monopoly & oligopoly - stennek.sestennek.se/onewebmedia/3 - monopoly & oligopoly...

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Monopoly & Oligopoly

Johan Stennek

Monopoly

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Monopoly

•  Defini,on – Many “small” buyers (consumers, small firms) – No close subs,tutes – Barriers to entry

•  Firm can set price without thinking about

– Other firms –  Individual consumers

Barriers to entry •  Q: Examples of entry barriers?

•  Legal –  Patents to protect R&D: pharmaceu,cals (subs,tutes?) –  Copy rights: Books (subs,tutes?) –  Consump,on control: liquor –  Fiscal: gambling

•  Economies of scale / market size –  District hea,ng in ci,es –  Food retailing in rural areas –  Telecom networks

•  Exclusive access to essen,al resource –  Natural resource –  Exclusive distribu,on agreement

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Why study monopoly?

•  Prepara,on for studying compe,ng firms

•  S,ll some important monopolies – Pharmaceu,cals, district hea,ng, …

•  Policy evalua,ons – compe,,on policy: ban on exclusion + merger control – press subsidies – deregula,on

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Examples

•  Pharmaceu,cals

–  Huge costs for R&D –  Patents for 20 years => Monopoly

•  Striking stylized fact –  Prices for the same drug differ hugely between countries

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Examples

•  Lipitor

–  Reduces cholesterol – Manufacturer prices per dosage in 1998 (10 mg tablets)

•  US: $ 1.46 •  Sweden: $ 0.94

•  Losec –  Ulcer treatment – Manufacturer prices per dosage in 1998 (20 mg tablets)

•  US: $ 2.99 •  Sweden: $ 1.74

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Examples

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Examples

•  Ques,ons

– Why are prices for the same good different in different geographical markets?

– Why do prices differ from costs (= similar in all countries)?

–  Is this pagern good or bad?

The monopoly model

Monopoly model

•  Behavioral assump,on – Firm wants to maximize profits

•  Choice – Price – Quan,ty

•  Exogenous condi,ons – Demand func,on [P(q) or Q(p)] – Cost func,on [C(q)]

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Monopoly model

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Price

Quan,ty

Choice variables

Monopoly model

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Price

Quan,ty

Unit cost

Exogenous condi4ons

Monopoly model

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€

Quan,ty

Note: Demand constrains the monopolist Wants to charge p = 9, can only sell q = 1 Want to sell q = 8, can only charge p = 2

9

1 8

2

Monopoly model

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€

9

1 8

2 1

€

9

1 8

2 1

π = (9 – 1)*1 = 8 π = (2 – 1)*8 = 8

Very high margin: 8 = 9 – 1 Very low sales: 1 => low profit: 8

Very low margin: 1 = 2 – 1 Very high sales: 8 => low profit: 8

Monopoly model

•  Demand constrains the monopolists behavior – Trade-‐off between margin and sales – Need to strike a balance

•  Now let’s try to find this balance – Profit = Revenues -‐ Cost – Need to study how revenues depend on sales

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How do revenues depend on sales?

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Revenues

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10

10

p

q

9

1

Revenues

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10

10

p

q

9

1

q p

0 10

1 9

2 8

3 7

4 6

5 5

6 4

7 3

Revenues

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10

10

p

q

9

1

q p R=pq

0 10 0

1 9 9

2 8

3 7

4 6

5 5

6 4

7 3

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8

3 7

4 6

5 5

6 4

7 3

Marginal revenue: Change in revenues from selling one unit more

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 ?

3 7

4 6

5 5

6 4

7 3

8

2

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7

4 6

5 5

6 4

7 3

8

2

Exercise: P = 8, but MR = 7 < p Why?

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7

4 6

5 5

6 4

7 3

8

2

+8

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7

4 6

5 5

6 4

7 3

8

2

+8

-‐1

the “inframarginal” consumer now pays 8 wherefrom the marginal revenue decreases with one unit

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7 21 ?

4 6

5 5

6 4

7 3

8

2 3

7

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7 21 5

4 6

5 5

6 4

7 3

8

2 3

7

Exercise: P = 7, but MR = 5 < p Why?

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7 21 5

4 6

5 5

6 4

7 3

8

2

-‐2

+7

3

7

the inframarginal consumers now pay 7 and the marginal revenue decreases with 2 more units

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7 21 5

4 6 24 3

5 5

6 4

7 3

8

2

-‐3

+6

3

7

4

6

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7 21 5

4 6 24 3

5 5 25 1

6 4

7 3

8

2

-‐4

+5

3

7

4

6

5

5

Revenues

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10

10

p

q

9

1

q p R=pq MR

0 10 0 -‐

1 9 9 9

2 8 16 7

3 7 21 5

4 6 24 3

5 5 25 1

6 4

7 3

8

2

-‐4

+5

3

7

4

6

5

5

The more I sell, the more costly it is to lower price by €1 =>

MR is falling

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Quan,ty

Price

P(q)

Revenues

Revenues TR = P q( )q

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Quan,ty

Price

MR = P q( ) + P ' q( )qHow revenue varies with quan,ty

P(q)

Revenues


Price of addi,onal unit

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Quan,ty

Price


P(q)

Revenues



Reduc,on in price on all units

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Quan,ty

Price

Marginal revenue


P(q)

Revenues



Reduc,on in price on all units

Monopolist’s choice of quan,ty

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Quan,ty

Price

qm

pm

Marginal cost

Marginal revenue

Profit maximiza,on 1. p = P(q) 2. MR(q) = MC(q)

Monopoly Op,mal price/quan,ty

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Quan,ty

Price

qm

pm

Marginal cost

Marginal revenue

Note: Price > Marginal cost

Monopoly Op,mal price/quan,ty

Monopoly

•  Defini,on – A firm has market power if it can set a price above marginal cost, without losing all sales

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What determines price?

