Chapter 12

1. Chapter 12 Monopolistic Competition and Oligopoly

2. Monopolistic Competition • Characteristics 1) Many firms 2) Free entry and exit 3) Differentiated product Chapter 12

3. Monopolistic Competition • The amount of monopoly power depends on the degree of differentiation. • Examples of this very common market structure include: • Toothpaste • Soap • Cold remedies Chapter 12

4. MC MC AC AC PSR PLR DSR DLR MRSR MRLR QSR QLR A Monopolistically CompetitiveFirm in the Short and Long Run $/Q $/Q Short Run Long Run Quantity Quantity

5. Deadweight loss MC AC MC AC P PC D = MR DLR MRLR QC QMC Comparison of Monopolistically CompetitiveEquilibrium and Perfectly Competitive Equilibrium Monopolistic Competition Perfect Competition $/Q $/Q Quantity Quantity

6. Oligopoly • Characteristics • Small number of firms • Product differentiation may or may not exist • Barriers to entry Chapter 12

7. Oligopoly • The barriers to entry are: • Natural • Scale economies • Patents • Technology • Name recognition Chapter 12

8. Oligopoly • The barriers to entry are: • Strategic action • Flooding the market • Controlling an essential input Chapter 12

9. Oligopoly • Management Challenges • Strategic actions • Rival behavior • Question • What are the possible rival responses to a 10% price cut by Ford? Chapter 12

10. Oligopoly • Equilibrium in an Oligopolistic Market • In perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price. • In oligopoly the producers must consider the response of competitors when choosing output and price. Chapter 12

11. Oligopoly • Equilibrium in an Oligopolistic Market • Defining Equilibrium • Firms do the best they can and have no incentive to change their output or price • All firms assume competitors are taking rival decisions into account. Chapter 12

12. Oligopoly • Nash Equilibrium • Each firm is doing the best it can given what its competitors are doing. Chapter 12

13. Oligopoly • The Cournot Model • Duopoly • Two firms competing with each other • Homogenous good • The output of the other firm is assumed to be fixed • Firms decide simultaneously how much to produce Chapter 12

14. If Firm 1 thinks Firm 2 will produce nothing, its demand curve, D1(0), is the market demand curve. D1(0) If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount. If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. MR1(0) D1(75) MR1(75) MC1 MR1(50) D1(50) 12.5 25 50 Firm 1’s Output Decision P1 Q1 Chapter 12

15. Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous example. Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Firm 2’s Reaction Curve Q2*(Q1) In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits. x Cournot Equilibrium x Firm 1’s Reaction Curve Q*1(Q2) x x Reaction Curves and Cournot Equilibrium Q1 100 75 50 25 Q2 25 50 75 100 Chapter 12

16. Oligopoly • Questions 1) If the firms are not producing at the Cournot equilibrium, will they adjust until the Cournot equilibrium is reached? 2) When is it rational to assume that a competitor’s output is fixed? Chapter 12

17. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium • Duopoly • Market demand is P = 30 - Q where Q = Q1 + Q2 • MC1 = MC2 = 0 Chapter 12

18. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium • Firm 1’s Reaction Curve Chapter 12

19. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium Chapter 12

20. Oligopoly The Linear Demand Curve • An Example of the Cournot Equilibrium Chapter 12

21. 30 Firm 2’s Reaction Curve Cournot Equilibrium 15 10 Firm 1’s Reaction Curve 10 15 30 Duopoly Example Q1 The demand curve is P = 30 - Q and both firms have 0 marginal cost. Q2 Chapter 12

22. Oligopoly Profit Maximization with Collusion Chapter 12

23. Oligopoly Profit Maximization with Collusion • Contract Curve • Q1 + Q2 = 15 • Shows all pairs of output Q1 and Q2 that maximizes total profits • Q1 = Q2 = 7.5 • Less output and higher profits than the Cournot equilibrium Chapter 12

24. Firm 2’s Reaction Curve For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium Competitive Equilibrium (P = MC; Profit = 0) 15 Cournot Equilibrium Collusive Equilibrium 10 7.5 Firm 1’s Reaction Curve Collusion Curve 7.5 10 15 Duopoly Example Q1 30 Q2 30 Chapter 12

25. First Mover Advantage--The Stackelberg Model • Assumptions • One firm can set output first • MC = 0 • Market demand is P = 30 - Q where Q = total output • Firm 1 sets output first and Firm 2 then makes an output decision Chapter 12

26. First Mover Advantage--The Stackelberg Model • Firm 1 • Must consider the reaction of Firm 2 • Firm 2 • Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = 15 - 1/2Q1 Chapter 12

27. First Mover Advantage--The Stackelberg Model • Firm 1 • Choose Q1so that: Chapter 12

28. First Mover Advantage--The Stackelberg Model • Substituting Firm 2’s Reaction Curve for Q2: Chapter 12

29. First Mover Advantage--The Stackelberg Model • Conclusion • Firm 1’s output is twice as large as firm 2’s • Firm 1’s profit is twice as large as firm 2’s • Questions • Why is it more profitable to be the first mover? • Which model (Cournot or Stackelberg) is more appropriate? Chapter 12