Chapter 7Chapter 7

The Continuum of the Market StructureThe Continuum of the Market Structure

Perfect Competition

n=infinityn=1

Monopoly

n large

Imperfect Competition

n= small

2 ~ 8 firmsOLIGOPOLY

No of firms, n

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

• Assumptions of monopolistic competition

• Each firm selling a different variety or brand

• There are many firms

– Act independently – ignore others REACTIONS

Equilibrium of the firm

• Freedom of Entry and Exit

• There is Symmetry

– New firms affect all old ones equally

• Assumptions of monopolistic competition

• Each firm selling a different variety or brand

• There are many firms

– Act independently – ignore others REACTIONS

Equilibrium of the firm

• Freedom of Entry and Exit

• There is Symmetry

– New firms affect all old ones equally

Suppose we consider the case of demand for eating out.Suppose we consider the case of demand for eating out.

£

Q O

Ps

Qs

Let’s make the Balti picture biggerLet’s make the Balti picture bigger

£

Q O

AC

MR

AR D

Ps

Qs

MC

£

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

D1

MR1

£

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 or D curve still slopes downAR or D curve still slopes down

• So not in perfect competition caseSo not in perfect competition case

• Still believe have some market power over Still believe have some market power over price and quantityprice and quantity

• But….But….

• Competition from new entrants is such that Competition from new entrants is such that such power is short livedsuch power is short lived

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

• Assumptions of monopolistic competition

• Equilibrium of the firm

– short run

– long run

– under-utilisation of capacity in long run

• Assumptions of monopolistic competition

• Equilibrium of the firm

– short run

– long run

– under-utilisation of capacity in long run

Under-utilisation of capacity in the long runUnder-utilisation of capacity in the long run

£

QO

LRAC

DL under monopolistic

competition

Q1

MONOPOLISTIC COMPETITIONMONOPOLISTIC COMPETITION

• Limitations of the model– imperfect information about profits and demand

– difficulty in identifying industry demand curve

– entry may not be totally free

– Indivisibilities/local monopolies

– importance of non-price competition

• Limitations of the model– imperfect information about profits and demand

– difficulty in identifying industry demand curve

– entry may not be totally free

– Indivisibilities/local monopolies

– importance of non-price competition

•The public interest

–comparison with perfect competition

–comparison with monopoly

Long run equilibrium of the firm under perfect andLong run equilibrium of the firm under perfect andmonopolistic competitionmonopolistic competition

£

QO

P1

LRAC

DL under perfect

competition

Q1

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

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

P=200-Q

TR= P.Q

TR=

TR=

MR=

Econ 106D exercise check result using chain rule with u=200-Q and v=Q

dQ

duv

dQ

dvu

dQ

vud

].[

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

Q=

P=200-Q

P =

P =

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 100 unfulfilled customersnotices there are 100 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?

100

MR

0

MC

P=100

MC2

It thinks it has demand

P=

P=

MR=

• 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

150

150

• 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

• 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

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

• EQUILIBRIUMEQUILIBRIUM

• What do we learn form this story? What do we learn form this story?

• Small number of firms, one firms actions Small number of firms, one firms actions affects the other.affects the other.

• Where the number of firsm are small we Where the number of firsm are small we have to think strategically!!have to think strategically!!

• What is the other guy (male or female) up to!What is the other guy (male or female) up to!

• How will they How will they reactreact to my to my actionsactions

• Will see more stories later.Will see more stories later.

• Note:Note:

• Firms wouldn’t go through this tortuous Firms wouldn’t go through this tortuous process, they would more likely figure out process, they would more likely figure out the situation pretty quickly and if firm 1 the situation pretty quickly and if firm 1 couldn’t stop 2 entering they would go to couldn’t stop 2 entering they would go to final equilibrium pretty quickly. final equilibrium pretty quickly.

• Called Cournot CompetitionCalled Cournot Competition

• Competing over market share – QuantitiesCompeting 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 =100=1/2of 200. =100=1/2of 200.

• 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 moving you closer to Perfect So oligopoly moving you closer to Perfect competition compared with monopolycompetition compared with monopoly

Cournot:Cournot:

• 1 firm supply ½ of market1 firm supply 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

• Reading:Reading:

• Lipsey and Chrystal: Positive EconomicsLipsey and Chrystal: Positive Economics– Ch 14 Appendix p274-277 8th EditionCh 14 Appendix p274-277 8th Edition

£

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)=

P= 200-133.33= 66.66

Industry Profits=2{TR-TC}

= 2{66.66 (66.66)-0}=8887.7

But under Monopoly p=100; Q=100 and Profits = 10,000

D1=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:

So get Collusion

or a CARTEL

D1=D2