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Two broad cases are noteworthy: Monopolistic Competition Until now, we have studied two extreme cases of competition: perfect competition and monopoly. Yet, reality is often in between: often, a firm’s residual demand curve is downward sloping. This is the case when fixed costs in an industry are large compared to market demand, but not as big as to create a natural monopoly. • Oligopoly: The good in question is relatively homogenous, but entry is limited because of (quasi-)fixed costs (or possibly regulation). • Monopolistic competition: The good of one supplier is unique, but there exist close substitutes for the good. In practice, the distinction between these two market forms is sometimes difficult to draw precisely. 1 Monopolistic competition is characterized by the following features: 1. A firm produces a specific variety of a good, which consumers perceive as different from that offered by competitors ( = product differentiation, e.g. geographic location, quality, taste, …) → Monopolistically competitive firm has market power; firm’s residual demand curve is downward sloping, because consumers only gradually shift away when firm raises its price. Firm’s MR curve is downward sloping. 3 2 2. The firm must pay high quasi-fixed costs to maintain its brand name (remember: quasifixed costs are paid independently of the quantity sold, if the quantity is positive). → ACs decline over a large range, and the industry’s minimum efficient scale is large. 3. Entry is possible in principle. → firms in a monopolistically competitive industry make (approximately) zero profits. 4 1 These features together imply that firm behaviour in monopolistic competition is given by two simple rules: p, $ per unit AC MC p = AC p 1. Marginal revenue equals marginal cost 2. Price equals average cost. MR r =MC In particular, the firm’s residual demand curve and its average cost curve are tangent at the firm’s optimal operating decision. MR r 5 Three points to note: • Monopolistically competitive equilibrium is inefficient: price is above marginal cost. • In monopolistically competitive industries, there is excess capacity: if there were fewer firms, each firm could slide down its average cost curve by expanding output (but careful: less variety). • Firms’ profits are driven to zero because of potential entry. But because quasi-fixed costs are large, not all profits need to be eroded. Hence, profits are only approximately zero. 7 Dr q, Units per year q p 300 6 Example: The Swiss coated cornflakes market (hypothetical numbers). 2 firms with quasi-fixed cost of SFr. 2.3 million: 275 π = $1.8 million 211 183 AC MC 147 D r for 2 firms MR r for 2 firms 0 64 137.5 275 q, Thousand tons per year 8 2 With 3 firms, the individual firm’s residual demand curve shifts inward. All 3 firms make zero profits. p Note: if fixed cost is larger than SFr. 2.3 million, the third firm does not enter, and both firms make positive profits (smaller than SFr. 1.8 million). 300 243 195 An example of product differentiation: geographic location (Hotelling) Imagine the beach of a sea-side resort. Suppose the beach is one kilometer long, and families are distributed equally along the beach. AC MC 147 D MR 0 48 r r for 3 firms for 3 firms 121.5 q , Thousand tons per year 243 9 10 Answer: At x = 0.25 and x = 0.75. The vendors have a clientele of [0, 0.5) and (0.5, 1], respectively. The average walking distance of all the people on the beach is minimized if the vendor sets up his shop at: x = 0.5 But if the two vendors are acting competitively, where do they locate? (To simplify assume that they charge the same price.) (where x = 0 represents the left end-point and x = 1 the right end-point of the beach). Now assume that there are two ice-cream vendors. Where should the two optimally locate? If there is one vendor who sells ice-cream, where should the vendor be located? The vendor at x = 0.25 has an incentive to move to the right: by doing this, she keeps all her old customers, but captures some new customers in the middle. 11 12 3 Another application: Circular City (Salop) Similarly, the vendor at x = 0.75 has an incentive to move to the left. Result: - Both vendors locate at x = 0.5. - The monopolistically competitive equilibrium is inefficient (too little variety). 13 Oligopoly We now turn to markets in which the good in question is relatively homogenous, but there are only few suppliers in the market because of high fixed costs or other entry barriers. In such markets (oligopolies), the production choice of each producer has a strategic impact on all other producers. 