Chapter 13 Market Structure Copyright (c)2014 John Wiley & Sons, Inc and Competition Chapter Thirteen Overview 1.1 Introduction: Cola Wars Introduction: Cola Wars 2.2 AATaxonomy of Market Structures Taxonomy of Market Structures 3.3 Monopolistic Competition Monopolistic Competition 4.4 Oligopoly – Interdependence of Strategic Decisions Oligopoly – Interdependence of Strategic Decisions •• Bertrand with Homogeneous and Differentiated Products Bertrand with Homogeneous and Differentiated Products Copyright (c)2014 John Wiley & Sons, Inc 5.5 The Effect of a Change in the Strategic Variable The Effect of a Change in the Strategic Variable •• Theory vs Observation Theory vs Observation •• Cournot Equilibrium (homogeneous) Cournot Equilibrium (homogeneous) •• Comparison to Bertrand, Monopoly Comparison to Bertrand, Monopoly •• Reconciling Bertrand, and Cournot Reconciling Bertrand, and Cournot 6.6 The Effect of a Change in Timing: Stackelberg Equilibrium The Effect of a Change in Timing: Stackelberg Equilibrium Chapter Thirteen Market Structures Four Key Dimensions ••The Thenumber numberofofsellers sellers ••The Thenumber numberofofbuyers buyers Copyright (c)2014 John Wiley & Sons, Inc ••Entry Entryconditions conditions ••The Thedegree degreeofofproduct productdifferentiation differentiation Chapter Thirteen Product Differentiation Definition: Product Differentiation between two or more products exists when the products possess attributes that, in the minds of consumers, set the products apart from one another and make them less than perfect substitutes Examples: Pepsi is sweeter than Coke, Brand Name batteries last longer Copyright (c)2014 John Wiley & Sons, Inc than "generic" batteries Chapter Thirteen Product Differentiation • "Superiority" (Vertical Product Differentiation) i.e one product is viewed as unambiguously better than another so that, at the same price, all consumers would buy the better product "Substitutability" (Horizontal Product Differentiation) i.e at the same price, some consumers would prefer the characteristics of product A while other consumers would prefer the characteristics of product B Chapter Thirteen Copyright (c)2014 John Wiley & Sons, Inc • Copyright (c)2014 John Wiley & Sons, Inc Types of Market Structures Chapter Thirteen Oligopoly Assumptions: Assumptions: •• Many ManyBuyers Buyersand andFew FewSellers Sellers •• Each Eachfirm firmfaces facesdownward-sloping downward-slopingdemand demandbecause becauseeach eachisisaalarge large •• There There isis no no one one dominant dominant model model ofof oligopoly oligopoly We We will will review review several several Chapter Thirteen Copyright (c)2014 John Wiley & Sons, Inc producer producercompared comparedtotothe thetotal totalmarket marketsize size Cournot Oligopoly Assumptions • • • • Firms set outputs (quantities)* Homogeneous Products Simultaneous Non-cooperative given the output level of its competitor(s), so as to maximize profits Price adjusts according to demand Residual Demand: Firm i's guess about its rival's output determines its residual demand Chapter Thirteen Copyright (c)2014 John Wiley & Sons, Inc *Definition: In a Cournot game, each firm sets its output (quantity) taking as Simultaneously vs Non-cooperatively Definition: Firms act simultaneously if each firm makes its strategic decision at the same time, without prior observation of the other firm's decision Definition: Firms act non-cooperatively if they set strategy independently, Chapter Thirteen Copyright (c)2014 John Wiley & Sons, Inc without colluding with the other firm in any way Residual Demand Definition: The relationship between the price charged by firm i and the demand firm i faces is firm is residual demand In other words, the residual demand of firm i is the market demand Copyright (c)2014 John Wiley & Sons, Inc minus the amount of demand fulfilled by other firms in the market: Q1 = Q - Q Chapter Thirteen 10 Perceived vs Actual Demand Price Demand (assuming price matching by all firms) • Demand assuming no price matching A d (P =50) A d (P =20) Quantity Chapter Thirteen 51 Copyright (c)2014 John Wiley & Sons, Inc 50 Market Equilibrium The Themarket marketisisininequilibrium equilibriumif:if: •• Each Each firm firm maximizes maximizes profit profit taking taking the the average average market marketprice priceas asgiven given Each Each firm firm can can sell sell the the quantity quantity itit desires desires atat the the Copyright (c)2014 John Wiley & Sons, Inc •• actual actual average averagemarket marketprice pricethat thatprevails prevails Chapter Thirteen 52 Short Run Chamberlinian Equilibrium A d(P =43) Quantity Chapter Thirteen 53 Copyright (c)2014 John Wiley & Sons, Inc Price Short Run Chamberlinian Equilibrium Price matching A d (P =50) A d(P =43) Quantity Chapter Thirteen 54 Copyright (c)2014 John Wiley & Sons, Inc Demand assuming no price Short Run Chamberlinian Equilibrium Price A Demand (assuming price matching by all firms P=P ) • Demand assuming no price matching A d (P =50) A d(P =43) Quantity Chapter