Lecture 5 - Oligopoly I PDF

Lecture 5 Oligopoly I 5ECON010C-n Intermediate Microeconomics  Monopolistic Competition and Oligopoly LECTURE OUTLINE 1.Monopolistic Competition 2.Oligopoly 3.Price Competition 4. Competition versus Collusion: The Cournot Model Copyright © 2016, 2012, 200...

Lecture 5 Oligopoly I 5ECON010C-n Intermediate Microeconomics  Monopolistic Competition and Oligopoly LECTURE OUTLINE 1.Monopolistic Competition 2.Oligopoly 3.Price Competition 4. Competition versus Collusion: The Cournot Model Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Monopolistic Competition and Oligopoly Monopolistic competition: Market in which firms can enter freely, each producing its own brand or version of a differentiated product. Oligopoly: Market in which only a few firms compete with one another, and entry by new firms is impeded. Monopolistic Competition The Makings of Monopolistic Competition A monopolistically competitive market has two key characteristics: 1.Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes. In other words, the cross-price elasticities of demand are large but not infinite. Examples: Toothpaste brands, restaurants, hair salons, clothing, shoes. 2.There is free entry and exit: It is relatively easy for new firms to enter the market with their own brands and for existing firms to leave if their products become unprofitable. Monopolistic Competition Equilibrium in the Short Run FIGURE 12.1 A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT Because the firm is the only producer of its brand, it faces a downward-sloping demand curve. Price exceeds marginal cost, and the firm has monopoly power. In the short run, described in part (a), price also exceeds average cost, and the firm earns profits shown by the yellow-shaded rectangle. Here firm’s market share is sufficiently big for optimum price to be higher than average cost Monopolistic Competition Equilibrium in the Long Run FIGURE 12.1 A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN In the long run, these profits attract new firms with competing brands. The firm’s market share falls, and its demand curve shifts downward. In long-run equilibrium, described in part (b), price equals average cost, so the firm earns zero profit even though it has monopoly power. Monopolistic Competition Equilibrium in the Short Run and the Long Run Monopolistic Competition and Economic Efficiency COMPARISON OF MONOPOLISTICALLY COMPETITIVE EQUILIBRIUM AND PERFECTLY COMPETITIVE EQUILIBRIUM FIGURE 12.2 Under perfect competition, price equals marginal cost (a). Under monopolistic competition, price exceeds marginal cost (b). Thus, there is a deadweight loss, as shown by the yellow-shaded area. The demand curve is downward-sloping, so the zero-profit point is to the left of the point of minimum average cost. In both types of markets, entry occurs until profits are driven to zero. Is Monopolistic Competition Undesirable? Is monopolistic competition then a socially undesirable market structure that should be regulated? The answer—for two reasons—is probably NO: 1.In most monopolistically competitive markets, monopoly power is small. Usually enough firms compete, with brands that are sufficiently substitutable, so that no single firm has much monopoly power. Any resulting deadweight loss will therefore be small. And because firms’ demand curves will be fairly elastic, average cost will be close to the minimum. 2. Any inefficiency must be balanced against an important benefit from monopolistic competition: product diversity. Most consumers value the ability to choose among a wide variety of competing products and brands that differ in various ways. The gains from product diversity can be large and may easily outweigh the inefficiency costs resulting from downward-sloping demand curves. EXAMPLE 12.1 MONOPOLISTIC COMPETITION IN THE MARKETS FOR COLAS AND COFFEE The markets for soft drinks and coffee illustrate the characteristics of monopolistic competition. Each market has a variety of brands that differ slightly but are close substitutes for one another. TABLE 12.1 ELASTICITIES OF DEMAND FOR COLAS AND COFFEE Blank Cell BRAND ELASTICITY OF DEMAND Colas RC Cola –2.4 Blank Cell Coke –5.2 to –5.7 Ground coffee Folgers –6.4 Blank Cell Maxell House –8.2 Blank Cell Chock Full o’ Nuts –3.6 With the exception of RC Cola and Chock Full o’ Nuts, all the colas and coffees are quite price elastic. With