Chapter 12 - Monopolistic competition and oligopoly Flashcards
What is monopolistic competition?
Monopolistic competition is competition between firms when each firm has some level of market power.
This is due to the fact that firms sell products that are not exactly equal.
There are still many firms, and entry and exit is not regulated. However, the products are a little different between firms.
Obviously, this means that the firm selling the best product will have the most monopoly power.
What is oligopoly?
Oligopoly is a market where we have a few firms competing, but entry is impeded.
So, there is difficult to enter such a market. Therefore, the firms in it can work together to achieve very large prices.
What is a cartel?
A cartel is a market in which some firms coordinate to get better control of the market. Aim is to maximize joint profits.
Why are oligopolies difficult to manage?
A lot of the success is dependent on game theory. How do our choices affect the other firms, and how do these firms respond?
Elaborate on equilibrium in monopoly vs equilibrium in perfectly competitive markets vs monopolistic competition.
On a general level, what is common between these markets
In perfect competition, we will find equilibrium where quantity supplied equals queneitty demanded.
In monopoly, equilibrium will occur wherever marginal revenue is equal to marginal cost.
In monopolistic competition, long run equilibrium establishes as long run profits goes towards 0.
These markets do not have to consider the impact of their choices on the other players. we can take price or quantity demanded as given, and ignore competitors. However, in oligopoly, a firm will set its prices based partly on the behavior of other players.
Is is possible to find some equilibrium point in such case?
What are the key characteristics of a monopolistically competitive market?
1) Firms are selling differentiated products that are highly substitutable, but not perfectly substitutable. Toothpaste, for instance.
2) Free entry and exit. It is relatively easy to enter. An example of industry that is NOT FREE ENTRY is cars, as it requires large amount of inputs.
Why is monopolistic competition similar to perfect competition?
Monopolistic competition is similar to perfect competition because the free entry and exit makes it easy for firms to enter the market if they see potential profit in it. Therefore, if profit is “available”, many firms will enter. As a result, each firm will receive less monopoly power, and the market will approach perfect competition. This drives economic profits to 0 (Zero-economic profits).
What happens to the demand curve of a firm in a monopolistic market as firms enter the market?
The individual demand curve that the single firm is facing will shift down.
The long run demand curve will be just tangent to the average cost curve. This implies zero economic profits.
What is the relation between monopoly power and demand curve?
As long as the demand curve is sloping down, the firm have monopoly power. This is because price is not given. The firm is not a price taker. We can set the price based on other factors than the market price.
What do we mean be economically efficient markets?
It means, the total consumer+producer surplus is as large as it can be. There is little deadweight.
What is Nash equilibrium?
Nash equilibrium is a market condition where each firm is doing the best it can given what its competitors are doing.
What is a duopoly?
Duopoly is a market with 2 players that compete against each other. So, it is an oligopoly but restricted to 2 players.
Elaborate on the Cournot Model
Goes like this:
Suppose the firms (duopoly) produce a homogeneous good and know the market demand curve. Each firm must make a decision on how much to produce, and the two firms make their decision at the same time. When making the decision, each firm takes the competitor into account.
If we consider one of the firms. This firm knows that the other firm is also making the same decision. Both firms knows that the market price will depend on the total output of both firms.
The essence of the Cournot model is that each firm treats the output level of the competitor as FIXED when deciding how much to produce.
What are reaction curves?
A reaction curve is the relationship between a firm’s profit maximizing output and the amount he thinks the competitor will produce. It is a decreasing schedule.
Elaborate on Cournot equilibrium
If we consider 2 firms, we first find the reaction curve of both firms. This gives 2 curves. The intersect between them curves will be the Cournot equilibrium. this point will give a certain number of production, which obviously is the same number for both firms.
In the Cournot equilibrium, each firm is maximizing profits based on what the competitor is thought to be doing.
Does the Cournot (Nash) equilibrium tell us anything about the process of dynamics?
No. Firms will not adjust outputs based on Cournot model.
IMPORTANT:
What is the idea of the Cournot model and Cournot equilibrium?
A firm will make a deicision on output level that is dependent on what it believes the other competitor will do. For instance, if firm X think firm Y will produce 100 units, it will find a level that maximize profits based on that information. If the firm do this for all possible output levels of the other firm, we get a nice curve that maps this relationship.
At the point of Cournot equilibrium, all firms are producing a level of output that it is happy with, since profits are maximized given the “information”. Therefore, no-one has any incentive to change anything.
In the Cournot equilibrium, each firm correctly assumes how much the other competitor will produce.
If initial guesses are wrong, there will be an adjustment process. However, since the Cournot model assumes the competitor has fixed its volume, this is where the model ends. It cannot predict the further behavior. As a result, this equilibrium is a situation that occurs if the firms somehow manage to assume correct from the beginning.
The Cournot equilibrium is not necessarily the goal, but is rather a symptom of the goal. The goal is to maximize profits given the other players. If every firm does this perfectly, then the Cournot equilibrium will arise.
