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Oligopolies and

monopolistic
competition

In between the two competition


benchmarks
Oligopolies and monopolistic competition

 Today we finish examining the


competition continuum we introduced
last week
 After today, you will know all four of the
main models used to explain the
different market structures
 The two extreme benchmarks (previous
weeks)
 The two “middle ground” models
Oligopolies and monopolistic competition

The “competition continuum”

Market power of firms

Perfect Monopolistic
Oligopoly Monopoly
competition competition
Many firms with a Many firms with A few A single
homogeneous differentiated producers producer
product products with high
market power
Oligopolies and monopolistic competition

 Importantly, the two cases we see today


are in the middle of the competition
continuum
 They are more realistic that the extreme
benchmarks of perfect competition and
pure monopoly
 More “powerful” models in that they
correspond better to the real world
 Unfortunately, this means that they are also
more complex
 These models have required the development
of new tools
Oligopolies and monopolistic competition

Oligopolies

Monopolistic competition
Oligopolies

 The oligopoly corresponds to the following


market structure :

 A few large producers


 Homogeneous products
 No entry of competing producers on the
market
 Perfect information
 Perfect mobility of inputs

 Apart from the few producers instead of one, this


is not much different from the monopoly
Oligopolies

 Oligopolies are usually caused by the


presence of barriers to entry which deter
potential competitors.

 Institutional or regulatory barriers


(Example: defence industry or utilities)
 The nature of the technology, which
determines the existence of returns to scale
and the minimal efficient scale of the firm
(Example : Aeronautical industry)
 Absolute cost differentials: Vertical
integration, access to an efficient supply or
distribution network (example: agribusiness)
Oligopolies

 This is a common situation in many industries


:
 Car industry, aeronautical industry
 Agribusiness (Nestlé, Danone, Kraft foods,
Coca-Cola Co)
 Electronics, computing
 Utilities, buildings, etc.

 Compared to the monopoly case, each firm


has an extra element to consider: The
behaviour of its competitors (introduced last
week)
 Because a firm’s output influences market
prices, competitors will react
 This will lead to strategic behaviour
Oligopolies

 A simple solution for the market price and


quantity is possible if the firms decide to
cooperate. This cooperative equilibrium is called a
cartel.

 OPEC is a good example: an organisation of


independent producers, producing the same
goods, who decide to coordinate their strategies,
so as to limit their output and increase prices.
 The good news: When firms do this (ie maximise
collective profit), they practise monopoly pricing and get
monopoly profits. This means the simple monopoly
model is enough
 The “bad” news: This practise is illegal in most countries!
Also, there is an incentive to cheat. So usually, firms will
not cooperate, and a more complex model is needed...
Oligopolies

Price The cooperative mCA


ACA
equilibrium

p G

Inverse demand
facing firm A
mRA
q Quantity
Oligopolies

 When firms in an oligopoly do not cooperate,


there is a non-cooperative equilibrium

 Compared to the monopoly and the cooperative


cartel case, it becomes difficult to characterise
the market equilibrium (equilibrium price and
quantity)
 If a firm changes its output (price), this changes the
market price, and the profits of competitors. They will
react to this change in profits by changing their output
(price).

 The optimal strategy of a firm depends on the


strategies of its competitors. There are as many
types of equilibria as there are combinations of
strategies.
Oligopolies

 As a simplification, economic theory typically


examines the duopoly: The case with two
producers on a market with barriers to entry

 There are many possible models of duopoly:


Quantity Price
competition competition
Simultaneous Cournot Bertrand
setting duopoly duopoly
Leader/Follow Stackelberg Price
er setting duopoly leadership
Oligopolies

 The Cournot duopoly (1838) :

 Isthe first and simplest model of a


duopoly: each firm considers the output
of its competitor as given

 The2 firms simultaneously choose their


output, and consider that the current
output of their competitor will not
change (not very realistic...)
Oligopolies

 The profits of the two firms is given by:


  1  p  q1  q2   q1  c1  q1 

  2  p  q1  q2   q2  c2  q2 

The cost of production depends


only on the firm’s output

The market price however,


depends on the aggregate output
q1 + q2
 For simplicity, we re-write them as:
  1  F1  q1 , q2 

