Unit 12 Monopolistic competition and Oligopoly
Outcomes • Define and explain monopolistic competition • Define and explain oligopoly market structures • Define and explain price competition • Describe difference between competition and collusion • Discuss oligopolistic pricing
Monopolistic competition • Monopolistic competition: • Market in which firms can enter freely, • Each producing it’s own brand or version • Of a differentiated product.
Monopolistic competition • Two key characteristics: • Firms compete by selling differentiated products which is highly substitutable but not perfect substitutes. • There is free entry and exit. • When market is in equilibrium, firms are doing their best and have no reason to change their price or output
SR and LR equilibrium
Monopolistic competition and economic efficiency • Perfect competitive market are desirable because = economic efficient. • Monopolistic competition is similar. • Two source of inefficiency in monopolistic competition: • Equilibrium price > MC: Value exceeds cost • Output below minimizing average cost: Excess capacity is inefficient.
Monopolistic competition and economic efficiency • Inefficiencies make consumers worse off: • Should this market be regulated? No, why: • Monopoly power is small. • Important benefit: Product diversity. Consumers value to choose between a wide variety.
Monopolistic competition and economic efficiency
Oligopoly • Market in which only a few firms compete with one another, and entry by new firm is impeded.
Oligopoly • Behaviour of other firms always taken into account. • Barriers to entry: Difficult or impossible for new firms to enter. • If just 2 firms = Duopoly • For our purpose, only focus on duopolies: One competitor to worry about.
Equilibrium in oligopoly • Equilibrium where MR=MC • Nash Equilibrium: Set of strategies or actions in which each firm does the best it can given its competitors’ action. • And so will the competitor do the best they can.
The Cournot model • Simple model of duopolies introduced by Augustin Cournot. • Firms produce homogenous goods • Know the market demand curve • Each firm must decide how much to produce • Two firms make their decision at the same time • Take competitor into account
Cournot model • Essence of model: • Level of output for competitor fixed • When deciding how much to produce • Reaction curve: Relationship between a firm’s profit maximizing output and the amount it thinks its competitor will produce. • Cournot equilibrium: Each firm correctly assumes how much its competitor will produce and sets its own production level accordingly
Firm 1’s output decisions
The Cournot model
The Stackelberg model- First mover advantage • First assumed: Duopolist make output decision at the same time. • Stackelberg model: Oligopoly module in which one firm sets its output before other firms do. • See example page 455 • Cournot and Stackleberg models are alternative representations of oligopolistic behaviors
Oligopoly: Setting the price- Price competition • Oligopolistic firms compete by setting quantities. • But, it can occur along price discrimination. • Nash equilibrium used to study price competition. • First in a industry producing homogeneous products, • Second, in a industry with some degree of product differentiation.
Price competition with homogeneous products • The Bertrand Model: • Oligopoly model • In which firms produce a homogenous good • Each firm treats the price of it’s competitors as fixed • All firms decide simultaneously what price to charge.
Bertrand model • Firms choose price instead of quantity. • Will dramatically affect market outcome. • View example on page 458 • Firm price at MC and make no profit!
Bertrand model • Criticism: • More natural to compete by setting quantities rather than price, as with a homogeneous good. • If firms do set prices and choose the same price, what share of total sales will go to each one? • Useful: • Shows how equilibrium output in oligopolies can depend crucially on the firms’ choice of strategic variable.
Price competition with differentiated products • Some degree of product differentiation. • Example: Gas station differs in location and service provided. • Market share not only determined by price but also differences in: • Design • Performance • Durability Natural for firm to compete on price!
Price competition with differentiated products • Simple example on page 458
Competition vs. Collusion:- The prisoner’s dilemma • Nash equilibrium = non-cooperative equilibrium: • Each firm makes the decisions that give it the highest possible profit, • given the actions of competitors • Non-cooperative game: Game in which negotiation and enforcement of binding contracts are not possible. • Collusion = Illegal: Coordinate prices and output levels to maximize joint profits = Cartel
Competition vs. Collusion:- The prisoner’s dilemma • Cooperation higher profits: Why not cooperate without explicitly colluding? • Set a price and hope competitor set the same price! • Problem: Competitor will not choose to set price at same level. Will do better by setting lower price. • See example page 461
Competition vs. Collusion:- The prisoner’s dilemma Table showing profit/payoff to each firm given its decision and decision of competitor Game theory example in which 2 prisoners must decide separately whether to confess to a crime. Confess = Lighter sentence and accomplice heaver sentence
Competition vs. Collusion:- The prisoner’s dilemma • Oligopolistic firm often find themselves in a prisoner’s dilemma. • Compete aggressively, gain market share, or • Compete passively, coexist with competitor and settle for market share. • Implicitly collude!
Implications of the prisoners’ dilemma for oligopolistic pricing • Firms price over and over again. • Continually observe competitors. • And adjust! • Competitors can develop mistrust if one firm ‘rocks the boat’ – by changing price or increase advertising.
Price rigidity • Definition: • Firms are reluctant to change prices even if costs or demand change • Basis for the kinked demand curve model: • Oligopoly model • Each firm faced a demand curve kinked at prevailing price • At higher price demand is elastic and vice versa
Kinked demand curve
Price signaling and price leadership • Price signaling: • Form of implicit collusion • Firm announces a price • Increase in the hope that other firms will follow suit • Price leadership: • Pattern of pricing • In which one firm • Regularly announces price changes • That other firms then match
The dominant firm model • Definition: • Firm with a large share of total sales • That sets price to maximize profits • Taking into account the supply response of smaller firms.
The dominant firm model
Cartels • Explicit agree to cooperate by setting price and output levels. • Often international – law poorly enforced. • OPEC cartel = international agreement. • Conditions for success: • Stable cartel organization must be formed, members agree on price and production levels, and must adhere to agreement. • Potential monopoly power.
Cartel
