Microeconomics Chapter 11 PDF

Chapter 11 Imperfect Competition Copyright © 2020 by Macmillan Learning. All Rights Reserved MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Introduction (1/2)...

Chapter 11 Imperfect Competition Copyright © 2020 by Macmillan Learning. All Rights Reserved MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Introduction (1/2) 11 Markets rarely fit all of the assumptions of perfect competition or monopoly. In this chapter, we explore market structures that are collectively referred to as imperfect competition. Market structures with characteristics between those of perfect competition and monopoly Chapter Outline Copyright © 2020 by Macmillan Learning. All Rights Reserved 11.1 What Does Equilibrium Mean in an Oligopoly? 11.2 Oligopoly with Identical Goods: Collusion and Cartels 11.3 Oligopoly with Identical Goods: Bertrand Competition 11.4 Oligopoly with Identical Goods: Cournot Competition 11.5 Oligopoly with Identical Goods but with a First-Mover: Stackelberg Competition 11.6 Oligopoly with Differentiated Goods: Bertrand Competition 11.7 Monopolistic Competition 11.8 Conclusion MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Introduction (2/2) 11 We relax a number of assumptions to examine markets in a more realistic manner: Allow for varying degrees of competition Copyright © 2020 by Macmillan Learning. All Rights Reserved Allow for differentiated products Allow for strategic behavior MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition What Does Equilibrium Mean in an Oligopoly? (1/2) 11.1 The first market structure we consider is oligopoly. Competition between a small number of firms It is important to examine what equilibrium means in an oligopoly. Under perfect competition or monopoly, short-run equilibrium refers to a price–quantity combination that results in a market clearing. Copyright © 2020 by Macmillan Learning. All Rights Reserved More complicated under oligopoly ‒ In an oligopolistic industry, each company’s actions influences what the other companies want to do. ‒ To determine an outcome when no firm wants to change its decision, we must determine more than just a price and quantity for the industry as a whole. ‒ An equilibrium in which each firm is doing its best, conditional on the actions taken by other firms, is called a Nash equilibrium. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition What Does Equilibrium Mean in an Oligopoly? (2/2): Question 1 11.1 What is the Nash Equilibrium for these two firms? (The first number in each cell denotes the payoff to Warner Brothers, the second – to Disney.) DISNEY Advertise Don’t Advertise WARNER BROTHERS Advertise 250, 250 550, −80 Copyright © 2020 by Macmillan Learning. All Rights Reserved Don’t Advertise −80, 550 320, 320 A. Warner Brothers will advertise, Disney will not B. Disney will advertise, Warner Brothers will not C. Neither will advertise D. Both will advertise MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition What Does Equilibrium Mean in an Oligopoly? (2/2): 11.1 Question 1 – Correct Answer What is the Nash Equilibrium for these two firms? DISNEY Advertise Don’t Advertise WARNER BROTHERS Advertise 250, 250 550, −80 Copyright © 2020 by Macmillan Learning. All Rights Reserved Don’t Advertise −80, 550 320, 320 A. Warner Brothers will advertise, Disney will not B. Disney will advertise, Warner Brothers will not C. Neither will advertise D. Both will advertise (correct answer) MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Collusion and Cartels (1/6) 11.2 There is an incentive for firms in oligopolistic markets to engage in collusion or to form a cartel. Collusion: Economic behavior in which all the firms in an oligopoly coordinate their production and pricing decisions to collectively act as a monopoly to gain monopoly profits to be split among themselves Copyright © 2020 by Macmillan Learning. All Rights Reserved Model Assumptions: Collusion and Cartels 1. Firms make identical products. 2. Industry firms agree to coordinate their quantity and pricing decisions. 3. No firm deviates from the agreement, even if breaking it is in the firm’s best interest. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Collusion and Cartels (2/6) 11.2 The Instability of Collusion and Cartels The problem with maintaining collusion is that each firm has an incentive to cheat. Consider two firms, A and B, producing an identical product. Inverse demand is P = 20 −Q, and marginal cost is MC = $4. Copyright © 2020 by Macmillan Learning. All Rights Reserved If the firms collude, they will produce the monopoly output. Equate marginal revenue and marginal cost: MR = 20 − 2Q = MC → 20 − 2Q = 4 → Q = 8 The monopoly price will be $12, and total profits will be $64. Assuming firms split production, each will produce 4 units, and each firm will earn $32 in profit. