MICROECONOMICS: IMPERFECT COMPETITION

MONOPOLY

A monopolist is a firm which has (in pure theoretical terms) 100% market share. It faces a downward sloping Demand (AR) curve and can choose to provide at any point along that curve. The monopolists· profit maximisation problem is much like the one facing the producer in a perfectly competitive market
y

MR = MC for profit max, as before

The big difference is that prices are NOT FIXED anymore We can describe the price as a function of output.
= P(Q).Q ² TC (Q, r, w) y Differentiate wrt Output and set to 0
y

MONOPOLY
Barriers To Entry A monopoly is created because firms cannot enter the industry because barriers to entry (or they may not enter because they may not be able to leave easily due to barriers to exit). Barriers to entry are either Artificial or Natural;

Natural barriers to entry largely arise from Increasing Returns to Scale ² such that the MES is at such a high level of production only one firm can really achieve it. y Artificial barriers may arise from legal process (patents and copyrights) or lobbying for regulation for protectionist measures.
y

MONOPOLY

Marginal Revenue Under perfect competition, we assumed that AR = MR = constant. However, since price is now a function of output, we can no longer assume that AR = MR. MR = d[P(Q).Q] / dQ
y y y

Using the Product Rule: d[P(Q)]/dQ . Q + P(Q). [dQ / dQ] MR = P + Q.[dP / dQ]

Because price falls as quantity rises, dP/dQ < 0, therefore MR < P (and as P = AR, MR < AR). In addition, we can show that P > MC:
y y

MR = P + Q.[dP/dQ] = MC P = MC ² {Q.[dP/dQ]} ; P > MC by abs[dP/dQ].Q MR = P[1 + (Q/P).(dP / dQ)] MR = P[1 + 1 / PeD] PeD is inelastic, PeD > -1, MR < 0 PeD is elastic, PeD < -1, MR > 0 PeD is unitary elastic, PeD = - 1, MR = 0; All these results make intuitive sense.

Finally we can also show the link between MR and Elasticity:
y y y y y

This connection between MR and elasticity can also show the degree of monopoly power in an industry via the Lerner index:
y

L.I = (P ² MC)/ P = -1 / PeD P / MC = PeD / [1 + PeD]

And also show the degree of mark up in an industry:
y

MONOPOLY

Solving the profit maximisation problem for the monopolist yields the optimal output Q*, and the optimal price, P* Because TR > TC at that level of output, the firm earns supernormal/abnormal profits (or monopoly rents), shown by the red square. In addition, there is a Deadweight Welfare Loss at that level of output, given by the black triangle. The DWL arises with the basis of comparison being a perfectly competitive market; which would produce at Q1. Moving from Q1 to Q*:
y y y

Price Monopoly Rents DWL P* AC=MC

Consumer surplus falls by the amount of the black triangle and red rectangle. Producer surplus rises by the red triangle. Therefore there is a net loss of the black triangle.

MR Q* Q1

AR Quantity

The diagram makes a simplifying assumption that AC = MC, but the results still hold if they face an upward sloping MC curve.

DEMAND FOR INPUTS

Assume that, despite being a price maker in the final goods market, it is a price TAKER in input markets. The demand for inputs can therefore be derived traditionally (using Q = F(K,L)):
= P[F(K,L)].F(K,L) ² (rK + wL) First Order Conditions (using chain + product rules):

d /dK = MPK.[P[F(K,L)] + MPK.[dP/dQ . F(K,L)] ² r = 0 MPK.{[P[F(K,L)] + [dP/dQ . F(K,L)] } = r MPK . MR = r; MRPK = r d /dL = MPL.[P[F(K,L)] + MPL.[dP/dQ . F(K,L)] ² w = 0 MPL . MR = w MRPL = w

y

y

y

The Marginal Revenue Product of a unit of output is the extra revenue gained from a one unit increase in the input under consideration. In a perfectly competitive model P = MR, thus MRPi = P.Mpi We can also apply Shephard·s lemma to monopolists ² evaluate the Total Cost function at the optimal quantity Q*, and take the derivative with respect to the input pay: L* = d{TC(Q*,r,w)} / dw

PRICE DISCRIMINATION

A firm is price discriminating if it sells a homogenous good at differing prices. Three degrees: First degree:
y

Producer extracts ALL consumer surplus for that individual ² it will charge him/her up until the point where he/she is indifferent to purchasing or not purchasing the good. Attempts to provide incentives to force the consumer to reveal his willingness to pay. It may do this by engaging in ¶block· pricing ² offering discounts for bulk purchases etc.

