Principles of economics openstax chapter10

MONOPOLISTIC COMPETITION AND OLIGOPOLY: IMPERFECT COMPETITION DR RICHARD GEARHART ENTERPRISE COLLEGE 06/20/2016 NOTES, DEFINITIONS, AND BASICS  Total Revenue (TR): the total amount of money earned by selling a certain amount of good TR = P * Q  Marginal Revenue (MR): the additional revenue earned from producing, and selling, an additional unit ∆TR TRQ − TRQ−1 MR = = = TRQ − TRQ−1 = ∆TR ∆Q ( Q) − ( Q−1)  Total Cost (TC): the total costs of producing a certain amount of units  Marginal Cost (MC): the additional costs of producing an additional unit of the good MC = ∆TC TCQ − TCQ−1 = = TCQ − TCQ−1 = ∆TC ∆Q ( Q) − ( Q−1)  Average Cost (AC): the cost per unit of producing a certain number of goods TC AC = Q Quantity Price Total Revenue Marginal (P*Q) Revenue Total Cost Marginal Cost 10 = (0)(10) = - - = (1)(9) = =9–0=9 =5–0=5 16 = 16 – = 10 = 10 – = 21 = 21 – 16 = 15 = 15 – 10 = 24 20 5 25 25 24 -1 30 21 -3 35 16 -5 40  Demand Curve: one way to view the demand curve is that each point on the demand curve represents a consumer’s maximum willingness to pay for that unit of the good • At point A (a price of 10 and a quantity of 1), the maximum the consumer is willing to pay (WTP) for the $10 • At point B, the maximum WTP, by the consumer, for the • At point C, the maximum WTP, by the consumer, for the nd rd unit is $9 unit is $8 st unit of the good is WHERE DO ALL FIRMS PRODUCE?  A firm will produce up until the point where it earns no additional profits from producing  This means that the firm will produce until its marginal profit (the additional profit from producing and selling one more good) is equal to PROFIT = TR− TC ∆PROFIT = ∆TR− ∆TC = ∆TR− ∆TC ∆TR = ∆TC MR = MC • Thus, all firms will produce (regardless of market structure) where: MR = MC • If MR is greater than MC, this means that the additional revenues from producing outweigh the additional costs You earn higher profits by producing, and should continue to produce MORE • If MR is less than MC, this means that the additional revenues from producing are outweighed by the additional costs You lower your profits by producing, so produce LESS MONOPOLISTIC COMPETITION  Monopolistic competition is a market structure where there are many firms  Each firm produces a slightly differentiated (heterogeneous) good  Big Mac vs Whopper  Coke vs Pepsi  Nike vs Reebok  Polo vs J Crew  In monopolistic competition, brand differentiation is of paramount importance  Brand differentiation allows one firm to price their comparable good differently than another firm  These comparable goods are known as substitutes  Brand differentiation is created through a variety of means  Advertising  Quality  Brand loyalty (Apple)  Innovation  Customer Service  Product Support  Warranty …  If oligopolies have interdependence, will they collude (work together to maximize market profits for ALL firms) or will they compete (work against each other to maximize individual profits for a firm)?  Several types of ways that firms can compete  Price (Bertrand competition)  Quantity (Cournot competition)  Entry into a new product market (Stackelberg competition)  Requires GAME THEORY; this is strategic interaction between people/firms/governments (any economic actor) COMPETITION OR COLLUSION  Known as the Prisoner’s Dilemma  Shows why collusion is very hard  Essentially, in the short-run, firms will benefit by agreeing to work in tandem, and then by breaking their word PRISONER B PRISONER A COOPERATE WITH OTHER CONFESS (SNITCH ON OTHER PRISONER PRISONER) A gets years, B gets years A gets 15 years, B gets years A gets years, B gets 15 years A gets 10 years, B gets 10 years COOPERATE WITH OTHER PRISONER CONFESS (SNITCH ON OTHER PRISONER What Should Prisoner B Do? • • • Suppose that Prisoner A will cooperate Then, B should confess (3 years from confessing is better than years from cooperating) Suppose that Prisoner A will confess Then, B should confess (10 years from confessing is better than 15 years from cooperating) No matter what Prisoner A does, Prisoner B will confess • We get the SAME result from looking at what Prisoner A should • Even though there is a better option (cooperating with each other), both will confess, and get 10 years • The reason this occurs is because of the fact that if one prisoner is “stupid” and continues to cooperate, the other, by confessing, will benefit and get very few years (3 years)  The Prisoner’s Dilemma states that, if you cannot force someone to cooperate with you (a contract or some other “enforcement” mechanism), then their best option is to snitch  Therefore, your best option is to snitch  Without “enforcement”, collusion WILL NOT occur  NATO/UN work because there are enforcement mechanisms in place  OPEC works because there is an enforcement mechanism in place (if you decide to produce more, then all countries will produce more to drive the price down, hurting the country that broke the “contract”)  One