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SECOND MEETING PJJ
ECN3101: MICROECONOMICS
SEMESTER 2, 2011/2012
Chapter 8
Perfect Competition Market Structure,
Profit Maximization and Competitive
Supply
Topics to be Discussed
 Perfectly Competitive Markets
 Profit Maximization
 Marginal Revenue, Marginal Cost, and Profit
Maximization
 Choosing Output in the Short-Run
 The Competitive Firm’s Short-Run Supply Curve
 Short-Run Market Supply
 Choosing Output in the Long-Run
©2005 Pearson Education, Inc.
Chapter 8
3
Perfectly Competitive Markets
Basic assumptions of perfectly competitive markets
 Many buyers and sellers
 Each buys and sells only a small fraction of the
total amount exchanged in the market
 Standardized or homogeneous product
 Buyers and sellers are fully informed about the
price and availability of all resources and products
 Firms and resources are freely mobile
 Individual firms have no control over the price
 Price is determined by market supply and demand
 Firm is free to produce whatever quantity
maximizes profit
©2005 Pearson Education, Inc.
Chapter 8
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Perfectly Competitive Markets
1.Price Taking
 The individual firm sells a very small share of
the total market output and, therefore, cannot
influence market price.
 Each firm takes market price as given – price
taker
 The individual consumer buys too small a
share of industry output to have any impact on
market price.
©2005 Pearson Education, Inc.
Chapter 8
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Perfectly Competitive Markets
2. Product Homogeneity
 The products of all firms are perfect substitutes.
 Product quality is relatively similar as well as
other product characteristics
 Agricultural products, oil, copper, iron, lumber
3. Free Entry and Exit
 There is no barriers or special costs that make it
difficult for a firm to enter (or exit) an industry
 Buyers can easily switch from one supplier to
another.
 Suppliers can easily enter or exit a market.
©2005 Pearson Education, Inc.
Chapter 8
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 Profit maximizing output for any firm whether
perfectly competitive or not basically focuses
on
Profit () = Total Revenue - Total Cost
Total Revenue (R) = Pq
 Costs of production depends on output
Total Cost (C) = Cq
 Profit for the firm, , is difference between
revenue and costs
 (q)  R(q )  C (q)
©2005 Pearson Education, Inc.
Chapter 8
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 Total revenue curve shows that a firm can
only sell more if it lowers its price
 Slope in total revenue curve is the marginal
revenue
 Slope of total cost curve is marginal cost
 As output rises, revenue rises faster than
costs leading to increasing profit
 Profit is maximized where MR = MC or where
slopes of the R(q) and C(q) curves are equal
©2005 Pearson Education, Inc.
Chapter 8
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Profit Maximization – Short Run
Cost,
Revenue,
Profit
($s per
year)
Profits are maximized where MR (slope
at A) and MC (slope at B) are equal
C(q)
A
R(q)
Profits are
maximized
where R(q) –
C(q) is
maximized
B
0
q0
©2005 Pearson Education, Inc.
q*
Chapter 8
Output
(q)
9
Marginal Revenue, Marginal
Cost, and Profit Maximization
 Profit is maximized at the point at which
an additional increment to output leaves
profit unchanged
  R C
 R C


0
q q q
 MR  MC  0
MR  MC
©2005 Pearson Education, Inc.
Chapter 8
10
The Competitive Firm
Demand curve faced by an individual
firm is a horizontal line – implies that
firm’s sales have no effect on market
price
Price
$ per
bushel
Firm
Demand curve faced by whole
market is downward sloping
Price
$ per
bushel
Industry
S
$4
d
$4
D
100
©2005 Pearson Education, Inc.
200
Output
(bushels)
Chapter 8
100
Output
(millions
11
of bushels)
The Competitive Firm
 The competitive firm’s demand
Individual producer sells all units for $4
regardless of that producer’s level of output.
MR = P with the horizontal demand curve
For a perfectly competitive firm, profit
maximizing output occurs when
MC (q)  MR  P  AR
©2005 Pearson Education, Inc.
Chapter 8
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Choosing Output: Short Run
 The point where MR = MC, the profit
maximizing output is chosen
MR=MC at quantity, q*, of 8
At a quantity less than 8, MR>MC so more
profit can be gained by increasing output
At a quantity greater than 8, MC>MR,
increasing output will decrease profits
©2005 Pearson Education, Inc.
