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Chapter 7.1 Monopolistic Competition and Oligopoly

Chapter 7.1 Monopolistic Competition and Oligopoly. The Continuum of the Market Structure. Perfect Competition. Monopoly. n=infinity. No of firms, n. n=1. n small Oligopoly. n large Monopolistic Competition. MONOPOLISTIC COMPETITION. Assumptions of monopolistic competition

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Chapter 7.1 Monopolistic Competition and Oligopoly

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  1. Chapter 7.1 Monopolistic Competition and Oligopoly

  2. The Continuum of the Market Structure Perfect Competition Monopoly n=infinity No of firms, n n=1 n small Oligopoly n large Monopolistic Competition

  3. MONOPOLISTIC 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

  4. MONOPOLISTIC COMPETITION • Equilibrium: • short run

  5. Suppose we consider the case of demand for eating out. The ‘Industry’ Demand Curve looks like this £ Ps O Qs Q

  6. Suppose we consider the case of demand for eating out. £ What about an individual restaurant? It is further in and flatter Why? Ps O Qs Q

  7. Suppose we consider the case of demand for eating out. Each restaurant type has a share of the industry But knows that it can only vary its price a little Ps £ O Qs Q

  8. Suppose we consider the case of demand for eating out. £ What if a new competitor appears? Demand line shifts in more and flattens more Getting closer and closer to Perfect Competition Ps O Qs Q

  9. So now suppose we have a firm like the blue line … and this restaurant is doing well in the short-run £ Ps O Qs Q

  10. Let’s make the picture bigger £ Ps AR =D MR O Qs Q

  11. Let’s make the picture bigger £ MC AC Ps AR =D MR O Qs Q

  12. Short-run equilibrium of the firm under monopolistic competition £ MC AC Ps ACs AR =D MR O Qs Q

  13. Short-run equilibrium £ MC AC Ps ACs AR =D MR O Qs Q

  14. What happens now? New Firms enter What happens to D? £ MC So P and Q down AC P1 ACs D MR O Qs Q

  15. What happens now? New Firms enter What happens to D? £ MC So P and Q down AC And Super-normal Profits down ACs D MR O Qs Q

  16. What happens now? New Firms enter What happens to D? £ MC So P and Q down And Super-normal Profits down AC ACs D MR O Qs Q

  17. What Happens Next? • Still Super-Normal Profits • So firms keep entering • P keeps falling and Super-normal profits keep falling until…. • In the LR • AR = AC and there are no supernormal profits

  18. Long-run equilibrium of the firm under monopolistic competition £ LRMC LRAC PL ARL=DL MRL O QL Q

  19. NOTICE: • AR (=D) curve still slopes down • So not in perfectly competitive case • Firms have market power (can choose price and quantity), but…. • Competition is such that this power is illusory (in the long run)

  20. MONOPOLISTIC COMPETITION • Limitations of the model • imperfect information about profits and demand • difficulty in identifying industry demand curve • indivisibilities/local monopolies • importance of non-price competition • Variety • Advertising

  21. MONOPOLISTIC COMPETITION • The public interest • comparison with perfect competition; • PRODUCTION WILL NOT OCCUR WHERE LRAC IS AT ITS MINIMUM (unlike perfect competition which is efficient)

  22. Long run equilibrium under perfect andmonopolistic competition (with decreasing or constant returns to scale) £ LRAC P1 DLunder perfect competition O Q1 Q

  23. Long run equilibrium under perfect andmonopolistic competition (with decreasing or constant returns to scale) £ LRAC P2 P1 DLunder perfect competition DLunder monopolistic competition O Q2 Q1 Q

  24. The Continuum of the Market Structure Perfect Competition Monopoly n=infinity No of firms, n n=1 n small Oligopoly n large Monopolistic Competition

  25. OLIGOPOLY • Key features of oligopoly • barriers to entry • interdependence of firms • ~What’s he up to? • incentives to compete versus incentives to collude

  26. Day 1: Suppose initially Monopoly firm in the Industry £ To make life simple suppose P=200-Q is the demand curve D O Q

  27. Suppose initially Monopoly firm in the Industry £ To make life simple suppose P=200-Q is the demand curve, And MC are zero 200 What is the MR curve? D O 200 Q

  28. Suppose initially Monopoly firm in the Industry £ P=200-Q TR= P*Q TR=[200-Q]*Q TR=200Q-Q2 MR=200-2Q 200 D O 200 Q

  29. Suppose initially Monopoly firm in the Industry £ P=200-Q TR= P*Q TR=[200-Q]*Q TR=200Q-Q2 MR=200-2Q 200 If MR = 0, 200=2Q D MR MC O 200 100 Q

  30. Suppose initially Monopoly firm in the Industry What quantity will this firm supply to the market MR=MC at 100 Q=100 P=200-Q P=200-100 =100 £ 200 P=100 MR D MC O 200 100 Q

