oligopoly and imperfect markets economics 310 chapter 11 professor kenneth ng cobae california state...

Oligopoly and Imperfect Markets

Economics 310Chapter 11 Professor Kenneth NgCOBAECalifornia State University, Northridge

Last Homework

Due Wed. Dec 6th, in class. 2 versions-one for each class. Any evidence that your answer was

copied from the notes from the earlier class will result in a 20 point deduction on final.

Imperfect CompetitionWe have considered two types of markets-perfect competition and monopoly.

Under perfect competition, the firms output decision has not effect on the market price. The firm is a price taker and can consider the price as fixed when making its’ output decision.

Under monopoly, there is only one firm producing the good. The monopolist’s output decision will have an effect on the market price. The firm is a price searcher and will maximize its’ profits using a combination of sophisticated pricing schemes.

Pricing in many markets falls between perfect competition and monopoly.

There are a limited number of firms producing a similar good. There output and pricing decision will affect the market price

but, in addition, the output and pricing decision of other firms producing similar goods will also affect the demand facing a firm.

In these markets, there are strategic considerations to the the firms output decision.

Price

PC

MCC

MR

D

Quantityper week

QC0

Pricing under Imperfect CompetitionA model of oligopoly pricing in

which each firm acts as a price taker even though there may be few firms is a quasi-competitive model.

As a price taker, a firm will produce where price equals long-run marginal costs.

This equilibrium will resemble the perfectly competitive solution, even with few firms.

In the figure, the quasi-competitive equilibrium is PC (= MC), QC.

This equilibrium represents the highest quantity and lowest price that can prevail in the long run given the demand curve D.

A lower price would not be sustainable in the long run because it would not cover average costs.

Price

PM

PA

PC

MCC

A

M

MR

D

Quantityper week

QM

QA

QC0

Pricing under Imperfect CompetitionA model of pricing in which firms coordinate their decisions is called a cartel model.

On the graph, if the firms act as price takers they will produce Qc, the price will be Pc and the firms will break even.

If they could successfully collude and collectively control output, they would produce Q, charge Pm, and earn a profit equal to the green area.

The plan would require a certain output by each firm and way to share the monopoly profits.

Cartel ModelMaintaining this cartel solution poses four problems:

Cartel are illegal, under Section I of the Sherman Act of 1890. Because they are illegal, cartels cannot use the normal system of

legal contracts to bind their behavior. They must rely on informal or alternative methods of binding behavior.

It requires a considerable amount of costly information be available to the cartel.

The cartel must be able to monitor each firm’s output to determine whether they are adhering to the price fixing agreement.

The cartel solution may be fundamentally unstable. Each member produces an output level for which price exceeds

marginal cost. Each member could increase its own profits by producing more

output than allocated by the cartel, i.e. there is an incentive to cheat.

If the cartel directors are not able to enforce their policies, the cartel my collapse.

The cartel is also vulnerable to the entry of new firms.Successful cartels are almost always:

Government enforced. Have some type of comparative advantage:

organized crime usually ethnically or family based.

APPLICATION : The De Beers CartelIn the 1870s the discovery of the rich diamond fields in South Africa lead to major gem and industrial markets.After a competitive start, the ownership of the richest mines became incorporated into the De Beers Consolidated Mines which continues to dominate the world diamond trade.Operation of the De Beers Cartel

Since the 1880s diamonds found outside of South Africa are usually sold to De Beers who markets the diamonds to the final consumers through its central selling organization (CSO) in London.

By controlling supply, the CSO maintains high prices which have been estimated to be as much as one thousand times marginal cost.

Dealing with Threats to the Cartel This large markup promotes threat of entry with any new diamond discovery. De Beers has used its market power to control would-be-chiselers.

They drove down prices when the former Soviet Union and Zaire tried market entry in the 1980s.

New finds in Australia were sold to the CSO rather than try to fight the cartel.

The Glamour of De Beers De Beers controls most print and television advertising, including “Diamonds

Are Forever”. They convinced Japanese couples to adopt the western habit of buying

engagement rings. De Beers has attempted to generate a brand name with customers to get

consumers to judge De Beers diamonds superior to other suppliers.

Price

PM

PA

PC

MCC

A

M

MR

D

Quantityper week

QM

QA

QC0

The Problem Facing Firms under Imperfect Competition.

The graph shows the demand for a product produced by a small number of firms.

If they act as competitive firms and produce as long as P>MC, they will collectively produce Qc, the price will be Pc and the firms will break even.

If the firms could collude perfectly (cartel), they could earn a maximum potential profit equal to the purple area.

If they are not able to form an effective cartel, but realize that the price of the good could be effected by their output decision and the output decision of the other firms, what will be the outcome?

