Chapter 12: Monopolistic Competition, Game Theory, Dominant Strategies, IESDS
Published 2 years ago
Published 2 years ago
12.1 Monopolistic Competition
- Monopolistic Competition – many firms with differentiated products.
- Market power depends on success in differentiating the product.
The Makings of Monopolistic Competition
- Two Key Characteristics:
- Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes.
- Cross-price elasticities of demand are large but not infinite.
- Example - Toothpaste market
- 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.
Equilibrium in the Short Run and the Long Run
- Monopolistic Competition Firms face downward-sloping demand curves – they have some monopoly power.
- Potential to attract new firms drives economic profits to zero.
- Price > MC and firm has monopoly power.
- SR: Price > AC and firm earns profits.
- LR: Profits attract new firms – demand curve shifts downward. Price = AC so firm earns zero profit despite its power.
- Profit Maximized at LR Demand tangent to firm’s AC curve.
Monopolistic Competition and Economic Efficiency
- Monopolistic Competition has two major sources of inefficiency.
- Equilibrium Price > Marginal Cost
- Value to consumers of additional units of output > cost of production.
- Thanks to monopoly power, there is deadweight loss.
- Output is Below that which Minimized Average Cost
- Zero-profit point occurs to the left of min AC because the demand curve is downward sloping.
(PC vs. Monopolistic Competition)
- Monopolistic Competition should not be regulated.
- Monopoly power is small – so DWL is small overall. Because firm’s demand curves are fairly elastic, AC is close to minimum.
- Product Diversity – consumers value the ability to choose among a wide variety of competing products and brands.
Chapter 12.2 Oligopoly
- Products may or may not be differentiated – a few firms account for most or all of total production due to barriers to entry.
- Example - automobiles, steel, aluminum, etc.
- Barriers to Entry may be caused by scale economies, patents or access to technology, and the need to spend money for name recognition and reputation.
Equilibrium in an Oligopolistic Market
- A firm sets price or output based partly on strategic considerations regarding the behaviour of its competitors.
- Competitors’ decisions depend on the first firm’s decision…
- Equilibrium - Marginal Revenue = Marginal Cost which maximizes profit.
- Nash Equilibrium – set of strategies or actions in which each firm does the best it can given its competitors’ actions.
- Duopoly – market in which two firms compete with each other.
The Cournot Model
- Oligopoly where firms produce a homogenous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce.
- Firm 1’s Output Decision graphically:
- Firm 1’s profit maximizing output depends on how much it thinks that Firm 2 produces.
- If it thinks Firm 2 produces nothing, Firm 1’s Demand Curve D1(0) is the same as the Market Demand Curve.
- If it thinks Firm 2 produces 50 units, Firm 1’s Demand Curve D1(50) is shifted to the left by 50, causing an output of 25 units.
- If it thinks Firm 2 produces 75 units, Firm 1’s Demand Curve D1(75) is shifted to the left by 50, causing an output of 12.5 units.
- If it thinks Firm 2 produces 100+ units, Firm 1 will produce nothing.
- Reaction Curve – relationship between a firm’s profit maximizing output and the amount it thinks its competitor will produce.
- The Firm’s output is a decreasing schedule of how much it thinks its competitor will produce.
- Reaction Curves and Cournot Equilibrium
- The Reaction Curve Schedule relates the firm’s output to how much it thinks its competitor will produce: Q1*(Q2) and Q2*(Q1)
- In Cournot Equilibrium, each firm correctly assumes the amount its competitor produces to thereby maximize its own profits. Neither firm moves from this equilibrium. (Intersection between Reaction Curves)
- Cournot Equilibrium – equilibrium in the Cournot Model in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.
- Found at the intersection of two reaction curves, and is an example of a Nash Equilibrium.
- Adjustment: Cournot Model says nothing about the firms’ adjustment dynamics as neither output is fixed.
- It is rational to assume fixed output if 2 firms choose their outputs only once.
The Linear Demand Curve (Example)
- Two identical firms face a linear market demand curve: P = 30 – Q
- Where Q = total production of both firms and MC = 0.
