Chapter 7.1Monopolistic Competition

and Oligopoly

Chapter 7.1Monopolistic Competition

and Oligopoly

The Continuum of the Market StructureThe Continuum of the Market Structure

Perfect Competition

n=infinityn=1

Monopoly

n large

Monopolistic Competition

n small

Oligopoly

No of firms, n

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

• Assumptions of monopolistic competition

• Each firm sells a different variety or brand (think

of coke or restaurants)

• There are many firms

– Act independently – ignore others’ reactions

• Freedom of Entry and Exit

• There is Symmetry

– New firms affect all old ones equally

• Assumptions of monopolistic competition

• Each firm sells a different variety or brand (think

of coke or restaurants)

• There are many firms

– Act independently – ignore others’ reactions

• Freedom of Entry and Exit

• There is Symmetry

– New firms affect all old ones equally

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

• Equilibrium:

– short run

• Equilibrium:

– short run

Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.

£

Q O

Ps

Qs

The ‘Industry’ Demand Curve looks

like this

Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.

£

Q O

Ps

Qs

What about an individual

restaurant?

It is further in

and flatter

Why?

Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.

£

Q O

Ps

Qs

Each restaurant type has a share of

the industry

But knows that it can only vary its

price a little

Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.

£

Q O

Ps

Qs

What if a new competitor appears?

Demand line shifts in more and flattens

more

Getting closer and closer to Perfect

Competition

£

Q O

Ps

Qs

So now suppose we have a firm like the blue line … So now suppose we have a firm like the blue line … and this restaurant is doing well in the short-runand this restaurant is doing well in the short-run

Let’s make the picture biggerLet’s make the picture bigger

£

Q O

MR

AR D

Ps

Qs

Let’s make the picture biggerLet’s make the picture bigger

£

Q O

AC

MR

AR D

Ps

Qs

MC

£

Q O

AC

MR

AR D

Ps

Qs

MC

ACs

Short-run equilibrium of the firm under monopolistic Short-run equilibrium of the firm under monopolistic competitioncompetition

£

Q O

AC

MR

AR D

Ps

Qs

MC

ACs

Short-run equilibriumShort-run equilibrium

£

Q O

AC

MR

D

Qs

MC

ACs

What happens now?What happens now? New Firms enter

What happens to D?

So P and Q down

P1

£

Q O

AC

MR

D

Qs

MC

ACs

What happens now?What happens now? New Firms enter

What happens to D?

So P and Q down

And Super-normal Profits down

£

Q O

AC

MR

D

Qs

MC

ACs

What happens now?What happens now? New Firms enter

What happens to D?

So P and Q down

And Super-normal Profits down

What Happens Next?What Happens Next?

• Still Super-Normal ProfitsStill Super-Normal Profits

• So firms keep enteringSo firms keep entering

• P keeps falling and Super-normal profits P keeps falling and Super-normal profits keep falling until….keep falling until….

• In the LRIn the LR

• AR = AC and there are no supernormal AR = AC and there are no supernormal profitsprofits

£

Q O

LRAC

MRL

ARL DL

PL

QL

LRMC

Long-run equilibrium of the firm under Long-run equilibrium of the firm under monopolistic competitionmonopolistic competition

NOTICE:NOTICE:

• AR (=D) curve still slopes downAR (=D) curve still slopes down

• So not in perfectly competitive caseSo not in perfectly competitive case

• Firms have market power (can choose price Firms have market power (can choose price and quantity), but….and quantity), but….

• Competition is such that this power is Competition is such that this power is illusory (in the long run)illusory (in the long run)

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

• Limitations of the model– imperfect information about profits and demand

– difficulty in identifying industry demand curve

– indivisibilities/local monopolies

– importance of non-price competitionVariety Advertising

• Limitations of the model– imperfect information about profits and demand

– difficulty in identifying industry demand curve

– indivisibilities/local monopolies

– importance of non-price competitionVariety Advertising

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

•The public interest

–comparison with perfect competition;

PRODUCTION WILL NOT OCCUR WHERE LRAC IS AT ITS MINIMUM (unlike perfect competition which is efficient)

Long run equilibrium under perfect andLong run equilibrium under perfect andmonopolistic competition (with decreasing or constant monopolistic competition (with decreasing or constant

returns to scale)returns to scale)£

QO

P1

LRAC

DL under perfect

competition

Q1

Long run equilibrium under perfect andLong run equilibrium under perfect andmonopolistic competition (with decreasing or constant monopolistic competition (with decreasing or constant

returns to scale)returns to scale)£

QO

P2

P1

LRAC

DL under perfect

competition

DL under monopolistic

competition

Q2 Q1

The Continuum of the Market StructureThe Continuum of the Market Structure

Perfect Competition

n=infinityn=1

Monopoly

n large

MonopolisticCompetition

n small

Oligopoly

No of firms, n

OLIGOPOLYOLIGOPOLY

• Key features of oligopolyKey features of oligopoly

– barriers to entrybarriers to entry

– interdependence of firmsinterdependence of firms

– ~What’s he up to?~What’s he up to?