Chapter 8
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A Competitive Firm
MC
Price
Lost Profit
for q2>q*
50
Lost Profit
for q2>q*
A
40
AR=MR=P
ATC
AVC
30
The point where MR = MC,
the profit maximizing
output is chosen q*= 8
20
q1 : MR > MC
q2: MC > MR
q0: MC = MR
10
0
1
2
3
4
5
6
7
q1
©2005 Pearson Education, Inc.
8
9
q* q2
Chapter 8
10
11
Output
14
A Competitive Firm – Positive Profits
Price
50
40
MC
Total
Profit =
ABCD
A
D
AR=MR=P
ATC
Profit per
unit = PAC(q) = A
to B
30 C
Profits are
determined
by output per
unit times
quantity
AVC
B
20
10
0
1
2
3
4
5
6
7
q1
©2005 Pearson Education, Inc.
Chapter 8
8
q*
9
q2
10
11
Output
15
A Competitive Firm – Losses
MC
Price
q *:
At
MR = MC
and P < ATC
B
C
D
A
Losses
= (P- AC) x
q* or ABCD
P = MR
AVC
q*
©2005 Pearson Education, Inc.
ATC
Chapter 8
Output
16
Choosing Output in the Short
Run
 Summary of Production Decisions
Profit is maximized when MC = MR
If P > ATC the firm is making profits.
If P < ATC the firm is making losses
©2005 Pearson Education, Inc.
Chapter 8
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Short Run Production
 Firm has two choices in short run
Continue producing
Shut down temporarily
Will compare profitability of both choices
 When should the firm shut down?
If AVC < P < ATC the firm should continue
producing in the short run
 Can cover some of its variable costs and all of
its fixed costs
If AVC > P < ATC the firm should shut-down.
 Can not cover even its fixed costs
©2005 Pearson Education, Inc.
Chapter 8
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A Competitive Firm – Losses
MC
Price
ATC
Losses
B
C
D
P < ATC but
AVC so
firm will
continue to
produce in
short run
A
P = MR
AVC
F
E
q*
©2005 Pearson Education, Inc.
Chapter 8
Output
19
Competitive Firm – Short Run
Supply
 Supply curve tells how much output will be
produced at different prices
 Competitive firms determine quantity to
produce where P = MC
Firm shuts down when P < AVC
 Competitive firms supply curve is portion of
the marginal cost curve above the AVC curve
©2005 Pearson Education, Inc.
Chapter 8
20
A Competitive Firm’s Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the
output level where P = MR = MC,
as long as P > AVC.
Supply is MC
above AVC
MC
S
P2
ATC
P1
AVC
P = AVC
q1
©2005 Pearson Education, Inc.
Chapter 8
q2 Output
21
Market Supply in the Short Run
S
The short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
$ per
unit
P3
P2
P1
Q
2
©2005 Pearson Education, Inc.
4
5
7 8
10
Chapter 8
15
21
22
Choosing Output in the Long
Run
 In short run, one or more inputs are fixed
Depending on the time, it may limit the
flexibility of the firm
 In the long run, a firm can alter all its inputs,
including the size of the plant.
 We assume free entry and free exit.
No legal restrictions or extra costs
©2005 Pearson Education, Inc.
Chapter 8
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Long-run Profit Maximization
 In the short run a firm faces a horizontal
demand curve
 Take market price as given
 The short-run average cost curve (SAC) and
short run marginal cost curve (SMC) are low
enough for firm to make positive profits (ABCD)
 The long run average cost curve (LRAC)
 Economies of scale to q2
 Diseconomies of scale after q2
©2005 Pearson Education, Inc.
Chapter 8
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Output Choice in the Long Run
Price
LMC
LAC
SMC
SAC
$40
D
A
P = MR
C
B
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1
©2005 Pearson Education, Inc.
Chapter 8
q2
q3
Output
25
Output Choice in the Long Run
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
LMC
Price
LAC
SMC
SAC
$40
D
C
A
E
P = MR
B
G
$30
F
q3 is
profitmaximizin
g output
Output
q1
q2
q3
Economies of scale
Diseconomies of scale
©2005 Pearson Education, Inc.
Chapter 8
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Long-run Competitive
Equilibrium
 Entry and Exit
The long-run response to short-run profits is
to increase output and profits.
Profits will attract other producers.
More producers increase industry supply
which lowers the market price.
