Chapter Thirteen Oligopoly and Monopolistic Competition.

Chapter Thirteen

Oligopoly and Monopolistic Competition

© 2009 Pearson Addison-Wesley. All rights reserved. 13-2

Topics

Market Structures. Cartels. Noncooperative Oligopoly. Cournot Model. Stackelberg Model. Comparison of Collusive, Cournot,

Stackelberg, and Competitive Equilibria. Bertrand Model. Monopolistic Competition.


Oligopoly

Oligopoly - a small group of firms in a market with substantial barriers to entry.

Cartel - a group of firms that explicitly agree to coordinate their activities.

Monopolistic competition - a market structure in which firms have market power but no additional firm can enter and earn positive profits


Market Structures

Markets differ according to: the number of firms in the market, the ease with which firms may enter and

leave the market, and the ability of firms in a market to

differentiate their products from those of their rivals.


Table 13.1 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Competition


Why Cartels Form

A cartel forms if members of the cartel believe that they can raise their profits by coordinating their actions.


Figure 13.1 Competition Versus CartelP

rice

,p, $

per

uni

t

(a) Fi rm

qc q*qmQuantit y, q, Units

per year

S

MR

Market demand

AC

MC

pm

MCm

pc

pmem

ec

MCm

pc

Pric

e, p

, $ p

er u

nit

(b) Ma rket

Qm Qc

Quantit y, Q, Unitsper year


Laws Against Cartels

Cartels persist despite these laws for three reasons: international cartels and cartels within

certain countries operate legally. some illegal cartels operate believing that

they can avoid detection or that the punishment will be insignificant.

some firms are able to coordinate their activity without explicitly colluding and thereby running afoul of competition laws.


Laws Against Cartels (cont).

In the late nineteenth century, cartels were legal and common in the United States. Examples: oil, railroad, sugar, and tobacco.

Sherman Antitrust Act in 1890 and the Federal Trade Commission Act of 1914, Prohibit firms from explicitly agreeing to

take actions that reduce competition.


Laws Against Cartels (cont).

The Organization of Petroleum Exporting Countries (OPEC) - an international cartel that was formed in 1960 by five major oil-exporting countries: Iran, Iraq, Kuwait, Saudi Arabia, and

Venezuela. In 1971, OPEC members agreed to take an

active role in setting oil prices.


Why Cartels Fail

Cartels fail if noncartel members can supply consumers with large quantities of goods.

Each member of a cartel has an incentive to cheat on the cartel agreement.


Maintaining Cartels

To keep firms from violating the cartel agreement, the cartel must be able to detect cheating and punish violators. keep their illegal behavior hidden from

customers and government agencies.


Mergers

U.S. laws restrict the ability of firms to merge if the effect would be anticompetitive.


Noncooperative Oligopoly

Duopoly - an oligopoly with two firms. Three models:

Cournot model Stackelberg model Bertrand model


Noncooperative Oligopoly (cont).

Three restrictive assumptions: All firms are identical in the sense that they

have the same cost functions and produce identical, undifferentiated products.

We initially illustrate each of these oligopoly models for a duopoly

The market lasts for only one period.


Noncooperative Oligopoly (cont).

Duopoly equilibrium:

A set of actions taken by the firms is a Nash equilibrium if, holding the actions of all other firms constant, no firm can

obtain a higher profit by choosing a different action.


Cournot Model

Four assumptions: (1) there are two firms and no other firms can

enter the market,

(2) the firms have identical costs,

(3) they sell identical products, and

(4) the firms set their quantities simultaneously.


Cournot Model of an Airlines Market

Example: American Airlines and United Airlines compete for customers on flights between Chicago and Los Angeles.

Cournot equilibrium (Nash-Cournot equilibrium) - a set of quantities sold by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity


Cournot Model of an Airlines Market (cont).

residual demand curve - the market demand that is not met by other sellers at any given price


Figure 13.2 American Airlines’ Profit-Maximizing Output

p , $

pe

r p

asse

nge

r

MC

MR D

(a) Monopoly

qA, Thousand American Airlinespassengers per quarter

339

147

243

0 339169.596

MRr Dr Dp,

$ p

er

pas

sen

ger

MC

(b) Duopoly

qA, Thousand American Airlinespassengers per quarter

qU = 64

339

147

275

211

0 339275137.564 128


Figure 13.3 American and United’s Best-Response Curves



Market demand function is

Q = 339 − p

p - dollar cost of a one-way flight Q total quantity of the two airlines (thousands of

passengers flying one way per quarter).

Each airline has a constant marginal cost, MC, and average cost, AC, of $147 per passenger per flight.



Residual demand American faces is:

qA = Q(p) − qU = (339 − p) − qU.

rewriting

p = 339 − qA − qU

The marginal revenue function is:

MRr = 339 − 2qA − qU



American Airlines’ best response is the output that equates its marginal revenue, and its marginal cost:

MRr = 339 − 2qA − qU = 147 = MC

and rearranging

qA = 96−1/2 qU



United’s best-response function is

qU = 96−1/2 qA

This statement is equivalent to saying that the Cournot equilibrium is a point at which the bestresponse curves cross.



To solve the model:

qA = 96−1/2 (96−1/2 qA)

and solve for qA.

Doing so, we find that qA = 64; qU = 64

Q = qA + qU = 128.

Cournot equilibrium price is $211.


The Cournot Equilibrium and the Number of Firms

We can write a typical Cournot firm’s profit-maximizing condition as:

If n = 1, the Cournot firm is a monopoly, The more firms there are, the larger the residual demand elasticity,

nε, a single firm faces.

As n grows very large, the residual demand elasticity approaches negative infinity , and the equation above becomes

p = MC, which is the profit-maximizing condition of a price-taking competitive

firm.