How do you find the reaction curve of a firm
The reaction curve of a firm is the curve of output levels based on the other firm’s fixed production.
We need to market demand curve.
We need the cost curve.
We need marginal revenue curve.
Marginal revenue curve is given as PQ1, for instance: (30 - Q)Q1
this gives us:
R_1 = 30Q1 - Q1^2 - Q2Q1
Then we differentiate with respect to Q1:
MR_1 = 30 - 2Q1 - Q2
Then we set this curve equal to the marginal cost curve. When we do this, and then repeat for all firms in the oligopoly, we get a system of equations. This system can be solved to get the individual production volumes. The market price is then given by the demand curve, P(Q) with Q = Total production, Q = Q1+Q2
The 2 equations we get are:
Q1 = 15 - 0.5Q2
Q2 = 15 - 0.5Q1
This gives us a Cournot equilibrium of Q1=Q2=10. The total quantity is then 20. This gives market price of P(20) = 30 - 20 = 10.
Then each firm would earn 10*10 = 100 bucks.
Total profit is 200.
What is the collusion curve?
The collusion curve is the curve corresponding to all pairs of outputs from firm A and firm B that maximize the profits when the two firms are collaborating. In other words, when the firms are trying to maximize the total profit.
We find the collusion curve by doing the same logic as with non-collab, but we disregard the fact that there are multiple firms at first.
Demand curve: P(Q) = 30 - Q
Cost curve: C(Q) = 0 (constant 0 cost)
R = P(Q)*Q = 30Q - Q^2
MR(Q) = 30 - 2Q
MR = MC –> 2Q = 30 –> Q = 15
IF the 2 firms agree to share all profits, they would typically produce half each, so that Q1 = Q2 = 7.5
The price would then be:
P(15) = 30 - 15 = 15
Each firm would get a profit of 15*7.5 = 112.5
total profit is 225. This happens to be 25 more than if both firms act separate.
Why is Cournot equilibrium not the same output level as the total profit maximization level?
Because, it would require both firms to slack their output a little. If one firm does this, the other firm could increase profits by upping production or remaining with the same output.
Elaborate on the case where one of the firms in a duopoly “moves first” (change output/set output first)
If firm A moves first by setting an output level, it will have to do so while considering what the other competitor might do in response.
for this, we use the STACKELBERG MODEL.
The Stackelberg model is simply an oligopoly model where one of the firms sets output before the other firms.
If we consider the case where firm A has already decided an output level, and that firm B has observed this. Then, firm B can treat this output level as fixed. As a result, the reaction curve of firm B will point to the point where the opposition produce the given quantity. This gives the output that firm B will produce as a response. Say the reaction curve was this:
Q2 = 15 - 0.5Q1
Then, Q2 = 15 - 0.5*x
So, the decision for the second firm is easy. But what about the first?
Firm A will maximize profits, MR = MC.
R1 = PQ1 = 30Q1 - Q1^2 - Q1Q2
We can see that R1 depends on Q2. Therefore, we must guess. What we do know (as firm A), is that firm B will choose an output that is on its reaction curve. Therefore, we can substitute Q2 with this curve.
R1 = 30Q1 - Q1^2 - Q1(15-0.5Q1)
R1 = 15Q1 - 0.5Q1^2
Therefore, marginal revenue becomes
MR1 = 15 - Q1
If we consider MC = 0, we get that Q1 = 15.
From the reaction curve of firm B, we get Q2 = 7.5
This implies that going first gives an advantage. Why is that? It is because the first firm will produce high. If the second firm also did so, it would drive the price down, which would cause both firms to loose money. So, 15 vs 7.5 is a better deal FOR BOTH firms than say 15 + 15.
This is called first mover advantage.
How does the Stackelberg model differ from the Cournot model? In one sentence
Stackelberg gives one firm the first move, while Cournot assumes both firms make the decision simultaneously.
What is price competition, as opposed to quantity focus?
Instead of focusing on what output to produce, price competition looks at strategic levels of price. For instance, what happens if we set price a little lower than our competitors?
What is the Bertrand model?
The Bertrand model is a model where each firm/competitor in an oligopoly produce homogenous good, and all firms treat the prices that the other firm(s) have sat at given. So, it contrasts with the Cournot model in the sense that it is now prices that are given, not volume.
just like with the Cournot model, the Bertrand model consider decisions at the same point in time.
There is nothing stopping us from using Bertrand on differenatiated goods.
If prices are homogenous, in the single-period case, the attempted undercut would be unavoidable, causing prices to be equal to MC. If prices are differentiated, we achieve equilbria that is somewhere between MC and monopoly pricing.
Consider the elasticity of demand for monopolistic competition, how is it likely to be?
Relatively elastic. -5 is not uncommon. The high elasticity is due to the large number of substitutes that stems from free entry.
Name the characteristics of monopolistic competition
There are 2 primary characteristics:
1) Free entry and exit
2) Differentiated products that are highly substituable, but not perfect substitutes.
This cause high elasticity of demand.