The Cournot ModelIn markets of imperfect competition, there are strategic considerations—the profits a given output will produce by a firm are dependent not only on the cost of production and the market demand for the good but also on the behavior of other firms. The Cournot model of duopoly was one of the earliest models of firm behavior under imperfect competition.

While it is too simplistic to accurately predict actual firm behavior, it is useful to highlight certain dimensions of a firm’s behavior under imperfect competition.

In a Perfectly Competitive market, the firm must consider only it’s own costs when deciding how much to produce. It assumes the market price as given.

A monopoly, must consider it’s costs and the effects of it’s output decision on the price of the good, i.e. the demand for the good.

In the Cournot model of duopoly, the management of a firm takes into account the cost of production, the demand for the good and the output decisions of other firms when deciding how much to produce.

In, the Cournot model of duopoly, each firm assumes the other firm’s output will not change if it changes its own output level, i.e. the firm takes the other firms output as given when deciding how much to produce.

In the Cournot model of duopoly, the firm takes into account the output decision of the other firm but it assumes the firm does not think to the next strategic level.

It might be able to manipulate the other firms output decision with it’s own output decision.

This is the main reason the Cournot model is too simplistic to accurately predict actual firm behavior

Price120

60

MR D Outputper week

60 1200

The Cournot Model: An ExampleAssume:

A single owner of a costless spring—the good, water, can be produced at zero MC.A downward sloping demand curve for water has the equation Q = 120 - P.

If Q=20, P=100 and Profit=$2000.If Q=50, P=70 and Profit=$3500

As shown, the monopolist would maximize profit using a simple pricing scheme by producing where MR=MC--- Q = 60 with a price = $60 and profits (revenue) = $3600.

Note, this output equals one-half of the quantity that would be demanded at a price of zero.

Assume a second spring is discovered.Now the monopolist will have to

consider the output of the other firm when deciding how much to produce.

Price120

60

MR D Outputper week

60 1200

The Cournot Model: An Example

Cournot assumed that firm A, say, chooses its output level (qA) assuming the output of firm B (qB) is fixed and will not adjust to A’s actions.

Firm A faces the “left over” demand, after firm B has decided how much to produce.

The total market output is given by:

.)120(

120

is curve demand s A'fixed, is Bq Assuming

Pqq

PqqQ

BA

BA

Price120

60

MR D Outputper week

60 1200


If the demand curve is linear, the marginal revenue curve will bisect the horizontal axis between the price axis and the demand curve.

Thus, the profit maximizing point is given by

2

120 BA

qq

In the example, the firm takes the total demand for the good (120 units) subtracts the amount the other firm produces (residual demand), and produces half the residual demand.

Price120

30

MR D Outputper week90 12060


Once the firm B decides how much to produce, firm A is left with the residual demand.

For instance, if firm B produces 60 units, firm A is left with the residual demand for 60 units.

Using a simple pricing scheme, Firm A will produce 30 units and charge $30.

Residual Dem

and

Cournot Reaction Function for Firm A

Market Demand:

PQ 120

Residual Demand for firm A:

.)120(

120

Pqq

PqqQ

BA

BA

The profit maximizing output level is given by:

2

120 BA

qq

If Firm B produces:

The Residual Demand will be:

Then Firm A will

Produce:

Price Firm A will

get:

Profit of Firm A:

10 110 55 55 302540 80 40 40 160060 60 30 30 90080 40 20 20 400100 20 10 10 100

Output offirm B(qB)

120

Firm A’s reactions

Output offirm A(qA)

60 1200

Cournot Reaction Functions in a Duopoly Market

Equation is called a reaction function which, in the Cournot model, is a function or graph that shows how much one firm will produce given what the other firm produces.

2

120 BA

qq

10

100

10 55

Output offirm B(qB)

120

60


EquilibriumFirm B’s reactions

Output offirm A(qA)

60 1200


Firm A’s reaction function is shown in the figure.

Firm B’s reaction function is given below and also shown in the figure.

2

120 AB

qq

Output offirm B(qB)

120

60



Output offirm A(qA)

60 1200


If firm B started producing 60 units of the good, firm A would “react by producing 30 units of the good.

Firm B would react to firm A producing 30 units of the good, by producing 45 units of the good.

Firm A would react to firm B reaction by producing 37.5 units of the good.

Etc.

45

Output offirm B(qB)

120

60



Output offirm A(qA)

60 1200


The actions of the two firms are consistent with each other only at the point where the two lines intersect.

The point of intersection is the Cournot equilibrium, a solution to the Cournot model in which each firm makes the correct assumption about what the other firm will produce.

