Unit 12
Monopolistic competition
and
Oligopoly
Outcomes
• Define and explain monopolistic
competition
• Define and explain oligopoly market
structures
• Define and explain price competition
• Describe difference between competition
and collusion
• Discuss oligopolistic pricing
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Monopolistic competition
• Monopolistic competition:
– Market in which firms can enter freely,
– Each producing it’s own brand or version
– Of a differentiated product.
3
Monopolistic competition
• Two key characteristics:
1. Firms compete by selling differentiated
products which is highly substitutable but not
perfect substitutes.
2. There is free entry and exit.
• When market is in equilibrium, firms are
doing their best and have no reason to
change their price or output
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SR and LR equilibrium
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Monopolistic competition and
economic efficiency
• Perfect competitive market are desirable
because = economic efficient.
• Monopolistic competition is similar.
• Two source of inefficiency in monopolistic
competition:
1. Equilibrium price > MC: Value exceeds cost
2. Output below minimizing average cost:
Excess capacity is inefficient.
6
Monopolistic competition and
economic efficiency
• Inefficiencies make consumers worse off:
• Should this market be regulated? No,
why:
1. Monopoly power is small.
2. Important benefit: Product diversity.
Consumers value to choose between a wide
variety.
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Monopolistic competition and
economic efficiency
8
Oligopoly
• Market in which only a few firms compete
with one another, and entry by new firm is
impeded.
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Oligopoly
• Behaviour of other firms always taken into
account.
• Barriers to entry: Difficult or impossible for
new firms to enter.
• If just 2 firms = Duopoly
– For our purpose, only focus on duopolies:
One competitor to worry about.
10
Equilibrium in oligopoly
• Equilibrium where MR=MC
• Nash Equilibrium: Set of strategies or
actions in which each firm does the best it
can given its competitors’ action.
– And so will the competitor do the best they
can.
11
The Cournot model
• Simple model of duopolies introduced by
Augustin Cournot.
– Firms produce homogenous goods
– Know the market demand curve
– Each firm must decide how much to produce
– Two firms make their decision at the same
time
– Take competitor into account
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Cournot model
• Essence of model:
– Level of output for competitor fixed
– When deciding how much to produce
• Reaction curve: Relationship between a
firm’s profit maximizing output and the
amount it thinks its competitor will produce.
• Cournot equilibrium: Each firm correctly
assumes how much its competitor will
produce and sets its own production level
accordingly
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Firm 1’s output decisions
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The Cournot model
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The Stackelberg model
- First mover advantage
• First assumed: Duopolist make output
decision at the same time.
• Stackelberg model: Oligopoly module in
which one firm sets its output before other
firms do.
• See example page 455
• Cournot and Stackleberg models are
alternative representations of oligopolistic
behaviors
16
Oligopoly: Setting the price
- Price competition
• Oligopolistic firms compete by setting
quantities.
• But, it can occur along price discrimination.
• Nash equilibrium used to study price
competition.
– First in a industry producing homogeneous
products,
– Second, in a industry with some degree of
product differentiation.
17
Price competition with
homogeneous products
• The Bertrand Model:
– Oligopoly model
– In which firms produce a homogenous good
– Each firm treats the price of it’s competitors as
fixed
– All firms decide simultaneously what price to
charge.
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Bertrand model
•
•
•
•
Firms choose price instead of quantity.
Will dramatically affect market outcome.
View example on page 458
Firm price at MC and make no profit!
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Bertrand model
• Criticism:
– More natural to compete by setting quantities
rather than price, as with a homogeneous good.
– If firms do set prices and choose the same price,
what share of total sales will go to each one?
• Useful:
– Shows how equilibrium output in oligopolies can
depend crucially on the firms’ choice of strategic
variable.
20
Price competition with
differentiated products
• Some degree of product differentiation.
– Example: Gas station differs in location and
service provided.
• Market share not only determined by price
but also differences in:
– Design
– Performance
– Durability
Natural for firm to compete on price!
21
Price competition with
differentiated products
• Simple example on page 458
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Competition vs. Collusion:
- The prisoner’s dilemma
• Nash equilibrium = non-cooperative equilibrium:
– Each firm makes the decisions that give it the highest
possible profit,
– given the actions of competitors
• Non-cooperative game: Game in which negotiation
and enforcement of binding contracts are not
possible.
• Collusion = Illegal: Coordinate prices and output
levels to maximize joint profits = Cartel
23
Competition vs. Collusion:
- The prisoner’s dilemma
• Cooperation  higher profits: Why not
cooperate without explicitly colluding?
– Set a price and hope competitor set the same
price!
– Problem: Competitor will not choose to set
price at same level. Will do better by setting
lower price.
• See example page 461
24
Competition vs. Collusion:
- The prisoner’s dilemma
Table showing
profit/payoff to each firm
given its decision and
decision of competitor
Game theory example in which
2 prisoners must decide
separately whether to confess to
a crime.
Confess = Lighter sentence and
accomplice heaver sentence
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Competition vs. Collusion:
- The prisoner’s dilemma
• Oligopolistic firm often find themselves in a
prisoner’s dilemma.
– Compete aggressively, gain market share, or
– Compete passively, coexist with competitor
and settle for market share.
– Implicitly collude!
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Implications of the prisoners’
dilemma for oligopolistic pricing
•
•
•
•
Firms price over and over again.
Continually observe competitors.
And adjust!
Competitors can develop mistrust if one
firm ‘rocks the boat’ – by changing price or
increase advertising.
27
Price rigidity
• Definition:
– Firms are reluctant to change prices even if
costs or demand change
• Basis for the kinked demand curve model:
– Oligopoly model
– Each firm faced a demand curve kinked at
prevailing price
– At higher price demand is elastic and vice
versa
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Kinked demand curve
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Price signaling and price
leadership
• Price signaling:
– Form of implicit collusion
– Firm announces a price
– Increase in the hope that other firms will
follow suit
• Price leadership:
– Pattern of pricing
– In which one firm
– Regularly announces price changes
– That other firms then match
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The dominant firm model
• Definition:
– Firm with a large share of total sales
– That sets price to maximize profits
– Taking into account the supply response of
smaller firms.
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The dominant firm model
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Cartels
• Explicit agree to cooperate by setting price
and output levels.
• Often international – law poorly enforced.
• OPEC cartel = international agreement.
• Conditions for success:
– Stable cartel organization must be formed,
members agree on price and production
levels, and must adhere to agreement.
– Potential monopoly power.
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Cartel
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