Monopolistic Competition and Oligopoly

Monopolistic Competition and Oligopoly Lesson 10 Ryan Safner 1 1 Department of Economics Hood College ECON 326 - Industrial Organization Spring 2017 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 1 / 71

Outline of This Lesson 1 Monopolistic Competition 2 Oligopoly Game Theory & Strategy Interactions Cartels Bertrand Competition Cournot Competition Stackelberg Competition 3 Industrial Organization & Comparing Market Structures Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 2 / 71

Monopolistic Competition Monopoly and perfect competition are the two extremes of the spectrum of market structures Most real life industries and firms operate in the middle Monopolistic competition describes a hybrid of monopoly and competition, where each firm has limited market power Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 3 / 71

Monopolistic Competition: Features/Assumptions 1 Goods are imperfect substitutes Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 4 / 71

Monopolistic Competition: Features/Assumptions 1 Goods are imperfect substitutes Consumers recognize non-price differences between sellers Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 4 / 71

Monopolistic Competition: Features/Assumptions 1 Goods are imperfect substitutes Consumers recognize non-price differences between sellers Branding, advertising, quality, location, convenience, etc 2 Entry and exit are free (no barriers to entry) Profits will attract entrants, losses will expel losers 3 Many firms, each with market power, as they are each selling a slightly different product Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 4 / 71

Monopolistic Competition: Features/Assumptions 1 Goods are imperfect substitutes Consumers recognize non-price differences between sellers Branding, advertising, quality, location, convenience, etc 2 Entry and exit are free (no barriers to entry) Profits will attract entrants, losses will expel losers 3 Many firms, each with market power, as they are each selling a slightly different product Each firm will face a (different) downward sloping demand curve for its own products Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 4 / 71

Monopolistic Competition P($) Firm (Short Run) MC AC Firm behaves identically to a monopolist MR D Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 5 / 71

Monopolistic Competition P($) Firm (Short Run) MC AC Firm behaves identically to a monopolist Sets MC = MR for Q* Q* MR D Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 5 / 71

Monopolistic Competition P($) Firm (Short Run) P* MC AC Firm behaves identically to a monopolist Sets MC = MR for Q* Sets P* = market demand at Q* Q* MR D Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 5 / 71

Monopolistic Competition P($) Firm (Short Run) P* AC MC AC Firm behaves identically to a monopolist Sets MC = MR for Q* Sets P* = market demand at Q* Earns profits (P AC) Q* MR D Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 5 / 71

Monopolistic Competition Firm (Long Run) P($) MC Over the long run, profits attract entrants AC D Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 6 / 71

Monopolistic Competition Firm (Long Run) P($) MC AC Over the long run, profits attract entrants Demand for this firm s products will decrease (consumers can go to other new firms) MR D 2 D Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 6 / 71

Monopolistic Competition Firm (Long Run) P*= AC P($) MC AC Over the long run, profits attract entrants Demand for this firm s products will decrease (consumers can go to other new firms) Continues until profits are zero, where P = AC Q* MR D 2 Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 6 / 71

Monopolistic Competition Firm (Long Run) P($) MC AC Monopolistic Competition is still different from perfect competition P*= AC P PC Q* MR Q PC D 2 Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 7 / 71

Monopolistic Competition Firm (Long Run) P*= AC P($) MC AC Monopolistic Competition is still different from perfect competition Firms produce less and at higher prices (P > MC) P PC Q* MR Q PC D 2 Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 7 / 71

Monopolistic Competition Firm (Long Run) P*= AC P PC P($) MC AC Monopolistic Competition is still different from perfect competition Firms produce less and at higher prices (P > MC) Fewer firms Yet still normal (0) profits Q* MR Q PC D 2 Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 7 / 71

Monopolistic Competition In monopolistic competition, the number of firms is determined by entry (short run profits) Demand for one product becomes more elastic with more entrants (e.g. more substitutes, albeit imperfect) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 8 / 71

Imperfect Competition & Market Concentration Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 10 / 71

Imperfect Competition & Market Concentration Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 11 / 71

