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Chapter 7.1Monopolistic Competition
and Oligopoly
Chapter 7.1Monopolistic Competition
and Oligopoly
The Continuum of the Market StructureThe Continuum of the Market Structure
Perfect Competition
n=infinityn=1
Monopoly
n large
Monopolistic Competition
n small
Oligopoly
No of firms, n
MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION
• Assumptions of monopolistic competition
• Each firm sells a different variety or brand (think
of coke or restaurants)
• There are many firms
– Act independently – ignore others’ reactions
• Freedom of Entry and Exit
• There is Symmetry
– New firms affect all old ones equally
• Assumptions of monopolistic competition
• Each firm sells a different variety or brand (think
of coke or restaurants)
• There are many firms
– Act independently – ignore others’ reactions
• Freedom of Entry and Exit
• There is Symmetry
– New firms affect all old ones equally
MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION
• Equilibrium:
– short run
• Equilibrium:
– short run
Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.
£
Q O
Ps
Qs
The ‘Industry’ Demand Curve looks
like this
Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.
£
Q O
Ps
Qs
What about an individual
restaurant?
It is further in
and flatter
Why?
Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.
£
Q O
Ps
Qs
Each restaurant type has a share of
the industry
But knows that it can only vary its
price a little
Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.
£
Q O
Ps
Qs
What if a new competitor appears?
Demand line shifts in more and flattens
more
Getting closer and closer to Perfect
Competition
£
Q O
Ps
Qs
So now suppose we have a firm like the blue line … So now suppose we have a firm like the blue line … and this restaurant is doing well in the short-runand this restaurant is doing well in the short-run
Let’s make the picture biggerLet’s make the picture bigger
£
Q O
MR
AR D
Ps
Qs
Let’s make the picture biggerLet’s make the picture bigger
£
Q O
AC
MR
AR D
Ps
Qs
MC
£
Q O
AC
MR
AR D
Ps
Qs
MC
ACs
Short-run equilibrium of the firm under monopolistic Short-run equilibrium of the firm under monopolistic competitioncompetition
£
Q O
AC
MR
AR D
Ps
Qs
MC
ACs
Short-run equilibriumShort-run equilibrium
£
Q O
AC
MR
D
Qs
MC
ACs
What happens now?What happens now? New Firms enter
What happens to D?
So P and Q down
P1
£
Q O
AC
MR
D
Qs
MC
ACs
What happens now?What happens now? New Firms enter
What happens to D?
So P and Q down
And Super-normal Profits down
£
Q O
AC
MR
D
Qs
MC
ACs
What happens now?What happens now? New Firms enter
What happens to D?
So P and Q down
And Super-normal Profits down
What Happens Next?What Happens Next?
• Still Super-Normal ProfitsStill Super-Normal Profits
• So firms keep enteringSo firms keep entering
• P keeps falling and Super-normal profits P keeps falling and Super-normal profits keep falling until….keep falling until….
• In the LRIn the LR
• AR = AC and there are no supernormal AR = AC and there are no supernormal profitsprofits
£
Q O
LRAC
MRL
ARL DL
PL
QL
LRMC
Long-run equilibrium of the firm under Long-run equilibrium of the firm under monopolistic competitionmonopolistic competition
NOTICE:NOTICE:
• AR (=D) curve still slopes downAR (=D) curve still slopes down
• So not in perfectly competitive caseSo not in perfectly competitive case
• Firms have market power (can choose price Firms have market power (can choose price and quantity), but….and quantity), but….
• Competition is such that this power is Competition is such that this power is illusory (in the long run)illusory (in the long run)
MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION
• Limitations of the model– imperfect information about profits and demand
– difficulty in identifying industry demand curve
– indivisibilities/local monopolies
– importance of non-price competitionVariety Advertising
• Limitations of the model– imperfect information about profits and demand
– difficulty in identifying industry demand curve
– indivisibilities/local monopolies
– importance of non-price competitionVariety Advertising
MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION
•The public interest
–comparison with perfect competition;
PRODUCTION WILL NOT OCCUR WHERE LRAC IS AT ITS MINIMUM (unlike perfect competition which is efficient)
Long run equilibrium under perfect andLong run equilibrium under perfect andmonopolistic competition (with decreasing or constant monopolistic competition (with decreasing or constant
returns to scale)returns to scale)£
QO
P1
LRAC
DL under perfect
competition
Q1
Long run equilibrium under perfect andLong run equilibrium under perfect andmonopolistic competition (with decreasing or constant monopolistic competition (with decreasing or constant
returns to scale)returns to scale)£
QO
P2
P1
LRAC
DL under perfect
competition
DL under monopolistic
competition
Q2 Q1
The Continuum of the Market StructureThe Continuum of the Market Structure
Perfect Competition
n=infinityn=1
Monopoly
n large
MonopolisticCompetition
n small
Oligopoly
No of firms, n
OLIGOPOLYOLIGOPOLY
• Key features of oligopolyKey features of oligopoly
– barriers to entrybarriers to entry
– interdependence of firmsinterdependence of firms
– ~What’s he up to?~What’s he up to?