This continues until there are no more profits
to be gained in the market – zero economic
profits
©2005 Pearson Education, Inc.
Chapter 8
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Long-Run Competitive
Equilibrium – Profits
•Profit attracts firms
•Supply increases until profit = 0
$ per
unit of
output
$ per
unit of
output
Firm
Industry
S1
LMC
$40
LAC
P1
S2
P2
$30
D
q2
©2005 Pearson Education, Inc.
Output
Chapter 8
Q1
Q2
Output
28
Long-Run Competitive
Equilibrium – Losses
•Losses cause firms to leave
•Supply decreases until profit = 0
$ per
unit of
output
Firm
LMC
$ per
unit of
output
LAC
$30
Industry
S2
P2
S1
P1
$20
D
q2
©2005 Pearson Education, Inc.
Output
Chapter 8
Q2
Q1
Output
29
Long-Run Competitive
Equilibrium
1. All firms in industry are maximizing
profits
 MR = MC
2. No firm has incentive to enter or exit
industry
 Earning zero economic profits
3. Market is in equilibrium
 QD = QD
©2005 Pearson Education, Inc.
Chapter 8
30
Chapter 10
Market Power: Monopoly
Topics to be Discussed
 Characteristics
 Average and Marginal Revenue
 Monopolist’s output decision
 Measuring monopoly power
 The Social Costs of Monopoly Power
 Regulating monopoly
©2005 Pearson Education, Inc.
Chapter 10
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Monopoly
 One seller (but many buyers), one product (no
substitutes), there are barriers to entry and price
maker
 The monopolist is the supply-side of the market
and has complete control over the amount offered
for sale.
 Monopolist controls price but must consider
consumer demand
 Profits will be maximized at the level of output
where MC = MR
 For monopolist’s P = AR = DD
 Its MR curve always below the demand curve
©2005 Pearson Education, Inc.
Chapter 10
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Total, Marginal, and Average Revenue
1. Revenue is zero when price is $6 - nothing is sold
2. At lower prices, revenue increases as quantity sold increases
3. When demand is downward sloping, the price (average revenue) is
greater than marginal revenue
4. For sales to increase, price must fall
5. When MR is positive, TR is increasing with quantity but when MR
is negative, TR is decreasing
©2005 Pearson Education, Inc.
Chapter 10
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Average and Marginal Revenue
$ per
unit of
output
7
Observations:
1. To increase sales the price must fall
2. MR < P
3. Compared to perfect competition MR
=P
6
5
Average Revenue (Demand)
4
3
2
1
Marginal
Revenue
0
1
©2005 Pearson Education, Inc.
2
3
4
Chapter 10
5
6
7 Output
35
Monopolist’s Output Decision
1. Profits maximized at the output level where MR =
MC
2. Cost functions are the same
 (Q)  R(Q)  C (Q)
 / Q  R / Q  C / Q  0  MC  MR
or MC  MR
©2005 Pearson Education, Inc.
Chapter 10
36
Monopolist’s Output Decision
$ per
unit of
output
MC
MC=MR
P1
1. At output levels
below MR = MC
the decrease in
revenue is greater
than the decrease
in cost (MR > MC).
P*
AC
P2
Lost
profit
D = AR
MR
Q1
Q*
©2005 Pearson Education, Inc.
Q2
Lost
profit
2. At output levels
above MR = MC
the increase in
cost is greater
than the decrease
in revenue (MR <
MC)
Quantity
Chapter 10
37
Example of Profit Maximization
C = TOTAL COST
$
r'
400
R = TOTAL REVENUE
300
c’
200
r
Profits
150
When profits
are maximized,
slope of rr’ and
cc’ are equal:
MR=MC
100
50
0
c
5
©2005 Pearson Education, Inc.
10
15
Chapter 10
20 Quantity
38
Profit Maximization
$/Q
40
Profit = (P - AC) x
Q = ($30 - $15)(10)
= $150
MC
P=30
AC
Profit
20
AR
AC=15
10
MR
0
5
©2005 Pearson Education, Inc.
10
15
Chapter 10
20
Quantity
39
Monopoly
 Monopoly pricing compared to perfect
competition pricing:
 Monopoly
 P > MC
 Price is larger than MC by an amount
that depends inversely on the elasticity
of demand
 Perfect Competition
 P = MC
 Demand is perfectly elastic so P=MC
©2005 Pearson Education, Inc.