elasticities on the order of −4 to −8, each brand has only limited monopoly power. This is typical of monopolistic competition. Oligopoly Oligopoly: Market in which only a few firms compete with one another, and entry by new firms is impeded. In oligopolistic markets, the products may or may not be differentiated. What matters is that only a few firms account for most or all of total production. In some oligopolistic markets, some or all firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for new firms to enter. Oligopoly is a prevalent form of market structure. Examples of oligopolistic industries include automobiles, steel, aluminum, petrochemicals, electrical equipment, and computers. Oligopoly: behavior Players in oligopolistic market may choose to compete or to collude If they choose to compete – they play a competition game When they collude – they play promise and trust game Thus, we use game theory in order to understand their behavior 5ECON010C-n Intermediate Microeconomics Oligopoly Equilibrium in an Oligopolistic Market NASH EQUILIBRIUM Nash equilibrium: Set of strategies or actions in which each firm does the best it can given its competitors’ actions. Nash Equilibrium: Each firm is doing the best it can given what its competitors are doing. Duopoly: Market in which two firms compete with each other (to keep things simple, we will use duopoly case to study oligopoly behavior). The Cournot Model 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.  Oligopoly: The Cournot Model FIGURE 12.3 FIRM 1’S OUTPUT DECISION Firm 1’s profit-maximizing output depends on how much it thinks that Firm 2 will produce. If it thinks Firm 2 will produce nothing, its demand curve, labeled D1(0), is the market demand curve. The corresponding marginal revenue curve, labeled MR1(0), intersects Firm 1’s marginal cost curve MC1 at an output of 50 units. If Firm 1 thinks that Firm 2 will produce 50 units, its demand curve, D1(50), is shifted to the left by this amount. Profit maximization now implies an output of 25 units. Finally, if Firm 1 thinks that Firm 2 will produce 75 units, Firm 1 will produce only 12.5 units. Oligopoly: The Cournot Model REACTION CURVES reaction curve: Relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce. FIGURE 12.4 REACTION CURVES AND COURNOT EQUILIBRIUM Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. Firm 2’s reaction curve shows its output as a function of how much it thinks Firm 1 will produce. In Cournot equilibrium, each firm correctly assumes the amount that its competitor will produce and thereby maximizes its own profits. Therefore, neither firm will move from this equilibrium. The Cournot Model Cournot model: reaction curve When we plot the reaction curves of both players, the crossing point is Cournot equilibrium Cournot equilibrium is reached when both players correctly predicted each other’s outputs and set their outputs accordingly Cournot Model: Example of Competitive Equilibrium Two identical firms face the following market demand curve: 𝑷 = 𝟑𝟎 – 𝑸 (where Q= 𝑄1 +𝑄2 ) Marginal costs for both firms is zero: 𝑴𝑪𝟏 = 𝑴𝑪𝟐 = 𝟎 Total revenue for Firm 1: 𝑹𝟏 = 𝑷𝑸𝟏 = (𝟑𝟎 – 𝑸)𝑸𝟏 ∆𝑹𝟏 Then: 𝑴𝑹𝟏 = = 𝟑𝟎 – 𝟐𝑸𝟏 – 𝑸𝟐 ∆𝑸𝟏 Setting 𝑀𝑅1 = 0 (MC) and solving for 𝑄1 , we find Firm 1’s reaction curve: 𝑄2 𝑄1 = 15 − 2 By the same calculation, Firm 2’s reaction curve: 𝑄1 𝑄2 = 15 − 2 Cournot equilibrium: 𝑄1 = 𝑄2 = 10 Total quantity produced: 𝑄1 + 𝑄2 = 20 5ECON010C-n Intermediate Microeconomics  Cournot Model: Example of Collusion If they collude, their combined revenues would be: R = PQ = (30 –Q)Q = 30Q – Q2 Marginal revenue is: MR = 30 – 2Q Setting 𝑀𝑅 = 𝑀𝐶 gives us profit maximizing 𝑄: 𝑸 = 𝟏𝟓 Two firms when colluding decide on how to divide the market: 𝑸𝟏 + 𝑸𝟐 = 𝟏𝟓 If the firms collude and share profits equally, each will produce 7.5. The above curve is called collusion curve 5ECON010C-n Intermediate Microeconomics The Cournot Equilibrium Compared using Monopoly Diagram 5ECON010C-n Intermediate Microeconomics Reading Mandatory reading Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 12 Optional reading https://www.researchgate.net/publication/265339003_Innovation_and_c ompetition_in_the_smartphone_industry_Is_there_a_dominant_design Apple and Samsung feel the sting of plateauing smartphones, https://www.theverge.com/2019/1/3/18166399/iphone-android-apple- samsung-smartphone-sales-peak (1,200 words) 5ECON010C-n Intermediate Microeconomics