Chapter 12yamamoto/files/Jul_6.pdf · LR MR LR Q SR P SR Q LR P LR ... Competitive Equilibrium (LR)...

Chapter 12

Monopolistic Competitionand Oligopoly

Chapter 12 2©2005 Pearson Education, Inc.

Topics to be Discussed

�Monopolistic Competition

�Oligopoly

�Price Competition

�Competition Versus Collusion: ThePrisoners’ Dilemma

Chapter 12 3©2005 Pearson Education, Inc.

Monopolistic Competition

� Characteristics1. Many firms

2. Free entry and exit

3. Differentiated product

Chapter 12 4©2005 Pearson Education, Inc.

Monopolistic Competition

� The amount of monopoly power dependson the degree of differentiation

�Examples of this very common marketstructure include:�Toothpaste

�Soap

�Cold remedies

Chapter 12 5©2005 Pearson Education, Inc.

Monopolistic Competition

� Toothpaste� Crest and monopoly power

� Procter & Gamble is the sole producer of Crest

� Consumers can have a preference for Crest –taste, reputation, decay-preventing efficacy

� The greater the preference (differentiation) thehigher the price

Chapter 12 6©2005 Pearson Education, Inc.

Monopolistic Competition

� 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

Chapter 12 8©2005 Pearson Education, Inc.

A Monopolistically CompetitiveFirm in the Short and Long Run

�Short run�Downward sloping demand – differentiated

product

�Demand is relatively elastic – goodsubstitutes

�MR < P

�Profits are maximized when MR = MC

�This firm is making economic profits

Chapter 12 9©2005 Pearson Education, Inc.

A Monopolistically CompetitiveFirm in the Short and Long Run

� 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 PerfectlyCompetitive Equilibrium (LR)

$/Q

Quantity

$/Q

D = MR

QC

PC

MC AC

DLR

MRLR

QMC

P

Quantity

Perfect Competition Monopolistic Competition

Chapter 12 11©2005 Pearson Education, Inc.

Monopolistic Competition andEconomic Efficiency

� The monopoly power yields a higherprice than perfect competition. If pricewas lowered to the point where MC = D,consumer surplus would increase by theyellow triangle – deadweight loss.

�With no economic profits in the long run,the firm is still not producing at minimumAC and excess capacity exists.

Chapter 12 12©2005 Pearson Education, Inc.

Monopolistic Competition andEconomic Efficiency

� Firm faces downward sloping demand sozero profit point is to the left of minimumaverage cost

�Excess capacity is inefficient becauseaverage cost would be lower with fewerfirms�Inefficiencies would make consumers worse

off

Chapter 12 13©2005 Pearson Education, Inc.

Monopolistic Competition

� If inefficiency is bad for consumers,should monopolistic competition beregulated?� Market power is relatively small. Usually

there are enough firms to compete withenough substitutability between firms –deadweight loss small.

� Inefficiency is balanced by benefit ofincreased product diversity – may easilyoutweigh deadweight loss.

Chapter 12 14©2005 Pearson Education, Inc.

The Market for Colas and Coffee (Ex12-1)

�Each market has much differentiation inproducts and tries to gain consumersthrough that differentiation�Coke vs. Pepsi

�Maxwell House vs. Folgers

�How much monopoly power do each ofthese producers have?�How elastic is demand for each brand?

Chapter 12 15©2005 Pearson Education, Inc.

Elasticities of Demand for Brands ofColas and Coffee (Ex 12-1)

Chapter 12 16©2005 Pearson Education, Inc.

The Market for Colas and Coffee (Ex12-1)

� The demand for Royal Crown is moreprice inelastic than for Coke

� There is significant monopoly power inthese two markets

� The greater the elasticity, the lessmonopoly power and vice versa

Chapter 12 17©2005 Pearson Education, Inc.

Oligopoly – Characteristics

�Small number of firms in a market�Product differentiation may or may not

exist�Barriers to entry

�Scale economies�Patents�Technology�Name recognition�Strategic action

Chapter 12 18©2005 Pearson Education, Inc.

Oligopoly

�Examples�Automobiles

�Steel

�Aluminum

�Petrochemicals

�Electrical equipment

Chapter 12 19©2005 Pearson Education, Inc.

