Microeconomics
Claudia Vogel
EUV
Winter Term 2009/2010
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Winter Term 2009/2010
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Monopolistic Competition and Oligopoloy
Lecture Outline
Part III Market Structure and Competitive Strategy
12
Monopolistic Competition and Oligopoloy
Monopolistic Competition
Oligopoly
Cartels
Summary
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Microeconomics
Monopolistic Competition and Oligopoloy
Monopolistic Competition and Oligopoly
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 ine another, and
entry by new rms is impeded.
cartel: Market in which some or all rms explicitly collude, coordinating
prices and output levels to maximize joint prots.
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Microeconomics
Monopolistic Competition and Oligopoloy
Winter Term 2009/2010
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Monopolistic Competition
Monopolistic Competition
A monopolistically competitive market has two key characteristics:
1
2
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 brand and for existing rms to leave if their products
become unprotable.
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Microeconomics
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Monopolistic Competition and Oligopoloy
Monopolistic Competition
Equilibrium in Monopolistic Competition
In the long run, these prots attract new rms with competing brands. Therefore
in long-run equilibrium (b) price equals average cost, so the rm earns zero prot
even though it has monopoly power.
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Microeconomics
Monopolistic Competition and Oligopoloy
Winter Term 2009/2010
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Monopolistic Competition
Monopolistic Competition and Economic Eciency
In both types of markets, entry occurs until prots are driven to zero.
In evaluating monopolistic competition, these ineciencies must be balanced
against the gains to consumers from product diversity.
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Microeconomics
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Monopolistic Competition and Oligopoloy
Monopolistic Competition
Example: Monopolistic Competition in the Markets for
Colas and Coee
Elasticities of Demand for Brands of Colas and Coee
Brand
Elasticity of Demand
Colas
Royal Crown
-2.4
Ground coee
Coke
Folgers
Maxwell House
Chock Full o'Nuts
-5.2 to -5.7
-6.4
-8.2
-3.6
With the expection of Royal Crown and Chock Full o'Nuts, all colas and coees
are quite price elastic. With elasticities on the order of -4 to -8, each brand has
only limited monopoly power. This is typical of monopolistic competition.
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Microeconomics
Monopolistic Competition and Oligopoloy
Winter Term 2009/2010
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Oligopoly
Oligopoly
In oligopolistic markets, the products may or may not be dierentiated. What
matters is that only a few rms account for most or all of total production.
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.
Nash equilibrium
Equilibrium in oligopoly markets means that each rm will want to do the best it
can given what its competitiors are doing, and these competitors will do the best
they can given what rm is doing. When a market is in equilibrium, rms are
doing the best they can and have no reason to change their price or output.
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Microeconomics
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Monopolistic Competition and Oligopoloy
Oligopoly
The Firm's Output Decision
duopoly: Market in which two rms
compete with each other.
Cournot model: Oligopoly model
in which rms produce a
homogeneous good, each rm treats
the output of its competitors as
xed, and all rms decide
simultaneously how much to
produce.
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Microeconomics
Monopolistic Competition and Oligopoloy
Winter Term 2009/2010
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Oligopoly
The Cournot Model
reaction curve: Relationship
between a rm's prot-maximizing
output and the amount it thinks its
competitor will produce.
Cournot equilibrium: Equilibrium
in the Cournot model in which each
rm correctly assumes how much its
competitor will produce and sets its
own production level accordingly.
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Microeconomics
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Monopolistic Competition and Oligopoloy
Oligopoly
The Linear Demand Curve - An Example 1/3
Duopolists face the following market demand curve P = 30 − Q (Q = Q1 + Q2 )
Also, MC1 = MC2 = 0
Total revenue for rm 1: R1 = PQ1 = (30 − Q ) Q1
4R1
then MR1 = 4
Q1 = 30 − 2Q1 − Q2
Setting MR1 = 0 (the rm's marginal cost) and solving for Q1 , we nd
Firm 1's reaction curve: Q1 = 15 − 12 Q2
By the same calculation, Firm 2's reaction curve: Q2 = 15 − 12 Q1
Cournot equilibrium: Q1 = Q2 = 10
Total quantity produced: Q = Q1 + Q2 = 20
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Winter Term 2009/2010
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Oligopoly
The Linear Demand Curve - An Example 2/3
If the two rms collude, then the total prot-maximizing quantity can be obtained
as follows:
Total revenue for the two rms: R = PQ = (30 − Q ) Q = 30Q − Q 2
4R
then MR = 4
Q = 30 − 2Q
Setting MR = 0 (the rm's marginal cost) we nd that total prot is maximized
at Q=15.
