lecfigtp_12

Profit maximisation under

Imperfect Competition

Profit maximisation under

Imperfect Competition

Monopolistic CompetitionMonopolistic Competition

Assumptions of monopolistic competition

large number of firms

• independence of firms

freedom of entry

differentiated product

downward-sloping demand curve

• elasticity depends on degree of product differentiation

Assumptions of monopolistic competition

large number of firms

• independence of firms

freedom of entry

differentiated product

downward-sloping demand curve

• elasticity depends on degree of product differentiation


Equilibrium of the firm

short run

• output where MC = MR

• level of supernormal profit depends on demand

• position of demand curve

• elasticity of demand curve


short run





£

Q O Qs

AR D

MC

AC

MR

Short-run equilibrium of the firmunder monopolistic competitionShort-run equilibrium of the firmunder monopolistic competition

Ps

ACs



short run





long run


short run





long run



short run





long run

• all supernormal profits competed away


short run





long run


Long-run equilibrium of the firmunder monopolistic competitionLong-run equilibrium of the firmunder monopolistic competition

ARL DL

MRL

£

Q O QL

PL

LRAC

LRMC



short run





long run


• underutilisation of capacity


short run





long run


• underutilisation of capacity

Long-run equilibrium of the firmunder monopolistic competitionLong-run equilibrium of the firmunder monopolistic competition

ARL DL

£

Q O QL

PL

LRAC


Limitations of the model imperfect information

difficulty in identifying industry demand curve

entry may not be totally free

indivisibilities

importance of non-price competition

Comparing monopolistic competition with perfect competition and monopoly comparison with perfect competition

Limitations of the model imperfect information

difficulty in identifying industry demand curve

entry may not be totally free

indivisibilities

importance of non-price competition

Comparing monopolistic competition with perfect competition and monopoly comparison with perfect competition

Q2

P2 DL under perfect

competition

Long run equilibrium of the firm under perfect andmonopolistic competition

Long run equilibrium of the firm under perfect andmonopolistic competition

£

QO

P1

LRAC

DL under monopolistic

competition

Q1

QQ A monopolistically competitive industry in the long run will experience excess capacity.

To which one of the following is this due?

QQ A monopolistically competitive industry in the long run will experience excess capacity.

To which one of the following is this due?

A. Firms will only make normal profit.

B. Firms will enter the industry if supernormal profits can be made.

C. Firms will produce along the upward-sloping portion of their marginal cost curve.

D. The tangency point of the firm’s AR and LRAC curves is to the left of the minimum LRAC.

E. The point where AR equals LRAC is vertically above the point where MR equals LRMC.

A. Firms will only make normal profit.

B. Firms will enter the industry if supernormal profits can be made.

C. Firms will produce along the upward-sloping portion of their marginal cost curve.

D. The tangency point of the firm’s AR and LRAC curves is to the left of the minimum LRAC.

E. The point where AR equals LRAC is vertically above the point where MR equals LRMC.


Limitations of the model imperfect information difficulty in identifying industry demand

curve entry may not be totally free indivisibilities importance of non-price competition

Comparing monopolistic competition with perfect competition and monopoly comparison with perfect competition comparison with monopoly

Limitations of the model imperfect information difficulty in identifying industry demand

curve entry may not be totally free indivisibilities importance of non-price competition

Comparing monopolistic competition with perfect competition and monopoly comparison with perfect competition comparison with monopoly

OligopolyOligopoly

Key features of oligopoly barriers to entry

interdependence of firms

incentives to compete versus incentives to collude

Factors favouring collusion

Collusive oligopoly: cartels equilibrium of the industry






£

Q O

Industry D AR

Profit-maximising cartelProfit-maximising cartel

£

Q O

Industry D AR

Industry MC

Industry MR

Q1

P1

Industry profit maximised at

Q1 and P1.

Industry profit maximised at

Q1 and P1.

Members must agree to restrict

total output to Q1.

Members must agree to restrict

total output to Q1.

Profit-maximising cartelProfit-maximising cartel

OligopolyOligopoly






allocating and enforcing quotas






allocating and enforcing quotas

QQ In which of the following circumstances would a cartel be most likely to work?

QQ In which of the following circumstances would a cartel be most likely to work?