  31. Suppose initially Monopoly firm in the Industry So monopolist supplies half the market in this case (Linear demand, MC=0) £ 200 P=100 MR D MC O 200 100 Q

  32. Day 2: Harmony is broken! Suppose now a new firm notices there are unfulfilled customers £ 200 What will new firm do? P=100 MR D MC O 200 100 Q

  33. Suppose now a new firm notices there are unfulfilled customers £ 200 What will new firm do? It thinks it has demand P=100-Q MR=100-2Q P=100 MR D MC O MC2 200 100 Q

  34. Suppose now a new firm notices there are unfulfilled customers It is just looking at this bit of the market Setting MC = MR =0 100=2Q Q=50 What will new firm do? 200 It thinks it has demand P=100-Q MR=100-2Q P=100 MR D MC MC2 100 0 Q

  35. So now firm 1 is supplying 100 units • And firm 2 is supplying 50 Units • Will firm 1 accept that? • How will it react?

  36. Day 3: The reckoning £ 200 Firm 1 sees that 50 people are already being supplied. So its market is P=200-Q –50 P=150-Q P=100 MR D MC O MC2 200 100 Q

  37. Day 3: The reckoning £ 200 Firm 1 sees that 50 people are already being supplied. So its market is P=200-Q –50 P=150-Q 150 P=100 MR D MC O 150 200 100 Q

  38. Day 3: The reckoning £ 200 And MR is now MR=150-2Q So when MR=MC=0 Q=75 150 P=100 D MR MC O 200 100 Q 75

  39. Firm 1 was supplying 100 units • Is Now Supply 75 units • Firm 2 is still producing 50 units • How will firm 2 react to the cut in firm 1’s production?

  40. This is essentially the story now £ 200 Firm 1 Supplies 75 Firm 2 Supplies 50 But now Firm 2 sees that there are 125 unsatisfied consumers P=100 MR1 Market D D1 D1 D2 MR2 MC O MC2 200 100 Q

  41. Day 4: The Mob Strikes BACK £ 200 Firm 2 sees that 75 people are already being supplied. So its market now is P=200-Q –75 P=125-Q 125 P=100 MR D MC O 200 125 100 Q

  42. Day 4: The Mob Strikes BACK £ 200 And MR is now MR=125-2Q So when MR=MC=0 Q=62.5 125 P=100 D MR2 MC O 62.5 200 100 125 Q

  43. Firm 1 was supplying 100 units • Firm 1 Is Now producing 75 units • Firm 2 was producing 50 units • Firm 2 is now Producing 62.5 units • Firm 1’s Q is going down as Firm 2 goes Up • Firm 2’s Q is going Up as Firm 1 goes down • When will equilibrium occur?

  44. Armageddon £ 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 200 133.3 P=100 D MC O 200 100 133.33 Q

  45. Armageddon £ If each firm sees that 66.66 people are already being supplied, then P=133.33-Q 200 133.3 And MR is now MR=133.33-2Q So when MR=MC=0 Q=66.66 P=100 D1=D2 D MR1= MR2 MC O 66.66 200 100 133.33 Q

  46. Firm 1 fall from supplying 100 units to 66.66 units • Firm 2 rises from supplying 0 units to 66.66 units • Given that firm 1 is supplying 66.66 units firm 2’s best response is 66.66 units • Given that firm 2 is supplying 66.66 units firm 1’s best response is 66.66 units • EQUILIBRIUM (Cournot equilibrium)

  47. What do we learn from this story? • With a small number of firms, one firm’s actions directly affects the other. • Where the number of firms are small, the firms will think strategically!! • What is the other guy (male or female) up to ? • How will they react to my actions

  48. Indeed: • Firms wouldn’t go through this tortuous process, they would figure out the situation pretty quickly and if firm 1 couldn’t stop 2 entering they would go to final equilibrium. • Called Cournot Competition (competing over market share - Quantities) • Can also model price competition- Bertrand

  49. Comparison of Cournot with Perfect Compt. and Monopoly • Under Monopoly Firm 1 with a linear demand curve Zero MC supplied half the market, that is Q1 =1/2 of 200=100 • Here with 2 firms each supply 1/3 of 200, that is, 66.66 and total output = 133.33 • Under perfect competition MC = 0 would produce at Q = 200 • So oligopoly moves the economy closer to perfect competition as compared with monopoly

  50. Cournot: • 1 firm supplies ½ of market • 2 firms supply 1/3 market each, 2/3 overall. • What about 3 firms? • 3 firms supply 1/4 market each, 3/4 overall. • ..and 4 firms? • 4 firms supply 1/5 market each, 4/5 overall. • n firms, supply 1/(n+1) of market each, n/(n+1) overall • So more firms getting closer and closer to perfect competition

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