Chapter 12 Slide 1 4 market structures nHomogenous products oligopoly markets = a small number of firms, homogenous product nDominant firm markets – one firm possesses a large share of the market but competes against numerous small firms, each offering identical products nDifferentiated products oligopoly markets - a small number of firms sell products that are substitutes for each other but also differ from each other in significant ways, including attributes, performance, packaging, and image. nMonopolistic competition - a market in which many firms produce differentiated products that are sold to many buyers Chapter 12 Slide 2 Oligopoly nCharacteristics lSmall number of firms lProduct differentiation may or may not exist lBarriers to entry nExamples: Automobiles, Steel, Aluminum, Petrochemicals, Electrical equipment, Computers Chapter 12 Slide 3 Oligopoly nBarriers to entry include: lScale economies; Patents; Technology; Name recognition lStrategic action: Flooding the market; Controlling an essential input nManagement Challenges lStrategic actions lRival behavior l l Chapter 12 Slide 4 THE COURNOT MODEL OF OLIGOPOLY lFirst model created in 1838 lpertains to a homogeneous products oligopoly lduopoly market: a market in which there are just two firms with identical marginal costs => firms charge the same price lThe firms select their output simultaneously, non-cooperatively (market is organized competitively) - The only decision each firm needs to make is how much to produce. lAim of maximazing the profit lThe output of other firm is fixed when decising => firms thus act as quantity takers leach firm selects a quantity to produce, and the resulting total output determines the market price (each firm’s output choice depends on the market price, but the market price depends on the combined output of the two firms) l l Chapter 12 Slide 5 Price Determination and Profit Maximization in the Cournot Model residual demand curve – the curve that traces out the relationship between the market price and a firm’s quantity when rival firms hold their outputs fixed. Samsung will choose the level of production that maximizes its profits, given what it thinks LG’s output will be, and LG will choose the level of production that maximizes its profits, given what output it thinks Samsung will produce Chapter 12 Slide 6 Cournot Reaction Functions and Equilibrium best response= A firm’s profit-maximizing choice of output given the level of output by rival firms. RS is Samsung’s reaction function. RLG is LG’s reaction function. Point E, where the two reaction functions intersect, is the Cournot equilibrium. Points A and B on RS represent the best responses for Samsung if LG produces 20 units and 50 units, respectively; each firm’s profit-maximizing output choice becomes smaller as its rival produces more output Chapter 12 Slide 7 Equilibrium in a Cournot Market = An equilibrium in an oligopoly market in which each firm chooses a profit-maximizing output given the output chosen by other firms = neither firm has any regret about its output choice lREMEMBER - The Cournot theory is a static model of oligopoly => It does not explain how the firms arrive at the output choices corresponding to the Cournot equilibrium l l Chapter 12 Slide 8 Equilibrium in a Cournot Market The market demand curve DM is given by P= 100 - Q1 - Q2, where Q1 is the amount of output Samsung produces and Q2 is LG’s level of output. The marginal cost of each firm is $10. a)Given this market demand curve, what is Samsung’s profit-maximizing quantity when LG produces 50 units? b)What is Samsung’s profit-maximizing output when LG produces an arbitrary output Q2 (i.e., what is the equation of Samsung’s reaction function)? c)Compute the Cournot equilibrium quantities and price in this market. l Chapter 12 Slide 9 Cournot Equilibrium versus Monopoly Equilibrium If Samsung and LG behave as a profit-maximizing cartel (monopoly) they will produce a total of 45 units. Splitting this equally gives each an output of 22.5. The cartel or monopoly quilibrium, point M, thus differs from the Cournot equilibrium, point E. Chapter 12 Slide 10 THE BERTRAND MODEL OF OLIGOPOLY leach firm selects a price and stands ready to meet all the demand for its product (once firms choose their prices, they will then adjust their production to satisfy all of the demand that comes their way). lIf firms produce identical products, the firm that sets the lowest price captures the entire market demand, and the other firms sell nothing. lBertrand equilibrium= An equilibrium in which each firm chooses a profit-maximizing price given the price set by other firms. las long as both firms set prices that exceed their common marginal cost, one firm can always increase its profits by slightly undercutting its competitor => This implies that the only possible equilibrium in the Bertrand model is achieved when each firm sets a price equal to its MC lthe Bertrand equilibrium with two firms results in the same outcome as a perfectly competitive market with a large number of firms l Chapter 12 Slide 11 Bertrand Price Competition If LG’s price is $40, Samsung’s demand curve is the broken line DS. By setting a price of $39, Samsung can increase its profit by area B minus area A. This tells us that each firm charging a price of $40, with each producing 30 units, is not the Bertrand Equilibrium. Chapter 12 Slide 12 Differences between CM and BM lIn CM, the PE > MC, and the Cournot equilibrium approaches the PC equilibrium only as the number of competitors in the market becomes large – in contrast in BM competition between even two firms is enough to replicate PC equilibrium lCM as a long-run capacity competition vs. BM as a short-run price competition when both firms have more than enough capacity to satisfy market demand at any