Chapter 10
40
Monopoly
 If demand is very elastic, Ed is a large
negative number thus price will be close to
MC – monopoly will look much like a
perfectly competitive market. So there is
little benefit to being a monopolist.
 Note also that a monopolist will never
produce a quantity in the inelastic portion of
demand curve (Ed < 1)
In inelastic portion, can increase revenue by
decreasing quantity and increasing price
©2005 Pearson Education, Inc.
Chapter 10
41
Elasticity of Demand and Price Markup
The more elastic is
demand, the less the
Markup – little monopoly power.
$/Q
The more inelastic is
demand, the more the
Markup – more monopoly power.
$/Q
P*
MC
MC
P*
P*-MC
D
P*-MC
MR
D
MR
Q*
©2005 Pearson Education, Inc.
Quantity
Chapter 10
Q*
Quantity
42
Monopoly Power
 Pure monopoly is rare.
 However, a market with several firms,
each facing a downward sloping demand
curve will produce so that price exceeds
marginal cost.
 Firms often product similar goods that
have some differences thereby
differentiating themselves from other
firms
©2005 Pearson Education, Inc.
Chapter 10
43
Measuring Monopoly Power
 How can we measure monopoly power to
compare firms
 What are the sources of monopoly
power?
©2005 Pearson Education, Inc.
Chapter 10
44
Measuring Monopoly Power
•
An important distinction between Perfect Competition
and Monopoly: PC : P = MC ; Monopoly : P > MC
•To measure monopoly power – look the extent to which
profit maximizing P exceeds MC
•Use the markup ratio of P – MC / P as the rule of thumb
for pricing
•This measure of monopoly power is called as Lerner
Index of Monopoly Power : L = (P-MC) / P
•The Lerner Index always has a value between 0 to 1
•The larger the value of L the greater the monopoly
power
©2005 Pearson Education, Inc.
Chapter 10
45
The Social Costs of Monopoly
 Monopoly power results in higher prices and
lower quantities.
 Perfectly competitive: produce where MC = D 
PC and QC
 Monopoly produces where MR = MC  PM and
QM
 There is a loss in consumer surplus when going
from perfect competition to monopoly
 A deadweight loss is also created
 The incentive to engage in monopoly practices is
determined by the profit to be gained.
 The larger the transfer from consumers to the
firm, the larger the social cost of monopoly.
©2005 Pearson Education, Inc.
Chapter 10
46
Deadweight Loss from
Monopoly Power
$/Q
Lost Consumer Surplus
Deadweight
Loss
Pm
A
MC
B
PC
Because of the
higher price,
consumers
lose A+B and
producer gains
A-C.
C
AR=D
MR
Qm
©2005 Pearson Education, Inc.
QC
Chapter 10
Quantity
47
Regulating Monopoly
Government can regulate monopoly
power through price regulation.
Price regulation can eliminate
deadweight loss with a monopoly.
Some countries use antitrust law to
prevent firms from obtaining
excessive market power
©2005 Pearson Education, Inc.
Chapter 10
48
 Natural Monopoly
A firm that can produce the entire output of
an industry at a cost lower than what it
would be if there were several firms.
Usually arises when there are large
economies of scale
We can show that splitting the market into
two firms results in higher AC for each firm
than when only one firm was producing
©2005 Pearson Education, Inc.
Chapter 10
49
Regulating the Price of a Natural Monopoly
$/Q
Unregulated, the monopolist
would produce Qm and
charge Pm.
Pm
If the price were regulate
to be Pc,
the firm would lose money
and go out of business.
Can’t cover average costs
AC
Pr
PC
Setting the price at
Pr giving profits as
large as possible
MC without going out
of business
AR
MR
Qm
©2005 Pearson Education, Inc.
Qr
Chapter 10
QC
Quantity
50
Chapter 11
Pricing with Market Power
(Price Discrimination by
Monopoly)
Introduction
 Pricing without market power such as in
perfect competition is determined by market
supply and demand.
 Pricing with market power (imperfect
competition) requires the individual producer
to know much more about the characteristics
of demand as well as manage production.
 The main objective of all pricing strategies is
to capture consumer surplus and transfer it to
the producer
©2005 Pearson Education, Inc.
52
Price Discrimination
 Monopoly increases it profit by charging higher prices
to those who value the product more.