– incentives to compete versus incentives to incentives to compete versus incentives to colludecollude

Day 1: Suppose initially Monopoly firm in the Day 1: Suppose initially Monopoly firm in the IndustryIndustry£

O Q

D

To make life simple suppose P=200-Q is the demand curve

Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry

£

O Q

D

To make life simple suppose P=200-Q is the demand curve,

And MC are zero

What is the MR curve?

200

200

Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry

£

O Q

D

P=200-Q

TR= P*Q

TR=[200-Q]*Q

TR=200Q-Q2

MR=200-2Q

200

200

Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry

£

O Q

D

P=200-Q

TR= P*Q

TR=[200-Q]*Q

TR=200Q-Q2

MR=200-2Q

200

200

MR

100

If MR = 0,

200=2Q

MC

Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry

£

O Q

D

What quantity will this firm supply to the

market

MR=MC at 100

Q=100

P=200-Q

P=200-100

=100

200

200

MR

100

MC

P=100

Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry

£

O Q

D

So monopolist supplies half the

market in this case

(Linear demand, MC=0)

200

200

MR

100

MC

P=100

Day 2: Harmony is broken! Suppose now a new firm Day 2: Harmony is broken! Suppose now a new firm notices there are unfulfilled customersnotices there are unfulfilled customers£

O Q

D

What will new firm do?

200

200

MR

100

MC

P=100

Suppose now a new firm notices there are unfulfilled Suppose now a new firm notices there are unfulfilled customerscustomers£

O Q

D

What will new firm do?

200

200

MR

100

MC

P=100

MC2

It thinks it has demand

P=100-Q

MR=100-2Q

Suppose now a new firm notices there are unfulfilled Suppose now a new firm notices there are unfulfilled customerscustomers

Q

D

What will new firm do?200

100

MR

0

MC

P=100

MC2

It thinks it has demand

P=100-Q

MR=100-2Q

It is just looking at this bit of

the market

Setting MC = MR

=0

100=2Q

Q=50

• So now firm 1 is supplying 100 unitsSo now firm 1 is supplying 100 units

• And firm 2 is supplying 50 UnitsAnd firm 2 is supplying 50 Units

• Will firm 1 accept that?Will firm 1 accept that?

• How will it react?How will it react?

Day 3: The reckoningDay 3: The reckoning£

O Q

D

Firm 1 sees that 50 people are already

being supplied. So its market is

P=200-Q –50

P=150-Q

200

200

MR

100

MC

P=100

MC2

Day 3: The reckoningDay 3: The reckoning£

O Q

D

Firm 1 sees that 50 people are already

being supplied. So its market is

P=200-Q –50

P=150-Q

200

200

MR

100

MC

P=100

150

150

Day 3: The reckoningDay 3: The reckoning£

O Q

D

And MR is now

MR=150-2Q

So when MR=MC=0

Q=75

200

200

MR

100

MC

P=100

150

75

• Firm 1 was supplying 100 unitsFirm 1 was supplying 100 units

• Is Now Supply 75 unitsIs Now Supply 75 units

• Firm 2 is still producing 50 unitsFirm 2 is still producing 50 units

• How will firm 2 react to the cut in firm 1’s How will firm 2 react to the cut in firm 1’s production?production?

This is essentially the story nowThis is essentially the story now£

O Q

Market D

Firm 1 Supplies 75

Firm 2 Supplies 50

But now Firm 2 sees that there are 125

unsatisfied consumers

200

200

MR1

100

MC

P=100

MC2

MR2

D1D1

D2

Day 4: The Mob Strikes BACKDay 4: The Mob Strikes BACK£

O Q

D

Firm 2 sees that 75 people are already

being supplied. So its market now is

P=200-Q –75

P=125-Q

200

200

MR

100

MC

P=100

125

125

Day 4: The Mob Strikes BACKDay 4: The Mob Strikes BACK£

O Q

D

And MR is now

MR=125-2Q

So when MR=MC=0

Q=62.5

200

200

MR2

100

MC

P=100

125

62.5 125

• Firm 1 was supplying 100 unitsFirm 1 was supplying 100 units• Firm 1 Is Now producing 75 unitsFirm 1 Is Now producing 75 units

• Firm 2 was producing 50 unitsFirm 2 was producing 50 units• Firm 2 is now Producing 62.5 unitsFirm 2 is now Producing 62.5 units

• Firm 1’s Q is going down as Firm 2 goes UpFirm 1’s Q is going down as Firm 2 goes Up• Firm 2’s Q is going Up as Firm 1 goes downFirm 2’s Q is going Up as Firm 1 goes down

• When will equilibrium occur?When will equilibrium occur?

