Item 11 - Imperfect Competition

Theory and Application of
Intermediate Microeconomics
11th edition
by
Walter Nicholson, Amherst College
Christopher Snyder, Dartmouth College
PowerPoint Slide Presentation
Philip Heap, James Madison University
© 2010 South-Western/Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole
or in part.
Chapter 12
Imperfect Competition
or in part.
Chapter Preview
 Most markets fall in between perfect competition and
monopoly.
 An oligopoly is a market with only a few firms, and their

behavior is interdependent.
 There is no one oligopoly model. In general we want to

consider:
 Short run: pricing and output decision of the firms.
 Long run: advertising, product development.
 Very long run: entry and exit.
or in part.
Pricing of Homogeneous Products: An Overview
Price
Monopoly and the perfect cartel
outcome.
Cournot outcome (firms choose output).
PM
Perfect competition and the
Bertrand model (firms choose
prices).
PPC MC = AC
MR D
QM QPC Quantity
per week
or in part.
Pricing of Homogeneous Products: An Overview
 So in an oligopoly there can be a variety of outcomes:
 If the firms act as a cartel, get the monopoly solution.
 If the firms choose prices simultaneously, get the

competitive solution.
 If the firms choose output simultaneously get some

outcome between perfect competition and monopoly.
or in part.
Cournot Model
 Cournot Model is a model in which firms simultaneously
choose quantities.
 There are two firms, A and B, that operate springs. The

water in the springs is homogeneous. The firms must
decide how much water, qA and qB, to supply. Marginal cost
is equal to zero.
 Market demand:
 Q = 120 – P
 P = 120 – Q, where Q = qA + qB
or in part.
Cournot Model
 We want to find the Nash equilibrium.
 Each firm will maximize profits by producing a level of output

where MR = MC.
 TRA = (120 – qA – qB) x qA

 MRA = 120 – 2qA – qB
 Setting MR = MC:
 120 – 2qA – qB = 0
 qA = (120 – qB) / 2
or in part.
Cournot Model
 qA = (120 – qB) / 2: Firm A’s best-response function.
 qB = (120 – qA) / 2: Firm B’s best-response function.
 A Nash equilibrium requires that each firm chooses its best

response to what the other firm is doing.
 Plugging one firm’s best response function into the other’s:

 qA = qB = 40
Q = 80, P = $40
 Profit per firm = $1,600
or in part.
Cournot Model
qB
120
A’s best-response
function
60
Nash equilibrium
40
B’s best-response
function
qA
40 60 120
or in part.
Cournot Model
 Compare the Cournot outcome to other markets:
 Perfect Competition: P = $0Q = 120
 Monopoly: P = $60 Q = 60
 Cournot: P = $40 Q = 80
 Cournot firms do not take into account that an increase in

their output lowers price, and therefore, the profits of the
other firm.
 The two firms would have an incentive to collude and restrict

their total output to the monopoly output.
or in part.
Cournot Model
 But this is not a Nash equilibrium. If I know you are going to
keep the agreement, I should break it ...
 The firms could increase profits by merging.
 Since consumers benefit from lower prices and greater

output, antitrust laws prohibit collusion and prevent some
mergers that would increase concentration in the market.
or in part.
Bertrand Model
 A Bertrand Model is a model in which firms simultaneously
choose prices.
 There are two firms, A and B, who each produce a

homogeneous product.
 Marginal cost is constant and the same for both firms.
 All sales go to the firm with the lowest price. If the prices
are equal, the firms share the market equally.
or in part.
Bertrand Model
 What is the Nash equilibrium?
 PA = PB = MC
 Explain why this is the equilibrium?

 If both firms are charging a P = MC, profits are zero.
Neither firm can do better by changing their price. Either
they would have no sales or they would have losses.
 Is this the only equilibrium?
or in part.
Bertrand Model
 Bertrand Paradox
 With only two firms in the market, you get the perfectly
competitive outcome. Firms have no market power.
 Although this results holds for any demand curve or

marginal cost it will not hold if we change some of the
assumptions:
 Firms choose output (Cournot).
 Products are differentiated.
 The firms have different marginal costs.
or in part.
Cournot and Bertrand Compared
 Bertrand:
 P = MC and profits equal to zero.
 Cournot
 P > MC and profits are greater than zero.
 In both cases, firms would be better off by “cooperating” but
cooperation is not stable since either firm has an incentive
to cheat on the agreement.
 Point is that you can get a wide range of outcomes in
oligopoly models: from perfect competition to monopoly.
or in part.
Product Differentiation
 Suppose now that the two firms in the market sell
differentiated products.
 How do they set prices and how does it compare to the