Oligopoly

�Management Challenges�Strategic actions to deter entry

� Threaten to decrease price against newcompetitors by keeping excess capacity

�Rival behavior� Because only a few firms, each must consider

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

Chapter 12 20©2005 Pearson Education, Inc.

Oligopoly – Equilibrium

� If one firm decides to cut their price, theymust consider what the other firms in theindustry will do�Could cut price some, the same amount, or

more than firm

�Could lead to price war and drastic fall inprofits for all

�Actions and reactions are dynamic,evolving over time

Chapter 12 21©2005 Pearson Education, Inc.

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 rivaldecisions 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

Chapter 12 22©2005 Pearson Education, Inc.

Oligopoly

� The Cournot Model�Oligopoly model in which firms produce a

homogeneous good, each firm treats theoutput of its competitors as fixed, and allfirms decide simultaneously how much toproduce

�Firm will adjust its output based on what itthinks the other firm will produce

Chapter 12 23©2005 Pearson Education, Inc.

���������������� �������������

French philosopher,mathematician and economist,Augustin Cournot has beenrightly hailed as one of thegreatest of the Proto-Marginalists . The uniqueinsights of his majoreconomics work, ����� ����� ������ �����������é���������������é� ������� ���������(1838)were without parallel. Although neglected in his time,the impact of Cournot work onmodern economics can hardlybe overstated.

Chapter 12 24©2005 Pearson Education, Inc.

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.

Chapter 12 25©2005 Pearson Education, Inc.

Oligopoly

� The Reaction Curve�The relationship between a firm’s profit-

maximizing output and the amount it thinksits competitor will produce

�A firm’s profit-maximizing output is adecreasing schedule of the expected outputof Firm 2

Chapter 12 26©2005 Pearson Education, Inc.

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 CournotEquilibrium

Q2

Q1

25 50 75 100

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

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.

Chapter 12 27©2005 Pearson Education, Inc.

Firm 2’s ReactionCurve Q*2(Q1)

Reaction Curves and CournotEquilibrium

Q2

Q1

25 50 75 100

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximizes its own profits.

CournotEquilibrium

Chapter 12 28©2005 Pearson Education, Inc.

Cournot Equilibrium

�Each firm’s reaction curve tells it howmuch to produce given the output of itscompetitor

�Equilibrium in the Cournot model, inwhich each firm correctly assumes howmuch its competitor will produce and setsits own production level accordingly

Chapter 12 29©2005 Pearson Education, Inc.

Oligopoly

� Cournot equilibrium is an example of aNash equilibrium (Cournot-NashEquilibrium)

� The Cournot equilibrium says nothingabout the dynamics of the adjustmentprocess� Since both firms adjust their output, neither

output would be fixed

Chapter 12 30©2005 Pearson Education, Inc.

The Linear Demand Curve

�An Example of the Cournot Equilibrium�Two firms face linear market demand curve

�We can compare competitive equilibrium andthe 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

Chapter 12 31©2005 Pearson Education, Inc.

Oligopoly Example

� Firm 1’s Reaction Curve � MR = MC

111 )30( QQPQR −== :Revenue Total

12211

1211

30

)(30

QQQQ

QQQQ

−−=

+−=

Chapter 12 32©2005 Pearson Education, Inc.

Oligopoly Example

�An Example of the Cournot Equilibrium

12

21

11

21111

2115

2115

0

230

QQ

QQ

MCMR

QQQRMR

−=

−=

==

−−=ΔΔ=

Curve Reaction s2' Firm

Curve Reaction s1' Firm

Chapter 12 33©2005 Pearson Education, Inc.

Oligopoly Example

�An Example of the Cournot Equilibrium

1030

20

10)2115(2115

21

1

1

=−=

=+=

=−−

=

QP

QQQ

Q

QQ 2:mEquilibriu Cournot

Chapter 12 34©2005 Pearson Education, Inc.

Duopoly ExampleQ1

Q2

Firm 2’sReaction Curve

30

15

Firm 1’sReaction Curve

15

30

10

10

Cournot Equilibrium

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

Chapter 12 35©2005 Pearson Education, Inc.

Chapter 12 36©2005 Pearson Education, Inc.