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Collusion and Cartels (3/6) 11.2 The Instability of Collusion and Cartels The problem is that each firm has an incentive to cheat. What happens if Firm A decides to produce 5 units instead of 4? ‒ Total production is 9 units instead of 8, and total industry profit will fall. Given inverse demand P = 20 −Q, the new price will be $11, and total profits will be $63. Copyright © 2020 by Macmillan Learning. All Rights Reserved However, Firm A has increased individual profit: Profit A = (P − c )× Q A ⇒ Profit A = (11 − 4)5 = $35 And Firm B has reduced profit: Profit B = (P − c )× QB ⇒ Profit B = (11 − 4)4 = $28 This incentive to cheat makes it difficult to maintain collusive agreements. A cheating firm imposes a negative externality on the rest of the cartel, b/c the cost of reduced revenue is split among all firms in a cartel while the benefit accrues to the cheating firm only. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Collusion and Cartels (4/6) 11.2 Figure 11.1 Cartel Instability Cartel members would maximize joint profits by acting like a monopoly. Firm A , however, has an incentive to cheat on Copyright © 2020 by Macmillan Learning. All Rights Reserved the agreement and produce another unit of output. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Collusion and Cartels (5/6) 11.2 The Instability of Collusion and Cartels Increasing the number of firms in the cartel also makes holding to the agreed production level more difficult. Having more firms in a cartel reduces the damages suffered by any Copyright © 2020 by Macmillan Learning. All Rights Reserved one firm that continues to abide by the agreement because profit losses caused by cheating are spread out across more firms. Every firm in the cartel has an incentive to cheat, making it difficult to persuade any one firm to collude in the first place. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Collusion and Cartels (6/6) 11.2 What Makes Collusion Easier? A number of things can make it easier to sustain collusive agreements: 1. Making it easy to detect and punish cheaters Copyright © 2020 by Macmillan Learning. All Rights Reserved 2. Little variation in marginal costs across producers; since the goal is to produce at lowest cost, it is difficult to share profits if production costs vary greatly across cartel members. 3. Long time horizon makes defection more costly, as future monopoly profits are given more weight. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Additional figure it out Suppose there are only two driveway paving companies in a small town, Asphalt, Inc. and Blacktop Bros. The inverse demand curve for paving services is 𝑃𝑃 = 1,600 − 20𝑄𝑄 where quantity is measured in pave jobs per month and price, in dollars per job. The firms have an identical marginal cost of $400 per driveway. Copyright © 2020 by Macmillan Learning. All Rights Reserved Answer the following questions: a. If the two firms collude, splitting the work and profits evenly, how many driveways will each firm pave, and at what price? How much profit will each firm make? b. Does Asphalt, Inc. have an incentive to cheat by paving one more driveway each month? c. Suppose each firm decides to pave one more driveway each month. Does Asphalt, Inc. have an incentive to cheat?  Additional figure it out a. If the firms collude, they will set marginal revenue equal to marginal cost MR = 1,600 − 40Q MR = MC → 1,600 − 40Q = 400 ⇒ Q = 30 P = 1,600 − 20(30 ) = $1,000 Copyright © 2020 by Macmillan Learning. All Rights Reserved and the profit for each firm (assuming they split output equally) is 1 Profit AI = Profit BB = (P − c )× Q = 1 (1,000 − 400)× 30 2 2 Profit AI = Profit BB = $9,000  Additional figure it out b. If Asphalt, Inc. paves one more driveway, total quantity rises to 31. The new price is P = 1,600 − 20(31) = $980 and Asphalt, Inc.’s profit is Profit AI = (P − c )× Q AI = (980 − 400 )× 16 Copyright © 2020 by Macmillan Learning. All Rights Reserved Profit AI = $9,280 which is larger than the $9,000 under collusion. Yes, Asphalt, Inc. has an incentive to cheat and pave one more driveway.  