Bertrand outcome?
 Firm A’s demand: qA = ½ - PA – PB

 Firm B’s demand: qA = ½ - PB – PA
 Notice that each firm’s demand curve is decreasing in its own

price and increasing in the price of its rival.
or in part.
If Firm B increases its price, the demand facing
firm A would increase, so it would respond by
increasing its price. A’s best-response
PB function
B’s best-response
function
PB*
Nash equilibrium
PA
PA*
or in part.
 With product differentiation we no longer get the Bertrand
Paradox: P > MC.
 What about product selection?
 Two stage game: Firms first choose “location” or the

characteristics of the product. They then choose price.
 Need to consider two opposing effects.
or in part.
 Direct effect:
 Firms will want to locate their product near the greatest
concentration of consumers, since demand is the
greatest.
 Therefore, firms will tend to locate near each other:
produce similar products.
 Strategic effect:
 Locating near each other toughens price competition:
price gets closer to MC.
 By locating further apart – greater differentiation – they
can they increase the price they charge.
or in part.
PB
BRA BRA’
BRB’
PB**
BRB
PB*
Shift in the Nash
equilibrium
PA
PA* PA**
or in part.
 The role of search costs.
 If consumers are not fully informed about prices, prices
may differ even if the products are homogeneous.
 A search cost is the cost to the consumer to learn the
prices that different firms charge.
 Assume that consumers have either low-search costs or
high-search costs.
 Possible that some firms specialize in serving the low-
search cost consumers at a low price; some firms serve
the high-search cost consumers at a high price.
or in part.
Tacit Collusion
 Under what condition(s) can collusion be sustained in the
Bertrand Model?
 Nash equilibrium: P = MC for both firms; profits = 0

 Collusion: P = PM, and they share the monopoly profits, πM.
 Treat this as a repeated game.
 Finite Time Horizon:

 The equilibrium is the same as when the game is not
repeated.
 Promises to maintain collusion are not credible since both
firms know that in the last period P = MC.
or in part.
Tacit Collusion
 Indefinite Time Horizon:
 If the two firms cooperate they earn πM/2 each.
 Ifa firm cheats on the agreement it earns πM in that

period.
 In each subsequent periods the firm earns 0.
 Let g be the probability that the game will continue.
 The expected stream of profits from collusion is:
 (πM/2)(1 + g + g2 + . . .) = (πM/2)(1/1-g)
or in part.
Tacit Collusion
 Cheating on the agreement will be unprofitable if:
 πM < (πM/2)(1/1-g)
g ≥½
 The more patient firms are, the more likely they are to
maintain the cooperative agreement.
 If the interest rate is relatively high, firms will be less patient

and more likely to break the agreement.
or in part.
Tacit Collusion
 Some generalizations:
 Suppose there are now N firms colluding. In this case

collusion can be sustained as long as:
 g ≥ 1 – 1/N
 The greater the number of firms colluding, the greater the
degree of patience necessary to maintain collusion.
 Therefore, as N increases, collusion is less likely.
 How would the condition change if the firms set output

(Cournot) instead of prices (Bertrand)?
or in part.
Entry and Exit
 Under perfect competition entry/exit decisions treated very
simply.
 With imperfect markets need strategic thinking.
 IfI decide to enter how will that affect the market price in
future periods?
 What will my rivals do in response to my entry?
or in part.
Entry and Exit
 Sunk costs and commitment
 By making a specific capital investment or making a sunk
decision that can’t be reversed later, the firm commits to
entry.
 First Mover Advantage
 By committing to serve a market a firm may be able to
limit responses by potential rivals.
 Consider the Cournot model from earlier: two spring
water firms. Each produced 40 units and earned $1,600.
 Market demand: P = 120 – qA - qB
or in part.
Entry and Exit
 Suppose that firm A can move first by committing to an
output. B observes that output and decides how much to
produce.
 Start with B’s best response function:
 qB = ½ x (120 – qA)
 Since firm A knows B’s best response function it has a net
demand of:
 qA = 120 – qB – P
 qA = 120 - ½ x (120 – qA) – P

 qA = 60 + ½ qA - P
or in part.
Entry and Exit
 qA = 60 + ½ qA – P
 Rewrite:
 P = 60 – ½ qA
 Set MR = MC
 60 – qA = 0 so qA = 60
 Given A’s output, B produces:
 qB = ½ (120 – 60) = 30
 Total output is 90 and price is $30
 Firm A earns $1,800 (+$2,000 over Cournot) and Firm B
earns $900.
or in part.
Entry and Exit
 A firm may be able to deter entry altogether by increasing
output even more.
 In the simple Cournot case it is not possible.
 To deter entry the first firm would have to produce 120.
 This would mean P = MC and profits would be zero.
 If there are economies of scale in production it may be
possible to deter entry.
 Suppose there is a fixed entry cost of $785.
 If qA = 60, then qB = 30, πB = $115: B enters
 If qA = 64, then qB = 28, πB = - $1: B does not enter
or in part.
Cournot and Stackleberg
qB
120
60
Cournot
40
Stackleberg
30
Entry deterrence
qA
40 60 120
or in part.
Entry and Exit
 Limit Pricing: A limit price is a price that prevents new firms
from entering the market.
 Prices are not “sunk” so there is a commitment issue.
 For limit pricing to work, prices must be related across time.