Imperfect Competition & Market Concentration Studio Movies Revenues Tickets Share Warner Bros. 29 $1,861,194,799 228,097,584 17.08% Walt Disney 18 $1,721,354,677 210,950,321 15.79% Universal 19 $1,415,663,293 173,488,139 12.99% Sony Pictures 20 $1,149,187,808 140,831,830 10.54% 20 th Century Fox 20 $1,069,359,977 131,049,009 9.81% Paramount 20 $1,017,528,833 124,697,152 9.34% Total of Big 6 126 $8,234,289,387 1,009,104,035 75.55% All 143 Others 619 $2,654,995,088 325,371,423 24.26% Table: Statistics on film distributors for 2013 (Nash 2013). Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 12 / 71

Oligopoly: Features/Assumptions 1 An oligopoly is a market with only a few (large) sellers, each with significant market power Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 13 / 71

Oligopoly: Features/Assumptions 1 An oligopoly is a market with only a few (large) sellers, each with significant market power Duopoly: a market with only two sellers; Triopoly: 3 sellers, etc. 2 Firms are interdependent and strategic each firm s choices depend on all other firms choices Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 13 / 71

Oligopoly: Features/Assumptions 1 An oligopoly is a market with only a few (large) sellers, each with significant market power Duopoly: a market with only two sellers; Triopoly: 3 sellers, etc. 2 Firms are interdependent and strategic each firm s choices depend on all other firms choices 3 Firms may be selling the same good, meeting one market demand Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 13 / 71

Oligopoly: Features/Assumptions 1 An oligopoly is a market with only a few (large) sellers, each with significant market power Duopoly: a market with only two sellers; Triopoly: 3 sellers, etc. 2 Firms are interdependent and strategic each firm s choices depend on all other firms choices 3 Firms may be selling the same good, meeting one market demand 4 Barriers to entry are usually high Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 13 / 71

Oligopoly: Features/Assumptions Unlike perfect competition or monopoly, there is no single theory of oligopoly! Depends heavily on the tools and assumptions we make about how oligopolists interact and make choices Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 14 / 71

Oligopoly: Features/Assumptions What does equilibrium mean in an oligopoly? Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 15 / 71

Oligopoly: Features/Assumptions What does equilibrium mean in an oligopoly? PC/monopoly: (P*, Q*) that leads to a stable outcome: consumers and producers have no incentive to change decisions Under oligopoly, strategic interdependence To find an outcome where no firm wants to change its decision, we need to find more than just a price or quantity for the industry as a whole Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 15 / 71

Oligopoly: Features/Assumptions What does equilibrium mean in an oligopoly? PC/monopoly: (P*, Q*) that leads to a stable outcome: consumers and producers have no incentive to change decisions Under oligopoly, strategic interdependence To find an outcome where no firm wants to change its decision, we need to find more than just a price or quantity for the industry as a whole No firm(s) must want to change their decision once they know what other firms are doing Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 15 / 71

Game Theory The most common approach to oligopoly is through game theory, A set of tools that model strategic interactions both conflict and cooperation between rational players ( games ) Games can be zero-sum, negative sum, or positive sum Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 16 / 71

Game Theory & Prisoner s Dilemma The most famous type of game (and relevant here) is a Prisoner s Dilemma Prisoner s Dilemma A type of game where it is in the best interest of the players to cooperate, but they each face an incentive to not cooperate Players can defect against each other or cooperate for mutual benefit Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 17 / 71

Oligopoly and Game Theory Suppose we have a duopoly between Apple and Google Each is planning to launch a new tablet, and choose to sell it at a High Price or a Low Price Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 18 / 71

Oligopoly and Game Theory Suppose we have a duopoly between Apple and Google Each is planning to launch a new tablet, and choose to sell it at a High Price or a Low Price Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 19 / 71

Oligopoly and Game Theory From perspective of Apple Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 20 / 71

Oligopoly and Game Theory From perspective of Apple Suppose Google chooses a High Price Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 20 / 71

Oligopoly and Game Theory From perspective of Apple Suppose Google chooses a High Price Then, Apple will choose a Low Price ($750,000 $500,000) to maximize profits Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 20 / 71

Oligopoly and Game Theory From perspective of Apple Suppose Google chooses a Low Price Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 21 / 71

Oligopoly and Game Theory From perspective of Apple Suppose Google chooses a Low Price Then, Apple will choose a Low Price ($250,000 $100,000) to maximize profits Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 21 / 71

Oligopoly and Game Theory From perspective of Apple Apple will always choose a Low Price (better off in both outcomes) Low Price is a dominant strategy for Apple Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 22 / 71

Oligopoly and Game Theory From perspective of Google Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 23 / 71

