introductory microeconomics (es10001) topic 5: imperfect competition
TRANSCRIPT
Introductory Microeconomics (ES10001)
Topic 5: Imperfect Competition
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.
I. Introduction
Two models of imperfect competition
Monopolistic Competition
Oligopoly
And in terms of Oligopoly
Non-Collusive
Collusive
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
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
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
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 > 0
p
0 Q
SMC
SAC
Q0
p0
LAC0D = AR
MR
Profit
Figure 1: Monopolosit Competition (SR)
π > 0
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)
p
0 Q
AR0
AR1
Figure 2: Impact on AR of entry of rival brands
p
0 Q
LMC
LAC
Q0
p0 = LAC0
D = ARMR
Figure 3: Monopolist LR Equilibrium
π = 0
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).
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
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
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
p
0 q
D = ARMR
MC
q0 q1
p0
p1
Figure 4: Collusion or Competition
E0
III. Oligopoly
But, since cartel p > 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 colludeSecond-Best: Neither renege; we both colludeThird-Best: We both renege
Cartels are inherently fragile!
p
0 q
D = ARMR
MC
q0 q1
p0
p1
Figure 4: Collusion or Competition
Cartel price is above cartel member’s marginal cost, thus incentive to renege (i.e. increase q)
Normal profit equilibrium
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
III. Oligopoly
In absence of collusion, each firm’s 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
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 > p0 and steeper for p < p0
p
0 q
DA
DB
q0
p0
Figure 5a: Kinked Demand Curve Model
E0
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
p
0 q
DA
DB
q0
p0
Figure 5b: Kinked Demand Curve Model
E0
MRBMRA
p
0 qD
q0
p0
Figure 5c: Kinked Demand Curve Model
E0
MR
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
p
0 qD
q0
p0
Figure 5a: Kinked Demand Curve Model
E0
MR
LMC
A
B
III. Oligopoly
But two key weaknesses:
EmpiricalFurther evidence suggested that agriculture prices did not behave asymmetrically
TheoreticalModel does not explain how we got to the initial equilibrium, or where we go if LMC moves outside of the discontinuity
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
III. Oligopoly
Two firms (a, b) costlessly produce identical spring water
Assume (normal) demand curve for spring water is:
qd = 100 – 5p
Assume that firm a believes that firm b will produce zero output (i.e. Ea{qb}= 0); firm a’s optimal q is that which maximises firm a’s total revenue vis.
p
0 q
D = AR
MR
10
50 100
20
Figure 6a: Cournot Competition
Firm a’s optimal output if Ea{qb}= 0
Ea1
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 a’s output
And firm b would make its optimal choice of output accordingly
p
0 q
D´ = AR´
MR
10
50 100
20
Figure 6b: Cournot Competition
Ea1
MR´
Firm a’s supply Firm b’s (residual) demand
p
0 q
D = AR
MR
5
25 50
10
Figure 6c: Cournot Competition
Firm b’s residual demand
Eb2
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. qa = 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
III. Oligopoly
Thus, firm a will choose the level of output that maximises total revenue given qb = 25
Firm a’s residual demand curve is thus:
Such that
p
0 q
D = AR
MR
7.5
37.5 75
15
Ea2
Figure 6d: Cournot Competition
Firm a’s residual demand
III. Oligopoly
This process will continue until neither firm ‘regrets’ its optimal choice of output
i.e. until its ‘conjectural variation’ regarding the other firm’s response is validated
The Cournot equilibrium is thus where:
qa = 33.33 = qb
p
0 q
D = AR
MR MR´
33.3 33.3 100
20
Ei
Figure 6d: Cournot Competition
Cournot Equilibrium
Ej
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
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’
III. Oligopoly
Monopoly
n = 1 qn = (1/2)qc
Duopoly
n = 2 qn = (2/3)qc
Perfect Competition
n = qn = qc
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
III. Oligopoly
Economists have re-interpreted Cournot’s 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
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
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.
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
p
0 q
D´ = AR´
MR
50 25 75 100
20
Figure 7: Stackelberg Competition
E1
MR´
E2
Es
5
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
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
III. Oligopoly
Bertrand presented an alternative to the Cournot model in his review of Cournot’s 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
III. Oligopoly
Conclusion
Completely different result emerges
Equilibrium which replicates perfectly competitive (i.e. allocatively efficient) equilibrium in which p = MC
III. Oligopoly
Firms compete with each other by marginally undercutting the other’s 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
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 Cournot’s approach
p
0 q
D = AR
MC
qb
MR
qm
pb
pm
Figure 8: Bertrand Competition
Em
Eb
Bertrand Equilibrium
Monopoly Equilibrium
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!
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
IV. Game Theory
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Prisoner’s Dilemma
Player 2 Confess Deny
Player 1
Confess -8, -8 0, -10
Deny -10, 0 -1, -1
IV. Game Theory
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma
IV. Game Theory
Nash Equilibrium ; Confess, Confess
Indeed, to confess is each player’s ‘dominant strategy vis. optimal strategy that is independent of the strategy of the other player(s)
Recall, ‘collusion versus competition’
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Renege Collude
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Collude Renege
Firm 1
Collude -8, -8 0, -10
Renege -10, 0 -1, -1
IV. Game Theory
Collusion versus Competition
Firm 2 Renege
Firm 1
Renege -8, -8 0, -10
Collude -10, 0 -1, -1
III. Oligopoly
First-best (i.e. dominant strategy) would be to renege
Second-best would be a voluntary arrangement to maintain the cartel output (but, restrictive practices are usually illegal and so agreements are usually tacit)
And again, temptation to reach the first-best renders the second-best unsustainable and so forces players to the third-best
III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma
III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma
III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma
III. Oligopoly
Nash equilibrium occurs when each player chooses his best strategy, given the strategies of the other players.
Consider …
Prisoners’ Dilemma