A. The coffee market, where the product is standardised and there are many coffee growers.

B. The market for copper, where there are very few producers and the product is standardised.

C. The car industry, where there are few producers but there is great product differentiation.

D. The fast-food market, where there are many producers but the demand for fast food is inelastic.

A. The coffee market, where the product is standardised and there are many coffee growers.

B. The market for copper, where there are very few producers and the product is standardised.

C. The car industry, where there are few producers but there is great product differentiation.

D. The fast-food market, where there are many producers but the demand for fast food is inelastic.

OligopolyOligopoly

Tacit collusion price leadership: dominant firm

price leadership: barometric



£

Q O

MR leader

AR D leader

AR D market

Price leader aiming to maximise profits for a given market sharePrice leader aiming to maximise profits for a given market share

Assume constantmarket share

for leader

£

Q O

AR D market

MC

MR leader

PL

QT

AR D leader

QL

l t

Price leader aiming to maximise profits for a given market sharePrice leader aiming to maximise profits for a given market share

OligopolyOligopoly



other forms of tacit collusion: rules of thumb




OligopolyOligopoly




• average cost pricing





OligopolyOligopoly





• price benchmarks





• price benchmarks

OligopolyOligopoly

Factors favouring collusion few firms open with each other similar cost structures similar products there is a dominant firm significant barriers to entry stable market conditions no government measures to curb collusion

Collusion and the law

Factors favouring collusion few firms open with each other similar cost structures similar products there is a dominant firm significant barriers to entry stable market conditions no government measures to curb collusion

Collusion and the law

OligopolyOligopoly

The breakdown of collusion

factors to consider in deciding whether to break an agreement

• how likely are rivals to retaliate?

• who would win a price war?

importance of considering rivals’ reactions

The breakdown of collusion

factors to consider in deciding whether to break an agreement

• how likely are rivals to retaliate?

• who would win a price war?

importance of considering rivals’ reactions

OligopolyOligopoly

Non-collusive oligopoly: assumptions about rivals’ behaviour rivals produce fixed quantity: Cournot

model• firms chose best output for remainder of the

market



market

O

Quantity

DMDA1

The Cournot model of duopoly:Firm A’s profit maximising position


QB1

Firm A believes that firm B will produce QB1.

Cos

ts a

nd r

even

ue

O

Quantity

DM

MCA

DA1MRA1

QA1 QB1

Firm A’s profit-maximising output and price are QA1 and PA.

PA1



Cos

ts a

nd r

even

ue

OligopolyOligopoly



market• profit will be less than under a cartel• but more than under perfect competition




O

Quantity

DM

MCA

DA1MRA1

QA1 QB1

Firm A’s profit-maximising output and price are QA1 and PA.

PA1



Cos

ts a

nd r

even

ue

OligopolyOligopoly




rivals set a particular price: Bertrand model




rivals set a particular price: Bertrand model

OligopolyOligopoly




rivals set a particular price: Bertrand model• the firm will undercut the rival




rivals set a particular price: Bertrand model• the firm will undercut the rival

OligopolyOligopoly




rivals set a particular price: Bertrand model• the firm will undercut the rival• this will probably trigger a price war until all

supernormal profits are eliminated




rivals set a particular price: Bertrand model• the firm will undercut the rival• this will probably trigger a price war until all

supernormal profits are eliminated

QQ Which one of the following statements is NOT applicable to the Bertrand model

QQ Which one of the following statements is NOT applicable to the Bertrand model

A. Firms choose price in response to the prices set by rivals.

B. Firms make only a small amount of supernormal profit.

C. In practice, firms have an incentive to collude.

D. Firms are likely to engage in price-cutting behaviour.

E. Nash equilibrium (in the absence of collusion) is where price is equal to average cost.

A. Firms choose price in response to the prices set by rivals.

B. Firms make only a small amount of supernormal profit.

C. In practice, firms have an incentive to collude.

D. Firms are likely to engage in price-cutting behaviour.

E. Nash equilibrium (in the absence of collusion) is where price is equal to average cost.

OligopolyOligopoly

Non-collusive oligopoly: assumptions about rivals’ behaviour (cont.)

Nash equilibrium

• when everyone makes a decision based on the alternatives rivals could adopt

• Nash equilibrium worse for the individual firms than the collusive equilibrium


Nash equilibrium

• when everyone makes a decision based on the alternatives rivals could adopt

• Nash equilibrium worse for the individual firms than the collusive equilibrium

OligopolyOligopoly


the kinked demand curve model

• assumptions of the model

• price cut followed by competitors

• price rise not followed by competitors

• the shape of the demand and MR curves







Kinked demand for a firm under oligopolyKinked demand for a firm under oligopoly£

QO

P1

Q1

Current priceand quantity

give one pointon demand curve.