 The practice of charging difference prices to different
customers is called price discrimination
Conditions:
Demand curve must slope downward – the firm has
some market power and control over price
At least two groups of consumers for the product,
each with a different price elasticity of demand
Ability, at little cost, to charge each group a
different price for essentially the same product
Ability to prevent those who pay the lower price
from reselling the product to those who pay the
higher price
•
•
•
•
•
©2005 Pearson Education, Inc.
53
Types of Price Discrimination
 First Degree Price Discrimination
Charge a separate price to each customer: the
maximum or reservation price they are willing to
pay.
 Second Degree Price Discrimination
In some markets, consumers purchase many units
of a good over time
Practice of charging different prices per unit for
different quantities of the same good or service
 Third Degree Price Discrimination
Practice of dividing consumers into 2 or more
groups with separate demand curves and
charging different prices to each group
1. Divides the market into two-groups.
2. Each group has its own demand function.
©2005 Pearson Education, Inc.
54
First-Degree Price Discrimination
 Examples of imperfect price discrimination
where the seller has the ability to segregate
the market to some extent and charge
different prices for the same product:
Lawyers, doctors, accountants
Car salesperson (15% profit margin)
Colleges and universities (differences in financial
aid)
©2005 Pearson Education, Inc.
55
First Degree Price Discrimination
$/Q
Pmax
P1
P2
P*
P3
P4
MC
PC
D
Q1 Q2 Q*
©2005 Pearson Education, Inc.
MR
Q3 Q4 Qc
Quantity
56
Second-Degree Price
Discrimination
 Practice
of charging different prices per unit for
different quantities of the same good or service
 Example-
water, electricity, fuel, quantity
discounts
 Quantity discounts are an example of 2nd
degree price discrimination (bulk buying)
pricing – the practice of charging different
prices for different quantities of ‘blocks’ of a
good. Ex: electric power companies charge
different prices for a consumer purchasing a set
block of electricity
 Block
©2005 Pearson Education, Inc.
57
Second-degree Price Discrimination
$/Q
P1
P0
P2
AC
MC
P3
D
MR
Q1
1st Block
Q0
2nd Block
Q2
Q3
Quantity
3rd Block
1. Different prices are charged for different quantities or
“blocks” of same good
2. Without PD: P = P0 and Q = Q0. With second-degree
discrimination there are three blocks with prices P1,
©2005 Pearson
Education,
58
P2, &
P3. Inc.
Third-Degree Price Discrimination
 Practice of dividing consumers into two
or more groups with separate demand
curves and charging different prices to
each group
1. Divides the market into two-groups.
2. Each group has its own demand function.
 Most common type of price
discrimination.
 Examples: airlines, discounts to students
and senior citizens, frozen v. canned
vegetables
©2005 Pearson Education, Inc.
59
Third degree Price Discrimination
1. Suppose the consumer are sorted into 2 groups with different demand elasticities
2. Assume the firm produces at a constant LRAC and MC =$1.00
3. At a given price, price elasticity of demand (panel b, elastic-more sensitive to price)
is greater than in panel a (inelastic).
4. The firm maximizes profit by finding the price in each market that equates
MC=MR
5. So consumers with lower price elasticity pay $3.00 and those with higher price
©2005 Pearson Education, Inc.
60
elasticity pay $1.50
Chapter 12
Monopolistic Competition and
Oligopoly
Topics to be Discussed
 Monopolistic Competition
 Oligopoly
 Price Competition
 Competition Versus Collusion: The
Prisoners’ Dilemma
 Implications of the Prisoners’ Dilemma
for Oligopolistic Pricing
 Cartels
©2005 Pearson Education, Inc.
62
Monopolistic Competition
 Characteristics
1. Many firms
2. Free entry and exit
3. Differentiated product
 The amount of monopoly power depends on
the degree of differentiation.
 Examples of this very common market
structure include:
 Toothpaste
 Soap
 Cold remedies
©2005 Pearson Education, Inc.
63
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
©2005 Pearson Education, Inc.
64
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
©2005 Pearson Education, Inc.
65
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
©2005 Pearson Education, Inc.
Quantity
MRLR
QLR
Quantity
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
©2005 Pearson Education, Inc.
Quantity
QMC
Excess
capacity
Quantity
Monopolistic Competition &
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.
©2005 Pearson Education, Inc.
68
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
©2005 Pearson Education, Inc.
