Unit 8: Imperfect Competition II oligopoly and monopolistic competition

Prof. Antonio Rangel February 12, 2014

Oligopoly
Oligopoly: more than one rm, but not enough for perfect competition Firms have some market power Intermediate case between monopoly (F = 1) and perfect competition (F large)

1.1

Oligopoly with two rms

Basic model Two rms q1 , q2 = quantities produced by the two rms ci (qi ) cost function of each rm, no FCs or SFCs Key assumption: Each rm maximizes prots taking the action taken by the other rm as xed Note: this assumes that rms anticipate each others actions correctly This gives rise to strategic considerations: Demand faced by rm i depends on choice of rm j 1

 Firm is problem

max qi pD (qi + qj ) ci (qi )

qi 0

qj is taken as given in this problem. FOCs (also sucient): dP D qi + pD = M C i dq | {z }

MR w.r.t. qi given qj

Key idea: rms problem is as in the monopoly case, but with demand shifted due to other rms actions
Let qi (qj ) denote the solution to the problem for rm i, as a function of qj . OL OL OL OL OL Oligopoly equilibrium: q1 , q2 such that q1 = q1 (q2 ) and q2 = OL q2 ( q1 )

Remarks: 1. Model assumes rational expectations: each rm correctly anticipates others action correctly in equilibrium 2. Firms best respond to each other 3. At equilibrium, rms have no incentive to deviate 4. Equilibrium concept generalizes to F > 2 (each rm best responds taking as given the choices of all other rms)

1.2

Example: Two identical rms

Look at case of oligopolistic competition with two identical rms and linear aggregate demand F = 2, c(qi ) = q pD (q1 + q2 ) = pmax m(q1 + q2 ) Demand faced by rm i is (pmax mqj ) mqi 2

 Firm i0 s problem: max qi (pmax mqi mqj ) qi

qi 0

FOC: pmax mqj 2mqi = Identical rms = symmetric equilibrium: qi = qj = q OL = q OL =

pmax 3m

DWL from oligopoly: Substituting in the inverse demand function: pOL = 2 + 1 pmax 3 3 DWL then given by: DW L = 1 opt q q OL (pOL p ) 2 1 2 max 1 max = (p ) (p ) 2 3m 3 (pmax )2 = 9m

Distribution and oligopoly

(table refers to graph in video lectures) PS CS SS Perfect Competition Oligopoly 0 B A+B+C A A+B+C A+B Change B -(B + C) -C

1.3

Example: Oligopoly vs. Monopoly

F = 2, pD = pmax mq , M C = for both rms

Consider oligopoly market with two identical rms:

What happens to DWL if the rms merge? Before: Oligopolistic equilibrium (as in previous section): q OL =
pmax 3m

 pOL = 2 + 1 pmax 3 3 DW LOL =

(pmax )2 9m

After: Monopolistic equilibrium (as in Unit 7): q mon = pmon =

pmax 2m 1 + 1 pmax 2 2 (pmax )2 8m

DW Lmon = If follows that q OL > q mon pOL < pmon

DW Lmon > DW LOL

1.4

Oligopoly with more than two rms

Basic model: F >2 Linear symmetric case: pD (q ) = pmax mq , M Ci (qi ) = for all i
OL OL Identical rms = qi = qj = q OL for all rms i, j

Demand faced by rm i: pmax (F 1)mq OL mqi Optimal choice for i: M Ri = M Ci implies pmax (F 1)mq OL 2mqi = Since rms are identical, in equilibrium must have qi = q OL for every rm i. Therefore, we get that each rm produces q OL = pmax (F + 1)m

 Equilibrium price is then given by pOL = pmax mF pmax 1 F = pmax + (F + 1)m F F +1

Note: As F increases, pOL converges to , which is equal to the competitive equilibrium price How does the DWL change with number of rms? 1 DW L(F ) = (pOL p )(q F q OL ) 2 max 1 pmax p = 2 F +1 m(F + 1) max 2 1 (p ) = 2m (F + 1)2 Note:DW L 0 with the square of the number of rms, so dont actually need many rms for the perfect competitive model to provide a good approximation of what happens in the market

Monopolistic competition
Basic model: F 2 pD (q ) = pmax mq Firms: Can pay SFC of F to create a brand and then produce at constant MC of Not create a brand and set q = 0

Key assumption: brands split the market equally and are monopolists within their brand Intuition: Each consumer becomes a loyal buyer of only one of the brands, but his demand curve for that brand is otherwise as before 5

 Model solution I = number of rms that create a brand and produce a positive amount Each rm faces demand pmax Imq Each rm sets M R = M C within its share of the market pmax pmax 2Imq = = q M C = 2Im max p = q tot = Iq M C = = q mon 2m pm ax + MC mon = p =p = 2 Equilibrium prots: M C = M C (pmax )2 F = F I 4mI (pmax )2 >F 4mi

Equilibrium number of rms: I M C = max i such that Remarks:

1. Multiple equilibria: model gives number of rms that create brands, but doesnt say which rms create brands 2. Logic of equilibrium: some rms dont create brands because they correctly anticipate that other rms do, and given this creating additional brands is not protable DWL analysis: q tot in M.C. = q mon = DW LM C = DW Lmon + I M C F max )2 = (p 8 m + IMCF Remarks: 1. In oligopoly, DW L 0 as F . In contrast, in monopolistic competiting the DW L can increase as F 2. SFC of brand creation is socially wasteful 3. Brand creation induces decision mistakes by consumers in which Decision utility 6= Experienced utility 6

Final remarks
Here is a summary of the results Look at markets with 2 F < many rms Two types of markets to consider Oligopoly: Firms produce identical goods Equilibrium converges quickly to competitive case as F increases Monopolistic competition: Firms create brands that induce consumers to have very strong and articial brand preferences Firms are monopolist within their brand Equilibrium outcome remains at monopolistic level as F increases