Output offirm B(qB)

120

60



Output offirm A(qA)

60 1200


In this Cournot equilibrium each firm produces 40 units of output.

Total industry profit is $3,200, $1600 for each firm).

Because the firms do not fully coordinate their actions, their profits are less than the cartel profit ($3,600) but much greater than the competitive solution where P = MC = 0.

The Cournot ModelIn markets of imperfect competition, there are strategic considerations—the profits a given output will produce by a firm are dependent not only on the cost of production and the market demand for the good but also on the behavior of other firms. The Cournot model highlights the following points applicable to markets of imperfect competition:

If two firms could successfully collude they could earn the most profits.

If environmental factors (such as the law and the inherent problems of cartels) prevent successful collusion, they must then try to profit maximize without coordinating their activity.

In the Cournot equilibrium, under simplistic assumptions, the output of the two firms is between the monopoly and the competitive output.

Collective profits are also between the monopoly profits and the competitive profits.

This highlights the fact that the two firms are settling for a second best method of coordinating their activities.

Price Leadership Model

A model in which one dominant firm takes reactions of all other firms into account in its output and pricing decisions is the price leadership model.A formal model assumes the industry is composed of a single price-setting leader and a competitive fringe which is a group of firms that act as price takers.


This model is shown in Figure 11.4.The demand curve D represents the total demand curve for the industry’s product.The supply curve SC represents the supply decisions of all the firms in the competitive fringe.

Price

D

SC

Quantityper week

0

FIGURE 11.4: Formal Model of Price Leadership Model


The demand curve (D’) for the dominant firm is derived as follows: For a price of P1 or above the competitive

fringe will supply the entire market. For a price of P2 or below, the dominant

firm will supply the entire market. Between P2 and P1 the curve D’ is

constructed by subtracting what the fringe will supply from the total market demand.

Price

P1

P2

D’

D

SC

Quantityper week

0



Given D’, the leader’s marginal revenue curve is MR’ which equals the leader’s marginal cost (MC) at the profit maximizing level QL.

Market price is PL and equilibrium output is QT (= QC + QL).The model does not explain how the leader is chosen.

Price

PL

P1

P2

D’

MR’ D

SC

MC

Quantityper week

QL

QC

QT

0


APPLICATION 11.2: Price Leadership in Financial Markets

The Prime Rate at New York Commercial Banks Major New York commercial banks quote a

“prime rate” which purports to be the interest rate that they charge on loans to their most creditworthy customers.

Recent research indicates actual pricing is more complex, but the prime provides a visible and influential indicator or rate change.


While rates changes are sluggish, when “large” changes (0.25 or more) are required one of the major banks will act like a leader and announce a new prime rate on a trial basis.After a few days, either most banks will follow or the initiator will return to its old rate.


A number of researchers have found that rates tend to rise soon after an increase in bank costs, but decline only slowly when costs fall.

Similarly, a rise in the prime tends to hurt the stock prices of banks that increase because the increase signals that profits hare being squeezed by costs.

Alternatively, stock prices rise when the prime rate falls.


Price Leadership in the Foreign Exchange Market The large market for world currencies is

dominated by major financial institutions and is heavily influenced by the “intervention” of various nations’ central banks.

Because central bank intervention is not announced in advance, well informed traders may have an information market advantage.


In a study of the German Mark (DM), an author found that one bank tended to pay the role of leader in setting the DM/$ exchange rate.

This leadership role arose because of the bank’s ability to foresee intervention by the German central bank in exchange markets. Quoted exchange rate between 25 and 60 minutes

before the intervention were copied by other banks, while within 25 minutes (with information more diffused) no clear cut pattern emerged.

Product Differentiation: Market Definition and Firms Choices

A product group is a set of differentiated products that are highly substitutable for one another.Assume few firms in each product group.Firms will incur additional costs to differentiate their product up to the point where the additional revenue from this activity equals the marginal cost.

APPLICATION 11.3: Breakfast Wars

The prevalence of breakfast cereal followed the demand for quickly produced breakfast and the “Better Breakfast” advertising campaign.Approximately 60 percent of all household buy an average of 50 boxes of cereal per year.


Industrial Concentration Three major firms control approximately

80 percent of the market. Returns on invested capital are more

than double those of the average industry.

It is unclear why the market is not more competitive since there do not seem to be any major economies of scale and no obvious barriers to entry.


The FTC Complaint and Product Differentiation In 1972 the U.S. Federal Trade

Commission (FTC) claimed the largest producers actions tended to establish monopolylike conditions. Proliferation of new, highly advertised,

brands left no room for potential new entrants.

Brand identification also prevented new entrants from duplicating existing cereal.