Then, Q1 + Q2 = 15 is the collusion curve.
If the rms agree to share prots equally, each will produce half of the total
output: Q1 = Q2 = 7.5
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Microeconomics
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Monopolistic Competition and Oligopoloy
Oligopoly
The Linear Demand Curve - An Example 3/3
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Oligopoly
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 1's
output, makes its output decision. In setting output, Firm 1 must therefore
consider how Firm 2 will react.
P = 30 − Q
(Q = Q1 + Q2 )
MC1 = MC2 = 0
Firm 2's reaction curve: Q2 = 15 − 12 Q1
Firm 1's revenue: R1 = PQ1 = 30Q1 − Q12 − Q1 Q2 = 15Q1 − 12 Q12
4R1
And MR1 = 4
Q1 = 15 − Q1
Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5
We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as
much prot. Going rst gives Firm 1 an advantage.
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Microeconomics
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Monopolistic Competition and Oligopoloy
Oligopoly
Price Competition - The Bertrand Model
Bertrand model: Oligopoly model in which rms produce a homogeneous
good, each rm treats the price of its competitors as xed, and all rms
decide simultaneously what price to charge.
P = 30 − Q
(Q = Q1 + Q2 )
MC1 = MC2 = $3
Q1 = Q2 = 9, and in Cournot equilibrium, the market price is $12, so that each
rm makes a prot of $81.
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.
In the Cournot model, because each rm produces only 9 units, the market price
is $12. Now the market price is $3. In the Cournot model, each rm made a
prot; in the Bertrand model, the rms price at marginal cost and make no prot.
Claudia Vogel (EUV)
Microeconomics
Monopolistic Competition and Oligopoloy
Winter Term 2009/2010
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Oligopoly
Price Competition with Dierentiated Products 1/2
Suppose each of two duopolists has xed costs of $20 but zero variable costs, and
that they face the same market demand curves:
Firm 1's demand: Q = 12 − 2P1 + P2
Firm 2's demand: Q = 12 − 2P2 + P1
Choosing Prices
Firm 1's prot: π1 = P1 Q1 − 20 = 12P1 − 2P12 + P1 P2 − 20
Firm 1's prot maximizing price:
4π1
4P1
= 12 − 4P1 + P2 = 0
Firm 1's reaction curve: P1 = 3 + 14 P2
Firm 2's reaction curve: P2 = 3 + 14 P1
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Microeconomics
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Monopolistic Competition and Oligopoloy
Oligopoly
Price Competition with Dierentiated Products 2/2
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Winter Term 2009/2010
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Oligopoly
Competition versus Collusion: The Prisoners' Dilemma
In our example, there are two rms, each of which has xed cost of $20 and zero
variable costs. They face the demand curves:
Firm 1's demand: Q = 12 − 2P1 + P2
Firm 2's demand: Q = 12 − 2P2 + P1
We found that in Nash equilibrium each rm will charge a price of $4 and earn a
prot of $12, whereas if the rms collude, they will charge a price of $6 and earn
a prot of $16.
But if Firm 1 charges $6 and Firm 2 charges $4, Firm 2's prot will increase to
$20. And it will do so at the expense of Firm 1's prot, which will fall to $4.
Firm 2
Firm 1 charge $4
charge $6
Claudia Vogel (EUV)
charge $4
$12, $12
$4, $20
Microeconomics
charge $6
$20, $4
$16, $16
Winter Term 2009/2010
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Monopolistic Competition and Oligopoloy
Cartels
Analysis of Cartel Pricing
Producers in a cartel explicitly agree to cooperate in setting prices and output
levels.
The CIPEC Copper Cartel
The OPEC Oil Cartel
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Summary
Summary 1/2
In a monopolistically competitive market, rms compete by selling
dierentiated products, which are highly substituable. New rms can enter or
exit easily. Firms have only a small amount of monopoly power. In the long
run, entry will occur until prots are driven to zero. Firms then produce with
excess capacity (i.e., at output levels below those that minimize average
cost).
In an oligopolistic market, only a few rms account for most or all
production. Barriers to entry allow some rms to earn substantial prots,
even over the long run. Economic decisions involve strategic considerations each rm must consider how its actions will aect its rivals, and how they are
likely to react.
In the Cournot model of oligopoly, rms make their output decisions at the
same time, each taking the other's output as xed. In equilibrium, each rm
is maximizing its prot given the output of its competitor, so no rm has an
incentive to change its output. The rms are therefore in a Nash equilibrium.
Each rm's prot is higher than it would be under perfect competition but
less than what it would earn by colluding.
