Lecture 18: Oligopoly & Monopolistic Competition

Xiaojia Bao
WISE, Xiamen U

Fall 2013

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Review
Monopoly Output Choice: MC=MR Price is decided by the demand curve for the optimal output level. No supply curve Monopoly power: L =
P MC P 1 = E d

Social cost related from Monopoly Sources of monopoly power: elasticity of market demand; # of rms; interactions of rms Monopsony Purchasing choice: MV = ME Price is based on the supply curve

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Review

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Concepts
Monopolistic Competition Market in which rms can enter freely, each producing its own brand or version of a dierentiated product. Oligopoly Market in which only a few rms compete with one another, and entry by new rms is impeded. eg. Cola; Shampoo; Automobiles... Cartel Market in which some or all rms explicitly collude, coordinating prices and output levels to maximize joint prots. eg. OPEC

X. Bao (Xiamen U)

Monopoly Competition and Oligopoly

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Monopolistic Competition

A monopolistically competitive market has two key characteristics: Firms compete by selling dierentiated 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 innite. There is free entry and exit: it is relatively easy for new rms to enter the market with their own brands and for existing rms to leave if their products become unprotable.

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Monopoly Competition and Oligopoly

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Monopolistic Competition: Short Run

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Monopoly Competition and Oligopoly

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Monopolistic Competition: Short Run & Long Run

In the long run, entry and exit become possible.

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Monopoly Competition and Oligopoly

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Monopolistic Competition and Eciency

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Monopoly Competition and Oligopoly

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Monopolistic Competition: Examples

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Monopoly Competition and Oligopoly

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Oligopoly

In some oligopolistic markets, some or all rms earn substantial prots over the long run because barriers to entry make it dicult or impossible for new rms to enter. Oligopoly is a prevalent form of market structure. Examples include automobiles, steel, aluminum, petrochemicals, electrical equipment, and computers.

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Oligopoly

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Oligopoly: Equilibrium

When a market is in equilibrium, rms are doing the best they can and have no reason to change their price or output. Nash Equilibrium Equilibrium in oligopoly markets where each rm will want to do the best it can given what its competitors are doing, and these competitors will do the best they can given what that rm is doing. Duopoly Market in which two rms compete with each other.

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Oligopoly

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Cournot Model
Cournot Model Assumptions: rms produce a homogeneous good; Each rm treats the output of its competitors as xed; All rms decide simultaneously how much to produce.

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Oligopoly

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Cournot Model (continue)

Reaction Curve Relationship between a rms prot-maximizing output and the amount it thinks its competitor will produce. Cournot equilibrium: Interaction points of two reactions curves.

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Oligopoly

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Cournot: Example
Duopolists face the following market demand curve: P = 30 Q . Also, MC1 = MC2 = 3 Total Revenue for company 1: TR1 = PQ1 = (30 Q1 Q2 )Q1 Prot for company 1: 1 = TR1 TC1 = (27 Q1 Q2 )Q1 First Order Condition:
dTR1 dQ1

= 27 Q2 2Q1 = 0
27Q2 2 27Q1 2 27Q2 2 :

Reaction curve for company 1: Q1 = Cournot Equilibrium: plug Q2 =

27Q1 2

Similarly, we can get company 2s reaction curve: Q2 = in Q1 =

Q1 = Q2 =9

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Oligopoly

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Compare Cournot equilibrium with other results

Optimization FOC Q1 = Q2 P1 = P2 1 = 2

Collusion Max
d (P 3)Q dQ

Monopolistic Comptt. =0 13.5 3 0

Cournot E. Max 1 and 2

d (P 3)Q1 dQ1

=0

=0

6.75 16.5 91.125

9 12 81

Note: Assume the xed cost for both companies are 0.

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Oligopoly

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Compare Cournot equilibrium with other results

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Oligopoly

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First Mover Advantage-The Stackelberg Model

Stackelberg Model Oligopoly model in which one rm sets its output before other rms do.
Suppose Firm 1 sets its output rst and then Firm 2, after observing Firm 1s output, makes its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react. P = 30 Q . Also, MC1 = MC2 = 0. Firm 2s reaction curve: Q2 =
30Q1 2

After predicting rm 2s move, rm 1s optimization: Max 1 = TR1 = PQ1 = (30 Q1 Q2 )Q1 30 Q1 )Q1 = (30 Q1 2 FOC: 15 Q1 = 0 So: Q1 = 15, Q2 = 7.5 Firm 1 produces twice as much as Firm 2 and makes twice as much prot. Going rst gives Firm 1 an advantage.
X. Bao (Xiamen U) Oligopoly 16/30

Bertrand Model: Price competition with homogenous goods

Bertrand model Oligopoly model in which each rm treats the price of its competitors as xed, and all rms decide simultaneously what price to charge. Nash equilibrium in the Bertrand model results in both rms setting price equal to marginal cost: P1 = P2 = 3. Then industry output is 27 units, of which each rm produces 13.5 units, and both rms earn zero prot.

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Oligopoly

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Price Competition with Dierentiated Products

Suppose each of two duopolists has xed costs of $20 but zero variable costs, and that they face the same demand curves: Firm 1s demand: Q1 = 12 2P1 + P2 Firm 2s demand: Q2 = 12 2P2 + P1 Choosing Prices: Firm 1s prot: 1 = P1 Q1 20 = P1 (12 2P1 + P2 ) 20 Firm 1s FOC:
d 1 dP1

= 12 + P2 4P1 = 0
12+P2 4 12+P1 4

Firm 1s reaction curve: P1 = In the equilibrium: P1 = P2 = 4

Similarly, Firm 2s reaction curve: P2 =

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Oligopoly

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Bertrand Model with Dierentiated Products

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Oligopoly

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Competition vs. Collusion

Prisoners Dilemma

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Oligopoly

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Price Competition: Example

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Oligopoly

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Price Competition: Example

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Oligopoly

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Oligopolistic Pricing

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Oligopolistic Pricing

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Oligopolistic Pricing

Price Rigidity Characteristic of oligopolistic markets by which rms are reluctant to change prices even if costs or demands change. Kinked Demand Curve Model Oligopoly model in which each rm faces a demand curve kinked at the currently prevailing price: at higher prices demand is very elastic, whereas at lower prices it is inelastic.

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Oligopolistic Pricing

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Price Signaling and Price Leadership

Price Signaling Form of implicit collusion in which a rm announces a price increase in the hope that other rms will follow suit. Price Leadership Pattern of pricing in which one rm regularly announces price changes that other rms then match.

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Oligopolistic Pricing

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The Dominant Firm Model

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Oligopolistic Pricing

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The Dominant Firm Model

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Oligopolistic Pricing

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Cartels
Producers in a cartel explicitly agree to cooperate in setting prices and output levels.

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Cartels

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Cartel: NCAA

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Cartels

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Cartel: Milk

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Cartels

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