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Ch 12 Monopolistic Competition and Oligopoly

by: Natalie Strawn

Ch 12 Monopolistic Competition and Oligopoly ECO 420K

Natalie Strawn
GPA 3.66

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About this Document

These notes cover the differences between monopolistic competition and oligopoly.
John Thompson
Class Notes
oligopoly, monopolistic competition, Economics
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This 5 page Class Notes was uploaded by Natalie Strawn on Monday July 4, 2016. The Class Notes belongs to ECO 420K at 1 MDSS-SGSLM-Langley AFB Advanced Education in General Dentistry 12 Months taught by John Thompson in Summer 2016. Since its upload, it has received 14 views. For similar materials see MICROECONOMIC THEORY in Economcs at 1 MDSS-SGSLM-Langley AFB Advanced Education in General Dentistry 12 Months.


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Date Created: 07/04/16
June 28, 2016 Ch 12 – Monopolistic Competition and Oligopoly Monopolistic competition (MC) and Oligopoly are between the endpoints of perfect competition and monopoly. *Monopolistic competition is a stylized model and oligopoly is a family of models.* Monopolistic competition markets have: a) Many firms b) Equal or similar size and cost c) Free or easy entry and exit d) A differentiated product The key feature to the MC is product differentiation. -MC firms typically advertise. Since a MC firm has a differentiated product, they have some market power. Examples: -fast food, delivery pizza, frozen foods, soft drinks, coffee, personal hygiene products, clothing MC firms maximize profits by producing the output where MC = MR, and pricing accordingly. (Just like perfect competition and monopoly) (Figure 12.1a) Profits are short run, as free entry and imitation will compete them away in the long run. As firms enter and imitate in the long run, the incumbent’s demand will become: -lower and more elastic In the long run, MC firms earn zero economic profits. (Figure 12.1b) However, unlike PC firms, MC firms can innovate and produce new differentiated products to increase demand and profits. MC markets result in a DWL. They are less efficient than PC markets, but more efficient than pure monopoly. (Figure 12.2) Oligopoly Oligopoly markets have significant barriers to entry and few firms competing. Strategic interdependence – the actions of a given firm will affect the profits of other firms and vice versa. *Firms choose their profit maximizing strategy (price, output, advertising, product development, etc.) based on their expectations of other firms’ actions. * Equilibrium occurs when the firms are doing the best they can, and have no reason to change price, output, etc. Nash Equilibrium – each firm is doing the best it can, given what its competitors are doing. -No firm can unilaterally increase their profits. The Cournot Model In this model, firms decide what quantity to produce, and price follows. -Classic case of a springwater duopoly. For simplicity, we assume a duopoly, or oligopoly with two firms. Firms 1’s optimal output depends on their expectation of Firm 2’s output choice. Firms maximize profits based on “residual demand”. Residual demand is “leftover” demand and depends on other firms’ output. Example: market demand P = 40 – Q Marginal cost MC1 = MC2 = 10 Two firms Q = Q1 + Q2 Solve for reaction functions Q1*,Q2*,Q*, and P*. Compare to monopoly and perfect competition. -P=MC, Q=15, P=25 Monopoly : Q = 15 P = $25 Cournot : Q = 2 P = $20 Perfect competition: Q = 30 P = $10 (Figure 12.5) *Cournot equilibrium is a Nash Equilibrium. Cournot competition with n firms (and constant MC) will result in an output of n/ (1+n) of the competitive output. The Stackelberg Model Similar to Cournot, except that one firm gets to choose their quantity first. Assume a duopoly, with a leader and a follower. Solve for follower’s reaction function; substitute into market demand. Rework example with demand P = 40 - Q and MC = 10 The Bertrand Model w/ Homogeneous Product The Bertrand Model is characterized by aggressive price competition. With a homogeneous product, the firm with the lower price will serve the entire market. So each firm has an incentive to undercut and price gets competed down to marginal cost. -Rework previous example Example: market demand P = 150 – Q ***KNOW FOR TEST*** Marginal cost MC = 30 Two firms Q = Q1 + Q2 Solve for output, price, and profits under: 1) Competition 2) Monopoly 3) Cournot 4) Stackelberg 5) Bertrand Price Competition with Product Differentiation Suppose we have two firms, 1 and 2, each with demand: Firm 1’s demand: Q1 = 12 – 2P1 + P2 Firm 2’s demand: Q2 = 12 – 2P2 + P1 Assume each has fixed costs of $20 and zero marginal cost. Solve for price, output, profits for each firm. Q1 = 12 -2P1 + P2 TR1 = 12P1 -2P1^2 + P1P2 Profit = 12P1 – 2P1^2 + P1P2 – 20 This is a Nash Equilibrium – each firm is doing the best it can, given other firm’s actions. *A Nash Equilibrium is a non-cooperative equilibrium. What if they collude and set their prices to maximize joint profits? Solve for collusive price and profits. Why not collude? -Colluding makes a higher price and profit If they collude to fix prices, is there an incentive to cheat? -Strong incentive to cheat on the collusive agreement. -The outcome of each firm charging $4 and earning $12 is a Nash Equilibrium. -To avoid cheating on price or output agreements, firms may want to form a cartel, which is a formal cooperative partnership. Most cartels are illegal in the U.S. The incentives here are similar to the Prisoners’ Dilemma… In a non-cooperative scenario, both Bonnie and Clyde have an incentive to confess and confess/confess is a Nash Equilibrium. The Prisoners’ Dilemma demonstrates the tension between conflict (self-interest) and cooperation (group interest). Because collusion tends to be fragile, firms have a desire for price stability. Price rigidity occurs in the oligopolistic markets when firms are reluctant to change price when costs or demand change. The kinked demand model demonstrates a firm who believes that competitors won’t follow a price increase, but will follow a price decrease. (Figure 12.7) -Shows why price may stay fixed even in the presence of changing costs. The dominant firm/competitive fringe model describes a market with one dominant firm with market power and a competitive “fringe” of small price takers. The dominant firm maximizes profits based on residual demand not satisfied by the competitive fringe. (Figure 12.9)


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