econ 384 intermediate microeconomics ii
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Econ 384 Intermediate Microeconomics II. Lorne Priemaza, M.A. [email protected] Various material courtesy of Wiley & Sons INC. Chapter 13. 13.1 Market Structure 13.2 Homogeneous Oligopoly 13.3 Dominant Firm Markets 13.4 Oligopoly with Horizontally Differentiated Products - PowerPoint PPT PresentationTRANSCRIPT
Econ 384
Intermediate Microeconomics II
Lorne Priemaza, M.A.
Various material courtesy ofWiley & Sons INC.
Chapter 13
13.1 Market Structure
13.2 Homogeneous Oligopoly
13.3 Dominant Firm Markets
13.4 Oligopoly with Horizontally Differentiated Products
13.5 Monopolistic Competition
Appendix
13.1 Market StructureMarket structure depends upon two spectrums:
1)Number of firms in market
2)Product Differentiation
Definition: Product Differentiation between two or more products exists when the products possess attributes that, in the minds of consumers, set the products apart from one another and make them less than perfect substitutes.
Examples: Pepsi is sweeter than Coke, Brand Name batteries last longer than "generic" batteries.
13.1 Market Structure
13.1 Market StructureA) Perfect Competition
1) Many Firms
2) Homogeneous Products
examples: Lemonade stands, fries
B) Monopolistic Competition
1) Many Firms
2) Differentiated Products
Examples: dry cleaning, socks, burgers
13.1 Market StructureC) Homogeneous Products Oligopoly
1) Few Firms
2) Homogeneous Products
Examples: Convenience Store, Apples
D) Differentiated Products Oligopoly
1) Few Firms
2) Differentiated Products
Examples: Cola, Breakfast Cereals
13.1 Market StructureE) Dominant Firm
1) One Large Firm, many small firms
2) Homogeneous Products
Examples: Ketchup, MP3 Players
F) Monopoly
1) One Firm
2) One Product
Examples: Canadian Uranium, Canadian Health Insurance (government monopoly)
13.1 Measuring Market Structure1) Four-firm Concentration Ratio (4CR)
-Sum of the top 4 sales revenue (in percentage terms) in an industry
ie1) Internet: Shaw (50%) and Telus (50%)
4CR = 50%+50%=100%
ie2) French Fries: New York (10%), McDonalds (7%), Wendy’s (4%), Red Robin (3%)
4CR = 10%+7%+4%+3%=24%*Note: Values are assumptions
13.1 Measuring Market Structure2) Herfindahl-Hirschman Index (HHI)
-∑(Market Share)2
ie1) Monopoly: HHI=1002=10,000
ie2) 100 Identical Firms: HHI=100(1)2=100
-HHI ranges from 0 (infinite firms) to 10,000 (one firm)
*Note that the textbook calculations are inconsistent for HHI
13.1 Measuring Market Structure-TYPICALLY:
-Industries closer to perfect competition or monopolistic competition have low 4CR’s and HHI’s
-Oligopolies have intermediate 4CR’s and HHI’s
-Industries closer to monopolies and dominant firms have high 4CR’s and HHI’s
-This is a GENERALIZATION (there are deviations)
13.1 Measuring Market Structure
13.2 Homogeneous OligopolyIn perfect competition, each firm can ignore all
other firms.
Oligopoly markets feature COMPETITIVE INDERDEPENDENCE – firm A’s decisions affect the profits of other firms.
ex) if Firm A overproduces, price falls and Firm B’s profits decrease
How does this close interdependence affect firm behavior?
13Chapter Thirteen
Cournot OligopolyAssumptions
• Firms set outputs (quantities)*• Homogeneous Products• Simultaneous• Non-cooperative
*Definition: In a Cournot game, each firm sets its output (quantity) taking as given the output level of its competitor(s), so as to maximize profits.
Price adjusts according to demand.
14Chapter Thirteen
Simultaneously vs. Non-cooperatively
Definition: Firms act simultaneously if each firm makes its strategic decision at the same time, without prior observation of the other firm's decision.
