Profit maximisation under Imperfect Competition

Monopolistic Competition

Assumptions of monopolistic competition

large

number of firms

independence of firms

freedom

of entry product

differentiated

downward-sloping

demand curve

elasticity depends on degree of product differentiation

Monopolistic Competition

Equilibrium of the firm

short

run

output where MC = MR level of supernormal profit depends on demand

position of demand curve elasticity of demand curve

Short-run equilibrium of the firm under monopolistic competition

MC AC

Ps ACs

AR = D

MR
O
Qs

Monopolistic Competition

Equilibrium of the firm

short

run

output where MC = MR level of supernormal profit depends on demand

position of demand curve elasticity of demand curve

long

run

Monopolistic Competition

Equilibrium of the firm

short

run

output where MC = MR level of supernormal profit depends on demand

position of demand curve elasticity of demand curve

long

run

all supernormal profits competed away

Long-run equilibrium of the firm under monopolistic competition

LRMC LRAC
PL

ARL = DL

MRL
O
QL

Monopolistic Competition

Equilibrium of the firm

short

run

output where MC = MR level of supernormal profit depends on demand

position of demand curve elasticity of demand curve

long

run

all supernormal profits competed away underutilisation of capacity

Long-run equilibrium of the firm under monopolistic competition

LRAC
PL

ARL = DL

QL

Monopolistic Competition

Limitations of the model

imperfect difficulty

information

in identifying industry demand

curve
entry

may not be totally free

indivisibilities

importance

of non-price competition

Comparing monopolistic competition with perfect competition and monopoly

comparison

with perfect competition

Long run equilibrium of the firm under perfect and monopolistic competition

LRAC P1 P2

DL under perfect
competition

DL under monopolistic
competition O

Q1

Q2

Q A monopolistically competitive industry in the long run will experience excess capacity. To which one of the following is this due?
A.

Firms will only make normal profit. Firms will enter the industry if supernormal profits can be made. Firms will produce along the upward-sloping portion of their marginal cost curve. The tangency point of the firms AR and LRAC curves is to the left of the minimum LRAC.

B.

C.

D.

E.

The point where AR equals LRAC is vertically above the point where MR equals LRMC.

Monopolistic Competition

Limitations of the model

imperfect

information difficulty in identifying industry demand curve entry may not be totally free indivisibilities importance of non-price competition

Comparing monopolistic competition with perfect competition and monopoly

comparison

with perfect competition comparison with monopoly

Oligopoly

Key features of oligopoly

barriers

to entry of firms

interdependence incentives

to compete versus incentives to

collude

Factors favouring collusion Collusive oligopoly: cartels

equilibrium

of the industry

Profit-maximising cartel

Industry D = AR
O Q

Profit-maximising cartel

Industry profit maximised at Q1 and P1.

Industry MC

P1
Members must agree to restrict total output to Q1.

Industry D = AR Industry MR
O

Q1

Oligopoly

Key features of oligopoly

barriers

to entry of firms to compete versus incentives to

interdependence incentives

collude

Factors favouring collusion Collusive oligopoly: cartels

equilibrium allocating

of the industry

and enforcing quotas

Q In which of the following circumstances would a cartel be most likely to work?

A. The coffee market, where the product is standardised and there are many coffee growers.
The market for copper, where there are very few producers and the product is standardised. The car industry, where there are few producers but there is great product differentiation. The fast-food market, where there are many producers but the demand for fast food is inelastic.

B.

C.

D.

Oligopoly

Tacit collusion
price price

leadership: dominant firm leadership: barometric

Price leader aiming to maximise profits for a given market share

Assume constant market share for leader

AR = D market

AR = D leader MR leader
O Q

Price leader aiming to maximise profits for a given market share

MC

PL

t
AR = D market

AR = D leader MR leader
O

QL

QT

Oligopoly

Tacit collusion
price price other

leadership: dominant firm leadership: barometric

forms of tacit collusion: rules of thumb

Oligopoly

Tacit collusion
price price other

leadership: dominant firm leadership: barometric

forms of tacit collusion: rules of thumb

average cost pricing

Oligopoly

Tacit collusion
price price other

leadership: dominant firm leadership: barometric

forms of tacit collusion: rules of thumb

average cost pricing price benchmarks

Oligopoly

Factors favouring collusion

few

firms open with each other similar cost structures similar products there is a dominant firm significant barriers to entry stable market conditions no government measures to curb collusion

Collusion and the law

Oligopoly

The breakdown of collusion

factors

to consider in deciding whether to break an agreement

how likely are rivals to retaliate? who would win a price war?

importance

of considering rivals reactions

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour

rivals

produce fixed quantity: Cournot model

firms chose best output for remainder of the market

The Cournot model of duopoly: Firm As profit maximising position

Costs and revenue

Firm A believes that firm B will produce QB1.

DA1
O Quantity QB1

DM

The Cournot model of duopoly: Firm As profit maximising position

Costs and revenue

MCA

Firm As profitmaximising output and price are QA1 and PA.

PA1

MRA1
O QA1

DA1
QB1 Quantity

DM

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour

rivals

produce fixed quantity: Cournot model

firms chose best output for remainder of the market profit will be less than under a cartel but more than under perfect competition

The Cournot model of duopoly: Firm As profit maximising position

Costs and revenue

MCA

Firm As profitmaximising output and price are QA1 and PA.