– incentives to compete versus incentives to incentives to compete versus incentives to colludecollude
Day 1: Suppose initially Monopoly firm in the Day 1: Suppose initially Monopoly firm in the IndustryIndustry£
O Q
D
To make life simple suppose P=200-Q is the demand curve
Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry
£
O Q
D
To make life simple suppose P=200-Q is the demand curve,
And MC are zero
What is the MR curve?
200
200
Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry
£
O Q
D
P=200-Q
TR= P*Q
TR=[200-Q]*Q
TR=200Q-Q2
MR=200-2Q
200
200
Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry
£
O Q
D
P=200-Q
TR= P*Q
TR=[200-Q]*Q
TR=200Q-Q2
MR=200-2Q
200
200
MR
100
If MR = 0,
200=2Q
MC
Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry
£
O Q
D
What quantity will this firm supply to the
market
MR=MC at 100
Q=100
P=200-Q
P=200-100
=100
200
200
MR
100
MC
P=100
Suppose initially Monopoly firm in the IndustrySuppose initially Monopoly firm in the Industry
£
O Q
D
So monopolist supplies half the
market in this case
(Linear demand, MC=0)
200
200
MR
100
MC
P=100
Day 2: Harmony is broken! Suppose now a new firm Day 2: Harmony is broken! Suppose now a new firm notices there are unfulfilled customersnotices there are unfulfilled customers£
O Q
D
What will new firm do?
200
200
MR
100
MC
P=100
Suppose now a new firm notices there are unfulfilled Suppose now a new firm notices there are unfulfilled customerscustomers£
O Q
D
What will new firm do?
200
200
MR
100
MC
P=100
MC2
It thinks it has demand
P=100-Q
MR=100-2Q
Suppose now a new firm notices there are unfulfilled Suppose now a new firm notices there are unfulfilled customerscustomers
Q
D
What will new firm do?200
100
MR
0
MC
P=100
MC2
It thinks it has demand
P=100-Q
MR=100-2Q
It is just looking at this bit of
the market
Setting MC = MR
=0
100=2Q
Q=50
• So now firm 1 is supplying 100 unitsSo now firm 1 is supplying 100 units
• And firm 2 is supplying 50 UnitsAnd firm 2 is supplying 50 Units
• Will firm 1 accept that?Will firm 1 accept that?
• How will it react?How will it react?
Day 3: The reckoningDay 3: The reckoning£
O Q
D
Firm 1 sees that 50 people are already
being supplied. So its market is
P=200-Q –50
P=150-Q
200
200
MR
100
MC
P=100
MC2
Day 3: The reckoningDay 3: The reckoning£
O Q
D
Firm 1 sees that 50 people are already
being supplied. So its market is
P=200-Q –50
P=150-Q
200
200
MR
100
MC
P=100
150
150
Day 3: The reckoningDay 3: The reckoning£
O Q
D
And MR is now
MR=150-2Q
So when MR=MC=0
Q=75
200
200
MR
100
MC
P=100
150
75
• Firm 1 was supplying 100 unitsFirm 1 was supplying 100 units
• Is Now Supply 75 unitsIs Now Supply 75 units
• Firm 2 is still producing 50 unitsFirm 2 is still producing 50 units
• How will firm 2 react to the cut in firm 1’s How will firm 2 react to the cut in firm 1’s production?production?
This is essentially the story nowThis is essentially the story now£
O Q
Market D
Firm 1 Supplies 75
Firm 2 Supplies 50
But now Firm 2 sees that there are 125
unsatisfied consumers
200
200
MR1
100
MC
P=100
MC2
MR2
D1D1
D2
Day 4: The Mob Strikes BACKDay 4: The Mob Strikes BACK£
O Q
D
Firm 2 sees that 75 people are already
being supplied. So its market now is
P=200-Q –75
P=125-Q
200
200
MR
100
MC
P=100
125
125
Day 4: The Mob Strikes BACKDay 4: The Mob Strikes BACK£
O Q
D
And MR is now
MR=125-2Q
So when MR=MC=0
Q=62.5
200
200
MR2
100
MC
P=100
125
62.5 125
• Firm 1 was supplying 100 unitsFirm 1 was supplying 100 units• Firm 1 Is Now producing 75 unitsFirm 1 Is Now producing 75 units
• Firm 2 was producing 50 unitsFirm 2 was producing 50 units• Firm 2 is now Producing 62.5 unitsFirm 2 is now Producing 62.5 units
• Firm 1’s Q is going down as Firm 2 goes UpFirm 1’s Q is going down as Firm 2 goes Up• Firm 2’s Q is going Up as Firm 1 goes downFirm 2’s Q is going Up as Firm 1 goes down
• When will equilibrium occur?When will equilibrium occur?
