries! Also, there is an incentive to cheat. So usually, firms will not cooperate, and a more complex model is needed...

Oligopolies

Price

Quantity

mCA ACA

Inverse demand facing firm A

mRA

q

p G

The cooperative equilibrium

Oligopolies

When firms in an oligopoly do not cooperate, there is a non-cooperative equilibrium

Compared to the monopoly and the cooperative cartel case, it becomes difficult to characterise the market equilibrium (equilibrium price and quantity) If a firm changes its output (price), this changes the market

price, and the profits of competitors. They will react to this change in profits by changing their output (price).

The optimal strategy of a firm depends on the strategies of its competitors. There are as many types of equilibria as there are combinations of strategies.

Oligopolies

As a simplification, economic theory typically examines the duopoly: The case with two producers on a market with barriers to entry

There are many possible models of duopoly:

Quantity competition

Price competition

Simultaneous setting

Cournot duopoly

Bertrand duopoly

Leader/Follower setting

Stackelberg duopoly

Price leadership

Oligopolies

The Cournot duopoly (1838) :

Is the first and simplest model of a duopoly: each firm considers the output of its competitor as given

The 2 firms simultaneously choose their output, and consider that the current output of their competitor will not change (not very realistic...)

Oligopolies

The profits of the two firms is given by:

For simplicity, we re-write them as:

1 1 11 1

2

2

2 21 22

q q qq

q q

p

p cq q

c

The cost of production depends only on the firm’s output

The market price however, depends on the aggregate output q1 + q2

1 1

2

2

12

1

2

,

,

q

q

F

F

q

q

Oligopolies

As for all firms, the maximum profit condition is given by the first order condition

These first order conditions can be rearranged to give a system of equations known as reaction functions

0i iq

11

22

1 2

1

2

2 2

1

1

,0

,0

q

q

q

q

q q

qF

q

F

2

2

1

1

1

2

q qf

qfq

A reaction function tells you the quantity q1 that maximises the profits of firm 1 given the quantity q2 produced by firm 2

Oligopolies

q2

q1

C

Reaction function of firm 1

Reaction function of firm 2

q*1

q*2

C0C1

C2

C3

Reaction functions and Cournot equilibrium

1 1 2q f q

2 2 1q f q

Oligopolies

The existence and the stability of an equilibrium in an oligopoly depends on the expectations that firms form about the strategies of their competitors Several different equilibria are possible depending on

the various combinations of strategies formulated. Most often, the tools of classical economics cannot

find these different equilibria... ...unless strong simplifying assumptions are made.

See the Cournot example: “treat output as given” Game theory was developed as a response to this

problem. This will be seen next week


Oligopolies



Monopolistic competition corresponds to the following market structure :

1. Large number of agents (Atomicity) 2. Differentiated products3. Free entry and exit from the market4. Perfect information5. Perfect mobility of inputs

The output of each producer is slightly different from the others ⇒ existence of varieties (brands)


Because each firm produces a slightly different good, consumers can have preferences over these different varieties.

There will be an element of “brand loyalty” in consumer behaviour, where one variety of a good will be preferred over another one.

Examples: Corner shops, restaurants, hair dressers, travel agents, etc.

Unfortunately, the algebra necessary to generate such “preference for variety” models is a bit complicated ⇒ We will only look at the diagrams


Each firm has a small amount of market power Because of “brand loyalty”, it can increase its price

a bit without loosing all its customers (as is the case in perfect competition)

The price elasticity of demand is not infinite The demand curve facing the firm is downward-

sloping (not flat as in perfect competition) There will be a (small) mark-up: Price is above mC

However, because firms can enter the market freely, economic profits are equal to zero in the long run


How does this work ? At the firm level, the short run equilibrium

diagram looks like the monopoly diagram It also solves like a monopoly ⇒ short run profits

The adjustment to the long run behaves like perfect competition: Extra firms enter the market, attracted by the

profits The demand facing each firm decreases until

profits are competed away


mC

AC

Price Price

D

Firm-market equilibrium

Firm level Market level

Quantityquantity

dp

Q

Positive profits in the short run

mR

S

q


mC

AC

Price Price

S

D

Firm-market equilibrium

Firm level Market level

Quantityquantityq Q

zero profits in the long run

dmR

S

Positive profits attract firms to the market (free entry + perfect information)

Q2q2

pp2


Price

Quantityq

p

DemandmR

In the long run, Total revenue is equal to Total cost ⇒ Profits are equal to zero

mC AC

Long run welfare implications

Similar to perfect competition. An improvement on monopolies/oligopolies

p = AC


Price

Quantity

mC AC

q

p

DemandmR

Even in the long run, there is a mark-up

p > mC

This implies some deadweight loss

Consumer surplus

Producer surplus



Price

Quantityq

p

DemandmR

Firms are not producing at the minimum AC. There is excess capacity (i.e. some production resources are wasted)

q*

mC AC



This model has a competitive limit The weaker the preferences of consumer

for variety (the “brand loyalty”), the less market power the firms have and the closer the model predictions are to perfect competition The demand curve becomes flatter The mark-up and deadweight loss are reduced

The equilibrium tends to P = mC = AC


mC

AC

Price Price

The competitive limit

Case 1 Case 2

Quantityquantity

dmR

p

q

mC

AC

dmR

q

p

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