Managerial Economics (BUSI 2050U) Chapter 11 PDF

Managerial Economics (BUSI 2050U) Chapter#11 Oligopoly and Monopolistic Competition 11-1 © 2014 Pearson Education, Inc. All rights reserved.  Market Structure 11-2...

Managerial Economics (BUSI 2050U) Chapter#11 Oligopoly and Monopolistic Competition 11-1 © 2014 Pearson Education, Inc. All rights reserved.  Market Structure 11-2 © 2014 Pearson Education, Inc. All rights reserved.  What Is Oligopoly? – Oligopoly is a market structure in which  Natural or legal barriers prevent the entry of new firms.  A small number of firms compete. 11-3 © 2014 Pearson Education, Inc. All rights reserved.  What Is Oligopoly? Barriers to Entry – Either natural or legal barriers to entry can create oligopoly. – Figure 15.1 shows two oligopoly situations. – In part (a), there is a natural duopoly—a market with two firms. 11-4 © 2014 Pearson Education, Inc. All rights reserved.  What Is Oligopoly? – In part (b), there is a natural oligopoly market with three firms. – A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms. 11-6 © 2014 Pearson Education, Inc. All rights reserved.  What Is Oligopoly? Small Number of Firms – Because an oligopoly market has only a few firms, they are interdependent and face a temptation to cooperate. – Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions. – Temptation to Cooperate: Firms in oligopoly face the temptation to form a cartel. – A cartel is a group of firms acting together to limit output, raise price, and increase profit. Cartels are illegal. 11-8 © 2014 Pearson Education, Inc. All rights reserved.  11.1 Cartels Cartel Objective: Higher Profits – Oligopolistic firms have an incentive to form cartels in which they collude in setting prices or quantities so as to increase their profits. – The Organization of Petroleum Exporting Countries (OPEC) is a well-known example of an international cartel. Cartel Basic Functioning – Typically, each member of a cartel agrees to reduce its output from the level it would produce if it acted independently. As a result, the market price rises and the firms earn higher profits. If the firms reduce market output to the monopoly level, they achieve the highest possible collective profit. – However, each member has an incentive to cheat. 11-9 © 2014 Pearson Education, Inc. All rights reserved.  11.1 Cartels Why Cartels Form – A cartel forms if members of the cartel believe that they can raise their profits by coordinating their actions. – A cartel takes into account how changes in any one firm’s output affect the profits of all members of the cartel. Therefore, the aggregate profit of a cartel can exceed the combined profits of the same firms acting independently. 11-10 © 2014 Pearson Education, Inc. All rights reserved.  11.1 Cartels Why Cartels Fail: External Reasons – Cartels are generally illegal in developed countries. High fines and jail terms may prevent collusion. – Some cartels fail because they do not control enough of the market to significantly raise the price. Why Cartels Fail: Internal Reasons – Cartel members have incentives to cheat if a member thinks its firm is just one of many firms, so its extra output hardly affects the market price and the other firms in the cartel can’t tell who is producing more. – As more and more firms cheat, monopoly price (pm) falls. Eventually, the cartel collapses. 11-11 © 2014 Pearson Education, Inc. All rights reserved.  11.1 Cartels Maintaining Cartels: Cheating Detection – Some cartels may give members the right to inspect each other’s accounts or divide the market by region or by customers. – Cartels may turn to industry organizations to collect data on a firm’s market share. Maintaining Cartels: Government and Barriers to Entry – Sometimes governments help create and enforce cartels, exempting them from antitrust and competition laws. – The fewer the firms in a market, high barriers to entry, the more likely it is that other firms will know if a given firm cheats and the easier it is to impose penalties. 11-12 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Cournot Model – Assumptions: small number of firms and no entry, identical costs and identical products, firms set their quantities independently and simultaneously. – Because the firms set quantities, the price adjusts as needed until the market clears and profits are interdependent. 11-13 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Residual Demand – Firms use their residual demand curves: market demand that is not met by other sellers at any given price, Dr(p) = D(p) – So(p). – A firm maximizes profit with best responses that come from MRr = MC. Example: Airlines Residual Demand – The strategies for American and United depend on their residual demand curves and marginal costs. – If American thinks United flies qU passengers, American’s residual demand is qA = Q(p) – qU. Alternatively, United’s residual demand is qU = Q(p) – qA 11-14 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Airlines: Best Responses – To maximize profit, American sets MRr=MC and finds its best response curve for all possible qU. Figure 11.3 shows that if qU = 64, American’s best response is qA = 64, shuts down if qU = 192, and so on. It also shows United’s best response curve. Equilibrium called: Nash-Cournot Equilibrium – A set of quantities chosen by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity. – The quantity of equilibrium must be on the best response curve for all firms. Airlines: Nash-Cournot Equilibrium – There is only one pair of outputs where both firms are on their best- response curves, qA = qU = 64. At this intersection both firms maximize profits, are on their best response curves, and don’t want to change their outputs. 