£

QO

P1

Q1

D

D

Assumption 1If the firm raises its price, rivals will not

Assumption 2If the firm reduces its price, rivals will feel forced to lower

theirs too.

Kinked demand for a firm under oligopolyKinked demand for a firm under oligopoly

QQ In the kinked demand curve model, this kink is due to the firm’s belief that its competitors:

QQ In the kinked demand curve model, this kink is due to the firm’s belief that its competitors:

A. will set a price at the kink of the demand curve.

B. will match any price increase it makes, but will not match a price reduction.

C. will not match a price increase but will match any price reduction.

D. will match all price increases and reductions.

E. will match neither price increases nor reductions.

A. will set a price at the kink of the demand curve.

B. will match any price increase it makes, but will not match a price reduction.

C. will not match a price increase but will match any price reduction.

D. will match all price increases and reductions.

E. will match neither price increases nor reductions.

OligopolyOligopoly







• stable prices







• stable prices

£

QO

P1

Q1

MC2

MC1

MR

a

bD AR

Stable price under conditions of a kinked demand curveStable price under conditions of a kinked demand curve

MR is discontinuous between a and b.

If MC is anywhere between MC1 and MC2,

profit is maximised at Q1.

OligopolyOligopoly







• stable prices

• limitations of the model







• stable prices

• limitations of the model

OligopolyOligopoly

Non-collusive oligopoly: game theory alternative strategies

• maximax• maximin

simple dominant strategy games



simple dominant strategy games

Profits for firms X and Y at different pricesProfits for firms X and Y at different prices

£2.00 £1.80

£2.00

£1.80

X’s price

Y’s price

A B

C D

£10m each

£8m each£12m for Y£5m for X

£5m for Y£12m for X

OligopolyOligopoly



simple dominant strategy games• the prisoners’ dilemma



simple dominant strategy games• the prisoners’ dilemma

Not confess Confess

Notconfess

Confess

Amanda's alternatives

Nigel'salternatives

A B

C D

Each gets1 year

Each gets3 years

Nigel gets3 months

Amanda gets10 years

Nigel gets10 years

Amanda gets3 months

The prisoners' dilemmaThe prisoners' dilemma

OligopolyOligopoly


• maximax and maximin simple dominant strategy games

• the prisoners’ dilemma• Nash equilibrium




OligopolyOligopoly




non-dominant strategy games




non-dominant strategy games

QQ A, B, C and D are four strategies that firm X can pursue. The table shows the effect on firm X’s profits according to which of 6 responses rival firms make.

Which of the four strategies is the maximax strategy?


Which of the four strategies is the maximax strategy?

Figures show firm X’s profits in £000s

A.

B.

C.

D.

A.

B.

C.

D.


Which of the four strategies is the maximin strategy?


Which of the four strategies is the maximin strategy?

Figures show firm X’s profits in £000s

A.

B.

C.

D.

A.

B.

C.

D.

OligopolyOligopoly




non-dominant strategy games the importance of threats and promises





OligopolyOligopoly





• are threats credible?





• are threats credible?

OligopolyOligopoly





• are threats credible? the importance of timing of decisions






OligopolyOligopoly






• decision trees






• decision trees

Boeingdecides

500

seat

er

500 seater

500 seater

400 seater

400 seater

400 seater

A decision treeA decision tree

Boeing –£10mAirbus –£10m

(1)

Boeing +£30mAirbus +£50m

(2)

Boeing +£50mAirbus +£30m

(3)

Boeing –£10mAirbus –£10m (4)

Airbusdecides

B2

Airbusdecides

B1

A

OligopolyOligopoly

Oligopoly and the consumer disadvantages

• worse if there is extensive collusion

advantages• countervailing power

• supernormal profits may allow higher R&D

• greater choice for consumers

difficulties in drawing general conclusions

Oligopoly and contestable markets importance of entry and exit costs

Oligopoly and the consumer disadvantages

• worse if there is extensive collusion

advantages• countervailing power

• supernormal profits may allow higher R&D

• greater choice for consumers

difficulties in drawing general conclusions

Oligopoly and contestable markets importance of entry and exit costs

lecfigtp_12

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