Additional figure it out c. If both firms pave one more driveway each month, the new price is P = 1,600 − 20(32 ) = $960 and profits for each firm are 1 Profit AI = Profit BB = (P − c )× Q AI = 1 (960 − 400)× 32 2 2 Profit AI = Profit BB = $8,960 Both firms are worse off. Copyright © 2020 by Macmillan Learning. All Rights Reserved Does Asphalt, Inc. have an incentive to cheat and pave one more driveway? With 33 driveways per month, the new price is P = 1,600 − 20(33) = $940 And Asphalt, Inc.’s profit is Profit AI = (P − c )× Q AI = (940 − 400 )× 17 Profit AI = $9,180 which is higher than $8,960, so yes, Asphalt, Inc. has an incentive to cheat.  Oligopoly with Identical Goods: Bertrand Competition (1/3) 11.3 With the collusion model, firms are focused on their output decision. In reality, firms often focus on their price decision instead. The Bertrand competition model describes an oligopoly in which each firm chooses the price of its product. Strategic interaction ensues, with each firm responding to its rivals’ price decision. Copyright © 2020 by Macmillan Learning. All Rights Reserved Model Assumptions: Bertrand Competition with Identical Goods 1. Firms make identical products. 2. Firms compete by choosing the price at which they sell their products. 3. Firms set their prices simultaneously. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Bertrand Competition (2/3) 11.3 Setting Up the Bertrand Model Suppose two firms, Target and Walmart, are selling Nintendo Switches. Products are identical; assume marginal cost is identical. Total quantity purchased is Q. Price at Walmart is PW; price at Target is PT.. Demand for Switches at Walmart Demand for Switches at Target Copyright © 2020 by Macmillan Learning. All Rights Reserved Q, if PW < PT Q, if PT < PW Q Q , if PW = PT , if PT = PW 2 2 0, if PW > PT 0, if PT > PW The only way to sell Switches is to match or beat your competitor. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Bertrand Competition (3/3) 11.3 Nash Equilibrium of a Bertrand Oligopoly What should Target do if Walmart lowers the price of the Nintendo Switch to less than Target’s? Target is left with two options if it still wants to sell the Nintento Switch. ‒ It can match Walmart, so that the market is shared equally. ‒ it can undercut Walmart, so that all consumers purchase from Target. Copyright © 2020 by Macmillan Learning. All Rights Reserved What is the Nash equilibrium in this structure? Equilibrium occurs when each firm charges the marginal cost of production. With identical firms and products, if one firm is charging more than its marginal cost, the other firm always has an incentive to undercut. Even though competition is imperfect, in Bertrand competition, market equilibrium is identical to perfect competition and price equals marginal cost. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (1/14) 11.4 If, instead, firms focus on the quantity decision: Oligopolists in a local market may compete on price, but producers in larger markets (e.g., commodities) may have to set production, because capacity constraints of the other firms may keep each firm from losing all of its customers. If capacity decisions are made in advance, firms compete on output rather than on price This type of structure is called Cournot competition. Copyright © 2020 by Macmillan Learning. All Rights Reserved In this model each firm chooses its production quantity rather than price Model Assumptions: Cournot Competition with Identical Goods 1. Firms make identical products. 2. Firms compete by choosing a quantity to produce. 3. All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market. 4. Firms choose quantities simultaneously. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Cournot Competition (2/14) 11.4 Setting Up the Cournot Model Assume there are two firms in a Cournot oligopoly. Each firm has a constant marginal cost c. Firms 1 and 2 simultaneously choose production quantities q1 and q2. Inverse demand is given by: Copyright © 2020 by Macmillan Learning. All Rights Reserved P = a − bQ ; Q = q1 + q2 π 1 = q1 (P − c ) Firm 1’s profit is: substituting in for P : π 1 = q1 × [(a − b(q1 + q2 )) − c ] Each firm’s profit depends on actions of the other firm. And Firm 2’s profit is:π 2 = q2 × [(a − b(q1 + q2 )) − c ] MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (3/14) 11.4 Equilibrium in a Cournot Oligopoly Assume only two countries, Saudi Arabia and Iran, supply oil to the world. Each has a constant marginal cost of $20 per barrel. Inverse demand is given by: P = 200 − 3Q ; Q = qSA + qI Copyright © 2020 by Macmillan Learning. All Rights Reserved Solving for the equilibrium in this model is similar to the monopoly case, except Q is the sum of quantities. Rewriting the inverse demand curve, P = 200 − 3Q = 200 − 3(qSA + qI ) P = 200 − 3qSA − 3qI MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (4/14) 11.4 Equilibrium in a Cournot Oligopoly The slope of the marginal revenue curve is twice the slope of the inverse demand curve. For Saudi Arabia: MRSA = 200 − 6qSA − 3qI Copyright © 2020 by Macmillan Learning. All Rights Reserved Solving for Saudi Arabia’s profit-maximizing output: MRSA = MC 200 − 6qSA − 3qI = 20 qSA = 30 − 0.5qI Similarly, Iran’s profit-maximizing output is: qI = 30 −0.5qSA MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (5/14) 11.4 Equilibrium in a Cournot Oligopoly This differs from the monopoly outcome in that the profit-maximizing output for each country depends on the choices of the other. For instance, if the Saudis expect Iran to produce 10 million barrels per day, they face the inverse demand curve: Copyright © 2020 by Macmillan Learning. All Rights Reserved P = 200 − 3qSA − 3qI = 200 − 3qSA − 3(10) = 170 − 3qSA This leftover demand is the residual demand curve. In Cournot competition, the demand remaining for a firm’s output given competitor firms’ production quantities Similarly, a residual marginal revenue curve is a marginal revenue curve corresponding to a residual demand curve. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (6/14) 11.4 Cournot Equilibrium: A Graphical Approach The relationship between two firms’ output decisions in a Cournot oligopoly can be seen graphically through the use of reaction curves. A function that relates a firm’s best response to its competitor’s possible actions Copyright © 2020 by Macmillan Learning. All Rights Reserved In Cournot competition, this is the firm’s best production response to its competitor’s possible quantity choices. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (7/14) 11.4 Figure 11.3 Reaction Curves and Cournot Equilibrium The same holds true for Iran. Saudi Arabia’s best Copyright © 2020 by Macmillan Learning. All Rights Reserved reaction to an increase in Iranian output is to lower output. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Cournot Competition (8/14) 11.4 Cournot Equilibrium: A Mathematical Approach We can also solve for a Cournot equilibrium mathematically. Substitute one firm’s reaction curve into the other. In the oil production example: qSA = 30 − 0.5qI , qI = 30 − 0.5qSA qSA = 30 − 0.5(30 − 0.5qSA) = 30 − 15 +0.25 qSA Copyright © 2020 by Macmillan Learning. All Rights Reserved qSA = 20 million Saudi Arabia’s equilibrium output is 20 million barrels per day. Since Iran and Saudi Arabia have identical production costs, Iran will also produce 20 million barrels per day, and the market price will be: P = 200 − 3qSA − 3qI = 200 − 3(20) − 3(20) = $80 per barrel MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (9/14) 11.4 Cournot Equilibrium: A Mathematical Approach Finally, we can compute the profit earned by Saudi Arabia: π SA =qSA × ( P − $20 ) =20 million × ( $80 − $20 ) =$1.2 billion and Iran: Copyright © 2020 by Macmillan Learning. All Rights Reserved qI × ( P − $20 ) = πI = 20 million × ( $80 − $20 ) = $1.2 billion Total output is 40 mln. barrels of oil per day, and total profit is $2.4 bln. In general, firm 1’s problem is max 𝑞𝑞𝑞 × 𝑎𝑎 − 𝑏𝑏 𝑞𝑞𝑞 + 𝑞𝑞𝑞 − 𝑀𝑀𝑀𝑀 𝑞𝑞𝑞 FOC: 𝑎𝑎 − 2𝑏𝑏𝑏𝑏𝑏 − 𝑏𝑏𝑏𝑏𝑏 − 𝑀𝑀𝑀𝑀 = 0; but 𝑞𝑞𝑞 = 𝑞𝑞𝑞 because the firms are 𝑎𝑎−𝑀𝑀𝑀𝑀 identical → FOC reduces to 𝑎𝑎 − 3𝑏𝑏𝑏𝑏𝑏 = 𝑀𝑀𝑀𝑀 and 𝑞𝑞𝑞 = = 𝑞𝑞𝑞 3𝑏𝑏 MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Cournot Competition (10/14) 11.4 Comparing Cournot to Collusion and to Bertrand Oligopoly Under collusion, Saudi Arabia and Iran will act as a single monopolist, splitting production evenly because production costs are the same. Following the normal procedure, that marginal revenue equals marginal cost, total output is 30 million barrels per day (BPD), with associated market price: Copyright © 2020 by Macmillan Learning. All Rights Reserved P = 200 − 3(30) = $110 Total profit is: π SA + π I =( P − $20 ) × Q =( $110 − $20 ) × 30 million =$2.7 billion Under collusion, production is less than that observed in the Cournot equilibrium (40 million BPD), and profits are higher by $300 million per day. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (11/14) 11.4 Comparing Cournot to Collusion and to Bertrand Oligopoly With Bertrand competition, firms compete on price. Price will equal marginal cost; using the inverse demand curve: P = MC 200 − 3Q = $20 Q = 60 million Copyright © 2020 by Macmillan Learning. All Rights Reserved The two countries would split this demand equally, selling 30 million barrels each. How much profit do Saudi Arabia and Iran earn? ‒ Because both firms sell at a price equal to MC, each earns zero economic profit. At the Bertrand equilibrium, output quantity is higher than at the Cournot equilibrium, price is lower, and there is no profit. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (12/14) 11.4 Comparing Cournot to Collusion and to Bertrand Oligopoly Table 11.2 Comparing Equilibria across Oligopolies Oligopoly Total Output Price ($ Industry Profit Structure (million bpd) per barrel) (per day) Copyright © 2020 by Macmillan Learning. All Rights Reserved Collusion 30 $110 $2.7 billion Bertrand (identical 60 20 0 products) Cournot 40 80 2.4 billion MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Cournot Competition (13/14) 11.4 Comparing Cournot to Collusion and to Bertrand Oligopoly In summary Output under the three industry structures: Q m < Qc < Q b ‒ Monopoly results in the lowest quantity produced, while Bertrand results in the most. Copyright © 2020 by Macmillan Learning. All Rights Reserved Market price under the three industry structures: Pb < Pc < Pm ‒ Bertrand yields the lowest price, while monopoly yields the highest. Profit under the three industry structures: πb = 0 < πc < πm ‒ Bertrand yields the lowest profit (0), while monopoly yields the highest. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Cournot Competition (14/14) 11.4 What Happens If There Are More than Two Firms in a Cournot Oligopoly? The approach presented in previous slides extends to the case of multiple firms. In general, as the number of firms increases, market outcomes still fall between the monopoly and perfectly competitive cases, but Copyright © 2020 by Macmillan Learning. All Rights Reserved ‒ outcomes will approach the perfectly competitive case. ‒ more competitors mean higher industry output, lower market price, and lower industry profit. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Cournot equilibrium with N firms  Let 𝑃𝑃 = 100 − 𝑄𝑄/2 and let 𝑇𝑇𝑇𝑇 = 52𝑄𝑄 → 𝑀𝑀𝑀𝑀 = 52  N identical firms 𝑞𝑞1 +∑𝑁𝑁 𝑖𝑖=2 𝑞𝑞𝑖𝑖  Firm 1’s problem: max 100 − 𝑞𝑞1 − 52𝑞𝑞1 𝑞𝑞1 2 𝑁𝑁  FOC: 100 − 𝑞𝑞1 − 0.5 ∑𝑖𝑖=2 𝑞𝑞𝑖𝑖 − 52 = 0; but the firms are Copyright © 2020 by Macmillan Learning. All Rights Reserved identical, implying that in equilibrium 𝑞𝑞1 = 𝑞𝑞𝑖𝑖 → 𝑁𝑁+1 𝑞𝑞1 96 𝑁𝑁 48 − = 0 → 𝑞𝑞1 = 𝑞𝑞𝑖𝑖 = ; 𝑃𝑃 = 100 − 48. 2 𝑁𝑁+1 𝑁𝑁+1 Note that as 𝑁𝑁 → ∞, 𝑞𝑞𝑖𝑖 → 0, 𝑃𝑃 → 𝑃𝑃𝐶𝐶 = 52. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition 34 Oligopoly with Identical Goods: Stackelberg Competition (1/7) 11.5 So far, we have considered only the case in which competitors with market power choose output or price simultaneously. In reality, firms may make decisions before or after observing a competitor’s choice. This type of structure is called Stackelberg competition. Oligopoly model in which firms make production decisions sequentially Copyright © 2020 by Macmillan Learning. All Rights Reserved Model Assumptions: Stackelberg Competition with Identical Goods 1. Firms make identical products. 2. Firms compete by choosing a quantity to produce. 3. All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market. 4. Firms DO NOT choose quantities simultaneously. One firm chooses quantity first and the other firm makes its choice after observing the first firm’s choice. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Stackelberg Competition (2/7) 11.5 Consider the outcomes of the Cournot competition model. Each firm chooses its optimal quantity based on what the firm believes its competitor(s) might do. What happens if one firm observes the other producing more than the Cournot output? Copyright © 2020 by Macmillan Learning. All Rights Reserved Reaction curves are downward-sloping; the best response is to reduce output compared to the Cournot equilibrium level. The ability of a first mover to manipulate its competitor’s output in Stackelberg competition means that there is a first-mover advantage. In Stackelberg competition, the advantage is gained by the initial firm in setting its production quantity. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Oligopoly with Identical Goods: Stackelberg Competition (3/7) 11.5 Let’s return to Saudi Arabia and Iran in Cournot competition. Inverse demand is given by (quantity measured in millions of barrels): P = 200 − 3Q ; Q = qSA + qI Each country has a constant marginal cost of production of $20 per barrel. Copyright © 2020 by Macmillan Learning. All Rights Reserved The two countries will produce where marginal revenue equals marginal cost, yielding the following reaction functions: Saudi Arabia Iran MRSA = 200 − 6qSA − 3qI = 20 MRI = 200 − 6qI − 3qSA = 20 qSA = 30 − 0.5qI qI = 30 − 0.5qSA MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Stackelberg Competition (4/7) 11.5 Stackelberg Competition and the First-Mover Advantage Now suppose Saudi Arabia is a Stackelberg leader. This means it chooses its optimal quantity of output before Iran does. Iran’s incentives remain the same; for any quantity Saudi Arabia chooses to produce, Iran’s reaction function describes the optimal response. Importantly, Saudi Arabia realizes that Iran will do this before it makes its first move. Copyright © 2020 by Macmillan Learning. All Rights Reserved ‒ However, Saudi Arabia’s reaction curve is different; specifically, we must substitute Iran’s reaction curve into the inverse demand curve. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Stackelberg Competition (5/7) 11.5 Stackelberg Competition and the First-Mover Advantage Substitute Iran’s reaction curve into the inverse demand curve and solve for the optimal output for Saudi Arabia. P = 200 − 3qSA − 3qI P = 200 − 3qSA − 3(30 − 0.5qSA) Copyright © 2020 by Macmillan Learning. All Rights Reserved P = 110 − 1.5qSA MRSA = 100 − 3qSA = 20 qSA = 30 Plug this in to Iran’s reaction function: qI = 30 − 0.5(30) = 15 MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Stackelberg Competition (6/7) 11.5 Let’s compare Saudi Arabia’s decisions under a Stackelberg competition structure to the Cournot outcome. In the Cournot equilibrium, each country produces 20 million barrels per day; now Saudi Arabia produces 30 million barrels per day and Iran, 15 million. Cournot Stackelberg Copyright © 2020 by Macmillan Learning. All Rights Reserved P = 200 − 3qSA − 3qI P = 200 − 3qSA − 3qI MRSA = 200 − 6qSA − 3qI = 20 P = 200 − 3qSA − 3(30 − 0.5qSA) qSA = qI  180 = 9qSA P = 110 − 1.5qSA qSA = qI = 20 MRSA = 110 − 3qSA = 20 P = 200 − 6*20 = 80 qSA = 30 qI = 30 − 0.5(30) = 15 MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Identical Goods: Stackelberg Competition (7/7) 11.5 Market price is P = 200 − 3(45) = $65 per barrel, and profit for each country is: Saudi Arabia Iran π SA = qSA (P − 20) = 30(65 − 20) π I = q I (P − 20) = 15(65 − 20) π SA = $1,350,000,000 / day π I = $675,000,000 / day Copyright © 2020 by Macmillan Learning. All Rights Reserved Saudi Arabia makes slightly more (by $150 million) than the Cournot equilibrium of $1.2 billion per day as a result of holding first-mover advantage, whereas Iran does much worse. What happens if both countries act as Stackelberg leader? Then both Saudi Arabia and Iran produce 30, resulting in market price of 20 and zero profit for each country. This is called Stackelberg warfare. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition  Additional figure it out Consider the case of two theaters, Jay’s Cinema (JC) and Mezzanine Inc. (MI). The inverse demand for theater tickets is given as where quantity is measured in thousands of theater tickets per year, representing the combined production of JC and MI, Q = qJC + qMI , and price is measured in dollars per ticket. JC has a marginal cost of $6 per ticket, and MI has a marginal cost of $8. Copyright © 2020 by Macmillan Learning. All Rights Reserved Answer the following questions: a. Suppose the market is a Stackelberg oligopoly and JC is the first mover. How much does each firm produce? What will the market price of a movie be? How much profit does each firm earn? b. Now suppose MI is the first mover. How much will each firm produce? What is the market price? How much profit does each firm earn?  Additional figure it out a. Since JC moves first, we must calculate MI’s reaction curve and plug that in to the market demand curve to determine what output level JC will choose. To find MI’s reaction curve, set marginal revenue equal to marginal cost MR = MC 120 − 4q JC − 8qMI = 8 qMI = 14 −.5q JC Copyright © 2020 by Macmillan Learning. All Rights Reserved Substituting MI’s reaction curve into the market demand curve yields P = 120 − 4(q JC + qMI ) = 120 − 4(q JC + 14 −.5q JC ) P = 120 − 4q JC − 56 + 2q JC P = 64 − 2q JC which is JC’s inverse demand curve as a first mover. Setting marginal revenue equal to marginal cost yields MR = MC 64 − 4q JC = 6 q JC = 14  Additional figure it out Substituting JC’s output choice into MI’s reaction function yields the latter’s output choice qMI = 14 − 0.5q JC qMI = 14 − 0.5(14) qMI = 7 To find the market price, return to the inverse demand curve P = 120 − 4(q JC + qMI ) Copyright © 2020 by Macmillan Learning. All Rights Reserved P = 120 − 4(14 + 7 ) P = $36 And the profit for each firm is given by, π JC = (P − $6 )× q JC π MI = (P − $8)× qMI π JC = ($36 − $6 )× 14,000 π MI = ($36 − $8)× 7,000 π JC = $420,000 