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Microeconomics
Winter Term 2009/2010
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Monopolistic Competition and Oligopoloy
Summary
Summary 2/2
In the Stackelberg model, one rm sets its output rst. That rm has a
strategic advantage and earns higher prot. It knows it can choose a large
output and that its competitors will have to choose small outputs if they
want to maximize prots.
Firms would earn higher prots by collusively agreeing to raise prices, but the
antitrust laws usually prohibit this. They might all set a high price without
colluding, each hoping its competitors will do the same, but they are in a
prisoners' dilemma, which makes this unlikely. Each rm has an incentive to
cheat by lowering its price and capturing sales from competitors.
In a cartel, producers explicitely collude in setting prices and output levels.
Successful cartelization requires that the total demand not be very price
elastic, and that either the cartel control most supply or else the supply of
noncartel producers be inelastic.
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Microeconomics
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Exerxises 10
Problem 1
1
2
3
4
5
What are the characteristics of a monopolistically competitive market? What
happens to the equilibrium price and quantity in such a market if one rm
introduces a new, improved product?
Why is the Cournot equilibrium stable? (i.e. Why don't rms have any
incentive to change their output levels once in equilibrium?) Even if they
can't collude, why don't rms set their outputs at the joint prot-maximizing
levels (i.e., the levels they would have chosen had they colluded)?
In the Stackelberg model, the rm that sets output rst has an advantage.
Explain why.
What do the Cournot and Bertrand models have in common? What is
dierent about the two models?
Why has the OPEC oil cartel succeeded in raising prices substantially while
the CIPEC copper cartel has not? What conditions are necessary for
successful cartelization? What organizational problems must a cartel
overcome?
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Exerxises 10
Problem 2
A monopolist can produce at a constant average (and marginal) cost of
AC=MC=$5. It faces a market demand curve given by Q = 53 − P .
1
Calculate the prot-maximizing price and quantity for this monopolist. Also
calculate its prots.
2
Suppose a second rm enters the market. Let Q1 be the output of the rst
rm and Q2 be the output of the second. Market demand is now given by
Q1 + Q2 = 53 − P . Assuming that this second rm has the same costs as the
rst, write the prots of each rm as functions of Q1 and Q2 .
3
Suppose (as in the Cournot model) that each rm chooses its
prot-maximizing level of output on the assumption that its competitor's
output is xed. Find each rm's reaction curve.
4
Calculate the Cournot equilibrium. What are the resulting market price and
prots of each rm?
5
Suppose Firm 1 is the Stackelberg leader (i.e., makes its output decisions
before Firm 2). Find the reaction curves that tell each rm how much to
produce in terms of the output of its competitor.
6
How much will each rm produce, and what will its prot be?
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Microeconomics
Winter Term 2009/2010
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Exerxises 10
Problem 3
Suppose that two identical rms produce widgets and that the are the only rms
in the market. Their costs are given by C1 = 60Q1 and C2 = 60Q2 , where Q1 is
the output of Firm 1 and Q2 the output of Firm 2. Price is determined by the
following demand curve: P = 300 − Q where Q = Q1 + Q2 .
1
Find the Cournot equilibrium. Calculate the prot of each rm at this
equilibrium.
2
Suppose the two rms form a cartel to maximize joint prots. How many
widgets will be produced. Calculate each rm's prot.
3
Suppose Firm 1 were the only rm in the industry. How would market output
and Firm 1's prot dier from that found in part (2) above?
4
Returning to the duopoly of part (2), suppose Firm 1 abides by the
agreement, but Firm 2 cheats by increasing production. How many widgets
will Firm 2 produce? What will be each rm's prots?
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Microeconomics
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Exerxises 10
Problem 4
Two rms compete by choosing price. Their demand functions are
Q1 = 20 − P1 + P2 and Q2 = 20 + P1 − P2 , where P1 and P2 are the prices
charged by each rm, respectively, and Q1 and Q2 are the resulting demands.
Note that the demand for each good depends only on the dierence in prices; if
the two rms colluded and set the same price, they could make that price as high
as they wanted, and , and earn innite prots. Marginal costs are zero.
1
Suppose the two rms set their prices at the same time. Find the resulting
equilibrium. What price will each rm charge, how much will it sell, and what
will its prot be? (Hint: Maximize the prot of each rm with respect to its
price.)
2
Suppose Firm 1 sets its price rst and the Firm 2 sets its price. What price
will each rm charge, how much will it sell, and what will its prot be?
3
Suppose you are one of these rms and that there are three ways you could
play the game: (i) Both rms set price at the same time; (ii) You set price
rst; or (iii) Your competitor sets price rst. If you could choose among these
options, which would you prefer? Explain why.
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