15 14 Reminder: The distinction between oligopoly and monopolistic competition is not always clear cut. On the one hand, homogenous goods offered by different firms are rarely exactly identical, on the other hand, even if a producer sells a differentiated product that protects her somewhat from market pressure, the other producers’ strategic choices will matter for her. 16 4 We study the simplest form of oligopoly: duopoly (“two sellers”) The strategic interaction in such a market can and does take many forms. In particular, one should ask: Assumptions: • Is the relevant choice variable price or quantity? • Is one firm dominant (leads in the decision making)? • (Both these questions are irrelevant in monopoly or in perfect competition) • Market with one homogenous product, market demand D(p) • Two firms in the market, no entry • Firm i has cost function C i (q ) . 17 The Cournot model 18 2 In this model (Augustin Cournot, 1838), neither firm is dominant (in the sense that it can directly influence the other’s decision making), and both firms choose quantities. The important point: Each firm’s optimal behaviour depends on what the other firm does. If, for example, firm 2 chooses quantity q , firm 1 faces a residual demand curve of D r ( p) = D( p ) − q 2. Firm 1 will, therefore, maximise its returns from pricing on this residual demand curve. If p(Q) = D −1(Q ) is the inverse market demand curve, this means that firm 1 chooses q1 to maximize p(q1 + q 2 )q1 − C 1(q1) 19 20 5 Assuming constant marginal cost: This argument gives an optimal quantity q1 = R1(q 2 ) for firm 1 as a function of what firm 2 produces. p Similarly, we can derive the optimal quantity of firm 2 as a function of what firm 1 does: q 2 = R 2 (q1) . MC The R i are called best-response functions or reaction functions. q 2 MR r 0 Dr D q1 21 The Cournot equilibrium is defined as the pair (q1, q 2 ) such that q1 = R1(q 2 ) and q 2 = R 2 (q1) . In words: firm 1’s behaviour is the best response to firm 2’s behaviour, and firm 2’s behaviour is the best response to firm 1’s behaviour. In other words: each firm chooses an output based on a belief about the other firm’s choice, and no firm has an incentive to change its behaviour, once it learns the competitor’s choice. 23 22 The Cournot equilibrium is the intersection point of the two best-response curves: q2 Firm 1’s best-response curve Cournot equilibrium Firm 2’s best-response curve 0 q1M q1 24 6 Application: Competition in the airline market On many air-traffic routes, there are very few direct flights. In Europe these flights are often limited to the national carriers. Example: Geneva – Berlin, where only Swiss and Lufthansa offer direct flights. The “production function” of air travel is characterized by • constant and relatively low marginal costs • high fixed costs We study competition between Swiss and Lufthansa on the Geneva - Berlin route by using a simple Cournot model, using rough estimates of cost and demand. Variables (expressed as one-way flight): • price p (in SFr) L S • quantity Q = q + q (1000 passengers/year) • Demand: D(p) = 300 – 0.3 p • Cost: VC(q) = 300q (identical for both L S carriers) and F = 13,000,000; F = 8,000,000) 25 The Cournot equilibrium is given by the intersection of these two reaction functions: The Swiss perspective: maximize pq S − 300 q S = (1000 − 3.33(q S + q L )) q S − 300q S q S = 105 − 0.5q L = 105 − 0.5(105 − 0.5q S ) = 70 By symmetry, also q L = 70 . This gives a total quantity of Q = 140 and a price of p = 533.33. At this price, each airline makes a profit of LH: (533.33 – 300)70,000 – 8,000,000 = 8.33 million/year) SWISS: (533.33 – 300)70,000 – 13,000,000 = 3.33 million/year The optimum is at q = 105 − 0.5q . L 26 S The Lufthansa perspective: maximize (1000 − 3.33( q S + q L ))q L − 300q L S L which yields q = 105 − 0.5q 27 28 7 Generalisation of Cournot model Consider n firms, all with identical cost structures, C(q) = cq. Remark: The model is simplified in several respects. One is the lack of price discrimination: airlines charge at least two prices for the same flight in the same class, one discounted for weekend travels and one marked up for within-week travel. Linear market demand: p = a - bQ (for Q < a/b). The individual firm maximizes profits: (a − b( q1 + ...q n ) − c)q i which gives the reaction function: qi = 29 a − c − b(q 2 + ... + q n ) − 2bq1 = 0 M • For n = 1, this is just the monopoly output (determined by a- 2bQ = c). n j Summing all these equations, using ∑ q = Q , j =1 yields n(a − c) − nbQ = bQ which means Q= n a−c n +1 b 30 This simple formula is very useful and reasonable: The n reaction functions form a system of n equations in n variables: a − c − b(q1 + ... + q n −1 ) − 2bq n = 0 1 (a − c − b∑ q j ) 2b j ≠i 31 • As n increases, Q increases. • As n becomes large, Q tends to (a – c)/b. But this is just the competitive output (given by c = a – bQ) 32 8 Summary Table Hence, the Cournot model provides a model that fits in between the monopoly outcome and the competitive outcome, and the number of firms indicates a “degree of competitiveness”. 33 34 9