way to create an enforcement mechanism is through manipulation of production  Suppose there is a cartel (a collection of firms that collude)  Suppose that one member of the cartel (Coca-Cola) decides to break their agreement  If Coca-Cola wants to produce a few more units, then all firms in the cartel agree to massively increase production so that the price rapidly drops  If Coca-Cola wants to raise prices a little bit, it will cut production All other firms will not change their behavior, so that the price does not increase that much  In both cases, total revenues for the firm that has broken the agreement will fall • Creates a kinked demand curve • Other firms act differently depending on how Coca-Cola acts moving away from point B (where total revenue was $75,000) • If Coca-Cola cuts production to raise the price (movement to point A), other firms nothing, and the massive decrease in production is met by only a modest increase in price Total revenues are now 50,000 • If Coca-Cola increases production (movement to point C), other firms massively increase production, and price falls dramatically Total revenues are now $37,500 PRICE COMPETITION  Known as Bertrand competition  Assume a duopoly (an oligopoly market with only firms)  Assume that the two large firms are producing an identical product, and that the costs of producing the good are the same by the firms  The cost of producing each unit of the good is known as the firm’s marginal cost  Assume that the marginal cost of production, for the good, is $10  Suppose that there are two firms Firm A and Firm B  Firm A sets the price of the good it sells at $15 What should Firm B do?  If it sets it slightly less than $15, because the goods are identical, no one will buy from Firm A, and so consumers will only buy from Firm B Thus, Firm B owns the whole market  Firm B therefore sets the price of the product at $14.50  Firm A notices this and, to “own” the entire market, will undercut the price set by Firm B  Firm A will now reduce price from $15 to $14  This competition occurs until firm’s price the good at the minimum price that they can sell at  Under Bertrand competition, prices reduce to P = MC  This is the perfectly competitive outcome  Thus, each firm sets the price at $10 and earns economic profit QUANTITY COMPETITION  Known as Cournot competition  Assume a duopoly (an oligopoly market with only firms)  Assume that the two large firms are producing an identical product, and that the costs of producing the good are the same by the firms  If every firm produces too much, the price for the good falls below marginal cost, and every firm loses money (and will go out of business)  In Cournot competition, firms will limit their production knowing that other firms are producing identical goods, so that the price does not fall too low  In Cournot competition, each firm will produce LESS than they should, knowing that one firm producing too much will cause them all to lose money ENTRY COMPETITION  Known as Stackelberg competition  Firms are competing on who can create a new product first  Assume that the two firms are producing an identical, new, product  A high capacity battery for an electric car, for instance  Whoever creates the new product first gets a first mover advantage  They earn monopoly profits while the other company continues to develop (or imitate) the product  After the other company enters the market with their identical product, the first company still earns near monopoly profits  The new entrant cannot produce as much (if it did, they would cause the price in the market to fall below marginal cost, meaning that both firms would lose money)  The new firm therefore produces a reduced amount, to earn some profit  This means that the first mover (the initial firm) earns high profits, while the second mover (the new entrant) earns positive, but small, profits  First mover advantage; want to be the first in the market, as consumers will tend to buy your product more  Explains the video game “console wars”, and why each company tries to release their product first DO WE THINK THIS IS REALISTIC  Stylized, but makes sense  What threats other companies have? Produce so much that even they lose money?  Maybe works for companies with very deep pockets trying to get a smaller company out of business  But big company vs big company? Unlikely to be effective ... profit (the additional profit from producing and selling one more good) is equal to PROFIT = TR− TC ∆PROFIT = ∆TR− ∆TC = ∆TR− ∆TC ∆TR = ∆TC MR = MC • Thus, all firms will produce (regardless of. .. Q−1)  Total Cost (TC): the total costs of producing a certain amount of units  Marginal Cost (MC): the additional costs of producing an additional unit of the good MC = ∆TC TCQ − TCQ−1 = = TCQ... competitive firm, and I am making positive economic profits, other firms will want to enter the market to capture some of these profits  Capture the profits by providing substitutes (alternatives) to