Thirteen 55 Copyright (c)2014 John Wiley & Sons, Inc • Short Run Chamberlinian Equilibrium Price A Demand (assuming price matching by all firms P=P ) 43 • • Demand assuming no price matching 15 mc 57 A d (P =50) A d(P =43) Quantity MR43 Chapter Thirteen 56 Copyright (c)2014 John Wiley & Sons, Inc 50 Short Run Monopolistically Competitive Equilibrium Computing Short Run Monopolistically Competitive Equilibrium •• MC MC==$15 $15 •• NN==100 100 Copyright (c)2014 John Wiley & Sons, Inc AA •• QQ==100 100- -2P 2P++PP AA •• Where: P Where: P isisthe theaverage averagemarket marketprice priceNNisisthe thenumber number ofoffirms firms Chapter Thirteen 57 Short Run Monopolistically Competitive Equilibrium A What is the equation of d40? What is the equation of D? • d40: Qd = 100 - 2P + 40 = 140 - 2P • A D: Note that P = P so that • QD = 100 - P • P = 40 => Qd = 140 - 80 = 60 QD = 100 - 40 = 60 A C For any given average price, P , find a typical firm's profit maximizing quantity Chapter Thirteen 58 Copyright (c)2014 John Wiley & Sons, Inc B Show that d40 and D intersect at P = 40 Inverse Perceived Demand AA PP==50 50- -(1/2)Q (1/2)Q++(1/2)P (1/2)P AA MR MR==50 50- -QQ++(1/2)P (1/2)P AA MR = MC => 50 Q + (1/2)P MR = MC => 50 - Q + (1/2)P ==15 15 Copyright (c)2014 John Wiley & Sons, Inc AA QQe ==35 ++(1/2)P 35 (1/2)P e AA PPe ==50 - -(1/2)Q ++(1/2)P 50 (1/2)Q e (1/2)P e e AA PPe ==32.5 + (1/4)P e 32.5 + (1/4)P Chapter Thirteen 59 Short Run Monopolistically Competitive Equilibrium D What is the short run equilibrium price in this industry? A In equilibrium, Qe = QD at P so that A A 100 - P = 35 + (1/2)P Copyright (c)2014 John Wiley & Sons, Inc A P = 43.33 Qe = 56.66 QD = 56.66 Chapter Thirteen 60 Monopolistic Competition in the Long Run At the short run equilibrium P > AC so that each firm may make positive At the short run equilibrium P > AC so that each firm may make positive profit profit Entry shifts d and D left until average industry price equals average cost Entry shifts d and D left until average industry price equals average cost This is long run equilibrium is represented graphically by: Copyright (c)2014 John Wiley & Sons, Inc MR = MC for each firm D = d at the average market price d and AC are tangent at average market price Chapter Thirteen 61 Long Run Chamberlinian Equilibrium Price Residual Demand shifts in as entry occurs P* Marginal Cost P** q** q* MR Copyright (c)2014 John Wiley & Sons, Inc Average Cost Quantity Chapter Thirteen 62 Summary Market structures are characterized by the number of buyers, the number of sellers, the degree of product differentiation and the entry conditions Product differentiation alone or a small number of competitors alone is not enough to destroy the long run zero profit result of perfect competition This was illustrated with the Chamberlinian and Bertrand models Chamberlinian) monopolistic competition assumes that there are many buyers, many sellers, Copyright (c)2014 John Wiley & Sons, Inc differentiated products and free entry in the long run Chapter Thirteen 63 Summary Chamberlinian sellers face downward-sloping demand but are price takers (i.e they not perceive that their change in price will affect the average price level) Profits may be positive in the short run but free entry drives profits to zero in the long run Bertrand and Cournot competition assume that there are many buyers, few sellers, and homogeneous or differentiated products Firms compete in price in Bertrand oligopoly and in quantity in Cournot oligopoly Bertrand and Cournot competitors take into account their strategic interdependence by means of constructing a Copyright (c)2014 John Wiley & Sons, Inc best response schedule: each firm maximizes profits given the rival's strategy Chapter Thirteen 64 Summary Equilibrium in such a setting requires that all firms be on their best response functions If the products are homogeneous, the Bertrand equilibrium results in zero profits By changing the strategic variable from price to quantity, we obtain much higher prices (and profits) Further, the results are sensitive to the assumption of simultaneous moves This result can be traced to the slope of the reaction functions: upwards in the case of Bertrand and downwards in the case of Cournot These slopes imply that "aggressivity" results in a "passive" response Copyright (c)2014 John Wiley & Sons, Inc in the Cournot case and an "aggressive" response in the Bertrand case Chapter Thirteen 65 ... price,taking takingasasgiven giventhe theprice(s) price(s)set setby byother other firm(s), firm(s),sosoasastotomaximize maximizeprofits profits Chapter Thirteen 16 Setting Price • Homogeneity implies... whereby the dominant firm keeps its price below the level that maximizes its current profit in order to reduce the rate of expansion by the Copyright (c)2014 John Wiley & Sons, Inc fringe Chapter. .. Copyright (c)2014 John Wiley & Sons, Inc minus the amount of demand fulfilled by other firms in the market: Q1 = Q - Q Chapter Thirteen 10 Residual Demand Price 10 units Residual Marginal Revenue