price greater than or equal to MC lThe Cournot firm takes its competitors’ outputs as given and assumes that its competitors will instantly match any price change the firm makes so that they can keep their sales volumes constant (competitors behave less aggressively than Bertrand competitors). l l Chapter 12 Slide 13 THE STACKELBERG MODEL OF OLIGOPOLY lin some situations, it might be more natural to assume that one firm chooses its quantity before the other firms make their choices. lThis model is a situation in which one firm acts as a quantity leader, choosing its quantity first, with all other firms acting as followers. lThe follower, observes the quantity Q1 chosen by the leader and chooses a profit-maximizing response to this quantity. Follower profit-maximizing response to any Q1 selected by leader is given by follower reaction function from the Cournot model. l l l Chapter 12 Slide 14 The Stackelberg Model and the Follower’s Profit Maximization The line RLG is LG’s reaction function. The table in the upper right-hand corner shows the market price and Samsung’s profits at various points along this reaction function. In the Stackelberg model, the leader (Samsung) chooses the point on the reaction function of the follower (LG) that makes the leader’s profits as high as possible. This occurs at point S. Chapter 12 Slide 15 DOMINANT FIRM MARKETS lsingle company with an overwhelming share of the market — what economists call a dominant firm— competes against many small producers, each of whom has a small market share lA model of price setting by a dominant firm which sets the market price and splits the market demand with a group of small firms that constitute the industry’s competitive fringe (fringe firms produce identical products and act as perfect competitors: each chooses a quantity of output, taking the market price as given) lThe dominant firm’s problem is to find a price that maximizes its profits, taking into account how that price affects the competitive fringe’s supply => dominant firm’s residual demand curve DR, which will tell us how much the dominant firm can sell at different prices lThe dominant firm finds its optimal quantity and P by equating the MRR associated with the residual demand curve to its MC lthe dominant firm creates a price umbrella that allows some fringe firms to operate profitably l l Chapter 12 Slide 16 Dominant Firm Market The dominant firm’s residual demand curve DR is the horizontal difference between the fringe’s supply curve SF and the market demand curve DM. The dominant firm’s profit-maximizing quantity is 50 units, and its profit-maximizing price is $50 per unit. At this price, the fringe supplies 25 units. Chapter 12 Slide 17 Dominant Firm Market When the Size of the Competitive Fringe Grows When the size of the fringe grows, the fringe’s supply curve rotates rightward to S´F (the fringe supplies more at a given price). causing the residual demand curve to rotate leftward to D´R. The new profit-maximizing quantity for the dominant firm is 50 units, and the profit-maximizing price is $42. At this price, the fringe supplies 33 units of the total market demand of 83 units. Chapter 12 Slide 18 Oligopoly nEquilibrium in an Oligopolistic Market lIn perfect competition, monopoly, and monopolistic competition the producers did not have to consider a rival’s response when choosing output and price. lIn oligopoly the producers must consider the response of competitors when choosing output and price. Chapter 12 Slide 19 Oligopoly nEquilibrium in an Oligopolistic Market lDefining Equilibrium uFirms do the best they can and have no incentive to change their output or price uAll firms assume competitors are taking rival decisions into account. nNash Equilibrium lEach firm is doing the best it can given what its competitors are doing. Chapter 12 Slide 20 Firm 2’s Reaction Curve Q2*(Q1) Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Reaction Curves and Cournot Equilibrium Q2 Q1 25 50 75 100 25 50 75 100 Firm 1’s Reaction Curve Q*1(Q2) x x x x 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. In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximizes its own profits. Cournot Equilibrium Chapter 12 Slide 21 Monopolistic Competition nCharacteristics n 1) Many firms n 2) Free entry and exit n 3) Differentiated product (but high degree of substitutability) nThe amount of monopoly power depends on the degree of differentiation. nExamples of this common market structure include: lToothpaste; Soap; Cold remedies; Soft Drinks; Coffee A Monopolistically Competitive Firm in the Short and Long Run Quantity $/Q Quantity $/Q MC AC MC AC DSR MRSR DLR MRLR QSR PSR QLR PLR Short Run Long Run Chapter 12 Slide 23 nObservations (short-run) lDownward sloping demand - differentiated product lDemand is relatively elastic - good substitutes lMR < P lProfits are maximized when MR = MC lThis firm is making economic profits Monopolistic Competition in the SR Chapter 12 Slide 24 nObservations (long-run) lProfits will attract new firms to the industry (no barriers to entry) lThe old firm’s demand will decrease to DLR lFirm’s output and price will fall lIndustry output will rise lNo economic profit (P = AC) Monopolistic Competition in the LR Deadweight loss MC AC Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium $/Q Quantity $/Q D = MR QC PC MC AC DLR MRLR QMC P Quantity Perfect Competition Monopolistic Competition Chapter 12 Slide 26 Monopolistic Competition nReduction in Economic Efficiency lThe monopoly power (differentiation) yields a higher price than perfect competition. If price was lowered to the point where MC = D, total surplus would increase by the yellow triangle. lAlthough there are no economic profits in the long run, the firm is still not producing at minimum AC and excess capacity exists.