Chapter 12: Monopolistic Competition, Game Theory, Dominant Strategies, IESDS

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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.
  • Graphically:
  • 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

  • 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 Curves

  • 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

  • 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.
  • Criticism
  • 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.
  • Firm1:
  • 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
  • Equilibrium
  • 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.

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