Say: We did uniform pricing and price discrimination at individual level, but we only bring uniform pricing to equilibrium.

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1 Page 1 1 Where are we? Firms are price-takers (Perfect competition) Firms have market power (Imperfect competition) (Sessions 1 6) Individual decisions Equilibrium (Sessions 7 11) (Sessions 12 15) Say: We did uniform pricing and price discrimination at individual level, but we only bring uniform pricing to equilibrium. 2 This distinction now matters P i d i (P i ) Q i Sources of market power: 1. Differentiated products: the firm s branded product is differentiated from other products. 2. Homogeneous goods: Though products are not differentiated, the firm is a big player: increased output pushes down the market price.

2 Page 2 3 We begin with Price competition with differentiated products Recall the pricing game from Session 12: Firm A Low Med High Firm B Low Med High We extend this to a full range of prices. 4 Let s use the same story Recently appointed CEOofFirmA Recently appointed CEOofFirmB

3 Page 3 5 Firm A s pricing problem 36 P A d A MC A This is uniform pricing with market power (Sessions 8 and 9) Q A MR A Q A 6 Nash equilibrium P A 24 d A P 24 B d B MC A MC B Q A Q B 6 Q A MR A 6 Q B MR B

4 Page 4 7 Let s use the numbers from Airbus-Boeing example Demand functions: Q A = 60 3P A + 2P B Q B = 60 3P B + 2P A Both firms have constant MC = Some best responses From the demand elasticity exercise Firm A s demand curve when P B = 24 and when P B = : P A 40 P B = Q A = 120 3P A 20 P B = 24 Q A = 108 3P A Q A

5 Page 5 9 In general: from Topic 9 on shifting demand Higher price by Firm B Firm A s demand curve shifts Volume? Elasticity? Higher Lower Firm A s profit-maximizing price goes up Thus, the pricing decisions are strategic complements 10 So remember, with price competition When the goods are substitutes, the pricing decisions are strategic complements. (Holds for linear demand, and usually in the real world.)

6 Page 6 11 Firm A s residual demand and best reply Q A = 60 3P A + 2P B Constant MC = 12 When Firm B charges P B, Firm A s demand curve is: Q A = (60 + 2P B ) 3P A Firm A s choke price is: P B Firm A s optimal price is: Firm A s reaction curve: P B+12 2 = P B P A = P B 12 Nash equilibrium Prices (P A, P ) such that: B In words As an equation P A is a best response by firm A to P B P A = P B P B is a best response by firm B to P A P B = P A

7 Page 7 13 Illustrating Nash equilibrium graphically P B P A = P B P B = P A P A 14 Wrap up: Price competition with differentiated products 1. Each firm s decision is same as pricing with market power : Topics 8&9. 2. Goods are substitutes prices are strategic complements. (Always with linear demand; almost always in real life.) 3. Interaction captured by Nash equilibrium. Each firm s price maximizes its own profit given price of the other firm.

8 Page 8 15 Next we do Quantity competition with homogeneous products Also called Cournot competition 1. Firms goods are perfect substitutes. 2. So firm doesn t set price; it chooses how much to sell. 3. Market determines market-clearing price. 4. But each firm s output decision affects this price. 16 Corning and glass substrate Corning has over 50% market share of glass substrate. There are different grades ( 5G, 6G, ), but for a particular grade the products of different suppliers are viewed as close substitutes. News item from December 2005 (for example): The aggressive capacity added by both Corning of the U.S., the world s No. 1 substrate supplier, and AGC, the No. 2, will lead to price drops for glass substrates and will especially benefit TV panel makers

9 Page 9 17 Indonesian Cement Market Three major players: 45%: Semen Gresik [State-owned] 37%: Indocement [Owned by HeidelbergCement since 2001] 17%: Holcim Indonesia [Owned by Holcim (Swiss) since 2006] 18 The protagonists Indocement Semen Gresik CEO of Indocement CEO of Semen Gresik

10 Page Nash equilibrium P 1 24 d 1 P 2 24 d MC MC Q Q 2 6 Q 1 MR 1 6 Q 2 MR 2 20 Market demand curve vs. Indocement s demand curve MARKET DEMAND Q = P INDOCEMENT S DEMAND When Q other = 500 P P Q Q i

11 Page Indocement s quantity decision (Constant MC = 10) When Q other = 200 When Q other = 500 P P Q i Q i 22 Nash equilibrium 1000 Q Q 1

12 Page Wrap up: Quantity competition with homogeneous goods 1. Each firm s output decision is same as pricing with market power : Topics 8&9. 2. Quantities are strategies substitutes. (Always with linear demand; almost always in real life.) 3. Use this model (rather than price competition) for homogeneous products like oil, lycine, glass substrate, to analyze investments in capacity. 24 Finally Imperfect competition with exit/entry

13 Page Falafel vendors on the beach of Beirut Beach 26 Numerical example: Cournot See website for details, but you don t have to be able to do this. Market demand curve: Q = P Constant MC = 10. Then I calculate the Nash equilibrium for any number N of firms.

14 Page Transition from monopoly to perfect competition Number of firms Q = P P = - Q/50 Total Output Price Output per firm Profit per firm , , , So what happens if fixed costs are lower?? Lower fixed costs

15 Page Recall special case of free entry All firms are identical, including unlimited pool of potential entrants. We focus on this case for simplicity. In reality, small or large differences between firms (competitive dis/advantage) determine who is in, and who is out. How fixed cost affects entry and price Q = P P = - Q/50 Number of firms Total Output Price Output per firm Profit per firm , , , FC N 6 3 P

16 Page Let s try again, this time using insights from IC+FE Q: Why do pharmaceutical companies charge so much for AIDS medicine? A: Because they have to recover R&D expenses. Higher R&D expenses do lead to higher prices, but Not because any firm takes them into account when setting prices. Instead, because the higher R&D expenses limit entry. The resulting lack of competition is what leads to higher prices. 32 Wrap up: Imperfect competition with free entry 1. Entry has two effects on profit: smaller market shares greater competitive pressure on prices 2. Higher FC less entry less intense competition higher prices (Even though no firm bases pricing on its fixed cost.)

17 Page What have we done today? Firms are price-takers (Perfect competition) Firms have market power (Imperfect competition) Individual decisions Equilibrium Individual decisions Equilibrium Price competition Quantity competition ( ) Different firms goods are ( ) Different firms goods are substitutes or complements perfect substitutes Fixed set of firms Entry and exit 34 What have we done today? Price competition Quantity competition ( ) Different firms goods are ( ) Different firms goods are substitutes or complements perfect substitutes Fixed set of firms Calculations Main ideas Entry and exit Heuristic picture Interpret tables