69
Oligopoly – Characteristics
 Small number of firms
 Product – identical or differentiation
 Barriers to entry
 Scale economies
 Patents
 Technology
 Name recognition
 Strategic action
 Examples
 Automobiles
 Steel
 Aluminum
 Petrochemicals
 Electrical equipment
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Oligopoly
In oligopoly the quantity sold by any one firm
depends on that firm’s price and on the
other firm’s prices and quantities sold
 So the main management challenges facing
oligopoly firms are to determine
The 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
Some might cut price , the same amount, or
more than firm
Could lead to price war and drastic fall in
profits for all
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Models in Oligopoly
Several models were developed to explain the
prices and quantities in oligopoly markets
 The Cournot Model
 Collusion Model: Cartels
 Stackelberg Model
 Bertrand Model
 Price Rigidity and Kinked Demand Curve
Model
 Game Theory : The Prisoners’ Dilemma
 The Dominant Firm Model
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Oligopoly – Equilibrium
 Defining Equilibrium
Equilibrium refers to situation where 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.
(Each firm interact with one another choosing the
best strategy given the strategies the others
have chosen)
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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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Firm 1’s Output Decision
1.
Assuming MC is constant at MC1.
2.
Firm 1’s profit-maximizing output
depends on how much it thinks
that Firm 2 will produce
3.
If firm 1 thinks Firm 2 will
produce nothing – D1(0) is the
market DD curve. MR1(0)
intersects Firm 1’s MC1 at Q=50
units
4.
If firm 1 thinks that Firm 2 will
produce 50 units, its demand
curve = D1(50). Profit
maximization output=25 units
5.
If Firm 1 thinks that Firm 2 will
produce 75, Firm 1 will produce
only 12.5 units
P1
D1(0)
MR1(0)
MC1
MR1(75) MR1(50)
12.5
25
D1(50)
D1(75)
50
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Q1
Firm 1
Firm 2
50
0
25
50
12.5
75
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First Mover Advantage – The
Stackelberg Model
 In Cournot Model it is assumed that two
duopolists make their output decisions at the
same time. In Stackelberg Model one firm sets
its output before other firms do.
 Two main questions are : First, is it
advantageous to go first? Second, how much
will each firm produce?
 Assumptions
 One firm can set output first
 Firm 1 sets output first and Firm 2 then makes an
output decision after seeing Firm 1 output
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First Mover Advantage – The
Stackelberg Model
 Conclusion
Going first gives firm 1 the advantage
Firm 1’s output is twice as large as firm 2’s
Firm 1’s profit is twice as large as firm 2’s
 Going first allows firm 1 to produce a
large quantity. Firm 2 must take that into
account and produce less unless wants
to reduce profits for everyone
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Price Competition with Homogenous Products –
The Bertrand Model
 Competition in an oligopolistic industry
may occur with price instead of output.
 The Bertrand Model (developed by French
economist, Joseph Bertrand, 1883)
It is a model of price competition between
doupoly firms which results in each charging
the price that would be charged under perfect
competition (known as marginal cost pricing)
In which each firm treats the price of its
competitors as fixed, and all firms decide
simultaneously what price to charge
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Price Competition – Bertrand
Model
 The questions is , what is the Nash Equilibrium
in this case?
 N.E. is where each firm interact with one another
choosing the best strategy given the strategies
the others have chosen
 In this case because there is an incentive to cut
prices, the N.E is the competitive outcome
where both firms will set P=MC
 Both firms earn zero profit
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Game Theory and The Prisoners’
Dilemma
 Game theory examines oligopolistic behavior as a series of
strategic moves and countermoves among rival firms
 It analyzes the behavior of decision-makers, or players, whose
choices affect one another
 Provides a general approach that allows us to focus on each
player’s incentives to cooperate or not
 There are 3 main features:
1. Rules
2. Strategies
3. Payoffs
 Payoff matrix is a table listing the rewards or penalties that each
can expect based on the strategy that each pursues. The
numbers in the matrix indicate the prison sentence in years for
each based on the corresponding strategies
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Example: Prisoners’ Dilemma - Payoff Matrix
 Suppose Art and Bob have been caught for stealing and will
receive a sentence of 2 years for the crime.
 During investigation it is suspected that A and B were
responsible for a bank robbery sometime ago. To proof this
they were placed in separate room to investigate.
