ECON2011- CHAPTER 11

Friday, 24 May, 2019 6:48 PM

Imperfect Competition
Imperfect competition - market structures with characteristics between those of PC and monopoly.

Assumptions:
1. Allow for varying degrees of competition
2. Allow for differentiated products
3. Allow for strategic behaviour

Oligopoly - competition between a small number of firms

- Each company's actions influences what the other companies want to do
- Determining an outcome when no firm wants to change its decision, we must determine more than just a price and quantity for the
industry as a whole
- Market clears BUT requires that no company want to change its behaviour (price or quantity) once it knows what other companies
are doing.

This means that there is an incentive for firms to engage in collusion or to form a cartel. This occurs when firms coordinate and collectively
act as a monopoly to gain monopoly profits.

Model assumptions (Collusion and Cartels):

1. Firms make identical products
2. Industry firms agree to coordinate their quantity and pricing decision
3. No firm deviates from the agreement, even if breaking it is in the firm's best interest.

Main problem: Each firm has an incentive to cheat

Given inverse demand is P = 20 - Q and MC is $4
If firms collude => monopoly output
1) Equate MR = MC ( Q = 8 )
2) Find the price and total profits ( P = $12 )
3) Split the production quantity between 2, and profit (technically) will be half too (each firm produces 4 units, and each firm's profit is
$32)

BUT the instability is that they each have incentive to cheat:

From example above, what is firm A decides to produce 5 units instead of 4? Total production becomes 9 units instead of 8. Even though
firm A's profit might increase, market price still falls and overall industry profit will fall.

Inverse demand: P = 20 - Q and the new price is $11, total profits will be $63

The incentive to defect makes it difficult to maintain collusive agreements.

What makes collusion easier?

- Making it easy to detect and punish cheaters
- Little variation in MC across producers since the goal is to produce at lowest cost, it is difficult to share profits if production costs
vary greatly across cartel members.
- Long time horizon makes defection more costly, as future monopoly profits are given more weight.

Oligopoly with Identical Goods: Bertrand Competition (firms that chooses the price of its products and not quantity)
1. Firms sell identical products
2. The firms compete by choosing the price at which they sell their products
3. The firms set their prices simultaneously

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Setting up the Bertrand Model:
Suppose two firms, Target and Walmart are selling Sony Playstations:
- Products are identical; assume MC is identical
- Total quantity purchased is Q. Price at Walmart Pw and target is Pt

*In another words: if your price is lower than your competitor, you will capture the whole market and vice versa. The only way to sell
Playstations is to match or beat your competitor

Nash Equilibrium of a Bertrand Oligopoly:

If Walmart lowers the price of Playstations to less than Target's:
- Target can match Walmart, so the market is shared equally
- Or it can undercut Walmart, so all consumers purchase from Target

Equilibrium occurs when each firms changes the MC of production.

With identical firms and products, if one firm is changing more than its MC, the other firm always has an incentive to undercut.

Even though competition is imperfect, in Bertrand competition, market equilibrium is identical to perfect competition and P=MC and
firms earn zero profit.

Oligopoly with Identical Goods: Cournot Competition (firms focus on the quantity decision)
1. Firms make identical products.
2. Firms compete by choosing a quantity to produce
3. All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market
4. Firms choose quantities simultaneously.

Setting up the Cournot Model

Assume:
- Constant MC denoted as c
- Firms 1 and 2 simultaneously choose production quantities q1 and q2

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This differs from the monopoly outcome in that the profit-maximizing output for each country depends on the choices of the other.

Mathematically:
-Substitute one firm's reaction curve into the other

The both have identical production costs, Iran will also produce 20million barrels per day and the market price will be:

Finally, we can compute the profits earned by both Saudi Arabia and Iran:

If Saudis expect Iran to produce 10million barrels per day, they face the inverse demand curve (similar mechanics to Stackelberg, just that
we already know how many of units the "first-mover" will produce beforehand)

Leftover demand: Residual demand curve. This is the demand remaining for a firm's output given competitor firms' production quantities

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Then, find the residual marginal revenue and equate with the marginal cost to find the quantity produced by Saudi Arabia.

Add up Qsa and Qi to get the industry quantity. Plug it back into the inverse demand curve to get the market price. Now with the market
price, we can find each firm's profit.

Similarly, a residual marginal revenue curve is a marginal revenue curve corresponding to a residual demand curve.

Comparing Cournot to Monopoly and to Bertrand Oligopoly:-

*Stackelberg sits between Bertrand and Cournot

What happens if there are more than two firms in a Cournot Oligopoly?
-The more firms there are, the closer these outcomes get to the perfectly competitive case with P=MC and economic profits being zero.

Oligopoly with Identical Goods: Stackelberg Competition (first-mover)

1. Firms sell identical products.
2. Firms compete by choosing a quantity to produce
3. All goods sell for the same price (which is determined by the sum total of quantities produced by all the firms combined)
4. Firms do not choose quantities simultaneously. One firm chooses its quantity first. The next firm observes this and then chooses its
quantity.

Each company has an incentive to try to choose its output level first and force its competitors to be the one who has to react. The firms
firm could increase its output ignoring what the Cournot Theory say what they should. Because the competitor's reaction curve slopes
downwards in this case, the other competitor seeing the high quantity the original firm is producing, would want to reduce its output. This
is a first-mover advantage in the market.

From the example above, suppose Saudi Arabia is a Stackelberg leader and chooses the quantity first, what will SA do with this first-mover
advantage?