Definition: Firms act non-cooperatively if they set strategy independently, without colluding with the other firm in any way
15Chapter Thirteen
Definition: The relationship between the price charged by firm i and the demand firm i faces is firm is residual demand
In other words, the residual demand of firm i is the market demand minus the amount of demand fulfilled by other firms in the market: Q1 = Q – Q2; firms are QUANTITY TAKERS (v. price takers in Perfect Competition)Note: We will initially assume only 2 firms, a DUOPOLY
Residual Demand
16
Price
Quantity0
Demand
Residual Demand when q2 = 10
10 units Residual Marginal Revenue when q2 = 10
MC
q1*
Residual Demand
Best response to q2 = 10
17Chapter Thirteen
Best Response/Reaction Function
Best Response- The point where (residual) marginal revenue equals marginal cost gives ONE best response of firm i to its rival's action.
Reaction Function-The graph of all possible best responses to rival actions
18q1
Reaction Function of Firm 1
0
Reaction Function of Firm 2
q1*
q2* •
Chapter Thirteen
q2
Reaction Functions
19Chapter Thirteen
Cournot Equilibrium
Equilibrium: No firm has an incentive to deviate in equilibrium; each firm is maximizing profits given its rival's output
Each Firm’s output is a BEST RESPONSE to each other firm’s output.
20Chapter Thirteen
P = 100 - Q1 - Q2 MC = AC = 10
What is firm 1's profit-maximizing output when firm 2 produces 50?Residual demand: P = (100 - Q1) – 50 = 50 - Q1
TR=PQ= 50Q1 - Q12
MR50 = ∂TR/ ∂Q1 = 50 - 2Q1
Since profit is maximized when MR=MC,MR50 = MC 50 - 2Q1 = 1040 = 2Q20 = Q
Cournot Equilibrium Example
21
Cournot Equilibrium Example
P = 100 - Q1 - Q2 MC = AC = 10
What is the equation of firm 1's reaction function?
Residual demand: P = (100 - Q2) - Q1
TR= PQ1 = 100Q1 - Q2 Q1 - Q12
MRr = ∂TR/ ∂Q1 =100 - Q2 - 2Q1
MRr = MC 100 - Q2 - 2Q1 = 10Q1r = 45 - Q2/2 firm 1's reaction function
•Similarly, Q2r = 45 - Q1/2
22Chapter Thirteen
Cournot Equilibrium Example
P = 100 - Q1 - Q2 MC = AC = 10Q1r = 45 - Q2/2 Q2r = 45 - Q1/2
Calculate the Cournot equilibrium.
Q1 = 45 - Q2/2Q1 = 45 - (45 - Q1/2)/2Q1* = 30Q2* = 30P = 100 - Q1 - Q2 = 100 - 30 - 30 = 40 1* = 2* = TR – TC = (P-MC)Q*1* = 2* = (40-10)(30) = 900
23Chapter Thirteen
Cournot Solving Steps
1) Calculate Residual Demand2) Calculate (residual) MR3) MR=MC to find reaction functions4) Use reaction functions to solve for Q’s5) Use Q’s to solve for P
-Remember that Q1+Q2=QM
6) Solve for 7) Summarize
24q1
1) Each firm can calculate Reaction Functions
0
Z
q1*
q2* •
Chapter Thirteen
q2
How do firms achieve Cournot Equilibria?
2) Firm 2 will never produce over A
A
3) Knowing this, Firm 1 will never produce under B
4) Knowing this, Firm 2 will never produce over C
C
B
5) This reasoning continues until point Z
Reaction Function of Firm 2
25
Cournot vs. Monopoly vs. PC
Since Pcournot > MC, Cournot prices are higher than perfect competition prices
Cournot firms have market powerBUT, a Cournot market produces more than a Monopoly, and at a lower price.Each firm’s pursuit of individual self-interest does not typically maximize the industry’s profits.
Each firm wishes the other would decrease quantityMonopoly profits are possible if firms collude (which is illegal)
26
PC vs. Cournot vs. Monopoly
Consider the following outcomes using our above example of P=100-Q:
The outcome changes greatly with number of firms.