PA1

MRA1
O QA1

DA1
QB1 Quantity

DM

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour

rivals

produce fixed quantity: Cournot model

firms chose best output for remainder of the market profit will be less than under a cartel but more than under perfect competition

rivals

set a particular price: Bertrand model

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour

rivals

produce fixed quantity: Cournot model

firms chose best output for remainder of the market profit will be less than under a cartel but more than under perfect competition

rivals

set a particular price: Bertrand model

the firm will undercut the rival

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour

rivals

produce fixed quantity: Cournot model

firms chose best output for remainder of the market profit will be less than under a cartel but more than under perfect competition

rivals

set a particular price: Bertrand model

the firm will undercut the rival this will probably trigger a price war until all supernormal profits are eliminated

Q Which one of the following statements is NOT applicable to the Bertrand model
A. Firms choose price in response to the prices set by rivals. B. Firms make only a small amount of supernormal profit.

C. In practice, firms have an incentive to collude.

D. Firms are likely to engage in price-cutting behaviour. E. Nash equilibrium (in the absence of collusion) is where price is equal to average cost.

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour (cont.)

Nash

equilibrium

when everyone makes a decision based on the alternatives rivals could adopt Nash equilibrium worse for the individual firms than the collusive equilibrium

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour (cont.)

the

kinked demand curve model

assumptions of the model

price cut followed by competitors price rise not followed by competitors

the shape of the demand and MR curves

Kinked demand for a firm under oligopoly

Current price and quantity give one point on demand curve. P1

Q1

Kinked demand for a firm under oligopoly

Assumption 1 If the firm raises its price, rivals will not

D
P1

Assumption 2 If the firm reduces its price, rivals will feel forced to lower theirs too.

D
O Q1

Q In the kinked demand curve model, this kink is due to the firms belief that its competitors:
A. will set a price at the kink of the demand curve. B. will match any price increase it makes, but will not match a price reduction. C. will not match a price increase but will match any price reduction.

D. will match all price increases and reductions.

E. will match neither price increases nor reductions.

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour (cont.)

the

kinked demand curve model

assumptions of the model

price cut followed by competitors price rise not followed by competitors

the shape of the demand and MR curves stable prices

Stable price under conditions of a kinked demand curve

MR is discontinuous between a and b. If MC is anywhere between MC1 and MC2, profit is maximised at Q1.

MC2
P1

MC1

a b
O Q1

D = AR
Q

MR

Oligopoly

Non-collusive oligopoly: assumptions about rivals behaviour (cont.)

the

kinked demand curve model

price cut followed by competitors price rise not followed by competitors

assumptions of the model

the shape of the demand and MR curves stable prices

limitations of the model

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax maximin

simple

dominant strategy games

Profits for firms X and Y at different prices

Xs price
2.00 1.80

A
2.00 10m each

B
5m for Y 12m for X

Ys price
1.80

C
12m for Y 5m for X

D
8m each

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax maximin

simple

dominant strategy games

the prisoners dilemma

The prisoners' dilemma

Amanda's alternatives
Not confess Not confess Confess

A
Each gets 1 year

Nigel's alternatives C Nigel gets

Confess
3 months Amanda gets 10 years

Nigel gets 10 years Amanda gets 3 months Each gets 3 years

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax and maximin

simple

dominant strategy games

the prisoners dilemma Nash equilibrium

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax and maximin

simple

dominant strategy games

the prisoners dilemma Nash equilibrium

non-dominant

strategy games

Q A, B, C and D are four strategies that firm X can pursue. The table shows the effect on firm Xs profits according to which of 6 responses rival firms make. Which of the four strategies is the maximax strategy?
A.
1 Other firms' responses 2 50 20 15 35 3 20 15 30 10 4 30 0 0 40 5 40 15 20 30 6 60 80 30 70

B. C. D.

Strategies for firm X

A B C D

25 20 0 20

Figures show firm Xs profits in 000s

Q A, B, C and D are four strategies that firm X can pursue. The table shows the effect on firm Xs profits according to which of 6 responses rival firms make. Which of the four strategies is the maximin strategy?
A.
1 Other firms' responses 2 50 20 15 35 3 20 15 30 10 4 30 0 0 40 5 40 15 20 30 6 60 80 30 70

B. C. D.

Strategies for firm X

A B C D

25 20 0 20

Figures show firm Xs profits in 000s

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax and maximin

simple

dominant strategy games

the prisoners dilemma Nash equilibrium

non-dominant

strategy games the importance of threats and promises

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax and maximin

simple

dominant strategy games

the prisoners dilemma Nash equilibrium

non-dominant

strategy games the importance of threats and promises

are threats credible?

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax and maximin

simple

dominant strategy games

the prisoners dilemma Nash equilibrium

non-dominant

strategy games the importance of threats and promises

are threats credible?

the

importance of timing of decisions

Oligopoly

Non-collusive oligopoly: game theory

alternative

strategies

maximax and maximin

simple

dominant strategy games

the prisoners dilemma Nash equilibrium

non-dominant

strategy games the importance of threats and promises

are threats credible?

the

importance of timing of decisions

decision trees

A decision tree
Boeing 10m (1) Airbus 10m

Airbus decides
B1

Boeing +30m (2) Airbus +50m

Boeing decides A

Boeing +50m (3) Airbus +30m

B2

Airbus decides

Boeing 10m (4) Airbus 10m

Oligopoly

Oligopoly and the consumer

disadvantages

worse if there is extensive collusion countervailing power supernormal profits may allow higher R&D

advantages

greater choice for consumers

difficulties

in drawing general conclusions of entry and exit costs

Oligopoly and contestable markets

importance