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Chapter 12

Imperfect Competition

Slide2The profit-maximizing output for the monopoly

2

If there are no other market entrants, the entrepreneur can earn monopoly profits that are equal to the area dcba.

Quantity

0

Price,

Cost

AC

MC

D

MR

c

a

b

d

Slide3Chapter Preview

Most markets fall in between perfect competition and monopoly.

An

oligopoly is a market with only a few firms, and their behavior is interdependent.There is no one oligopoly model. In general we want to consider:Short run: pricing and output decision of the firms.Long run: advertising, product development.Very long run: entry and exit.

Slide4Pricing of Homogeneous Products: An Overview

Price

Quantity per week

D

MR

MC = AC

Q

PCP

MPPC

Q

M

Perfect competition and the Bertrand model (firms choose prices).

Monopoly and the perfect cartel outcome.

Cournot outcome (firms choose output).

Slide5Pricing of Homogeneous Products: An Overview

So in an oligopoly there can be a variety of outcomes:

If the firms act as a cartel, get the monopoly solution.

If the firms choose prices simultaneously, get the competitive solution.If the firms choose output simultaneously get some outcome between perfect competition and monopoly.

Slide6Cournot Theory of Duopoly & Oligopoly

Cournot model

Two firms

Choose quantity simultaneouslyPrice - determined on the marketCournot equilibriumNash equilibrium

6

Slide7The demand curve facing firm 1

7

Quantity

0

Price, Cost

MC

MR

M

D

M

(q

1

)

A

D

1

(q

1

,q

2

)

A-bq

2

q

1

2

q

1

1

D

2

(q

1

,q

2

’)

A-bq

2

’

MR

1

MR

2

q

1

d

eclines as firm 2 enters the market and expands its output

q

M

P=A-b(q1+q2)

Slide8Profit Maximization in a duopoly market

Inverse demand function – linear

P=A-b(q1+q2)Maximize profits π1= [A-b(q1+q2)]·q1 - C(q1) π2= [A-b(q1+q2)]·q

2 - C(q2)

8

Slide9Reaction functions (best-response)

Profit maximization:

Set MR=MC

MR now depends on the output of the competing firm Setting MR1=MC1 gives a reaction function for firm 1Gives firm 1’s output as a function of firm 2’s output

Slide10Reaction functions (best-response)

10

Given firm 2’s choice of q

2

, firm 1’s optimal response is q

1=f1

(q2).

Output of firm 1 (q

1)

0

Output of firm 2 (q

2

)

q

1

=f

1(q2)

Slide11Reaction FunctionsPoints on reaction function

Optimal/profit-maximizing choice/output

Of one firm

To a possible output level – other firmReaction functions q1= f1(q2) q2 = f2(q1)

11

Slide12Reaction functions (best-response)

12

Given firm 1’s choice of q

1

, firm 2’s optimal response is q

2=f2

(q1).

Output of firm 1 (q

1)

0

Output of firm 2 (q

2

)

q

2

=f

2(q1)

Slide13Alternative Derivation -Reaction Functions

Isoprofit curves

Combination of

q1 and q2 that yield same profit Reaction function (firm 1)Different output levels – firm 2Tangency points – firm 1

13

Slide14Reaction Function

14

Output of firm 1 (q

1

)

0

Output of firm 2 (q

2

)

x

y

q’

2

q

2

q

1

q’

1

Firm 1’s Reaction Function

q

1

m

Slide15Deriving a Cournot Equilibrium

Cournot

equilibrium

Intersection of the two Reaction functionsSame graph

15

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