Oligopoly and Game Theory From perspective of Google Suppose Apple chooses to a High Price Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 23 / 71

Oligopoly and Game Theory From perspective of Google Suppose Apple chooses to a High Price Then, Google will choose a Low Price ($750,000 $500,000) to maximize profits Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 23 / 71

Oligopoly and Game Theory From perspective of Google Suppose Apple chooses a Low Price Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 24 / 71

Oligopoly and Game Theory From perspective of Google Suppose Apple chooses a Low Price Then, Goole will choose a Low Price ($250,000 $100,000) to maximize profits Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 24 / 71

Oligopoly and Game Theory From perspective of Google Google will always choose to Defect (better off in both outcomes) Low Price is a dominant strategy for Google Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 25 / 71

Oligopoly and Game Theory Both firms will always choose Low Price! This leads to an equilibrium where both players set a Low Price, and both earn $250,000 profit Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 26 / 71

Oligopoly and Game Theory Both firms will always choose Low Price! This leads to an equilibrium where both players set a Low Price, and both earn $250,000 profit But: a better outcome if they both set a High Price and both earn $500,000 profit! Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 26 / 71

Oligopoly and Cartels Google and Apple could cooperate with one another and agree to both raise prices, acting as a cartel, where a group of sellers coordinate to raise prices to act like a collective monopoly and split the profits Cartels are illegal in the U.S. under the antitrust laws Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 27 / 71

Oligopoly and Cartels People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices. Wealth of Nations (1776): Book I, Chapter 2.2 Adam Smith (1723-1790) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 28 / 71

Oligopoly and Cartels The goal of a cartel is collectively restrict output and raise price to generate profits like a monopolist, split by each of the cartel members Cowen & Tabarrok, p.289 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 29 / 71

Oligopoly and Cartels Even if they were legal, cartels are also inherently unstable Suppose Apple and Google collude and both set high prices Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 30 / 71

Oligopoly and Cartels Even if they were legal, cartels are also inherently unstable Suppose Apple and Google collude and both set high prices Google knows that Apple will charge a High Price; so if Google sets a Low Price, they can capture more customers (and profits) Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 30 / 71

Oligopoly and Cartels Even if they were legal, cartels are also inherently unstable Suppose Apple and Google collude and both set high prices Google knows that Apple will charge a High Price; so if Google sets a Low Price, they can capture more customers (and profits) This is cheating on the cartel agreement! Apple has the same incentive! Apple High Price Low Price Google High Price Low Price $500,000 $100,000 $500,000 $750,000 $750,000 $250,000 $100,000 $250,000 Payoffs represent profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 30 / 71

Oligopoly and Cartels Each member of the cartel has an incentive to increase its output and lower price to gain greater profits as consumers buy from the cheater and not from the cartel. Cowen & Tabarrok, p.284 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 31 / 71

Oligopoly and Cartels Cartels often break up quickly because: Incentive for each member to cheat is too strong Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 32 / 71

Oligopoly and Cartels Cartels often break up quickly because: Incentive for each member to cheat is too strong Entrants (non-cartel members) can threaten lower prices Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 32 / 71

Oligopoly and Cartels Cartels often break up quickly because: Incentive for each member to cheat is too strong Entrants (non-cartel members) can threaten lower prices Difficult to monitor whether firms are upholding agreement Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 32 / 71

Oligopoly and Cartels Cartels often break up quickly because: Incentive for each member to cheat is too strong Entrants (non-cartel members) can threaten lower prices Difficult to monitor whether firms are upholding agreement Cartels are illegal, must be discrete Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 32 / 71

Sherman Antitrust Act (1890) Section 1: Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal. Section 2: Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony [...] 26 Stat. 209, 15 U.S.C. 1 7 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 33 / 71

Oligopoly and Cartels Archer Daniels Midland (USA), Ajinomoto (Japan), Koywa Hakko Kogyo (Japan), Sewon American Inc (South Korea) held secret meetings to fix the price of lysine, a food additive to animal feed in the 1990s. An FBI informant brought the cartel down. Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 34 / 71

Oligopoly and Cartels Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 35 / 71

Oligopoly and Cartels Some cartels persist because they are supported or legalized by the government National Industrial Recovery Act of 1933 cartelized many industries to artificially raise prices of goods. It was ultimately found unconstitutional (in Schechter Poultry Corp. v. United States (1935)) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 36 / 71

