MicroEconomics 5e by besanko braeutigam chapter 13

Chapter 13

Market Structure

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and Competition

1


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

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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
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Market Structures

Four Key Dimensions
••The
Thenumber
numberofofsellers
sellers

••The
Thenumber
numberofofbuyers
buyers

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••Entry
Entryconditions
conditions

••The
Thedegree
degreeofofproduct
productdifferentiation
differentiation

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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

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than "generic" batteries.

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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

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•

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Types of Market Structures

Chapter Thirteen

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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.

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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.
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*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

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without colluding with the other firm in any way

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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

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minus the amount of demand fulfilled by other firms in the market:
Q1 = Q - Q 2

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Residual Demand

Price

10 units

Residual Marginal Revenue when q2 = 10

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Residual Demand when q2 = 10

MC
Demand

0

Quantity

q1*
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Profit Maximization
Profit Maximization: Each firm acts as a monopolist on its residual
Profit Maximization: Each firm acts as a monopolist on its residual
demand curve, equating MRr to MC.
demand curve, equating MRr to MC.
MRr = p + q1(∆p/∆q) = MC
MRr = p + q1(∆p/∆q) = MC

Best Response Function:

(rivals') actions.

For every possible output of the rival(s), we can determine firm i's best response. The sum of all these points
makes up the best response (reaction) function of firm i.

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The point where (residual) marginal revenue equals marginal cost gives the best response of firm i to its rival's


Profit Maximization
q2
Example: Reaction Functions, Quantity Setting

Reaction Function of Firm 1

•

0

Reaction Function of Firm 2

q1 *

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q2 *

q1
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Equilibrium
Equilibrium: No firm has an incentive to deviate in equilibrium in the sense that each firm is maximizing profits given its rival's
output

What is the equation of firm 1's reaction function?
P = 100 - Q1 - Q2

What is firm 1's profit-maximizing output when firm 2
produces 50?

Firm 1's residual demand:

•
•
•

P = (100 - 50) - Q1
MR50 = 50 - 2Q1
MR50 = MC  50 - 2Q1 = 10

Firm 1's residual demand:

•
•
•
•
•

P = (100 - Q2) - Q1
MRr = 100 - Q2 - 2Q1
MRr = MC  100 - Q2 - 2Q1 = 10
Q1r = 45 - Q2/2 firm 1's reaction function
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MC = AC = 10

Similarly, one can compute that

Q2r = 45 - Q1/2

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Profit Maximization

Now, calculate the Cournot equilibrium.

Q1 = 45 - (45 - Q1/2)/2
Q1* = 30
Q2* = 30
P* = 40
π1* = π2* = 30(30) = 900

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•
•
•
•
•

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Bertrand Oligopoly (homogeneous)
Assumptions:

•

•
•
•

Firms set price*
Homogeneous product
Simultaneous
Non-cooperative

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*Definition:
*Definition: InInaaBertrand
Bertrandoligopoly,
oligopoly,each
eachfirm
firmsets
sets
its
itsprice,
price,taking
takingasasgiven
giventhe
theprice(s)
price(s)set
setby
byother
other
firm(s),
firm(s),sosoasastotomaximize

maximizeprofits.
profits.

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Setting Price

•

Homogeneity implies that consumers will buy from the low-price seller.

•

Further, each firm realizes that the demand that it faces depends both on
its own price and on the price set by other firms

•

Specifically, any firm charging a higher price than its rivals will sell no

•

Any firm charging a lower price than its rivals will obtain the entire market
demand.

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output.


Residual Demand Curve – Price Setting
Price
Market Demand

Residual Demand Curve (thickened line
segments)

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•

Quantity

0
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Residual Demand Curve – Price Setting

Assumptions

Assume firm always meets its residual demand (no capacity constraints)

•

Assume that marginal cost is constant at c per unit.

•

Hence, any price at least equal to c ensures non-negative profits.
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•

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Best Response Function

Each firm's profit maximizing response to the other firm's price is to undercut (as long as P >
MC)

Definition: The firm's profit maximizing action as a function of the action by the rival firm is
the firm's best response (or reaction) function

Example:

2 firms
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Bertrand competitors

Firm 1's best response function is P1=P2- e
Firm 2's best response function is P2=P1- e

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Equilibrium

IfIfwe
weassume
assumeno
nocapacity
capacityconstraints
constraintsand
andthat
thatall
allfirms
firmshave
havethe
thesame
same
constant
constantaverage
averageand
andmarginal

marginalcost
costofofccthen:
then:
For
Foreach
eachfirm's
firm'sresponse
responsetotobe
beaabest
bestresponse
responsetotothe
theother's
other'seach
eachfirm
firm
must
mustundercut
undercutthe
theother
otherasaslong
longasasP>
P>MC
MC

Chapter Thirteen

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Where
Wheredoes

doesthis
thisstop?
stop?PP==MC
MC(!)
(!)

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Equilibrium

1. Firms price at marginal cost

Key Points

2. Firms make zero profits

3. The number of firms is irrelevant to the price level as long as more than one firm is
present: two firms is enough to replicate the perfectly competitive outcome.

Copyright (c)2014 John Wiley & Sons, Inc.

Essentially, the assumption of no capacity constraints combined with a
constant average and marginal cost takes the place of free entry.

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Stackelberg Oligopoly

Stackelberg model of oligopoly is a situation in which one firm acts as a quantity leader, choosing its quantity first, with all
other firms acting as followers.

Call the first mover the “leader” and the second mover the “follower”.

The second firm is in the same situation as a Cournot firm: it takes the leader’s output as given and maximizes profits
accordingly, using its residual demand.

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The second firm’s behavior can, then, be summarized by a Cournot reaction function.

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Stackelberg Equilibrium vs. Cournot
q2
Profit for firm 1 at A…0
Profit for firm 1 at A…0
0

0

at C…1012.5
at C…1012.5

•

at Cournot Eq…900
at Cournot Eq…900

Former Cournot Equilibrium

•
C

•

Follower’s Cournot Reaction
B

Function

(q1= 90)

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•

q1
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A

at B…
at B…


Dominant Firm Markets
A single company with an overwhelming market share (a
dominant firm) competes against many small producers
(competitive fringe), each of whom has a small market
share.

Limit Pricing – a strategy 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

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fringe.

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