π MI = $196,000  Additional figure it out b. We repeat the same process for part b. Since MI moves first, we must calculate JC’s reaction curve, and plug that in to the market demand curve to determine what output level MI will choose. To find JC’s reaction curve, set marginal revenue equal to marginal cost MR = MC 120 − 8q JC − 4qMI = 6 q JC = 14.25 − 0.5qMI Copyright © 2020 by Macmillan Learning. All Rights Reserved Substituting JC’s reaction curve into the market demand curve yields P =120 − 4 ( qJC + qMI ) =120 − 4(qMI + 14.25 − 0.5qMI ) P = 120 − 4qMI − 57 + 2qMI P = 63 − 2q JC which is MI’s inverse demand curve as a first mover. Setting marginal revenue equal to marginal cost yields MR = MC 64 − 4qMI = 6 qMI = 14.5  Additional figure it out Substituting MI’s output choice into JC’s reaction function yields the latter’s output choice. q = 14.25 − 0.5q JC MI q JC = 14.25 − 0.5(14.5) q JC = 7 To find the market price, return to the inverse demand curve. P = 120 − 4(q JC + qMI ) Copyright © 2020 by Macmillan Learning. All Rights Reserved P = 120 − 4(7 + 14.5) P = $34 The profit for each firm is given by π JC = (P − $6 )× q JC π MI = (P − $8)× qMI π JC = ($34 − $6 )× 7,000 π MI = ($34 − $8)× 14,500 π JC = $196,000 π MI = $377,000  Oligopoly with Differentiated Goods: Bertrand Competition (1/6) 11.6 Every model we have considered so far has shared a common assumption: that all firms in a particular market sell an identical product. A more realistic situation—particularly with consumer goods—is that products in a specific market are differentiated in important ways A differentiated product market is a market with multiple varieties of a common product. Copyright © 2020 by Macmillan Learning. All Rights Reserved We start by examining Bertrand competition with differentiated products. Model Assumptions: Bertrand Competition with Differentiated Goods 1. Firms do not sell identical products. They sell differentiated products, meaning consumers do not view them as perfect substitutes. 2. Each firm chooses the price at which it sells its product. 3. Firms set prices simultaneously. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Differentiated Goods: Bertrand Competition (2/6) 11.6 Equilibrium in a Differentiated-Products Bertrand Market Suppose there are two snowboard manufacturers, Burton and K2. Products are substitutes but not perfect substitutes. Differentiation means each firm faces a unique demand curve. For simplicity, assume the marginal cost of producing snowboards is zero Let demand curves for the two companies’ snowboards be: Copyright © 2020 by Macmillan Learning. All Rights Reserved Burton K2 qB = 900 − 2pB + pK qK = 900 − 2pK + pB Note that because the firms compete on price, they maximize profit, pB*qB and pK*qK , respectively, with respect to price. As the price of Burton snowboards increases, Burton is in less demand but K2 is in greater demand, and vice versa. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Differentiated Goods: Bertrand Competition (3/6) 11.6 Equilibrium in a Differentiated-Products Bertrand Market Each company sets its price to maximize profits. Burton and K2 set their price so that marginal revenue is equal to zero (because MC=0). Below are the reaction curves for Burton and K2; as the competitor’s price rises, their own price rises, i.e., reaction curves are positively sloped Copyright © 2020 by Macmillan Learning. All Rights Reserved ‒ This is the opposite of quantity reaction in Cournot competition. Why does this occur? Burton K2 MRB = 900 − 4pB + pK = 0 MRK = 900 − 4pK + pB = 0 4pB = 900+ pK 4pK = 900+ pB pB = 225+ 0.25pK pK = 225+ 0.25pB MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Differentiated Goods: Bertrand Competition (4/6) 11.6 Equilibrium in a Differentiated-Products Bertrand Market To find the equilibrium prices, plug one company’s reaction curve into the other’s: pB = 225 + 0.25pK pB = 225 + 0.25*(225 + 0.25pB) Copyright © 2020 by Macmillan Learning. All Rights Reserved 0.9375pB = 281.25 pB = $300 Plugging this price in to K2’s reaction curve yields K2’s equilibrium price. PK = 225 + 0.25(300) = $300 We can also find the equilibrium graphically. