Introductory Microeconomics (ES10001)

1
Introductory Microeconomics (ES10001)

• Topic 5 Imperfect Competition

2
I. Introduction

• PC Monopoly are useful benchmarks.
• But, in more than half of the 800 major UK
  manufacturing product categories, 70 of market
  is shared by 5 largest firms in the market.
• Real world markets are imperfectly competitive
• Imperfectly competitive (IC) firms cannot sell as
  much as want at going market price they face a
  downward sloping demand curve.

3
I. Introduction

• Two models of imperfect competition
• Monopolistic Competition
• Oligopoly
• And in terms of Oligopoly
• Non-Collusive
• Collusive

4
II. Monopolistic Competition

• Theory originally developed by Chamberlain (USA)
  and Robinson (UK) in early 1930s
• Many sellers producing similar, but not
  identical, products that are close substitutes
  for each other
• Each firm has only a limited ability to affect
  the market price

5
II. Monopolistic Competition

• Assumptions
• Large number of small firms firms assume own
  behaviour has no influence on rivals actions
• Similar, but not identical, products
• Free entry and exit into industry

6
II. Monopolistic Competition

• Implication
• Each firm can, to some extent, influence its
  market share by changing its price relative to
  its competitors
• Demand curve is downward sloping because
  different firms products are only limited
  substitutes for each other
• Advertising product differentiation

7
II. Monopolistic Competition

• Short-run equilibrium of typical monopolistically
  competitive firm
• Profit-maximising monopolist in its own brand
• Thus MR MC and (we assume) profit gt 0

8
Figure 1 Monopolosit Competition (SR) p gt 0
p
SMC
p0
SAC
Profit
LAC0
D AR
MR
Q
0
Q0
9
II. Monopolistic Competition

• Existence of supernormal profit induces other
  firms to enter industry with their own brands
• This shifts down/left demand curve facing
  existing monopolistically competitive firms
• Moreover, demand curve becomes more elastic since
  consumers now have a greater variety of choice
• Process continues until no more firms enter
  industry (i.e. all firms are earning normal
  profit)

10
Figure 2 Impact on AR of entry of rival brands
p
AR0
AR1
Q
0
11
Figure 3 Monopolist LR Equilibrium p 0
p
LMC
LAC

p0 LAC0
D AR
MR
Q
0
Q0
12
II. Monopolistic Competition

• Long-run tangency equilibrium where p LAC
• Monopolistically competitive firms are neither
  electively nor productively efficient
• ... too many firms each producing too little
  output. (Chamberlain)
• But
• ... excess capacity is the cost of
  differentness. (Chamberlain).

13
III. Oligopoly

• Competition among the few
• Few producers, each of whom recognises that its
  own price depends on both its own output and the
  output of its rivals
• Thus, firms are of a size and number that each
  must consider how its own actions affect the
  decisions of its relatively few competitors.
• For example, firm must consider likely response
  of rivals before embarking on a price cutting
  strategy

14
III. Oligopoly

• Collusion or competition?
• Key element of all oligopolistic situations
• Collusion agreement between existing firms to
  avoid competition with one another
• Can be explicit or implicit

15
III. Oligopoly

• For example, existing firms might collude to
  maximise joint profits by behaving as if they
  were a multi-plant monopolist
• i.e. restricting q to monopolist level, say q0,
  and then negotiating over the division of q and
  monopoly profits
• Note, might not agree to divide up q equally
  sensible for more efficient members of the cartel
  to produce q

16
Figure 4 Collusion or Competition
p
E0
p0
p1
MC
MR
D AR
q
q0 q1
0
17
III. Oligopoly

• But, since cartel p gt MC, each firm has an
  incentive to renege on the collusive agreement
• ... temptation to reach the first best renders
  the second best unsustainable and drives firms
  to third best
• First-Best I renege, you collude
• Second-Best Neither renege we both collude
• Third-Best We both renege
• Cartels are inherently fragile!

18
Figure 4 Collusion or Competition
p
Cartel price is above cartel members marginal
cost, thus incentive to renege (i.e. increase q)
p0
Normal profit equilibrium
p1
MC
MR
D AR
q
q0 q1
0
19
III. Oligopoly

• Collusion is easiest when formal agreements
  between firms are legally permitted (e.g. OPEC).
• More common in 19th century, but increasingly
  outlawed
• Collusion is more difficult the more firms there
  are in the market, the less the product is
  standardised, and the more demand and cost
  conditions are changing in the absence of
  collusion

20
III. Oligopoly

• In absence of collusion, each firms demand curve
  depends upon how competitors react, and firms
  have to make assumptions about this
• A simple model of this was developed by Sweezy
  (1945) to explain that apparent fact that prices
  once set as a mark-up on average costs, tend not
  too change
• Kinked Demand Curve model