- Firm’s Total Revenue Curve:
- R1 = PQ1 = (30 – Q)Q1
- Rearranged: R1 = 30Q1 – Q12 – Q2Q1
- Firm’s Marginal Revenue
- MR1 = ΔR1/ ΔQ1 = 30 – 2Q1 – Q2
- Firm’s Reaction Curve
- Derived from setting MR1 = 0 (MR) and solving for Q1
- Firm 1’s reaction curve: Q1 = 15 – ½Q2
- Firm 2’s reaction curve: Q2 = 15 – ½Q1
- Cournot Equilibrium
- Values of Q for each firm at the intersection of the two reaction curves.
- Q1 = Q2 = 10
- Total Quantity = 20.
- Market Price: P = 30 - Q, or 10.
- Collusive Equilibrium
- Both firms collude and set outputs to max total profit, split evenly.
- R = PQ = (30 – Q)Q = 30Q – Q2
- MR = ΔR/ ΔQ = 30 – 2Q
- If MR = 0, Q = 15.
- Each firm produces half of total output, Q1 = Q2 = 7.5
- Cournot Equilibrium is better than perfect competition but not as good as collusion.
- Duopoly Graphically:
- Collusion curve shows combinations of Q1 and Q2 that maximize total profits.
- If profits are shared equally, each produces 7.5.
- Competitive Equilibrium: Price = MC and Profit = 0.
First Mover Advantage – The Stackelberg Model
- Stackelberg Model – Oligopoly model in which one firm sets its output before other firms do.
- Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its output decision.
- Firm 2’s Profit Maximizing Output
- Profit max at Cournot Reaction Curve Q2 = ½Q1
- Firm 1’s Profit Maximizing Output
- Profit max at MR = MC = 0, Firm 1 anticipates how much Firm 2 produces and knows they will choose Q2 according to the reaction curve.
- Sub Reaction Curve for Firm 2 Q2:
- R1 = 30Q1 – Q12 – Q1(15 – ½Q1)
- MR1 = ΔR1/ ΔQ1 = 15 – Q1
- Set MR = 0 to get Q1 = 15.
- Fait Accompli - Going first gives Firm 1 an advantage because no matter what the competitor does, the firm will always produce a large output.
- Competitor must take the large output level as given and set a low level of output for itself.
Oligopoly (cont’d), Factor Markets (Types of Labour Markets, Labour Demand Functions)
12.3 Price Competition
- Competition occurs along price dimensions – use Nash Equilibrium to study price competition.
Price Competition with Homogenous Products – the Bertrand Model
- Bertrand Model – oligopoly in which firms produce a homogenous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge.
- Duopoly Example: P = 30 - Q
- Q = Q1 + Q2 is total production of the homogenous good.
- MC1 = MC2 = $3
- Cournot Equilibrium: Q1 = Q2 = 9, with P = $12, so each firm makes a profit of $81.
- Simultaneously choose a price instead of quantity – consumers purchase from the lowest price seller only.
- Nash Equilibrium at Price = Marginal Cost: P = $3 for both firms due to zero profit.
- If either firm lowers price just a little, it captures the entire market and doubles its profit.
- It is more natural to compete by setting quantities rather than prices.
- We assume that sales are divided equally among the firms but there is no reason for this.
- Useful to show how the equilibrium outcome in an oligopoly can depend crucially on the firm’s choice of strategic variable.
Price Competition with Differentiated Products
- Market shares are determined by prices, as well as differences in design, performance, and durability of products.
- Example: Choosing Prices:
- Two Duopolists with Fixed Costs $20 and Variable Cost = $0
- Demand Curves: Q = 12 – 2P + P
- Both firms set prices at the same time and each firm takes its competitor’s price as fixed.
- Profit = Revenue less Fixed Costs
- π = P1Q1 – 20
- Sub in Q1 from Demand Curve: π = 12P1 – 2P12 + P1P2 - 20
- Profit Maximized depending on P2, or when incremental profit from a very small increase in its own price is zero.
- Δ π1/ Δ P1 = 12 – 4P1 + P2 = 0
- Reaction Curve found by rewriting the profit maximizing price.
- P1 = 3 + ¼P2
- Firm2: P2 = 3 + ¼P1
- Point of Intersection of the two reaction curves, with a price of $4 and profit of $12.
- Because each firm is doing the best it can given the price its competitor has set, neither firm has an incentive to change its price.
- Collusion – If both firms decide to charge the same price to maximize both of their profits, for a higher collusive equilibrium of P = $6 and profit of $16.
- If Firm 1 sets prices first, there is a first mover disadvantage because it gives the firm that moves second an opportunity to undercut and capture a larger market share.