Demise of the Legal Case Firms claimed that they were engaging in

active competition by creating new cereal brands.

Also, many new “natural” cereals did enter the market in the 1970s.

The case was quietly dropped in 1982.

Recent studies still indicate a lack of competition and continued higher profits.

Product Differentiation: Market Equilibrium

The demand curve for each firm depends on the prices and product differentiation activities of its competitors.The firm’s demand curve may shift frequently, and its position at any point in time may only be partially understood. Each firm must make assumptions about its

competitors’ actions, and whatever one firm decides may affect its competitor’s actions.

Product Differentiation: Entry by New Firms

The degree to which firms can enter the market plays an important role.Even with few firms, to the extent that entry is possible, long-run profits are constrained.If entry is completely costless, long-run economic profits will be zero (as in the competitive case).

Zero-Profit Equilibrium

If firms are price takers, P = MR = MC for profit maximization.Since P = AC, if entry is to result in zero profits, production will take place where MC = AC (at minimum average cost).If, say through product differentiation, firms have some control over price, each firm faces a downward sloping demand curve.

Zero-Profit Equilibrium

Entry still may reduce profits to zero, but production at minimum cost is not assured.Monopolistic competition is a market in which each firm faces a negatively sloped demand curve and there are no barriers to entry.This type of market is illustrated in Figure 11.5.

Price,costs

P*

mr

d

MC AC

Quantityper week

q*0

FIGURE 11.5: Entry Reduces Profitability in Oligopoly

Monopolistic Competition

Initially the demand curve is d, marginal revenue is mr, and q* is the profit-maximizing output level.If entry is costless, the entry shifts the firm’s demand curve inward to d’ where profits are zero.At output level q’, average costs are not minimum, and qm - q’ is excess capacity.

Price,costs

P*

P’

mr’

mr

d

d’

MC AC

Quantityper week

q*q’ qm

0

FIGURE 11.5: Entry Reduces Profitability in Oligopoly

Competition in Versus for the Market

Monopolistic competition focuses only on the behavior of actual entrants but ignores the effects of potential entrants.A broader perspective of the “ invisible hand” is the distinction between competition in the market and competition for the market.

Contestable Markets and Market Equilibrium

A contestable market is a market in which entry and exit are costless.No potential competitor can enter by cutting price and still make a profit since, if profit opportunities existed, potential entrants would take advantage of them.The assumption of price taking is replaced by free entry and exit.


In a contestable market equilibrium requires that P = MC = AC.The number of firms is determined by market demand and by the output level that minimizes average cost.The equilibrium in Figure 11.5 is not a contestable market since P > MC which provides a profit opportunity for an entrant.


The only market that would be impervious to hit-and-run tactics would be one in which firms earn zero profits and price at marginal costs.This requires that firms produce at the low points of their long-run average cost curves where P = MC = AC.

Determination of Industry Structure

Let q* represent that output level for which average costs are minimized.Let Q* represent the total market for the commodity when price equals market (and average) cost.The number of firms, n, in the industry (which may be relatively small) is given by

[11.7] *

*

q

Qn

Determination of Industry Structure

As shown in Figure 11.6, for example, only four firms fulfill the market demand Q*.The contestability assumption will ensure competitive behavior even though firms may recognize strategic relationships among themselves.The potential for entrants constrains the types of behavior that are possible.

Price

P*

AC1AC2 AC3 AC4

D

Quantityper week2*q 3*q Q* = 4*

qq*0

FIGURE 11.6: Contestability and Industry Structure

APPLICATION 11.4: Airline Deregulation Revisited

Airlines Contestability Since planes are mobile, they can be moved

into a market that promises excess profits. Such potential entry should hold prices at

competitive levels even with few firms. However, terminal facilities are market

specific and brand loyalty appears to exist. Also, some major airports have limited

potential for growth.


Effects of Deregulation Studies suggest that fares declined after

deregulation with one study suggesting yearly gains to customers of about $8.6 billion.

However, this study found that additional welfare gains of about $2.5 billion were not realized because of the limitations of landing slots and computer reservations systems may aid in price collusion among major airlines.


Trend in Airline Competition Many new airlines entered after the 1978

deregulation, but they were often consolidated into larger carriers.

Several existing airlines went out of business. The hub-and-spoke designs of flight networks

were introduced which has lead to dominance of one or two airlines in a hub city which may have resulted in higher fares.

Barriers to Entry

The existence of barriers to entry change the type of analysis.In addition to those previously discussed, barriers include brand loyalty and strategic pricing. Firms may drive out potential entrants

with low prices followed later by price increases or they may buy up smaller firms.

oligopoly and imperfect markets economics 310 chapter 11 professor kenneth ng cobae california state...

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