21
III. Oligopoly

• Assume firm is at E0 selling q0 output at a unit
  price of p0
• Firm believes that if it raises price, its rivals
  will not raise their price (i.e. DA), but that if
  it lowers price, then its rivals will follow him
  (i.e. DB)
• Thus demand curve is kinked at E0 being flatter
  for p gt p0 and steeper for p lt p0

22
Figure 5a Kinked Demand Curve Model
p
E0
p0
DA
DB
q
0
q0
23
III. Oligopoly

• Both the no-follow demand curve (DA) and the
  follow demand curve (DB) will have an
  associated MR curve (MRA, MRB)
• Thus MR is discontinuous (i.e. vertical) at q0
  since an increase in q beyond q0 will lead to a
  discontinuous fall in total revenue

24
Figure 5b Kinked Demand Curve Model
p
E0
p0
DA
DB
q
0
q0
MRA
MRB
25
Figure 5c Kinked Demand Curve Model
p
E0
p0
D
q
0
q0
MR
26
III. Oligopoly

• Thus, fluctuations in marginal cost within the
  discontinuous part of the MR curve (i.e. within
  A-B) do not lead to a change in the firms
  profit-maximising level of output
• Sweezy used the model to model the inflexibility
  of US agricultural prices in the face of cost
  changes

27
Figure 5a Kinked Demand Curve Model
p
LMC
E0
p0
A
B
D
q
0
q0
MR
28
III. Oligopoly

• But two key weaknesses
• Empirical
• Further evidence suggested that agriculture
  prices did not behave asymmetrically
• Theoretical
• Model does not explain how we got to the initial
  equilibrium, or where we go if LMC moves outside
  of the discontinuity

29
III. Oligopoly

• Cournot (1833)
• Firms compete over quantities with conjectural
  variation that other firm(s) will hold their
  output constant
• Cournot originally envisaged two firms producing
  identical spring water at zero cost

30
III. Oligopoly

• Two firms (a, b) costlessly produce identical
  spring water
• Assume normal (inverse) demand curve for spring
  water is
• qd 100 5p ltgt pd 20 0.2q
• Assume that firm a believes that firm b will
  produce zero output (i.e. Eaqb 0) firm as
  optimal q is that which maximises firm as total
  revenue vis.

31
Figure 6a Cournot Competition Firm as optimal
output if Eaqb 0
p
20
Ea1
10
D AR
q
50
100
0
MR
32
III. Oligopoly

• However, if firm a were to produce 50 units, then
  firm b would presume that it (i.e. firm b) faces
  a (residual) demand curve of
• i.e. a residual demand given by the market demand
  for the good less firm as output
• And firm b would make its optimal choice of
  output accordingly

33
Figure 6b Cournot Competition
p
Firm as supply Firm bs (residual)
demand
20
Ea1
10
D AR
q
50
0
100
MR
MR
34
Figure 6c Cournot Competition Firm bs
residual demand
p
10
Eb2
5
D AR
q
25
0
50
MR
35
III. Oligopoly

• Thus, if qa 50, then firm b would maximise its
  profit (i.e. revenue) by setting qb 25
• But this would imply that firm a would want to
  change its initial level of output i.e. qa1 50
  was optimal under the assumption that qb 0
• But now that qb 25, firm a will want to revise
  its choice of q accordingly

36
III. Oligopoly

• Thus, firm a will choose the level of output that
  maximises total revenue given qb 25
• Firm as residual demand curve is thus
• Such that

37
Figure 6d Cournot Competition
p
Firm as supply Firm as
(residual) demand
20
Eb2
15
D AR
MR
q
25
0
100
38
Figure 6e Cournot Competition Firm as
residual demand
p
15
Ea3
7.5
D AR
q
37.5
0
75
MR
39
III. Oligopoly

• This process will continue until neither firm
  regrets its optimal choice of output
• i.e. until its conjectural variation regarding
  the other firms response is validated
• The Cournot equilibrium is thus where

40
Figure 6d Cournot Competition Cournot
Equilibrium
p
20
Ea
Eb
D AR
q
0
33.3 33.3
100
MR MR
41
III. Oligopoly

• Cournot market shares

Round 1 2 3 4 n
Firm a 50 50 37.5 37.5 33.33
Firm b 0 25 25 31.25 33.33
42
III. Oligopoly

• It can be shown that total (i.e. market)
  equilibrium output under Cournot competition is
  given by
• where qc is the perfectly competitive level of
  output (i.e. where p MC)
• N.B. Usually termed Nash-Cournot equilibrium,
  hence superscript n

43
III. Oligopoly

• Monopoly
• n 1 qn (1/2)qc
• Duopoly
• n 2 qn (2/3)qc
• Perfect Competition
• n qn qc

44
III. Oligopoly

• Cournot originally envisaged his model in term of
  sequential decision making on the part of firms
• But it would irrational for each firm to persist
  with the conjectural variation that its rival
  will hold output constant when they only do so in
  equilibrium
• Moreover, the model implies the existence of a
  future, in which case it can be shown that
  profitable collusion is sustainable