27
P = a-bQ MC = c N identical firms
Find Cournot Equilibrium QuantityResidual demand P = a-b(Q1 + Qother)TR = PQ = aQ1-bQ1
2 – bQotherQ1
MR = ∂TR/ ∂Q = a-2bQ1 – bQother
Since profit is maximized when MR=MC,MR = MC a-2bQ1 – bQother = cQ1=(a-c)/2b – (1/2)Qother Since Qother = (N-1) Q1,
Q1=(a-c)/2b – (1/2)[(N-1)Q1] Since Q1=Q*
Cournot Equilibrium, Many Firms
)()1(
1*
b
ca
NQ
28
P = a-bQ MC = c N identical firms
Find Cournot Equilibrium Market PriceSince there are N firms,
Cournot Equilibrium, Many Firms
)()1( b
ca
N
NQM
cN
N
N
aP
b
ca
N
NbaP
bQaP M
)1()1(
)()1(
29Chapter Thirteen
Cournot Solving Steps Multi-Firm
1) Calculate Residual Demand2) Calculate (residual) MR3) MR=MC to find reaction functionsNew 3b) Remember that Qother = (N-1) Q1
4) Use reaction functions to solve for Q’s5) Use Q to solve for P
-Remember that ∑Qi=QM
6) Solve for 7) Summarize
30Chapter Thirteen
Outcome comparisons
Given the relationship P=a-bQ and MC=c,
13.2 Bertrand Oligopoly (Homogeneous Products)
Cournot Oligopoly –Firms compete on QUANTITY
Bertrand Oligopoly –Firms compete on PRICES
-Goods must be homogeneous/identical
-A firm’s residual demand depends on the other firm’s price:
Zero demand at prices higher than the other firm
Market demand at prices lower than the other firm
32
Bertrand Oligopoly (homogeneous)
Assumptions:
• Firms set price*• Homogeneous product• Simultaneous • Non-cooperative
*Definition: In a Bertrand oligopoly, each firm sets its price, taking as given the price(s) set by other firm(s), so as to maximize profits.
*Definition: In a Bertrand oligopoly, each firm sets its price, taking as given the price(s) set by other firm(s), so as to maximize profits.
33Quantity
Price
Market Demand
•Firm 1’s Residual Demand Curve
0Chapter Thirteen
Residual Demand Curve – Price Setting
P2
13.2 Bertrand Oligopoly (Homogeneous Products)
Firm A must undercut firm B’s price to sell anything
This will force firm B to undercut Firm A
... This will continue until neither firm can
decrease price further, P=MC The Perfect Competition Result!
35
Bertrand Equilibrium Example
P = 100 - QT MC = AC = 10
What is the Bertrand Equilibrium?
P = MC=10
P = 100 – QT
10 = 100 – QT
90 = QT
∏=TR-TC∏=(P-MC)Q∏=(10-10)90 = 0
Bertrand vs. Cournot
Cournot – Long-Run Competition (Firms choose output capacity)
Bertrand – Short-Run Competition (Firms have excess output)
------------------------------------------------------------------
Cournot – Firms can quickly adjust their price, so price competition is useless
Bertrand – Firms can only slowly adjust price, so firms believe a price cut can temporarily increase profits
37
Stackelberg model of oligopoly is a situation in which one firm acts as a quantity leader, choosing its quantity first, with all other firms acting as followers.
Call the first mover the “leader” and the second mover the “follower”.
The second firm is in the same situation as a Cournot firm: it takes the leader’s output as given and maximizes profits accordingly, using its residual demand.
The second firm’s behavior can, then, be summarized by a Cournot reaction function.
Stackelberg Oligopoly
38
Stackelberg Leader Choice
P = 100 - QL - QF MC = AC = 10
What is the equation of the follower’s reaction function?
Residual demand: P = (100 - QL) - QF
TR= PQF = 100QF - QF QL - QF2
MRFr = ∂TR/ ∂Q1 =100 - QL - 2QF
MRFr = MC 100 - QL - 2QF = 10QFr = 45 - QL/2 follower’s reaction function
The Stackelberg leader knows the follower’s reaction function, and can use that to choose its production:
39Chapter Thirteen
Stackelberg Leader Choice
P = 100 - QL - QF MC = AC = 10QFr = 45 - QL/2
Calculate the Stackelberg equilibrium.