 If both confess – each will get 3 years sentence
 If one confess and other deny – the one who confess gets 1 year
and the other one will get 10 year sentence
 Each of them have 2 option or strategies : confess or deny
 Payoffs – both confess
both deny
Art confess and Bob denies
Bob confess and Art denies
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Prisoners’ Dilemma Payoff Matrix
Art’s Strategies
Confess
Confess
Bob’s
Strategies
Deny
3 years
Deny
10 years
3 years
1 year
2 years
1 year
2 years
10 years
1. The equilibrium of the game occurs when player A takes the possible action given
the action of player B and the player B takes the best possible action given the
action of player A
2. In the case of prisoners’ dilemma, the equilibrium occurs when Art makes his best
choice given Bob’s choice and when Bob makes his choice given Art’s choice.
3. Art’s point of view – if Bob confess, Art also must confess because he gets 3 years
compared to 10 years. If Bob does not confess, it still pays Art to confess because
he receives 1 year rather than 2 years – so the best action for Art is to confess
4. Bob’s point of view – if Art confess, Bob must confess because he gets 3 years
rather than 10 years. If Art does not confess, it still pays Bob to confess because
he receives 1 years rather than 2 years – Bob’s best action is to confess
5. ©2005
ThusPearson
the equilibrium
of the game is to confess and each gets 3-year prison term83
Education, Inc.
Price Rigidity and Kinked Demand
Curve Model
In other oligopoly markets, the firms are very
aggressive and collusion is not possible.
a. Firms are reluctant to change price because of the
likely response of their competitors.
b. In this case prices tend to be relatively rigid.
 Price rigidity – characteristic of oligopolistic
markets by which firms are reluctant to change
prices even if costs or demands change
 Fear lower prices will send wrong message to
competitors leading to price war
 Higher prices may cause competitors to raise theirs
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A Kinked Demand Curve Oligopoly Model
 Assumption:
i. Firms believe that rivals will follow if they cut prices
but not if they raise prices
ii. Assume the elasticity of demand in response to an
increase in price is different from the elasticity of
demand in response to a price cut – which result a
‘kink’ in the demand for a single firm’s product
 With a kinked demand curve, marginal revenue curve is
discontinuous
 Firm’s costs can change without resulting in a change
in price
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The Kinked Demand Curve
$/Q
So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.
MC’
P*
MC
D
Quantity
Q*
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1. Above P*, demand is
very elastic.
2. If P>P*, other firms
will not follow
3. Below P*, demand is
very inelastic.
4. If P<P*, other firms
will follow suit
MR
86
Price Signaling and Price
Leadership
Generally it is difficult to make collusion on
pricing as cost and demand conditions are
always changing. So firms adopt price
signaling or price leadership.
 Price Signaling
 Implicit collusion in which a firm announces a price
increase in the hope that other firms will follow suit
 Price Leadership
 Pattern of pricing in which one firm (leader)
regularly announces price changes that other firms
(price followers) then match
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 Signaling and price leadership might lead to
an antitrust lawsuit especially when there is a
large firm which naturally emerge as a leader
 Price leadership also serve as a way for
oligopolistic firm to deal with firms that are
reluctance to change prices ( fear for being
undercut). As demand and cost change,
firms may find it necessary to change price
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Cartels
 Producers in a cartel explicitly agree to
cooperate in setting prices and output.
 Typically only a subset of producers are
part of the cartel and others benefit from
the choices of the cartel
 If demand is sufficiently inelastic and
cartel is enforceable, prices may be well
above competitive levels
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Cartels
 Examples of
successful cartels
 OPEC
 International Bauxite
Association
 Mercurio Europeo
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 Examples of
unsuccessful cartels
 Copper
 Tin
 Coffee
 Tea
 Cocoa
90
A Summary of Market Structures
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Assumptions
Number of firms
Very many
Many
Few
One
Output of
different firms
Standardized
Differentiated
Standardized or
Differentiated
-
View of pricing
Price taker
Price setter
Price setter
Price setter
Barriers to entry
or exit
No
No
Yes
Yes
strategic
interdependence
No
No
Yes
No
Predictions
P and Q decisions
MC = MR
Short-run profit
Long-run profit
Through strategic
interdependence
MC = MR
Positive, zero, Positive, zero,
negative
negative
Positive, zero, negative
Positive,
zero,
negative
zero
zero
Positive or zero
Positive or
zero
Almost always
Maybe, if differentiated
Sometimes
91
Advertising
never
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Inc.
MC = MR