 Advertised prices may be difficult to reverse later.
 With a learning curve, a low price today allows the firm to
increase production and reduce costs. Allows the firm to
be more aggressive tomorrow.
 Consumers may face switching costs.
or in part.
Entry and Exit
Prices may also be related across time if there is asymmetric
information.
Probability ½ A
Nature
. Probability ½ A
. .
high cost low cost
B B
No entry Entry No entry Entry
4, 0 1, 3 6, 0 3, -1
or in part.
Entry and Exit
 B would enter the market since its expected profits from
entering ($1) are greater than its profits from not entering
($0).
 Firm A may be able to use a signaling strategy to deter B
from entering.
 If firm A charges a low price it may make B believe that A is
a low-cost firm. Therefore, B would not enter.
 If firm A is a high-cost firm the strategy may work as long as
the gains from deterring entry exceed the losses from
charging the low price.
or in part.
Price Leadership Model
 In a price leadership model there is one dominant firm that
behaves strategically, and a group of small firms that
behave as price takers (competitive fringe).
 How would the dominant firm decide what price to charge?
or in part.
Price Leadership Model
Price Fringe S
PL Residual demand
MC
Market D
MR
QF QL QT Quantity
or in part.
Monopolistic Competition
 Monopolistic Competition is a market in which each firm
faces a downward sloping demand curve and there are no
barriers to entry.
 Each firm produces a slightly differentiated product so
has some market power.
 With no barriers to entry competition will drive profits to
zero in the long run.
or in part.
Price
MC
In the short run the
firm earns and
economic profit.
P* AC
MR d
q* MCQuantity
or in part.
The profit attracts new
Price firms to the industry, so
MC the demand facing an
existing firm falls.
P* AC
Entry will continue until
P’ all firms earn zero
economic profit.
d’
MR’ MR d
q’ q* MCQuantity
or in part.
Barriers to Entry
 Saw with a monopoly that there are both technical and legal
barriers to entry.
 Other barriers to entry:

 Product differentiation and advertising create brand loyalty.
 Strategic pricing decisions.
 Whether there are barriers to entry can be important when

two or more firms wish to merge.
or in part.
Recap
 Since there are few firms in imperfect markets, strategic
interaction is important, and game theory is a useful tool.
 Equilibrium outcomes with few firms can vary from perfect

competition (Bertrand) to monopoly (tacit collusion) with
outcomes in between (Cournot)
 The strategic variables chosen (price vs. quantities), the

degree of product differentiation, the presence of capacity
constraints, information, and repeated interaction, all may
have an impact on the outcome.
or in part.
Recap
 Firms may increase their profits through tacit collusion.
Collusion is likely to be sustained, the more patient firms,
the lower the interest rate, and the fewer the number of
firms.
 Two-stage models can be used to analyze issues such as

advertising, product selection, capacity choice, and entry
deterring decisions.
 Although somewhat simple, short-hand models such as

price leadership and monopolistic competition can be used
to illustrate some outcomes in imperfect markets.
or in part.

Item 11 - Imperfect Competition

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Item 11 - Imperfect Competition

Uploaded by

Copyright:

Available Formats

Theory and Application of

 An oligopoly is a market with only a few firms, and their

 There is no one oligopoly model. In general we want to

Cournot outcome (firms choose output).

 If the firms act as a cartel, get the monopoly solution.

 If the firms choose prices simultaneously, get the

 If the firms choose output simultaneously get some

 There are two firms, A and B, that operate springs. The

 Each firm will maximize profits by producing a level of output

 TRA = (120 – qA – qB) x qA

 qB = (120 – qA) / 2: Firm B’s best-response function.

 A Nash equilibrium requires that each firm chooses its best

 Plugging one firm’s best response function into the other’s:

 Cournot firms do not take into account that an increase in

 The two firms would have an incentive to collude and restrict

 The firms could increase profits by merging.

 Since consumers benefit from lower prices and greater

 There are two firms, A and B, who each produce a

 Marginal cost is constant and the same for both firms.

 Explain why this is the equilibrium?

 Is this the only equilibrium?

 Although this results holds for any demand curve or

 How do they set prices and how does it compare to the

 Firm A’s demand: qA = ½ - PA – PB

 Notice that each firm’s demand curve is decreasing in its own

 What about product selection?

 Two stage game: Firms first choose “location” or the

 Need to consider two opposing effects.

 Nash equilibrium: P = MC for both firms; profits = 0

 Finite Time Horizon:

 Ifa firm cheats on the agreement it earns πM in that

 The expected stream of profits from collusion is:

 If the interest rate is relatively high, firms will be less patient

 Suppose there are now N firms colluding. In this case

 How would the condition change if the firms set output

 With imperfect markets need strategic thinking.

 qA = 120 - ½ x (120 – qA) – P

 If qA = 64, then qB = 28, πB = - $1: B does not enter

 Prices are not “sunk” so there is a commitment issue.

 For limit pricing to work, prices must be related across time.

No entry Entry No entry Entry

 How would the dominant firm decide what price to charge?

 Other barriers to entry:

 Whether there are barriers to entry can be important when

 Equilibrium outcomes with few firms can vary from perfect

 The strategic variables chosen (price vs. quantities), the

 Two-stage models can be used to analyze issues such as

 Although somewhat simple, short-hand models such as

You might also like