P = 100 - QL - QF = 100 - QL – (45 - QL/2 )P = 55 – QL/2
TR= PQL = 55QL – QL2/2
MRL = ∂TR/ ∂QL = 55 – QL
MRL = MC 55 – QL = 10QL = 45
40Chapter Thirteen
Stackelberg Leader Choice
P = 100 - QL - QF MC = AC = 10QFr = 45 - QL/2 QL = 45
Continue Calculating the Stackelberg equilibrium.QFr = 45 - QL/2 = 45 - 45/2 QFr = 22.5
P = 100 - QL - QF = 100 - 45 – 22.5 = 32.5 L* = TR – TC = (P-MC)QL* = (32.5-10)45 = 1,012.5F* = TR – TC = (P-MC)QF* = (32.5-10)22.5 = 506.25
41
Stackelberg Leader Choice
With a Stackelberg leader, price is $32.50, with the leader producing 45 units for a profit of $1,012.50 and the following producing 22.5 units for a profit of $506.25.
Notice that:
1) Price is lower than the Cournot equilibrium
2) Leader profits are higher than the cournot equilibrium
3) Follower profits are lower than the Cournot equilibrium
There is an advantage to moving first
42Chapter Thirteen
Stackelberg Solving Steps
1) Calculate Leader’s Residual Demand2) Calculate Leaders (residual) MR3) Leader’s MR=MC to find QL
4) Use QL to solve for QF
5) Use Q’s to solve for P -Remember that QL+QF=QM
1) Solve for ’s2) Summarize
13.3 Dominant Firm Model
The dominant firm model features:
1) A single company with an overwhelming market share (a dominant firm), D
2) many small producers (competitive fringe), each of whom has a small market share, F
The dominant firm faces market demand, and residual demand that takes into account the competitive fringe’s supply:
44
The dominant firm’s residual demand (DR) is market demand minus competitive fringe supply (in terms of Q)
Dominant Firm
45
Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10
MCD = AC = 10
What is the equation of the Dominant Firm’s Residual Demand?QR = QT – QF
QR = 100-P – (P-10)QR = 110-2PP = 55-QR/2
46
Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10MCD = AC = 10 QR = 90-2P (P = 55-QR/2)
Calculate Dominant Firm Quantities and PriceTRDR = PQD = 55QD-QD
2/2MRL = ∂TR/ ∂QL = 55 – QD
MRL = MC 55 – QD = 10QD = 45
P = 55-QR/2P = 55-45/2 = 32.5
47
Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10MCD = AC = 10 QR = 90-2P (P = 55-QR/2)
Calculate and check Competitive Fringe QuantitiesSF: P =10+QF
32.5 = 10+QF
QF = 22.5
QT = QD + QF
QT = 45 + 22.5 = 67.5
P = 100 – QT
32.5 = 100 – 67.5 = 32.5
48
Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10MCD = AC = 10 QR = 90-2P (P = 55-QR/2)QF = 22.5, QD = 45, P=32.5
Calculate market share and dominant firm profitD: Market Share = QD/ QT = 45/67.5*100 = 66.6%F: Market Share = QD/ QT = 22.5/67.5*100 = 33.3%
D* = TR – TC = (P-MC)QD* = (32.5-10)45 = 1,012.5At a price of $32.50, the dominant firm produces
45 units for a profit of $1,012.50, and fringe firms produce 22.5 total.
49Chapter Thirteen
Dominant Firm Solving Steps
1) Calculate Dominant Firm`s Residual Demand2) Calculate Dominant Firm`s (residual) MR3) Leader’s MR=MC to find QD
4) Use QD to solve for P5) Use P to solve for QF
-Remember that QD+QF=QM
1) Solve for and Market Share2) Summarize
50
Aside: Calculating SF
Fringe Firm: MC=5+20q, 40 firmsCalculate Fringe SupplyMC=5+20qq=(P-5)/20QF=40(P-5)/20QF=2P-10
Recall: A competitive firm’s supply comes from its MC
curve Identical firms supply can be summed (through q)
51
Growing Fringe:
As the size of the fringe grows, the price, and the production and profits of the dominant firm decreases (next slide):
There is therefore an incentive for the dominant firm to practice limit pricing (illegal in Canada):
Limit Pricing – a strategy whereby the dominant firm keeps its price below the level that maximizes its current profit in order to reduce the rate of expansion by the fringe
52