Competition among banks. Managerial Economics MBACatólica

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1 Fernando Branco Fall Quarter Session 6 Part I Competition through price: The Bertrand oligopoly There are a few suppliers; The outputs are perfect substitutes; Marginal costs are constant and equal across firms; Each supplier must take its pricen decision without knowing the others prices; Customers have perfect information and there are no transaction costs; There are entry barriers. Example: Competition among banks. Competition among banks The interest rate (price) is the most important variable for the competition among banks, both at the level of deposits and the level of loans. Nevertheless, several studies for Portugal have shown that the competition is not as intense as in a Bertrans oligopoly. 1

2 Suppliers decisions in a Bertrand oligopoly The customers will buy from the firm with the lowest price. If a supplier new the price of the other supplier, what price would he want to choose? A price slightly below (as long as not below the marginal cost)! Equilibrium in a Bertrand oligopoly In equilibrium both suppliers will choose a price equal to marginal cost. With price competition and perfectly substitute outputs, two firms are enough drive profits to zero. Cost differences in the Bertrand oligopoly What if the suppliers had different marginal costs? What if marginal costs are increasing? 2

3 The Bertrand oligopoly in the real life It is not easy to find markets that correspond to Bertrand oligopolies. Two firms are enough to drive profits down to zero! Therefore, firms try to differentiate their outputs (or to follow collusive strategies) Leadership in prices: the dominant firm oligopoly There are a few firms; Outputs are perfect substitutes; One of the firms leads in price (the dominant firm); The others follow the price and choose the output level. Example: The market for diamonds. The market for diamonds The world market for diamonds is controlled by De Beers, that has a market share of 80% and acts market leader. There are several other small producers, that follow De Beers price decisions. The model of a dominant firm provides a reasonable framework for the analysis of this market. 3

4 The decisions of the followers The suppliers in the competitive fringe accept the price set by the leader. Each supplier sets output to maximize profit. Hence, they decide as the competitive suppliers: Output is adjusted to equalize marginal cost to price. The decision of the dominant firm The leader sets price to maximize profit: Max p [ D( p) Q ( p) ] C ( D( p) Q ( p)) F The dominant firm behaves as a monopolist on the residual demand D F Oligopoly with a dominant firm: A numerical example Market demand: Costs of D: Costs of two F s: Q D ( p) =10 C ( q ) = q p D D D 2 C S ( qs ) = qs Supply of F s: Q S ( p) = p Residual demand: 10 2 p Price: 10 4 p + 2 = 0 p = 3 Outputs: qd = 4; qs = qs =

5 Oligopoly with a dominant firm: A graphical description P D MC F Q F D R P MC D Q Fi Q D Q Q Competition in prices with differentiated outputs The strategic interactions are similar to those in the Cournot (simultaneous) and the Stackelberg (sequential) oligopolies Fundamental difference: Reaction curves slope upward. Graphical descriptions. Simultaneous choice of prices: Graphical description p 2 R 1 p 2 R 2 p 1 p 1 5

6 Sequential choice of prices: Graphical description p S R 1 p S R2 p L p L Chosing to differentiate: The Hotelling oligopoly The previous analysis takes a given differentiation. Companies may choose how much to differentiate. Two types of differentiation: Horizontal differentiation; Vertical differentiation. Two types of differentiation Horizontal differentiation (variety): There is no unanimous ranking of the output. Example: Renault Clio vs. Opel Corsa. Vertical differentiation (quality): For equal prices, all customers prefer one of the outputs. Example: car with vs car without airbag. 6

7 The Hotelling duopoly There are two suppliers in the market; Outputs are differentiated through an indicator in [0,1]; Each consumer has an ideal product; Each supplier chooses the characteristic of its output without knowing the characteristic chosen by the other. Example: Geographic location of a store; Example: Programatic choices of political parties. What are the equilibrium choices? Analoguous to the Bertand duopoly: Both suppliers choose to locate in the middle point. 7

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