ArmageddonArmageddon£
O Q
D
200
200100
MC
P=100
133.3
133.33
If each firm sees that 66.66 people are already being supplied, then it
sees its market as
P=200-Q –66.66
P=133.33-Q
ArmageddonArmageddon£
O Q
D
And MR is now
MR=133.33-2Q
So when MR=MC=0
Q=66.66
200
200
MR1= MR2
100
MC
P=100
133.3
66.66 133.33
If each firm sees that 66.66 people are already being
supplied, then P=133.33-Q
D1=D2
• Firm 1 fall from supplying 100 units to 66.66 Firm 1 fall from supplying 100 units to 66.66 unitsunits
• Firm 2 rises from supplying 0 units to 66.66 Firm 2 rises from supplying 0 units to 66.66 unitsunits
• Given that firm 1 is supplying 66.66 units Given that firm 1 is supplying 66.66 units firm 2’s best response is 66.66 unitsfirm 2’s best response is 66.66 units
• Given that firm 2 is supplying 66.66 units Given that firm 2 is supplying 66.66 units firm 1’s best response is 66.66 unitsfirm 1’s best response is 66.66 units
• EQUILIBRIUM (Cournot equilibrium)EQUILIBRIUM (Cournot equilibrium)
• What do we learn from this story? What do we learn from this story?
• With a small number of firms, one firm’s With a small number of firms, one firm’s actions directly affects the other.actions directly affects the other.
• Where the number of firms are small, the Where the number of firms are small, the firms will think strategically!!firms will think strategically!!
• What is the other guy (male or female) up What is the other guy (male or female) up to ?to ?
• How will they How will they reactreact to my to my actionsactions
• Indeed:Indeed:
• Firms wouldn’t go through this tortuous Firms wouldn’t go through this tortuous process, they would figure out the situation process, they would figure out the situation pretty quickly and if firm 1 couldn’t stop 2 pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium.entering they would go to final equilibrium.
• Called Cournot Competition (competing Called Cournot Competition (competing over market share - Quantities)over market share - Quantities)
• Can also model price competition- BertrandCan also model price competition- Bertrand
Comparison of Cournot Comparison of Cournot with Perfect Compt. and Monopolywith Perfect Compt. and Monopoly
• Under Monopoly Firm 1 with a linear Under Monopoly Firm 1 with a linear demand curve Zero MC supplied half the demand curve Zero MC supplied half the market, that is Qmarket, that is Q11 =1/2 of 200=100 =1/2 of 200=100
• Here with 2 firms each supply 1/3 of 200, Here with 2 firms each supply 1/3 of 200, that is, 66.66 and total output = 133.33that is, 66.66 and total output = 133.33
• Under perfect competition MC = 0 would Under perfect competition MC = 0 would produce at Q = 200produce at Q = 200
• So oligopoly moves the economy closer to So oligopoly moves the economy closer to perfect competition as compared with perfect competition as compared with monopolymonopoly
Cournot:Cournot:
• 1 firm supplies ½ of market1 firm supplies ½ of market
• 2 firms supply 1/3 market each, 2/3 overall.2 firms supply 1/3 market each, 2/3 overall.
• What about 3 firms?What about 3 firms?
• 3 firms supply 1/4 market each, 3/4 overall.3 firms supply 1/4 market each, 3/4 overall.
• ..and 4 firms?..and 4 firms?
• 4 firms supply 1/5 market each, 4/5 overall.4 firms supply 1/5 market each, 4/5 overall.
• n firms, supply 1/(n+1) of market each, n firms, supply 1/(n+1) of market each, n/(n+1) overalln/(n+1) overall
• So more firms getting closer and closer to So more firms getting closer and closer to perfect competitionperfect competition
£
O Q
D
200
200
MR1= MR2
100
MC
P=100
133.3
66.66 133.33
Profits Under Cournot
P= 200-2(66.66)=
= 200-133.33= 66.66
Industry Profits=2(TR-TC)
=2{66.66(66.66)}=8887.7
But under Monopoly p=100; Q=100 and
Profits = 100*100
=10,000D1=D2
£
O Q
D
200
200
MR1= MR2
100
MC
P=100
133.3
66.66 133.33
So two firms would be better off if they could get together
and agree to limit market:
Collusion
D1=D2
Profits Under Cournot: 8,888
Profits under monopoly: 10,000
OLIGOPOLYOLIGOPOLY
• Key features of oligopolyKey features of oligopoly
– barriers to entrybarriers to entry
– interdependence of firms~What’s s/he up to?interdependence of firms~What’s s/he up to?
– incentives to compete versus incentives to incentives to compete versus incentives to colludecollude
• Factors favouring collusionFactors favouring collusion
• Collusive oligopoly: cartelsCollusive oligopoly: cartels
– equilibrium of the industryequilibrium of the industry
OLIGOPOLYOLIGOPOLY
• Key features of oligopolyKey features of oligopoly
– barriers to entrybarriers to entry
– interdependence of firmsinterdependence of firms
– incentives to compete versus incentives to incentives to compete versus incentives to colludecollude
• Factors favouring collusionFactors favouring collusion
• Collusive oligopoly: cartelsCollusive oligopoly: cartels
– Join forces and act collectively as a monopolyJoin forces and act collectively as a monopoly
– allocating and enforcing quotasallocating and enforcing quotas
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