Oligopoly and Imperfect Markets

1
Oligopoly and Imperfect Markets

• Economics 310
• Chapter 11
• Professor Kenneth Ng
• COBAE
• California State University, Northridge

2
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.

3
Imperfect Competition

• We 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 monopolists 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.

4
Pricing under Imperfect Competition

• A 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.

5
Pricing under Imperfect Competition

• A 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.

6
Cartel Model

• Maintaining 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 firms
  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.

7
APPLICATION The De Beers Cartel

• In 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.

8
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 PgtMC,
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?
9
The Cournot Model

• In markets of imperfect competition, there are
  strategic considerationsthe 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 firms behavior under
  imperfect competition.
• In a Perfectly Competitive market, the firm must
  consider only its own costs when deciding how
  much to produce. It assumes the market price as
  given.
• A monopoly, must consider its costs and the
  effects of its 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 firms 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 its own output decision.
• This is the main reason the Cournot model is too
  simplistic to accurately predict actual firm
  behavior

10
The Cournot Model An Example

• Assume
• A single owner of a costless springthe good,
  water, can be produced at zero MC.
• A downward sloping demand curve for water has the
  equation Q 120 - P.
• If Q20, P100 and Profit2000.
• If Q50, P70 and Profit3500
• As shown, the monopolist would maximize profit
  using a simple pricing scheme by producing where
  MRMC--- 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.

Price
120
60
MR
D
Output per week
60
120
0
11
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 As actions.
• Firm A faces the left over demand, after firm B
  has decided how much to produce.
• The total market output is given by

Price
120
60
MR
D
Output per week
60
120
0
12
The Cournot Model An Example

• 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

Price
120
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.
60
MR
D
Output per week
60
120
0
13
The Cournot Model An Example

• 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.

Price
120
Residual Demand
30
MR
D
Output per week
120
90
60
14
Cournot Reaction Function for Firm A
The profit maximizing output level is given by
Market Demand
Residual Demand for firm A
15
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.

Output of firm B(qB)
120
Firm As reactions
100
10
Output of firm A(qA)
60
120
0
55
10
16
Cournot Reaction Functions in a Duopoly Market

• Firm As reaction function is shown in the
  figure.
• Firm Bs reaction function is given below and
  also shown in the figure.

Output of firm B(qB)
120
Firm As reactions
60
Equilibrium
Firm Bs reactions
Output of firm A(qA)
60
120
0
17
Cournot Reaction Functions in a Duopoly Market
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.
Output of firm B(qB)
120
Firm As reactions
60
Equilibrium
Firm Bs reactions
Output of firm A(qA)
60
120
0
45
18
Cournot Reaction Functions in a Duopoly Market

• 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 of firm B(qB)
120
Firm As reactions
60
Equilibrium
Firm Bs reactions
Output of firm A(qA)
60
120
0
19
Cournot Reaction Functions in a Duopoly Market

• 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.

Output of firm B(qB)
120
Firm As reactions
60
Equilibrium
Firm Bs reactions
Output of firm A(qA)
60
120
0
20
The Cournot Model

• In markets of imperfect competition, there are
  strategic considerationsthe 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.

21
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.

22
Price Leadership Model

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

23
FIGURE 11.4 Formal Model of Price Leadership
Model
Price
SC
D
Quantity per week
0
24
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.

25
FIGURE 11.4 Formal Model of Price Leadership
Model
Price
SC
P
1
D
P
2
D
Quantity per week
0
26
Price Leadership Model

• Given D, the leaders marginal revenue curve is
  MR which equals the leaders 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.

27
FIGURE 11.4 Formal Model of Price Leadership
Model
Price
SC
P
1
D
P
L
P
2
MC
MR
D
Quantity per week
Q
Q
Q
0
L
C
T
28
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.

29
APPLICATION 11.2 Price Leadership in Financial
Markets

• 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.

30
APPLICATION 11.2 Price Leadership in Financial
Markets

• 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.

31
APPLICATION 11.2 Price Leadership in Financial
Markets

• 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.

32
APPLICATION 11.2 Price Leadership in Financial
Markets

• 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 banks
  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.

33
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.

34
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.

35
APPLICATION 11.3 Breakfast Wars

• 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.

36
APPLICATION 11.3 Breakfast Wars

• 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.

37
APPLICATION 11.3 Breakfast Wars

• 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.

38
Product Differentiation Market Equilibrium

• The demand curve for each firm depends on the
  prices and product differentiation activities of
  its competitors.
• The firms 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 competitors actions.

39
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).

40
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.

41
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.

42
FIGURE 11.5 Entry Reduces Profitability in
Oligopoly
Price, costs
d
mr
AC
MC
P
0
Quantity per week
q
43
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 firms
  demand curve inward to d where profits are zero.
• At output level q, average costs are not
  minimum, and qm - q is excess capacity.

44
FIGURE 11.5 Entry Reduces Profitability in
Oligopoly
Price, costs
d
mr
AC
MC
d
mr
P
P
0
Quantity per week
q
q
qm
45
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.

46
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.

47
Contestable Markets and Market Equilibrium

• 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 gt MC which provides a
  profit opportunity for an entrant.

48
Contestable Markets and Market Equilibrium

• 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.

49
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

50
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.

51
FIGURE 11.6 Contestability and Industry Structure
Price
AC
AC
AC
AC
2
3
4
1
P
D
Quantity per week
0
2
3
Q
4
q
q
q
q
52
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.

53
APPLICATION 11.4 Airline Deregulation Revisited

• 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.

54
APPLICATION 11.4 Airline Deregulation Revisited

• 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.

55
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.