Lecture 3

• Monopolistic competition


  Many firms, all with small market share
• Monopolistic competition

  • Cn HHI is 0
  • Differentiated products, but very close substitutes (but not perfect substitutes)
  • In the long-run, free entry and exit
• Short-run price-quantity decision


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• Short- run price-quantity decision


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• Transition to long-run equilibrium


  1. New firms enter the market (attracted by excess profits)

  2. The firm's demand curve (AR) and Marginal revenue curve (MR) shift inwards (consumers attracted by the presence of alternative substitutes)
• Effect of Entry on Market Price and Output


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• Long run Equilibrium


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• Long-run equilibrium


  • P=ATC
  • P is (not =) min ATC (excess capacity)
  • P> MC
  • Therefore, allocative and productive inefficiency
• Oligopoly


  • Industry characterized by a small number of firms
  • Usually (but not always) producing differentiated products
  • Substantial barriers to entry
• Interdependence


  Key feature of oligopoly industries
• Conjectural variation is therefore important in oligopoly industries
• Cournot quantity-setting duopoly


  • Two firms produce identical products
  • Market price is determined by demand and supply
  • Each firm assumes the other will not react to its output decision
  • ’Naive’ behaviour
  • In the simples Cournot model, MC = 0 (but thus can be relaxed)
• 'Naïve' behaviour


  In the simple Cournot model, MC = 0 (but this can be relaxed)
• If P = a-bQ, then the horizontal intercept is 0 = a-bQ, hence a=bQ, so a/b =Q
• General solution for Cournot duopoly

  1. Start with a monopoly

  2. P = a - bQ

  3. MR = a-2bQ

  4. Marginal cost = c

  5. a-2bQ = c

  6. Q = (a-c)/2b

  7. P=a-b(a-c/2b)= (a/2) + (C/2)
• In perfect competition, P= MC

  • So, a-bQ = c
  • Q = a-c / b
• With linear demand and constant marginal cost, the competitive equilibrium output is twice the monopoly output
• In a Cournot duopoly


  1. P=(a-bQ2)-bQ1

  2. This is firm 1's residual demand curve. The terms in parenthesis are 'fixed' from the perspective of firm 1
• Marginal revenue curve for firm 1 is obtained by multiplying the inverse demand curve by Q1 and differentiating:

  MR = (a - bQ2) - 2bQ1

  Setting MC = MR, and solving for Q1, yields:

  RF1:

  Q1 = (a-c / 2b) - (1/2)Q2

  RF2:

  Q2 = (a-c/2b) - (1/2)Q1
• Because each firm has the same marginal cost (not strictly necessary), in equilibrium, each firm must produce the same quantity

  Imposing symmetry, the equilibrium output of each firm by equating Q1 and Q2 along a firms reaction function:

  • Q* = (a-c/2b) - (1/2)Q*
  • or:
  • Q* = (a-c/3b)
• Equations 12-13


  Represent the equilibrium output per firm
• Total market equilibrium output is twice the equilibrium output per firm

  2/3 (a-b/b)
• Cournot duopoly situation


  Output is only 2/3 of the competitive equilibrium output
• Cournot Reaction functions


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• Why do the reaction functions have these characteristics?


  1. If firm 2 produced zero units of output, the profit maximizing level of output for firm 1 would be Q₁ monopoly, and vice versa

  2. When firm 2 increases its output, the AR and MR for firm 1 decline

  3. The profit maximising response by Firm 1 is to reduce its level of output
• Cournot reactions functions


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• Isoprofit curves


  Defines the combinations of outputs of all firms that yield a given firm the same level of profits
• Isoprofit curves that lie closer to Firm 1's monopoly output Q1^m


  Are associated with higher profits for that firm. Thus n2 implies higher profits than n1
• Isoprofit curves for firm 1


  Reach their peak where they intersect Firm 1's RF, so n0 at point A; N1 at point, B and n2 at point c
• Isoprofit curves


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• Cournot model


  • General criticisms:
  • How long does it take to reach equilibrium?
  • The adjustment process (from a position of disequilibrium) is inconsistent with the assumption the opponent will not react
  • What happens if the number of firms increases (approach a perfectly competitive industry)
  • Do firms compete on output? What happens if we focus on price competition?
• Bertrand model


  Each firm assumes other firms will not react to its price decision
• Bertrand model


  • Products are homogenous (to be relaxed later)
  • Price is the only variable which influences consumer choice
• The 'game' is played for one period only
• Firms have excess capacity to meet extra demand if price declines
• Because every firm sells at the same price, the firm with the lowest price secures the market
• Bertrand Paradox


  p-mc/ p = 0

  therefore 0 profits for all firms

  Hard to believe that firms in highly concentrated industries do not conclude to increase profits;
• Relaxing the assumption of homogenous products


  • Each firm has some ability to raise its prices above rivals without losing all their customers
• Multi-period competition


  Short term gains may be outweighed by the subsequent reaction of rivals
• Capacity constraints


  • If one firm is at capacity, the other can raise price above MC, because in the short-term, the other firm may be unable to respond by increasing its output