4. Firm Heterogeneity, Market Power and Price Discrimination

Question 1

Recap: Market power

Answer 1

Classification of market structures:
Perfect comp
Potential comp
Monopolistic competition & Competitive selection
Oligopoly
Dominant firm
Monopoly
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Market power increasing order

Question 2

Competitive selection model
Jovanovich 1982, Econometrica

Answer 2

Competitive MKt where each firm is charaterized by θ (estimate of the value of own productivity, capability):

Π=pq - “q” ^2/”θ”
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Time is made by several periods. At the beginning of each period, each firm decides whether to remain active or not. Next, active firms decide how much to produce, which they do by choosing the quantity that max profits.
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1° order condition: p - 2𝑞/”θ” = 0; so: q* = 𝟏/𝟐 p θ
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Maximum profit levels: Π = 1/2 𝑝^2 “θ” – 〖(1/2 𝑝”θ” )〗^2/ θ ; so: Π* = 𝟏/𝟒 𝒑^𝟐 “θ”

Question 3

Monopolistic competition

Answer 3

Competitive selection model
Jovanovich 1982, Econometrica

Firms defer in their innovative capability to organise production. Some are more able than others.]

Most firms discover their own theta by entering the market. They jump in the water and then learn if they can swim or not.
All firms are price takers. They want to maximise their own profit.

If more capable, they have reduced total cost.
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Time is divided by several period at the beginning of each period firms decide whether to remain active or not. Those firms who prove theta is v low, total cost function increases more than revenue, will exit market. New firms meanwhile that don’t know their own theta will enter the market.
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Those who decide to stay, need to max profit
Marginal cost < marginal revenue
Q maximises profit of the firm
1° order condition: p - 2q/”θ” = 0; so: q* = 1/2 p θ
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Maximum profit levels: Π = 1/2 p^2 “θ” – 〖(1/2 p”θ” )〗^2/ θ ; so: Π* = 1/4 p^2 “θ”
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Quantity is a positive function of theta. Higher theta more capable the larger you are since you produce more. Co-relation between own productivity and capability.

Question 4

Monopolistic competition

Answer 4

Chamberlin (1933, p. 57): “It is evident that virtually all products are differentiated, at least slightly, and that over a wide range of economic activity differentiation
is of considerable importance” (from The Theory of Monopolistic Competition)
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Focus is on the observation that it’s unlikely firms will produce the exact same product, there is a degree of differentiation even if firms competing in the same market. Characteristics of product differ. Packaging, flavour, etc are competing in the same market but are different
Eg: Cornflakes
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Question 5

5 central assumptions of perfect competition

Answer 5

5 central assumptions of perfect competition
- Atomicity
- Product differentiation instead of homogeneity.
- Perfect information (every agent, firms and consumers) know the price charged by every firm.
- Firms have access to all technologies.
- No entry and exit barriers (free entry and exit)
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We move from price taking to price making.
Firm is a price-maker. Each firm faces a downward-sloping demand curve.
Greater differentiation makes demand less elastic. There is always some degree of market power.
Let’s take the spatial competition model:

Question 6

Class discussion on the graphs

Answer 6

Let’s take market for cornflakes

Missed this one

Price chosen by first firm p1
Firm 2 price p2




All these consumers will buy from firm 1


Same w p2


These consumers won’t buy from anyone

Because their utility level exceeds from the benefit they will get


Price is different
Even if they raise price, demand is not null, it may decrease but won’t be null

So they have some degree of market power. They can decide the price they charge.
Monopolistic competition is straightforward
Each firm in market will face downward facing demand curve. They will maximise profit, marginal revenue = marginal cost . Profit maximisation
All assumptions of perfect Competition will be the same. Let’s enter this market and compete with the active firms in the market. Once the consequence, their demand will shift to left and reduce. This movement will end up until the point that the signal for entry is not active anymore. When there is not extra profit to be realised.

There is some inefficiency in terms of social welfare. Productive efficiency. Firms do not produce at the min of avg cost curve, they stop much before that. One typical result is that compared to the situation where they max social welfare. There is over proliferation of brands and they are producing too little. That’s why productive inefficiency.
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Allocative inefficiency, willingness to pay off some customers is greater than marginal costs of production.
Price is higher than what it would be in perfect competition. So there are inefficiencies in productive and allocative inefficiencies.

Question 7

Final taxonomy

Answer 7

P. C. : p min; Q max; Sc max; Null extra-profits; max W (from a static point of view).
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Potential Competition: close (or not too distant) results to (from) p.c.
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Monopolistic competition (with moderate differentiation) and Comp. selection: close (or not too distant) results to (from) p.c.
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Oligopoly: p intermediate; Q intermediate; Sc intermediate; Positive extra-profits; Intermediate W (static).
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Dominant Position: close (or not to distant) results to (from) monopoly (see below)
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Monopoly: p max; Q min; Sc min; Extra-profits max; W min (static)