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Differentiated Goods: Bertrand Competition (5/6) 11.6 Figure 11.4 Nash Equilibrium in a Bertrand Market The same holds for K2. As K2's chosen price rises, Burton's best response is to raise its price. Copyright © 2020 by Macmillan Learning. All Rights Reserved MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Oligopoly with Differentiated Goods: Bertrand Competition (6/6): 11.6 Discussion Question How do firms with identical products differentiate themselves in the market? Copyright © 2020 by Macmillan Learning. All Rights Reserved MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (1/7) 11.7 So far, we have focused exclusively on markets whose number of firms is fixed. If, instead, there are no barriers to entry in a differentiated product market, we have monopolistic competition. ‒ A market structure characterized by many firms selling a differentiated product and with no barriers to entry Copyright © 2020 by Macmillan Learning. All Rights Reserved Model Assumptions: Monopolistic Competition 1. Industry firms sell differentiated products that consumers do not view as perfect substitutes. 2. Other firms’ choices affect a firm’s residual demand curve, but the firm ignores any strategic interactions between its own quantity or price choice and that of its competitors. 3. The market allows free entry and exit. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (2/7) 11.7 Equilibrium in Monopolistically Competitive Markets To understand how equilibrium is reached in a monopolistically competitive market, first examine how free entry affects noncompetitive market outcomes. Consider a small town with a single fast-food burger restaurant. Copyright © 2020 by Macmillan Learning. All Rights Reserved The restaurant is effectively a monopolist. The demand curve is Done, indicating a single firm. The firm will choose a level of production that equates marginal revenue with marginal cost. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (3/7) 11.7 Figure 11.5 Demand and Cost Curves for a Monopoly Copyright © 2020 by Macmillan Learning. All Rights Reserved How do we identify the level of output chosen by the monopolist to produce? MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (4/7) 11.7 Equilibrium in Monopolistically Competitive Markets The result is a monopoly outcome. Now, suppose a second firm notices the profitability of operating a fast- food restaurant in this town. With no barriers to entry, the second firm opens a restaurant. Copyright © 2020 by Macmillan Learning. All Rights Reserved Two things happen to the demand curve, DONE, when another firm enters. 1. First, because the second firm offers an (imperfect) substitute product, the demand curve for the first firm’s food becomes flatter (more elastic). 2. Second, because demand is now split across two firms, DONE shifts in as well. Unlike in previous oligopoly models, each firm takes the other’s actions as given, and there is no strategic response to the behavior of rivals. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (5/7) 11.7 Figure 11.6 The Effect of Firm’s Entry on Demand for a Monopolistically Competitive Firm Copyright © 2020 by Macmillan Learning. All Rights Reserved As a second firm enters, demand shifts downward and becomes more elastic. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (6/7) 11.7 Equilibrium in Monopolistically Competitive Markets Just as with perfect competition, entry will continue to occur until economic profit is equal to zero. However, unlike with perfect competition, this does not mean that price is equal to marginal cost. Copyright © 2020 by Macmillan Learning. All Rights Reserved The firms always face a downward-sloping demand curve. Entry will occur until demand is tangent with the average total cost curve. This is the point at which economic profits are exhausted. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Monopolistic Competition (7/7) 11.7 Figure 11.7 Long-Run Equilibrium for a Monopolistically Competitive Market Because there is free entry, in the long run firms in monopolistic Copyright © 2020 by Macmillan Learning. All Rights Reserved competition cannot sustain economic profit. However, since each firm faces a downward-sloping demand curve, in the long run average total costs are not minimized in monopolistic competition. IS THIS INEFFICIENT? MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition Conclusion (1/1) 11.8 In this chapter, we examined a number of models of imperfect competition. Bertrand, Cournot, and Stackelberg competition with identical goods Collusion Bertrand competition with differentiated goods Monopolistic competition Copyright © 2020 by Macmillan Learning. All Rights Reserved Choosing which model is a good fit for a particular market requires judgment on the part of the economist. In the next chapter, we look more closely at the concept of strategic interaction, which underlies some of the models from this chapter. MICROECONOMICS Goolsbee | Levitt | Syverson | Third Edition