11-15 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Airlines with Calculus: Inverse Residual Demand, MR and MC – The market demand function is Q = 339 – p – The residual demand function for American is qA = (339 – p) – qU – Inverse residual demand is p = 339 – qA – qU – American’s revenue function: RA = pqA = (339 – qA – qU)qA= 339qA – q2A – qUqA – American’s marginal revenue function: – MRr = dRA/dqA= 339 – 2qA – qU – United’s revenue function: RU = 339qU – q2U – qUqA – United’s marginal revenue function: – MRr = dRU/dqU= 339 – 2qU – qA 11-16 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Residual Demand, MR and MC – The market demand function is Q = 339 – p. The residual demand function for American is qA = (339 – p) – qU or p = 339 – qA – qU. – American’s marginal revenue function is MRr = 339 – 2qA – qU. – Both airlines have MC = AC = $147 per passenger per flight. MR = MC and Best Responses – MRr = MC, so 339 – 2qA – qU = 147 – American’s best-response: qA = 96 – 0.5 qU – Similarly, United’s best response: qU = 96 – 0.5 qA Nash-Cournot Equilibrium – Solving the two best responses by substitution, qA = 96 – 0.5 (96 – 0.5 qA) – The Nash-Cournot equilibrium values: qA = qU = 64, – Q= qA + qU = 128, – p=$211 11-17 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Figure 11.3 Best-Response Curves for American and United Airlines 11-18 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly The Number of Firms Matter – If two Cournot firms set output independently, the price to consumers is lower than the monopoly price. If there are more than two, the price is even lower. Individual Output and Total Output – Consider the airlines’ inverse market demand function p = 339 – Q and n identical firms with MC=AC=$147. – The best response for any firm is q= 192/(n+1) – Total output is Q = qn = 192n/(n+1) Number of Firms and Nash-Cournot Equilibrium – If n = 1, Q = (192 × 1)/2 = 96, p = 243, a monopoly outcome. – If n = 2, Q = (192 × 2)/3 = 128, p = 211, a duopoly outcome as we found earlier. – If n is very large, Q = 192 and p = 147 = MC. The Nash-Cournot equilibrium approaches the competitive outcome. 11-19 © 2014 Pearson Education, Inc. All rights reserved.  11.2 Cournot Oligopoly Mergers – Mergers could be vertical or horizontal and both want to increase profit. – Vertical mergers may lower cost with a more efficient supply chain organization. Horizontal mergers may increase market power and reduce competition. More Market Power May Not Be Enough – Cournot with 3 firms: Using Q=192n/(n+1), each firm flies 48k passengers, p=$195 and earns ($195 - $147) * 48K = $2.3 million. – Two firms merge, Cournot duopoly: Now, each of the remaining two firms flies 64k passengers and earns $4.1 million. Bad for the merged firms ($2.05 < $2.3). Cost Advantage Pays Off – If the merger results in even a modest cost advantage, the merger may be worthwhile. In our example, if MC of the merged firms drops from $147 to $138, profit becomes $4.9 million. Great for the merged firms ($2.45 > $2.3). – In general, the reduction in the number of firms may raise price insufficiently to make a merger profitable unless there is cost reduction. 11-20 © 2014 Pearson Education, Inc. All rights reserved.  11.3 Bertrand Oligopoly Setting Prices - Oligopoly firms set prices and then consumers decide how many units to buy. - The Bertrand equilibrium differs from the Cournot equilibrium; it depends on whether firms produce identical or differentiated products. Best Responses – In a duopoly setting, Firm 1’s best response curve comes from answering “What is Firm 1’s best response—what price should it set—if Firm 2 sets a price of p2 = x?” for all possible values of x. – Similarly, Firm 2’s best response curve: “What is Firm 2’s best response (p2) if Firm 1 sets a price of p1 = y?” for all possible values of y. Nash-Bertrand Equilibrium – Nash-Bertrand equilibrium: a set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge these prices. 11-21 © 2014 Pearson Education, Inc. All rights reserved.  11.3 Bertrand Oligopoly Figure 11.5 Nash-Bertrand Identical Products Equilibrium with Identical – Two firms with identical costs and Products identical products, MC = AC = $5. – In Figure 11.5, Firm 1’s best- response curve starts at $5 and then lies slightly above the 45° line. That is, Firm 1 undercuts its rival’s price as long as its price remains above $5. – Firm 2’s best response curve also starts at $5 and undercuts its rival’s price if p2 > 5. – Nash-Bertrand Equilibrium at intersection point e, p2 = p1 = $5 = MC. Same as perfect competition equilibrium. 11-22 © 2014 Pearson Education, Inc. All rights reserved.  11.3 Bertrand Oligopoly Bertrand versus Cournot with Identical Products - The Nash-Bertrand equilibrium differs substantially from the Nash-Cournot equilibrium. Zero profits (p = MC) versus positive profits (p > MC). - The Cournot model seems more realistic than the Bertrand model in two ways. Bertrand’s “Competitive” Equilibrium is Implausible – In a market with few firms, why would the firms compete so vigorously that they would make no profit? – Oligopolies typically charge a higher price than competitive firms. So, the Nash-Cournot equilibrium is more plausible. Bertrand’s Equilibrium Price Depends on Cost Only – The Nash-Cournot equilibrium price is sensitive to demand conditions and the number of firms as well as on cost. 11-23 © 2014 Pearson Education, Inc. All rights reserved.  