MCn

pMR

1

1


Table 13.2 Cournot Equilibrium Varies with the Number of Firms


The Cournot Equilibrium and the Number of Firms

Cournot firm’s Lerner Index depends on the elasticity the firm faces

Thus, a Cournot firm’s Lerner Index equals the monopoly level, −1/ε, if there is only one firm:

np

MCp 1


Application Air Ticket Prices and Rivalry


Figure 13.4a Effect of a Government Subsidy on a Cournot Equilibrium


Figure 13.4b Effect of a Government Subsidy on a Cournot Equilibrium (cont’d)


Solved Problem 13.1

Derive United Airlines’ best-response function if its marginal cost falls to $99 per unit.


Solved Problem 13.2

Intel and Advanced Micro Devices (AMD) are the only two firms that produce central processing units (CPUs), which are the brains of personal computers. Both because the products differ physically and because Intel’s advertising “Intel Inside” campaign has convinced some consumers’ of its superiority, consumers view the CPUs as imperfect substitutes. Consequently, the two firms’ inverse demand functions differ:

pA = 197 − 15.1qA − 0.3qI, pI = 490 − 10qI − 6qA,

where price is dollars per CPU, quantity is in millions of CPUs, the subscript I indicates Intel, and the subscript A represents AMD. Each firm faces a constant marginal cost of m = $40 per unit. (For simplicity, we will assume there are no fixed costs.) Solve for the Cournot equilibrium quantities and prices.


Stackelberg Model

In the Cournot model, both firms make their output decisions at the same time. Suppose, however, that one of the firms,

called the leader, can set its output before its rival, the follower, sets its output.


Figure 13.5 Stackelberg Equilibrium


Solved Problem 13.3

Use algebra to solve for the Stackelberg equilibrium quantities and market price if American Airlines were a Stackelberg leader and United Airlines were a follower. (Hint: As the graphical analysis shows,American Airlines, the Stackelberg leader, maximizes its profit as though it were a monopoly facing a residual demand function.)


Why Moving Sequentially Is Essential

When the firms move simultaneously, United doesn’t view American’s warning that it will produce a large quantity as a credible threat. If United believed that threat, it would

indeed produce the Stackelberg follower output level.


Strategic Trade Policy

Suppose that two identical firms in two different countries compete in a world market. Both firms act simultaneously, so neither

firm can make itself the Stackelberg leader. A government may be tempted to intervene

to make its firm a Stackelberg leader.


Problems with Intervention.

For government subsidies to work five conditions must hold: government must be able to set its subsidy

before the firms choose their output levels. other government must not retaliate. government’s actions must be credible. government must know enough about how

firms behave to intervene appropriately. government must know which game the

firms are playing.


Table 13.3 Effects of a Subsidy Given to United Airlines


Solved Problem 13.4

If governments subsidize identical Cournot duopolies with a specific subsidy of s per unit of output, what is the qualitative effect (direction of change) on the equilibrium quantities and price? Assume that the before-subsidy best-response functions are linear.


Solved Problem 13.4


Comparison of Collusive, Cournot, Stackelberg, and Competitive Equilibria

How would American and United behave if they colluded? They would maximize joint profits by

producing the monopoly output, 96 units, at the monopoly price, $243 per passenger.


Table 13.4 Comparison of Airline Market Structures


Figure 13.6a Duopoly Equilibria


Figure 13.6b Duopoly Equilibria


Application Deadweight Losses in the Food and Tobacco Industries


Bertrand Model

Bertrand equilibrium (Nash-Bertrand equilibrium) - a Nash equilibrium in prices; a set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge these prices. Bertrand equilibrium depends on whether

firms are producing identical or differentiated products.


Best-Response Curves.

Suppose that each of the two price-setting oligopoly firms in a market produces an identical product and faces a constant marginal and average cost of $5 per unit. What is Firm 1’s best response if Firm 2

sets a price of p2 = $10?


Figure 13.7 Bertrand Equilibrium with Identical Products


Bertrand Versus Cournot.

Cournot equilibrium price for firms with constant marginal costs of $5 per unit by:

where n is the number of firms and ε is the market demand elasticity.

If the market demand elasticity is ε = −1 and n = 2, the Cournot equilibrium price is $5/(1− 1 2) = $10 which is double the Bertrand equilibrium price.

)/(11

$

)/(11 n

S

n

MCp


Bertrand Equilibrium with Differentiated Products

In markets with differentiated products such markets, the Bertrand equilibrium is plausible, and the two “problems” of the homogeneous-goods model disappear: Firms set prices above marginal cost, and prices are sensitive to demand conditions.


Figure 13.8 Bertrand Equilibrium with Differentiated Products


Monopolistic Competition

Monopolistically competitive markets do not have barriers to entry, so firms enter the market until no new firm

can enter profitably. monopolistically competitive firms face

downward-sloping residual demand curves, so they charge prices above marginal cost.


Monopolistically Competitive Equilibrium

Two conditions hold in a monopolistically competitive equilibrium: Marginal revenue equals marginal cost

because firms set output to maximize profit, and

price equals average cost because firms enter until no further profitable

entry is possible


Figure 13.9 Monopolistically Competitive Equilibrium


Minimum efficient scale

minimum efficient scale - (full capacity) the smallest quantity at which the average cost curve reaches its minimum


Fixed Costs and the Number of Firms

The number of firms in a monopolistically competitive equilibrium depends on firms’ costs. The larger each firm’s fixed cost, the

smaller the number of monopolistically competitive firms in the market equilibrium.


Figure 13.10 Monopolistic Competition Among Airlines


Solved Problem 13.5

What is the monopolistically competitive airline equilibrium if each firm has a fixed cost of $3 million?

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Chapter Thirteen Oligopoly and Monopolistic Competition.

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