Second degree:
y

Third degree:
Based on the assumption that separable markets exist for the product; these markets can be differentiated by price elasticities. y Therefore, with different price elasticities, the producer can charge different prices in each market; this can be seen with last minute vs early bookings in train fares for example.
y

All these are based on the assumption of NO ARBITRAGE; if consumers could resell goods, then they would aim to undercut the firm and therefore reduce price differentials.

REGULATION

Regulation of monopolies is desirable because of the DWL. However, for natural monopolies that exhibit IRS (as shown), operating at P = MC will incur losses. Thus, there are two main solutions: First Best; MC pricing.
y

Price
D=AR

Force firm to operate at P = MC, and subsidise it for losses.

Second Best; AC (full cost) pricing.
y y

y

y

Force firm to operate at P = AC. Not the most efficient point, but close to and there is no need for subsidies ² the firm earns a normal profit. Can be achieved by using two tier pricing; essentially second degree price discrim, segmenting the markets into two groups depending on Q bought. The gains made by those who pay above AC should cancel out the losses made by those who pay less than AC.

P=AC P= MC

1 AC MR
Y

2 MC

Quantity

OLIGOPOLY
Price + Output decisions in an Oligopoly can be modelled in two ways: Cournot Model:

y

Model where all firms set QUANTITIES simultaneously Model where all firms set PRICES simultaneously.

Bertrand Model:
y

Both models assume the firms face constant (and equal) MC, are identical in terms of production functions and sell identical goods. Furthermore, we will be using a version which focuses on a DUOPOLY ² a market with only two providers. For both models we will also consider the ¶leader· case ² where a firm set their output or price first.

COURNOT MODEL

Reaction Functions To derive the Cournot Model, consider an industry where two firms produce Q1 and Q2 respectively. Total industry output is therefore Q = (Q1 + Q2). However, the inverse demand function for either firm depends on this quantity:
y

P = p(Q) = p(Q1 + Q2)

Firm 1 therefore assumes a given level of Q2, and vice versa for Firm 2, in order to find the optimal level of Q1. Problem for Firm 1:
y y y

= P(Q1 + Q2).Q1 ² TC (Q1) d /dQ1 = P(Q1 + Q2) + [dP/dQ1].Q1 ² dTC/dQ1 = 0 MR1 = MC1

An identical (but respective) version of this holds for Firm 2. These results lead us to REACTION FUNCTIONS, graphically shown on the next slide. Reaction Functions are the locus of points where the Isoprofit curves are at their maximum ² each isoprofit curve showing potential profit for a firm GIVEN A CERTAIN LEVEL OF THE OTHER FIRM·S OUTPUT. Reaction Function for Firm 1: Q1 = R1(Q2) Reaction Function for Firm 2: Q2 = R2(Q1)

REACTION FUNCTIONS + ISOPROFIT
CURVES

q2

q2

Firm 1¶s reaction function

I

p

v

Isoprofit curves

Firm 2 reaction function ·s

q1

q1

COURNOT MODEL

To graphically derive the optimal output level, simply overlay the two Reaction Curves and find the point where they intersect ² this is COURNOT EQUILIBRIUM. It is a Nash Equilibrium ² each firm is doing it·s best given what it believes the other firm is doing. If both firms have the same technology, then Q1* = Q2*. Factoids:
Cournot Equilibrium produces a HIGHER OUTPUT than a monopoly model, but a LOWER OUTPUT than a perfectly competitive model; with all the implications for the size of the DWL. y As the number of firms in the industry rises, the output rises, up until the limit of perfect competition ² however, the DWL shrinks very fast, suggesting that it only takes relatively few firms to simulate perfect competition.
y

COURNOT MODEL W/ LEADERS

Quantity Leadership ² The Stackelberg Model Assume that Firm 1 produces first, followed by Firm 2; and let us work backwards. The problem for Firm 2 is EXACTLY THE SAME as in the original model ² it still has to produce a reaction function that depends on Q1:
y

q2

Q2 = R2(Q1)

However, the problem is slightly different for the first firm:
y y

= P(Q1 + Q2).Q1 ² TC (Q1) = P(Q1 + R2(Q1)).Q1 ² TC (Q1)

Because we are able to substitute in Firm 2·s reaction function, we can solve the above problem as we would for a normal firm, and achieve a concrete unconditional optimal Quantity:
y y

q2Cournot q2Stackelberg

Firm 2¶s reaction function

Firm 1 produces Q1* Firm 2 Produces Q2* = R2(Q1*)

q 1Cournot q1Stackelberg

q1

Graphically this is shown by Firm 1 producing on it·s lowest Isoprofit line tangential to Firm 2·s Reaction Function ² thus producing the most and gaining the most profit; IT IS ADVANTAGEOUS TO GO FIRST IN COURNOT.