Oligopoly and Cartels Marvin Horne, a small raisin grower, recently won a Supreme Court case allowing him to refuse handing over his raisins to the Raisin Administrative Committee (yes, that s a thing) which confiscates raisins from farmers and holds them off from the market to raise raisin prices under the world s most outdated law (Forbes, NPR) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 37 / 71

Oligopoly and Cartels The Interstate Commerce Commission was set up to regulate the robber barons monopolistic railroads. But economic historians widely believe it actually cartelized a fiercely competitive industry and helped it keep rates artificially high! Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 38 / 71

Oligopoly and Cartels [B]ecause of their inability to maintain their cartels [prior to the ICC], railroads were big supporters of the [Interstate Commerce Act] because the newly-formed ICC could coordinate cartel prices...using the new law as authority, the railroads revamped their freight classification, raised rates, eliminated passes and fare reductions, and revised less than carload rates on all types of goods, including groceries. (1963). The Triumph of Conservatism: A Reinterpretation of American History, 1900-1916 Gabriel Kolko (1932-2014) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 39 / 71

Oligopoly and Cartels The Organization of Petroleum Exporting Countries (OPEC) is a series of governments acting collusively to try to raise global oil prices by cutting its member countries oil production Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 40 / 71

Oligopoly and Cartels Other cartels, like the illegal drug cartels in Mexico, persist because the governments have failed to provide order in black markets for illegal goods, where disputes are settled by violence, rather than the rule of law Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 41 / 71

Oligopoly and Cartels The Wire: The New Day Co-Op Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 42 / 71

Oligopoly and Cartels The Wire: Marlo Dismantles the Co-Op Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 43 / 71

Models of Oligopolies Collusion and cartels acting like a collective monopolist are rare due to the instability from cheating What we want is a more stable model of an equilibrium where firms compete directly against one another Economists have developed several: Bertrand Competition (compete on price simultaneously) Cournot Competition (compete on quantity simultaneously) Stackleberg Competition (compete on quantity sequentially) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 44 / 71

Bertrand Competition: Features/Assumptions Assume firms sell identical products, compete on price, and set their prices simultaneously Consumers buy from the seller with the lower price Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 45 / 71

Bertrand Competition Example e.g. Walmart and Target both sell identical Sony Playstations with same MC Total quantity purchased is Q. Price at Walmart P W and Price at Target P T Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 46 / 71

Bertrand Competition Example e.g. Walmart and Target both sell identical Sony Playstations with same MC Total quantity purchased is Q. Price at Walmart P W and Price at Target P T Demand for Playstations at Walmart Demand for Playstations at Target Q if P W P T Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 46 / 71

Bertrand Competition Example e.g. Walmart and Target both sell identical Sony Playstations with same MC Total quantity purchased is Q. Price at Walmart P W and Price at Target P T Demand for Playstations at Walmart Q if P W P T Demand for Playstations at Target Q if P W > P T Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 46 / 71

Bertrand Competition Example e.g. Walmart and Target both sell identical Sony Playstations with same MC Total quantity purchased is Q. Price at Walmart P W and Price at Target P T Demand for Playstations at Walmart Q if P W P T Demand for Playstations at Target Q if P W > P T Q 2 if P W = P T Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 46 / 71

Bertrand Competition Example e.g. Walmart and Target both sell identical Sony Playstations with same MC Total quantity purchased is Q. Price at Walmart P W and Price at Target P T Demand for Playstations at Walmart Q if P W P T Demand for Playstations at Target Q if P W > P T Q 2 if P W = P T 0 if P W < P T Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 46 / 71

Bertrand Competition Example e.g. Walmart and Target both sell identical Sony Playstations with same MC Total quantity purchased is Q. Price at Walmart P W and Price at Target P T Demand for Playstations at Walmart Demand for Playstations at Target Q if P W P T Q 2 if P Q W = P T 2 if P W = P T 0 if P W > P T 0 if P W < P T The only way to sell Playstations is to match or beat your competitor Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 46 / 71

Bertrand Competition If you are Target, and Walmart lowers their price below yours: Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 47 / 71

Bertrand Competition If you are Target, and Walmart lowers their price below yours: You can match Walmart s price and split the market OR Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 47 / 71

Bertrand Competition If you are Target, and Walmart lowers their price below yours: You can match Walmart s price and split the market OR Try to price lower than Wal-mart to capture entire market Any time price is higher than MC, the other firm can charge a lower price, until no possible undercutting at P=MC The Nash Equilibrium occurs when both firms charge their (identical) marginal cost of production (and earn no profits) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 47 / 71

