(sessions 1–6) - inseadfaculty.insead.edu/vanzandt/pm/session13/slides-13-p.pdf · 2012. 10....

Where are we?

(Sessions 1–6)

Firms are price-takers(Perfect competition)

Firms have market power(Imperfect competition)

(Sessions 7–11)

Individualdecisions

(Sessions 12–15)

Equilibrium

Say: We did uniform pricing and price discrimination atindividual level, but we only bring uniform pricing toequilibrium.

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 13 • Imperfect competition Slide 1

This distinction now matters …

Qi

Pi

di (Pi )

Sources of market power:

1. Differentiated products: the firm’s branded product is differentiatedfrom other products.

2. Homogeneous goods: Though products are not differentiated, the firmis a big player: increased output pushes down the market price.



We begin with …

Price competition with differentiated products

Recall the pricing game from Session 12:

Firm BLow Med High

Low19

20

18

25

10

31

Firm A Med24

23

28

31

21

38

High30

15

40

27

34

42

We extend this to a full range of prices.



Let’s use the same story

Recently appointed Recently appointed

CEO of Firm A CEO of Firm B



Firm A’s pricing problem

6

12

18

24

30

36

−6

20 40 60 80 100

€

QA

MRA

dA

MCA

Q∗A

P∗A

This is

“uniform pricing with market power”

(Sessions 8 and 9).



Nash equilibrium

6

12

18

24

30

36

−6

20 40 60 80 100

€

QA

MRA

dA

MCA

Q∗A

P∗A

6

12

18

24

30

36

−6

20 40 60 80 100

€

QB

MRB

dB

MCB

Q∗B

P∗B



Let’s use the numbers from Airbus-Boeing example

Demand functions:

QA = 60 − 3PA + 2PB

QB = 60 − 3PB + 2PA

Both firms have constant MC = 12 .



Some best responses … From the demandelasticity exercise

Firm A’s demand curve when PB = 24 and when PB = 30 :

PA

QA

10

20

30

40

30 60 90 120

PB = 30 ⇒ QA = 120 − 3PA

PB = 24 ⇒ QA = 108 − 3PA



In general: from Topic 9 on shifting demand …

Higher price by Firm B ⇒ Firm A’s demand curve shifts …

Volume? Higher

Elasticity? Lower

⇒ Firm A’s profit-maximizing price goes up

Thus, the pricing decisions are strategic complements



So remember, with price competition …

When the goods are substitutes,

the pricing decisions are strategic complements.

(Holds for linear demand, and usually in the real world.)



Firm A’s “residual” demand and best replyQA = 60 − 3PA + 2PB

Constant MC = 12

When Firm B charges PB , Firm A’s demand curve is:

QA = (60 + 2PB ) − 3PA

⇒ Firm A’s choke price is:

20 + 23 PB

⇒ Firm A’s optimal price is:

20+ 23 PB+12

2 = 16 + 13 PB

Firm A’s reaction curve:

PA = 16 + 13 PB



Nash equilibrium

Prices (P∗A , P∗

B ) such that:

In words … As an equation …

P∗A is a best response by firm A to P∗

B PA = 16 + 13 PB

P∗B is a best response by firm B to P∗

A PB = 16 + 13 PA



Illustrating Nash equilibrium graphically

5

10

15

20

25

30

35

40

45

50

55

5 10 15 20 25 30 35 40 45 50 55

PB

PA

PA = 16 + 13 PB

PB = 16 + 13 PA



Wrap up:

Price competition with differentiated products

1. Each firm’s decision is same as“pricing with market power”: Topics 8&9.

2. Goods are substitutes ⇒ prices are strategic complements.(Always with linear demand; almost always in real life.)

3. Interaction captured by Nash equilibrium.Each firm’s price maximizes its own profit given price of the other firm.



Next we do …

Quantity competition with homogeneous products

Also called Cournot competition

1. Firms’ goods are perfect substitutes.

2. So firm doesn’t set price; it chooses how much to sell.

3. Market determines market-clearing price.

4. But each firm’s output decision affects this price.



Corning and glass substrate

Corning has over 50% market share of glass substrate.

There are different grades (“5G, 6G, …”), but for a particular grade theproducts of different suppliers are viewed as close substitutes.