COURNOT MODEL W/ COLLUSION

If the two firms collude, they will behave as a single monopolist would in setting output:
y

= P(Q1 + Q2).(Q1+Q2) ² TC1 (Q1) ² TC2(Q2) d /dQ1 = P(Q1 + Q2) + [dP/dQ1].(Q1+Q2) ² dTC1/dQ1 = 0 d /dQ2 = P(Q1 + Q2) + [dP/dQ1].(Q1+Q2) ² dTC2/dQ2 = 0 MC1 = MR = MC2; If one firm has a cost advantage it will simply have to PROVIDE MORE.

Differentiating to find the profit maximising conditions:
y y

Hence:
y

There is, however, a temptation to cheat in a cartel, as the Marginal Profit from expanding output (cheating) is given by
y

d /dQ1 = P(Q1 + Q2) + [dP/dQ1].(Q1) ² dTC1/dQ1 P(Q1 + Q2) + [dP/dQ1].(Q1+Q2) ² dTC1/dQ1 = P(Q1 + Q2) + [dP/dQ1].(Q1) + [dP/dQ1].(Q2) ² dTC1/dQ1 {P(Q1 + Q2) + [dP/dQ1].(Q1) + [dP/dQ1].(Q2) ² dTC1/dQ1} ² {P(Q1 + Q2) + [dP/dQ1].(Q1) ² dTC1/dQ1} = [dP/dQ1].(Q2) > 0 If either firm believes the other will stick to the deal, it has an incentive to cheat. If either firm believes the other will cheat, it has an incentive to cheat faster.

Which, when compared to the Marginal Profit under collusion:
y y y y

Therefore, Firm 1 faces a positive MR when it cheats (same holds for Firm 2):
y y

BERTRAND MODEL

Much like the Cournot Model, except instead of setting OUTPUT, the firms set PRICES. Other assumptions remain the same, however;
The firms are profit maximisers. y They have identical products. y They make their decisions simultaneously.
y

Instead of considering the inverse demand functions, consider the normal demand functions:
Firm 1: Q1 = D1(P1,P2) y Firm 2: Q2 = D2(P1,P2)
y

Then solve via normal methods:
y

= P1.[D1(P1,P2)] ² TC[D1(P1,P2)] d /dP1 = D1 + P1.[dD1 / dP1] ² {dTC/dQ1}.{dD1/dP1} =0

FOC (using the Chain rule for MC):
y

BERTRAND MODEL

P1 Firm 2·s Reaction Curve

Therefore, we arrive at a conclusion that Firms 1 and 2 will have REACTION FUNCTIONS:
y y

P1 = R1(P2) P2 = R2(P1)

The R.F are UPWARD SLOPING, as shown to the side. However, it is important to note that the only Nash Equilibrium in this game is if both firms price at MC. If a firm does not price at MC, then the other firm can simply undercut and take all profits. The firm cannot operate at a loss either, therefore only ONE sensible policy is left. However, this is paradoxical; the Bertrand Model suggests that P=MC in an oligopoly, which is the same result for perfect competition. This isn·t true. We need to alter the assumptions.

P1*
Firm 1·s Reaction Curve

Nash Equilibrium

P2*

P2

BERTRAND MODEL VS COURNOT MODEL

Price Leadership in the Bertrand Model is NOT advantageous. This is because of the SLOPE of the Reaction Functions; the leader will actually do worse (it will have a higher price) than the follower if it acts aggressively. The precise mathematics of the sequential game are broadly similar to the maths of the Stackelberg Cournot instance. In any instance, you want to induce the other firm to act less aggressively:
y y

If the RF SLOPE UPWARDS:

Act like a ¶puppy dog· to make the other firm act like one too. Act like the ¶Top Dog· to make the other firm act like a ¶puppy dog·.

If the RF SLOPE DOWNWARDS:

BERTRAND PRICE LEADERSHIP
P1

P1 P1*

‡Sub ² Optimal Nash Equilibrium with price leadership ‡Prices are higher than they are in the original model and output is lower.
Nash Equilibrium

P2*

P2=R2(P1)

P2

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