ArmageddonArmageddon£

O Q

D

200

200100

MC

P=100

133.3

133.33

If each firm sees that 66.66 people are already being supplied, then it

sees its market as

P=200-Q –66.66

P=133.33-Q

ArmageddonArmageddon£

O Q

D

And MR is now

MR=133.33-2Q

So when MR=MC=0

Q=66.66

200

200

MR1= MR2

100

MC

P=100

133.3

66.66 133.33

If each firm sees that 66.66 people are already being

supplied, then P=133.33-Q

D1=D2

• Firm 1 fall from supplying 100 units to 66.66 Firm 1 fall from supplying 100 units to 66.66 unitsunits

• Firm 2 rises from supplying 0 units to 66.66 Firm 2 rises from supplying 0 units to 66.66 unitsunits

• Given that firm 1 is supplying 66.66 units Given that firm 1 is supplying 66.66 units firm 2’s best response is 66.66 unitsfirm 2’s best response is 66.66 units

• Given that firm 2 is supplying 66.66 units Given that firm 2 is supplying 66.66 units firm 1’s best response is 66.66 unitsfirm 1’s best response is 66.66 units

• EQUILIBRIUM (Cournot equilibrium)EQUILIBRIUM (Cournot equilibrium)

• What do we learn from this story? What do we learn from this story?

• With a small number of firms, one firm’s With a small number of firms, one firm’s actions directly affects the other.actions directly affects the other.

• Where the number of firms are small, the Where the number of firms are small, the firms will think strategically!!firms will think strategically!!

• What is the other guy (male or female) up What is the other guy (male or female) up to ?to ?

• How will they How will they reactreact to my to my actionsactions

• Indeed:Indeed:

• Firms wouldn’t go through this tortuous Firms wouldn’t go through this tortuous process, they would figure out the situation process, they would figure out the situation pretty quickly and if firm 1 couldn’t stop 2 pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium.entering they would go to final equilibrium.

• Called Cournot Competition (competing Called Cournot Competition (competing over market share - Quantities)over market share - Quantities)

• Can also model price competition- BertrandCan also model price competition- Bertrand

Comparison of Cournot Comparison of Cournot with Perfect Compt. and Monopolywith Perfect Compt. and Monopoly

• Under Monopoly Firm 1 with a linear Under Monopoly Firm 1 with a linear demand curve Zero MC supplied half the demand curve Zero MC supplied half the market, that is Qmarket, that is Q11 =1/2 of 200=100 =1/2 of 200=100

• Here with 2 firms each supply 1/3 of 200, Here with 2 firms each supply 1/3 of 200, that is, 66.66 and total output = 133.33that is, 66.66 and total output = 133.33

• Under perfect competition MC = 0 would Under perfect competition MC = 0 would produce at Q = 200produce at Q = 200

• So oligopoly moves the economy closer to So oligopoly moves the economy closer to perfect competition as compared with perfect competition as compared with monopolymonopoly

Cournot:Cournot:

• 1 firm supplies ½ of market1 firm supplies ½ of market

• 2 firms supply 1/3 market each, 2/3 overall.2 firms supply 1/3 market each, 2/3 overall.

• What about 3 firms?What about 3 firms?

• 3 firms supply 1/4 market each, 3/4 overall.3 firms supply 1/4 market each, 3/4 overall.

• ..and 4 firms?..and 4 firms?

• 4 firms supply 1/5 market each, 4/5 overall.4 firms supply 1/5 market each, 4/5 overall.

• n firms, supply 1/(n+1) of market each, n firms, supply 1/(n+1) of market each, n/(n+1) overalln/(n+1) overall

• So more firms getting closer and closer to So more firms getting closer and closer to perfect competitionperfect competition

£

O Q

D

200

200

MR1= MR2

100

MC

P=100

133.3

66.66 133.33

Profits Under Cournot

P= 200-2(66.66)=

= 200-133.33= 66.66

Industry Profits=2(TR-TC)

=2{66.66(66.66)}=8887.7

But under Monopoly p=100; Q=100 and

Profits = 100*100

=10,000D1=D2

£

O Q

D

200

200

MR1= MR2

100

MC

P=100

133.3

66.66 133.33

So two firms would be better off if they could get together

and agree to limit market:

Collusion

D1=D2

Profits Under Cournot: 8,888

Profits under monopoly: 10,000

OLIGOPOLYOLIGOPOLY

• Key features of oligopolyKey features of oligopoly

– barriers to entrybarriers to entry

– interdependence of firms~What’s s/he up to?interdependence of firms~What’s s/he up to?

– incentives to compete versus incentives to incentives to compete versus incentives to colludecollude

• Factors favouring collusionFactors favouring collusion

• Collusive oligopoly: cartelsCollusive oligopoly: cartels

– equilibrium of the industryequilibrium of the industry

OLIGOPOLYOLIGOPOLY

• Key features of oligopolyKey features of oligopoly

– barriers to entrybarriers to entry

– interdependence of firmsinterdependence of firms

– incentives to compete versus incentives to incentives to compete versus incentives to colludecollude

• Factors favouring collusionFactors favouring collusion

• Collusive oligopoly: cartelsCollusive oligopoly: cartels

– Join forces and act collectively as a monopolyJoin forces and act collectively as a monopoly

– allocating and enforcing quotasallocating and enforcing quotas