News item from December 2005 (for example):

The aggressive capacity added by both Corning of the U.S., theworld’s No. 1 substrate supplier, and AGC, the No. 2, will lead toprice drops for glass substrates and will especially benefit TV panelmakers …



Indonesian Cement Market

Three major players:

• 45%: Semen Gresik [State-owned]

• 37%: Indocement [Owned by HeidelbergCement since 2001]

• 17%: Holcim Indonesia [Owned by Holcim (Swiss) since 2006]



The protagonists

Indocement Semen Gresik

CEO of Indocement CEO of Semen Gresik



Nash equilibrium

6

12

18

24

30

36

−6

20 40 60 80 100

€

Q1

MR1

d1

MC1

Q∗1

P∗1

6

12

18

24

30

36

−6

20 40 60 80 100

€

Q2

MR2

d2

MC2

Q∗2

P∗2



Market demand curve vs. Indocement’s demand curve

MARKET DEMAND

Q = 1500 − 50P

5

10

15

20

25

30

500 1000 1500

P

Q

INDOCEMENT’S DEMAND

When Qother = 500

5

10

15

20

25

30

500 1000 1500

P

Qi



Indocement’s quantity decision (Constant MC = 10)

When Qother = 200

5

10

15

20

25

30

500 1000 1500

P

Qi

When Qother = 500

5

10

15

20

25

30

500 1000 1500

P

Qi



Nash equilibrium

200

400

600

800

1000

200 400 600 800 1000

Q2

Q1



Wrap up:

Quantity competition with homogeneous goods

1. Each firm’s output decision is same as“pricing with market power”: Topics 8&9.

2. Quantities are strategies substitutes.(Always with linear demand; almost always in real life.)

3. Use this model (rather than price competition)

• for homogeneous products like oil, lycine, glass substrate,

• to analyze investments in capacity.



Finally …

Imperfect competition with exit/entry



Falafel vendors on the beach of Beirut

Beach



Numerical example: Cournot See website for details, but youdon’t have to be able to do this.

• Market demand curve:

Q = 1500 − 50P

• Constant MC = 10 .

Then I calculate the Nash equilibrium for any number N of firms.



Transition from monopoly to perfect competition

Number

of firms

Total

OutputPrice

Output

per firm

Profit per

firm

Q = 1500 - 50P || P = 30 - Q/50

1 500 20.00 500 5,000

2 667 16.67 333 2,222

3 750 15.00 250 1,250

4 800 14.00 200 800

5 833 13.33 167 556

6 857 12.86 143 408

7 875 12.50 125 313

8 889 12.22 111 247

9 900 12.00 100 200

10 909 11.82 91 165

11 917 11.67 83 139

12 923 11.54 77 118

13 929 11.43 71 102

14 933 11.33 67 89

15 938 11.25 63 78



So what happens if fixed costs are lower??

Lower fixed costs ⇒



Recall special case of “free entry”

All firms are identical, including unlimited pool of potential entrants.

We focus on this case for simplicity.

In reality, small or large differences between firms (competitivedis/advantage) determine who is in, and who is out.



How fixed cost affects entry and price

Number

of firms

Total

OutputPrice

Output

per firm

Profit per

firm

Q = 1500 - 50P || P = 30 - Q/50

1 500 20.00 500 5,000

2 667 16.67 333 2,222

3 750 15.00 250 1,250

4 800 14.00 200 800

5 833 13.33 167 556

6 857 12.86 143 408

7 875 12.50 125 313

8 889 12.22 111 247

9 900 12.00 100 200

10 909 11.82 91 165

11 917 11.67 83 139

12 923 11.54 77 118

13 929 11.43 71 102

14 933 11.33 67 89

15 938 11.25 63 78

FC 350 1000

N∗ 6 3

P∗ 12.86 15.00



Let’s try again, this time using insights from IC+FE

Q: Why do pharmaceutical companies charge so much for AIDS medicine?

A: Because they have to recover R&D expenses.

Higher R&D expenses do lead to higher prices, but …Not because any firm takes them into account when settingprices.Instead, because the higher R&D expenses limit entry.The resulting lack of competition is what leads to higher prices.



Wrap up:

Imperfect competition with free entry

1. Entry has two effects on profit:

• smaller market shares

• greater competitive pressure on prices

2. Higher FC ⇒ less entry ⇒ less intense competition ⇒ higher prices

(Even though no firm bases pricing on its fixed cost.)



What have we done today?

Firms are price-takers(Perfect competition)

Individualdecisions

Equilibrium

Firms have market power(Imperfect competition)

Individualdecisions

Equilibrium

Price competition Quantity competition(Different firms’ goods are

substitutes or complements

) (Different firms’ goods are

perfect substitutes

)

Fixed set of firms

Entry and exit



What have we done today?

Price competition Quantity competition(Different firms’ goods are

substitutes or complements

) (Different firms’ goods are

perfect substitutes

)

Fixed set of firms Calculations Main ideas

Entry and exit Heuristic picture Interpret tables



(sessions 1–6) - inseadfaculty.insead.edu/vanzandt/pm/session13/slides-13-p.pdf · 2012. 10....

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