Bertrand Competition If you are Target, and Walmart lowers their price below yours: You can match Walmart s price and split the market OR Try to price lower than Wal-mart to capture entire market Any time price is higher than MC, the other firm can charge a lower price, until no possible undercutting at P=MC The Nash Equilibrium occurs when both firms charge their (identical) marginal cost of production (and earn no profits) This is the perfectly competitive outcome! Even with just 2 firms! Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 47 / 71

Cournot Model: Features/Assumptions Firms compete only quantity produced Firms make simultaneous output decisions Firms make identical products All products sell at market price determined by the sum of quantities produced by all firms Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 48 / 71

Cournot Model Duopoly between two producers of spring water in Recherches sur les Principes Mathematiques de la Theorie des Richesses (1838) Antoine Augustin Cournot (1801-1877) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 49 / 71

Cournot Model Example Assume two firms, each with a constant MC=c. Firms 1 and 2 simultaneously choose production quantities q 1 and q 2. The market (inverse) demand is given by: P = a bq Q = q 1 + q 2 Firm 1 s profit is given by π 1 = q 1 (P c) π 1 = q 1 [(a b(q 1 + q 2 )) c] Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 50 / 71

Cournot Model Example Assume two firms, each with a constant MC=c. Firms 1 and 2 simultaneously choose production quantities q 1 and q 2. The market (inverse) demand is given by: P = a bq Q = q 1 + q 2 Firm 1 s profit is given by π 1 = q 1 (P c) π 1 = q 1 [(a b(q 1 + q 2 )) c] Identically, firm 2 s profit is given by π 2 = q 2 [(a b(q 1 + q 2 )) c] Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 50 / 71

Cournot Model Example Assume two firms, each with a constant MC=c. Firms 1 and 2 simultaneously choose production quantities q 1 and q 2. The market (inverse) demand is given by: P = a bq Q = q 1 + q 2 Firm 1 s profit is given by π 1 = q 1 (P c) π 1 = q 1 [(a b(q 1 + q 2 )) c] Identically, firm 2 s profit is given by π 2 = q 2 [(a b(q 1 + q 2 )) c] Notice each firm s profit depends on the action of the other firm! Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 50 / 71

Cournot Model Example Assume Saudi Arabia and Iran are the only two oil producers, each has a constant MC=20. The market (inverse) demand is given by: P = 200 3Q Q = q 1 + q 2 P = 200 3Q P = 200 3(q SA + q I ) P = 200 3q SA 3q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 51 / 71

Cournot Model Example Assume Saudi Arabia and Iran are the only two oil producers, each has a constant MC=20. The market (inverse) demand is given by: P = 200 3Q Q = q 1 + q 2 P = 200 3Q P = 200 3(q SA + q I ) P = 200 3q SA 3q I Solving for Saudi Arabia, recalling that MR is twice the slope of the inverse demand curve: MR SA = 200 6q SA 3q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 51 / 71

Cournot Model Saudi Arabia maximizes profit at the Q* where MR=MC MR SA = MC 200 6q SA 3q I = 20 q SA = 30 0.5q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 52 / 71

Cournot Model Saudi Arabia maximizes profit at the Q* where MR=MC MR SA = MC 200 6q SA 3q I = 20 q SA = 30 0.5q I Since Iran is identical, its Q* is: q I = 30 0.5q SA Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 52 / 71

Cournot Model Equilibrium for each firm depends on the choice of the other firm Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 53 / 71

Cournot Model Equilibrium for each firm depends on the choice of the other firm e.g. if Saudi Arabia expects Iran to produce 10 (million barrels per day), Saudi Arabia s inverse demand is: P = 200 3q SA 3q I P = 200 3q SA 3(10) = 170 3q SA Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 53 / 71

Cournot Model Equilibrium for each firm depends on the choice of the other firm e.g. if Saudi Arabia expects Iran to produce 10 (million barrels per day), Saudi Arabia s inverse demand is: P = 200 3q SA 3q I Called residual demand P = 200 3q SA 3(10) = 170 3q SA Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 53 / 71

Cournot Model q SA Each firm has a reaction curve describing its optimal response to the other firm s output decision 60 55 50 45 40 35 30 25 20 15 10 5 Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 54 / 71

