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Chapter 12
Monopolistic Competition
and Oligopoly
Topics to be Discussed
Monopolistic Competition
Oligopoly
Price Competition
Competition Versus Collusion: The
Prisoners’ Dilemma
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Monopolistic Competition
Characteristics
1. Many firms
2. Free entry and exit
3. Differentiated product
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Monopolistic Competition
The amount of monopoly power depends
on the degree of differentiation
Examples of this very common market
structure include:
Toothpaste
Soap
Cold remedies
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Monopolistic Competition
Toothpaste
Crest and monopoly power
Procter
& Gamble is the sole producer of Crest
Consumers can have a preference for Crest –
taste, reputation, decay-preventing efficacy
The greater the preference (differentiation) the
higher the price
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Monopolistic Competition
Two important characteristics
Differentiated but highly substitutable
products
Free entry and exit
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A Monopolistically Competitive
Firm in the Short and Long Run
$/Q
Short Run
$/Q
MC
Long Run
MC
AC
AC
PSR
PLR
DSR
DLR
MRSR
QSR
Quantity
MRLR
QLR
Quantity
A Monopolistically Competitive
Firm in the Short and Long Run
Short run
Downward sloping demand – differentiated
product
Demand is relatively elastic – good
substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits
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A Monopolistically Competitive
Firm in the Short and Long Run
Long run
Profits will attract new firms to the industry
(no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC some monopoly power
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Monopolistically and Perfectly
Competitive Equilibrium (LR)
$/Q
Monopolistic Competition
Perfect Competition
$/Q
MC
Deadweight
loss
AC
MC
AC
P
PC
D = MR
DLR
MRLR
QC
Quantity
QMC
Quantity
Monopolistic Competition and
Economic Efficiency
The monopoly power yields a higher
price than perfect competition. If price
was lowered to the point where MC = D,
consumer surplus would increase by the
yellow triangle – deadweight loss.
With no economic profits in the long run,
the firm is still not producing at minimum
AC and excess capacity exists.
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Monopolistic Competition and
Economic Efficiency
Firm faces downward sloping demand so
zero profit point is to the left of minimum
average cost
Excess capacity is inefficient because
average cost would be lower with fewer
firms
Inefficiencies would make consumers worse
off
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Monopolistic Competition
If inefficiency is bad for consumers,
should monopolistic competition be
regulated?
Market power is relatively small. Usually
there are enough firms to compete with
enough substitutability between firms –
deadweight loss small.
Inefficiency is balanced by benefit of
increased product diversity – may easily
outweigh deadweight loss.
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The Market for Colas and Coffee
(Ex
12-1)
Each market has much differentiation in
products and tries to gain consumers
through that differentiation
Coke vs. Pepsi
Maxwell House vs. Folgers
How much monopoly power do each of
these producers have?
How elastic is demand for each brand?
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Elasticities of Demand for Brands of
Colas and Coffee (Ex 12-1)
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The Market for Colas and Coffee
(Ex
12-1)
The demand for Royal Crown is more
price inelastic than for Coke
There is significant monopoly power in
these two markets
The greater the elasticity, the less
monopoly power and vice versa
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Oligopoly – Characteristics
Small number of firms in a market
Product differentiation may or may not
exist
Barriers to entry
Scale economies
Patents
Technology
Name recognition
Strategic action
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Oligopoly
Examples
Automobiles
Steel
Aluminum
Petrochemicals
Electrical equipment
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Oligopoly
Management Challenges
Strategic actions to deter entry
Threaten
to decrease price against new
competitors by keeping excess capacity
Rival behavior
Because
only a few firms, each must consider
how its actions will affect its rivals and in turn
how their rivals will react
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Oligopoly – Equilibrium
If one firm decides to cut their price, they
must consider what the other firms in the
industry will do
Could cut price some, the same amount, or
more than firm
Could lead to price war and drastic fall in
profits for all
Actions and reactions are dynamic,
evolving over time
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Oligopoly – Equilibrium
Defining Equilibrium
Firms are doing the best they can and have no
incentive to change their output or price
All firms assume competitors are taking rival
decisions into account
Nash Equilibrium
Each firm is doing the best it can given what its
competitors are doing
We will focus on duopoly
Markets in which two firms compete
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Oligopoly
The Cournot Model
Oligopoly model in which firms produce a
homogeneous good, each firm treats the
output of its competitors as fixed, and all
firms decide simultaneously how much to
produce
Firm will adjust its output based on what it
thinks the other firm will produce
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French philosopher,
mathematician and economist,
Augustin Cournot has been
rightly hailed as one of the
greatest of the ProtoMarginalists . The unique
insights of his major
economics work, Pcafcpafcq
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were without parallel.
Although neglected in his time,
the impact of Cournot work on
modern economics can hardly
be overstated.
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Firm 1’s Output Decision
P1
Firm 1 and market demand curve,
D1(0), if Firm 2 produces nothing.
D1(0)
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(0)
D1(75)
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MR1(75)
MC1
MR1(50)
12.5 25
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D1(50)
50
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Q1
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Oligopoly
The Reaction Curve
The relationship between a firm’s profitmaximizing output and the amount it thinks
its competitor will produce
A firm’s profit-maximizing output is a
decreasing schedule of the expected output
of Firm 2
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Reaction Curves and Cournot
Equilibrium
Q1
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model.
100
75
Firm 2’s Reaction
Curve Q*2(Q1)
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce.
50 x
25
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
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50
x
75
Chapter 12
x
100
Q2
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Reaction Curves and Cournot
Equilibrium
Q1
100
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits.
75
Firm 2’s Reaction
Curve Q*2(Q1)
50 x
25
Cournot
Equilibrium
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
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50
x
75
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x
100
Q2
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Cournot Equilibrium
Each firm’s reaction curve tells it how
much to produce given the output of its
competitor
Equilibrium in the Cournot model, in
which each firm correctly assumes how
much its competitor will produce and sets
its own production level accordingly
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Oligopoly
Cournot equilibrium is an example of a
Nash equilibrium (Cournot-Nash
Equilibrium)
The Cournot equilibrium says nothing
about the dynamics of the adjustment
process
Since both firms adjust their output, neither
output would be fixed
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The Linear Demand Curve
An Example of the Cournot Equilibrium
Two firms face linear market demand curve
We can compare competitive equilibrium and
the equilibrium resulting from collusion
Market demand is P = 30 - Q
Q is total production of both firms:
Q = Q1 + Q2
Both firms have MC1 = MC2 = 0
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Oligopoly Example
Firm 1’s Reaction Curve MR = MC
Total Revenue : R1 = PQ1 = (30 − Q )Q1
= 30Q1 − (Q1 + Q2 )Q1
= 30Q1 − Q12 − Q2Q1
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Oligopoly Example
An Example of the Cournot Equilibrium
MR1 = ΔR1 ΔQ1 = 30 − 2Q1 − Q2
MR1 = 0 = MC1
Firm 1' s Reaction Curve
Q1 = 15 − 1 2 Q2
Firm 2' s Reaction Curve
Q2 = 15 − 1 2 Q1
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Oligopoly Example
An Example of the Cournot Equilibrium
Cournot Equilibrium : Q1 = Q2
15 − 1 2(15 − 1 2Q1 ) = 10
Q = Q1 + Q2 = 20
P = 30 − Q = 10
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Duopoly Example
Q1
30
Firm 2’s
Reaction Curve
The demand curve is P = 30 - Q and
both firms have 0 marginal cost.
Cournot Equilibrium
15
10
Firm 1’s
Reaction Curve
10
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Q2
34
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