  2  F2  q1 , q2 
Oligopolies

 As for all firms, the maximum profit condition


is given by the first order condition  i qi  0
  1 F1  q1 , q2 
  0
 q1 q1

  2  F2  q1 , q2   0
 q q2
 2

 These first order conditions can be rearranged


to give a system of equations known as
reaction functions
A reaction function tells you the
 q1  f1  q2  quantity q1 that maximises the

 q2  f 2  q1 
profits of firm 1 given the
quantity q2 produced by firm 2
Oligopolies

Reaction functions and Cournot


q2
equilibrium
Reaction function of firm 1
q1  f1  q2 

Reaction function of firm 2

C1 q2  f 2  q1 
C0
C3
C2 C
q*2

q*1 q1
Oligopolies

 The existence and the stability of an equilibrium


in an oligopoly depends on the expectations that
firms form about the strategies of their
competitors
 Several different equilibria are possible depending
on the various combinations of strategies
formulated.
 Most often, the tools of classical economics
cannot find these different equilibria...
 ...unless strong simplifying assumptions are made.
See the Cournot example: “treat output as given”
 Game theory was developed as a response to this
problem.
 This will be seen next week
Oligopolies and monopolistic competition

Oligopolies

Monopolistic competition
Monopolistic competition

 Monopolistic competition corresponds to the


following market structure :

 Large number of agents (Atomicity)


 Differentiated products
 Free entry and exit from the market
 Perfect information
 Perfect mobility of inputs

 The output of each producer is slightly different


from the others ⇒ existence of varieties (brands)
Monopolistic competition

 Because each firm produces a slightly different


good, consumers can have preferences over
these different varieties.
 There will be an element of “brand loyalty” in
consumer behaviour, where one variety of a good
will be preferred over another one.

 Examples: Corner shops, restaurants, hair


dressers, travel agents, etc.

 Unfortunately, the algebra necessary to generate


such “preference for variety” models is a bit
complicated ⇒ We will only look at the diagrams
Monopolistic competition

 Each firm has a small amount of market power


 Because of “brand loyalty”, it can increase its price
a bit without loosing all its customers (as is the
case in perfect competition)
 The price elasticity of demand is not infinite
 The demand curve facing the firm is downward-
sloping (not flat as in perfect competition)
 There will be a (small) mark-up: Price is above mC

 However, because firms can enter the market


freely, economic profits are equal to zero in
the long run
Monopolistic competition

 How does this work ?


 At the firm level, the short run equilibrium
diagram looks like the monopoly diagram
 It also solves like a monopoly ⇒ short run profits

 The adjustment to the long run behaves like


perfect competition:
 Extra firms enter the market, attracted by the
profits
 The demand facing each firm decreases until
profits are competed away
Monopolistic competition

Firm-market equilibrium
Firm level Market level
Price Price
mC
Positive
profits in the
short run S
AC

p
d
mR
D
q quantity Q Quantity
Monopolistic competition

Firm-market equilibrium
Firm level Market level
Price Price
Positive profits attract firms
mC to the market (free entry +
zero profits
in the long run perfect information)
S S
AC

p
p2 d
mR
D
q2 q quantity Q Q2 Quantity
Monopolistic competition

Price
Long run welfare implications
mC AC
In the long run, Total
revenue is equal to Total
cost ⇒ Profits are equal
to zero
p = AC Similar to perfect
p competition. An
improvement on
monopolies/oligopolies
Demand
mR
q Quantity
Monopolistic competition

Price
Long run welfare implications
mC AC

Even in the long run,


Consumer surplus
there is a mark-up
p > mC
This implies some
p deadweight loss

Demand
mR
Producer surplus q Quantity
Monopolistic competition

Price
Long run welfare implications
mC AC

Firms are not producing


at the minimum AC.
There is excess capacity
(i.e. some production
p resources are wasted)

Demand
mR
q q* Quantity
Monopolistic competition

 This model has a competitive limit


 The weaker the preferences of consumer
for variety (the “brand loyalty”), the less
market power the firms have and the
closer the model predictions are to perfect
competition
 The demand curve becomes flatter
 The mark-up and deadweight loss are reduced

 The equilibrium tends to P = mC = AC


Monopolistic competition

The competitive limit


Case 1 Case 2
Price Price
mC mC

AC AC

p p d
d mR
mR
q quantity q Quantity