As a first-mover in a Stackelberg oligopoly, SA's demand has become:

*This is found by plugging in the reaction curve of Iran equation into the inverse demand curve of Saudi Arabia

We did this because SA recognizes that by going first, its output choice affect its demand and therefore its MR both directly and indirectly
through its effect on Iran's production decision.

Further simplifying this equation gives:

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To find the profit-maximizing output: equate MR = MC

As the first-mover, SA finds it optimal to producer 30million bpd, 10million more than the Cournot oligopoly output of 20million bpd.

To find how SA's decision affects Iran's optimal production level. Plug SA's output level into Iran's reaction curve:

Iran now produces only 15million bpd rather than 20 as in the Cournot case. By moving first, SA gets the jump on Iran, leaving Iran no
choice but to drop its output level from 20 to 15 million bpd.

Therefore total production is 45million bpd in the Stackelberg case. This is more than the output produced in the Cournot Oligopoly
(40million). Because production is higher, the market price must belower under the sequential production decisions than under Cournot's
simultaneous-decision framework. Specifically, the price is 200 - 3 (30+15) = $65 per barrel instead of the Cournot equilibrium price of $80

Profit for SA 30 x (65-20) = $1,350 million/day which is $150 million more than its $1200 million/day profit in the Cournot oligopoly. =>
Advantage of being the first-mover

Profit for Iran 15 X (65-20) = $675 million per day, which is well below the Cournot Profit level of $1200 million per day.

Oligopoly with Differentiated Goods: Bertrand Competition

1. Firms do not sell identical products. They sell differentiated products, meaning consumers do not view them as perfect substitutes.
2. Each firm chooses the price at which it sells its product.
3. Firm set prices simultaneously.

Consider the following demand curves for the two companies' ( Burton and K2 ) snowboard, where price is measured in dollars:

As the price of Burton snowboards increases, Burton is in less demand but K2 is in greater demand and vice versa.

Each company sets its price to maximize profits:

Assume MC is 0,

These are the reaction curves for Burton and K2: as the competitor's price rises, their own price rises.
This is the opposite of quantity reaction in Cournot competition since the reaction curves are in terms of the opponent's price)

Nash equilibrium in Bertrand Competition with Differentiated Goods:

Graphically:

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In a differentiated product market, if there is no barriers to enter and exit, then that is a monopolistic competition.
1. Industry firms sell differentiated products that consumers do not view as perfect substitutes.
2. Other firms' choices affect a firm's residual demand curve
3. Firms ignore any strategic interactions between their own quantity or price choice and their competitor's choices.
4. The market allows free entry and exit.

*Producer surplus will not be affected by the change in cost since its difference between the market PRICE and the PRICE producers willing
to receive.

This is a monopoly outcome.

Suppose a second firm notices the profitability of operating a fast-food restaurant in this town. With no barriers to entry, the second firm
opens a restaurant.

Two things happen to the Done:

1. Because the second firm offers an imperfect substitute product, the demand curve for the first firm's food becomes flatter (more
elastic)
2. Because demand is now split across two firms, Done shift in as well.

This model has no strategic response to the behaviour of rivals, it is solely based on the profits and the barrier to enter and exit.

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Entry of new firms will drive the economic profit down to zero.

BUT P =/= MC

Firms always face a downward sloping demand curve, entry will occur until demand is tangent with the AC and that is the point where
economic is exhausted.

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Answers:

Mathematical Summary for Each of the Market Structures:-

1. Collusion/ Oligopoly (monopoly output)

Given inverse demand is P = 20 - Q and MC is $4
1) Equate MR = MC ( Q = 8 )
2) Find the price and total profits ( P = $12 )
3) Split the production quantity between 2, and profit (technically) will be half too (each firm produces 4 units, and each firm's
profit is $32)

2. Cournot Competition
1) Replace total demand (Qa + Qb) as Q into the market inverse demand curve
2) Derive EACH FIRM's marginal revenue curve (2 equations)
3) Set EACH FIRM's MR to MC to maximize profit and obtain each firm's reaction curve (2 equations)
4) To solve for equilibrium - substitute one reaction curve into another
5) Substitute quantities back into inverse demand curve to get the market price
6) Profit = TR - TC

3. Stackelberg Competition
1) Get reaction curves for each firm (MR = MC)
2) Substitute the "slow-mover" reaction curve into the inverse market demand (Inverse demand for first-mover) with Q as Qslow
and Qfirst mover
3) Derive to get MR for first-mover and equate with MC to get the profit maximizing output
4) Substitute into slow-mover's reaction curve to find the quantity produced by the slow mover
5) Substitute both quantities into market demand curve to find the market price
6) Profit = TR - TC

4. Bertrand Competition (Differentiated Goods)

1) Find total revenue if not given and find the MR (in terms of Price!!!!) for each firm and equate with MC -> each firm's reaction
curve (2 equations)

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 curve (2 equations)
2) Solve for equilibrium PRICES by substituting them into one another (this is also the profit maximizing price)
3) To find optimal output, plug the prices back into the inverse demand curves for each firms.

5. Monopolistic Competition
1) Profit maximizing output MC = MR
2) Plug the output back into the demand curve to find the profit maximizing price
3) Profit = TR-TC
4) Long run equilibrium : zero economic profit (so firms will be bearing fixed costs)

6. Bertrand Competition with Identical Goods

1) Equilibrium occurs where MR=MC (as if in a competition situation)
2) Because if you charge more than your competitor, they will be able to undercut and get the entire market.

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