Cournot Model q SA Each firm has a reaction curve describing its optimal response to the other firm s output decision e.g. if q I = 10, SA should produce 25 60 55 50 45 40 35 30 25 20 15 10 5 Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 54 / 71

Cournot Model q SA Each firm has a reaction curve describing its optimal response to the other firm s output decision e.g. if q I = 10, SA should produce 25 e.g. if q I = 40, SA should produce 10 60 55 50 45 40 35 30 25 20 15 10 5 Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 54 / 71

Cournot Model q SA Each firm has a reaction curve describing its optimal response to the other firm s output decision e.g. if q I = 10, SA should produce 25 e.g. if q I = 40, SA should produce 10 e.g. if q SA = 50, I should produce 5 60 55 50 45 40 35 30 25 20 15 10 5 Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 54 / 71

Cournot Model q SA Each firm has a reaction curve describing its optimal response to the other firm s output decision e.g. if q I = 10, SA should produce 25 e.g. if q I = 40, SA should produce 10 e.g. if q SA = 50, I should produce 5 e.g. if q SA = 40, I should produce 10 60 55 50 45 40 35 30 25 20 15 10 5 Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 54 / 71

Cournot Model q SA The Nash Equilibrium is where both firms reaction curves intersect Saudi Arabia will produce 20 Iran will produce 20 60 55 50 45 40 35 30 25 20 15 10 5 Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 55 / 71

Cournot Model We can also find this algebraically by plugging in one firm s reaction curve into the other s q SA = 30 0.5q I q I = 30 0.5q SA q SA = 30 0.5(30 0.5q SA ) q SA = 30 15 0.25q SA q SA = 20 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 56 / 71

Cournot Model We can also find this algebraically by plugging in one firm s reaction curve into the other s q SA = 30 0.5q I q I = 30 0.5q SA q SA = 30 0.5(30 0.5q SA ) q SA = 30 15 0.25q SA q SA = 20 Since both countries have the same costs and same reaction curve, q I = 20 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 56 / 71

Cournot Model The market price of oil again was P = 200 3q SA 3q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 57 / 71

Cournot Model The market price of oil again was P = 200 3q SA 3q I Both countries produce 20 P = 200 3(20) 3(20) P = $80 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 57 / 71

Cournot Model The market price of oil again was P = 200 3q SA 3q I Both countries produce 20 P = 200 3(20) 3(20) P = $80 Now we can find the profit for each country π SA = q SA (P 20) π SA = 20(80 20) = 1200 π I = 20(80 20) = 1200 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 57 / 71

Cournot Model & Collusion Now suppose both firms collude and act like a single monopolist, who sets: MR = MC 200 6Q = 20 30 = Q Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 58 / 71

Cournot Model & Collusion Now suppose both firms collude and act like a single monopolist, who sets: MR = MC The monopoly price will then be 200 6Q = 20 30 = Q P = 200 3Q P = 200 3(30) = $110 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 58 / 71

Cournot Model & Collusion Now suppose both firms collude and act like a single monopolist, who sets: MR = MC The monopoly price will then be Total profit will be: 200 6Q = 20 30 = Q P = 200 3Q P = 200 3(30) = $110 π = Q(P 20) = 30(110 20) = 2, 700 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 58 / 71

Cournot Model & Collusion q SA Under collusion, each firm would produce 15 (half of 30), and earn a profit of 1,400 (half of 2,700) 60 55 50 45 40 35 30 25 20 15 10 5 Collusion Iran q I = 30 0.5q SA Saudi Arabia q SA = 30 0.5q I 5 10 15 20 25 30 35 40 45 50 55 60 q I Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 59 / 71

Cournot vs. Bertrand Models Imagine Bertrand competition between Saudi Arabia and Iran instead (price competition) Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 60 / 71

Cournot vs. Bertrand Models Imagine Bertrand competition between Saudi Arabia and Iran instead (price competition) Firms will set P = MC, so: P = MC 200 3Q = 20 Q = 60 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 60 / 71

Cournot vs. Bertrand Models Imagine Bertrand competition between Saudi Arabia and Iran instead (price competition) Firms will set P = MC, so: P = MC 200 3Q = 20 Q = 60 Both countries split demand equally, each selling 30 units Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 60 / 71