45
III. Oligopoly

• Economists have re-interpreted Cournots model in
  terms of a one-shot game
• i.e. only one amount of output actually put onto
  market vis. Cournot equilibrium level of output
  qn
• But, it is assumed that each firm goes through a
  rational sequential decision making process
  before implementing its output choice

46
III. Oligopoly

• The Cournot equilibrium may be re-interpreted in
  this sense as a Nash Equilibrium
• That is, an equilibrium in which each party is
  maximising his utility given the behaviour of all
  the other parties
• I am doing the best I can do, given what you are
  doing and vice versa

47
III. Oligopoly

• Stackelberg competition
• Variation of Cournot in which firm a announces
  its output and, once that announcement is made,
  the output cannot be changed.
• i.e. one-shot game or repeated game in which firm
  a produces the same level of output in each
  period.

48
III. Oligopoly

• Assume
• Firm 1 - market leader
• Firm 2 - market follower
• N.B. firm 1 has to be able to make a credible,
  binding commitment to a particular output level

49
Figure 7 Stackelberg Competition
p
20
E1
E2
Es
5
D AR
q
50 25 75
0
100
MR
MR
50
III. Oligopoly

• Bertrand Competition
• Both Cournot and Stackelberg assume that firms
  chose outputs with prices determined by the
  inverse demand functions.
• But in many oligopolistic markets firms appear to
  set prices and then sell whatever the market
  demands at those prices

51
III. Oligopoly

• In perfect competition and monopoly, it makes no
  difference whether we carry out analysis in terms
  of prices or quantities
• That is, price determines quantity and quantity
  determines price
• But in oligopoly the distinction is crucial

52
III. Oligopoly

• Bertrand presented an alternative to the Cournot
  model in his review of Cournots book.
• He asked the question, what would be the outcome
  if the two firms chose prices
• (a) simultaneously
• (b) independently
• And then sold all the output that was demanded at
  these prices via the inverse demand functions

53
III. Oligopoly

• Conclusion
• Completely different result emerges
• Equilibrium which replicates perfectly
  competitive (i.e. allocatively efficient)
  equilibrium in which p MC

54
III. Oligopoly

• Firms compete with each other by marginally
  undercutting the others price (assuming
  homogenous good, costs etc.) and thus taking the
  whole market
• Process continues until the only equilibrium is
  one where each firm sets price equal to marginal
  cost

55
III. Oligopoly

• Nash equilibrium in Bertrand is p1 MC p2
• Rationalisation for the equilibrium is on the
  same lines as in Cournot model vis. no other pair
  of prices has the property of mutual consistency.
  
• Bertrand intended this to be a reductio ad
  absurdum and to demonstrate the weakness of
  Cournots approach

56
Figure 8 Bertrand Competition
p

Monopoly Equilibrium
Em

pm
Bertrand Equilibrium
Eb
MC AC
pb
D AR
q
0
qb
qm

MR
57
III. Oligopoly

• Bertrand model yields a striking prediction from
  a quite reasonable model
• If outputs are homogenous, an increase in the
  number of firms in the market from one to two
  leads from the monopoly equilibrium directly to
  the perfectly competitive equilibrium!

58
IV. Game Theory

• Game situation in which intelligent decisions
  are necessarily interdependent
• The players in the game attempt to maximise their
  own payoffs via a strategy
• Strategy game plan describing how the player
  will act (or move) in every conceivable
  situation.
• Equilibrium Concept - Nash

59
IV. Game Theory

• Nash equilibrium occurs when each player chooses
  his best strategy, given the strategies of the
  other players.
• Consider
• Prisoners Dilemma

60
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
61
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
62
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
63
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
64
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
65
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
66
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
67
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
68
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
69
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
70
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
71
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
72
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
73
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
74
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
75
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
76
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
77
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
78
IV. Game Theory

• Prisoners Dilemma

Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
79
IV. Game Theory

• Nash Equilibrium Confess, Confess
• Indeed, to confess is each players dominant
  strategy vis. optimal strategy that is
  independent of the strategy of the other
  player(s)
• Recall, collusion versus competition

80
IV. Game Theory

• Collusion versus Competition

Firm 2 Renege Collude
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
81
IV. Game Theory

• Collusion versus Competition

Firm 2 Renege Collude
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
82
IV. Game Theory

• Collusion versus Competition

Firm 2 Renege Collude
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
83
IV. Game Theory

• Collusion versus Competition

Firm 2 Renege Collude
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
84
IV. Game Theory

• Collusion versus Competition

Firm 2 Renege Collude
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
85
III. Oligopoly

• First-best (i.e. dominant strategy) would be to
  renege given that the other firm colludes
• Second-best would to both collude (i.e. a
  voluntary agreement to maintain the cartel output
  but restrictive practices are usually illegal
  and so agreements are usually tacit)
• Third-best is to both renege and compete

86
III. Oligopoly

• Again
• Temptation to reach the first-best renders the
  second-best unsustainable and so forces players
  to the third-best