11.3 Bertrand Oligopoly Figure 11.6 Nash-Bertrand Differentiated Products Equilibrium with Differentiated – Two firms, identical costs MC = AC = Products $5 and differentiated products – In Figure 11.6, neither firm’s best- response curve lies along a 45° line through the origin because Coke and Pepsi are similar but some consumers prefer one to the other independently of the price. So neither firm has to exactly match a price cut by its rival. – Nash-Bertrand Equilibrium at intersection point e, p2 = p1 = $13 > MC – Plausible: Firms set p > MC, and prices are sensitive to demand conditions and number of firms 11-24 © 2014 Pearson Education, Inc. All rights reserved.  11.4 Monopolistic Competition Monopoly/Oligopoly + Competitive Behavior - Monopolistic competition: market structure that has the price setting characteristics of monopoly or oligopoly and the free entry of perfect competition. - These firms have oligopoly market power (face downward sloping demand curves), but earn zero profit due to free entry, as do perfectly competitive firms. 1st Reason for Downward Sloping Demand – Market demand may be limited so there is room for only few firms. So, the residual demand curve facing a single firm is downward sloping. – For example in a small town, the market may be large enough to support only a few plumbing firms, each of which provides a similar service. 2nd Reason for Downward Sloping Demand – Firms differentiate their products. So each firm can retain those customers who particularly like that firm’s product even if its price is higher than those of rivals. – For example, gourmet food trucks serve differentiated food in monopolistically competitive markets. 11-25 © 2014 Pearson Education, Inc. All rights reserved.  11.4 Monopolistic Competition Equilibrium – Firms have identical cost Figure 11.7 Monopolistic functions and produce Competition identical products. – In Figure 11.7, a monopolistically competitive firm, facing the firm-specific demand curve D, sets its output where MR = MC. – At that quantity, the firm’s average cost curve, AC, is tangent to its demand curve, p = AC – At the equilibrium the monopolistically competitive firm makes zero profit. The entry and exit responses of firms ensure this. 11-26 © 2014 Pearson Education, Inc. All rights reserved.  11.4 Monopolistic Competition Profitability: If Identical Costs & Products, Zero Profit – If all firms in a monopolistically competitive market produce identical products and have identical costs: each firm earns zero economic profit in the long run. – Thus, all firms in the industry are on the margin of exiting the market because even a slight decline in profitability would generate losses. Profitability: If Differentiated Costs & Products, Positive Profit – If those firms have different cost functions or produce differentiated products: most likely firms differ from each other in their profitability. – If so, low-cost firms or firms with superior products may earn positive economic profits in the long run. 11-27 © 2014 Pearson Education, Inc. All rights reserved.  What Is Monopolistic Competition? Product Differentiation – A firm in monopolistic competition practices product differentiation if the firm makes a product that is slightly different from the products of competing firms. 11-28 © 2014 Pearson Education, Inc. All rights reserved.  What Is Monopolistic Competition? Competing on Quality, Price, and Marketing – Product differentiation enables firms to compete in three areas: quality, price, and marketing.  Quality includes design, reliability, and service.  Because firms produce differentiated products, the demand for each firm’s product is downward sloping. But there is a tradeoff between price and quality.  Because products are differentiated, a firm must market its product. Marketing takes the two main forms: advertising and packaging. 11-29 © 2014 Pearson Education, Inc. All rights reserved.  Monopolistic Competition Entry and Exit – There are no barriers to entry in monopolistic competition, so firms cannot make an economic profit in the long run. Examples of Monopolistic Competition – Producers of audio and video equipment, clothing, jewelry, computers, and sporting goods operate in monopolistic competition. 11-30 © 2014 Pearson Education, Inc. All rights reserved.  Price and Output in Monopolistic Competition The Firm’s Short-Run Output and Price Decision – A firm that has decided the quality of its product and its marketing program produces the profit- maximizing quantity (the quantity at which MR = MC). – Price is determined from the demand for the firm’s product and is the highest price that the firm can charge for the profit-maximizing quantity. – Figure 14.1 shows a firm’s economic profit in the short run. 11-31 © 2014 Pearson Education, Inc. All rights reserved.  Price and Output in Monopolistic Competition – The firm in monopolistic competition operates like a single-price monopoly. – The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price. – It makes an economic profit (as in this example) when P > ATC. 11-32 © 2014 Pearson Education, Inc. All rights reserved.