Cournot vs. Bertrand Models Imagine Bertrand competition between Saudi Arabia and Iran instead (price competition) Firms will set P = MC, so: P = MC 200 3Q = 20 Q = 60 Both countries split demand equally, each selling 30 units Profit for both countries would be 0, since P = MC Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 60 / 71

Cournot vs. Bertrand Models Oligopoly Industry Market Industry Type Output Price Profit Collusion 30 $110 $2,700 Cournot 40 $80 $2,400 Bertrand 60 $20 $0 Output: Q m < Q c < Q b Market price: P b < P c < P m Profit: π b = 0 < π c < π m Where subscript m is monopoly (collusion), c is Cournot, b is Bertrand Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 61 / 71

Stackelberg Model: Features/Assumptions Firms make identical products Firms compete by choosing a quantity to produce All products sell at market price determined by the sum of the quantities produced by all firms Firms make their output decisions sequentially Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 62 / 71

Stackelberg Model Under Cournot competition, reaction curves are downward sloping If one firm could go first, and produce more than the Cournot amount, how would rival respond? There is often a first-mover advantage in a market with sequential choices Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 63 / 71

Stackelberg Model Example Return to Saudi Arabia and Iran. Inverse demand was again P = 200 3Q, Q = q SA + q I We saw each country produces at MR = MC (MC is $20), so the reaction functions were: q SA = 30 0.5q I q I = 30 0.5q SA Suppose Saudi Arabia is the Stackelberg leader and sets its output first Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 64 / 71

Stackelberg Model Example Return to Saudi Arabia and Iran. Inverse demand was again P = 200 3Q, Q = q SA + q I We saw each country produces at MR = MC (MC is $20), so the reaction functions were: q SA = 30 0.5q I q I = 30 0.5q SA Suppose Saudi Arabia is the Stackelberg leader and sets its output first Iran s incentives are the same, must react to q S A according to it s reaction function Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 64 / 71

Stackelberg Model Example Return to Saudi Arabia and Iran. Inverse demand was again P = 200 3Q, Q = q SA + q I We saw each country produces at MR = MC (MC is $20), so the reaction functions were: q SA = 30 0.5q I q I = 30 0.5q SA Suppose Saudi Arabia is the Stackelberg leader and sets its output first Iran s incentives are the same, must react to q S A according to it s reaction function Saudi Arabia, however, knows exactly how Iran will respond Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 64 / 71

Stackelberg Model Example So we substitute in Iran s reaction curve into the inverse demand curve to find Saudi Arabia s optimal output P = 200 3q SA 3q I P = 200 3q SA 3(30 0.5q SA ) P = 110 1.5q SA Find MR from Demand: MR SA = 110 3q SA Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 65 / 71

Stackelberg Model Example Set MR=MC: 110 3q SA = 20 q SA = 30 How will Iran respond? Check it s reaction function: q I = 30 0.5q SA q I = 30 0.5(30) = 15 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 66 / 71

Stackelberg Model Under Cournot, Saudi Arabia and Iran each produced 20, for a total industry output of 40 Under Stackelberg, Saudi Arabia produces 30, Iran 15, for a total industry output of 45 Example Market price will become: Profit for each country then is: P = 200 3Q P = 200 3(45) = 65 π SA = q SA (P 20) = 30(65 20) = 1, 350 π I = q I (P 20) = 15(65 20) = 675 Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 67 / 71

Stackelberg vs. Cournot Models Cournot (P*=$80) Stackelberg (P*=$65) Country Output Profit Output Profit Saudi Arabia 20 $1,200 30 $1,350 Iran 20 $1,200 15 $675 Industry 40 $2,400 45 $2,025 1 st mover Saudi Arabia increased its output and increased its profits 2 nd mover Iran was forced to lower its output and accept lower profits Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 68 / 71

Comparing Market Structures Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 70 / 71

Comparing Market Structures Long Run Consumer Market Price Quantity Profits Surplus Perfect Competition Lowest (MC) Highest 0 Highest Monopolistic Competition Low (P > MC) High 0 High Oligopoly (Noncooperative) High* Low* Positive* Low* Monopoly (Cartel) Highest Lowest Highest Lowest * Bertrand competition: P = MC; Higher Quantity; Normal (0) LR Profits Barriers to entry: Monopoly, Oligopoly DWL: Monopoly, Oligopoly, Monopolistic Competition Ryan Safner (Hood College) ECON 306 - Lesson 10 Spring 2017 71 / 71