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What determines price? Exercise: Assume marginal cost increases from € 1 to € 2. What happens to price?

What determines price? Solu4on: Cost increase € 1 Monopolists wants to produce 50 units less Price increase € .5


•  Conclusion: Price is increasing in cost – Marginal cost (but not fixed cost) – Pass through = 1/2 (but only in linear case) –  In general: pass through 0 -‐ ∞

– By symmetry •  If cost reduced, firms reduce price •  but not necessarily by same amount

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•  Ques,ons – So, don’t fixed costs mager at all for prices?

•  Answer – Short term: No!

•  Only marginal cost. – Long run: Yes!

•  If average costs are not covered => exit => less compe,,on => higher prices

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What determines price? Exercise: Assume WTP falls by € 2. What happens to price?

What determines price? Solu4on: WTP falls by € 2 Price falls by € 1

What determines price? •  Conclusion: Price is (typically) increasing in demand – High demand ó high WTP

•  Pricing to market – WTP for pharmaceu,cals differ between different countries

–  Prices of pharmaceu,cals lower in Greece than in Sweden, despite “same” produc,on cost

–  3rd degree price discrimina,on

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•  Topics for discussion: – Under what condi,ons can firms charge different prices from different consumers based on WTP?

–  Is it a good or a bad thing that prices of pharmaceu,cals is lower in Greece than in Sweden?

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What determines price? •  Condi,ons for price discrimina,on:

–  Informa,on about WTP – No arbitrage (but internal market)

•  Are price differences good or bad? –  Bad: Inefficient distribu,on of given amount of goods

– Good: Otherwise firms may set high price, and not sell in poor countries

– Good/Bad: If firm must earn p > c to finance R&D, it may be fair that countries with low income pays less

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What determines price? Exercise: Assume demand elas,city falls? What happens to price?

What determines price? Solu4on: Price is increased!


•  Conclusion: Firms charge lower prices if consumers are price sensi,ve – Main discipline on monopoly pricing is that consumers are price sensi,ve

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Welfare & Efficiency

Welfare

•  Q: How much welfare is created in a market? – Firm owners?

•  = profit – Consumers? –  = consumer’s surplus (Q: def?) –  consumer’s surplus = WTP – p – Employees?

•  = no gain if w = cost of working (which is assumed)

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Monopoly Welfare

qm

pm

Profit

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Monopoly Welfare

qm

pm

Profit

Consumer surplus

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qm

pm

Profit

Consumer surplus

Total welfare in equilibrium -‐ Here: don’t care about distribu,on

Monopoly Welfare

Efficiency

•  Q: Is it possible to increase welfare in this market? – Q: Define Pareto efficiency

•  Alloca,on is in-‐efficient if it is possible to improve situa,on for one agent without making it worse for somebody else

– Q: Define Compensa,on principle •  Alloca,on is in-‐efficient if it can be changed in such a way that those who gain could compensate those who lose

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DWL

qm

pm

Profit

Consumer surplus

Welfare loss -‐  There are un-‐served customers, who are willing to pay more than cost

Efficiency

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DWL

qm

pm

Profit

Consumer surplus

Q: There is “money on the table” -‐ Why doesn’t the firm sell more?

Efficiency

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TR = P q( )qMR = P q( ) + P ' q( )q < P q( )

A: To sell one more unit, the monopolist has to lower price, not only on the last unit, but on all units

Efficiency

Quan,ty

Price

Marginal revenue P(q)

P q( )

P q( ) + P ' q( )q

Efficiency

•  Ques,on – What other inefficiencies may follow from monopoly?

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Efficiency

•  Inefficiencies – Dead weight loss –  Cost

•  Can pass on cost increases to consumers

–  Rent-‐seeking •  The monopoly profit is worth lobbying for

– Other •  Choice of quality •  Investment •  …

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Price sezng Same ques,on as before – slightly different analysis

Derive convenient formula

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Monopoly Price sezng

Profitπ p( ) = p − c( )D p( ) Here we use the demand func,on D(p)

not the indirect demand func,on P(q)

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Profitπ p( ) = p − c( )D p( )

First order conditionπ p p( ) = D p( ) + p − c( )Dp p( ) = 0

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Rewritep − cp

= −D p( )pDp p( )

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Rewritep − cp

= −D p( )pDp p( )

Elasticity of demand

η p( ) ≡pDp p( )D p( )

Market power (Lerner index)

L ≡ p − cp

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Rewritep − cp

= −D p( )pDp p( )

Interpretation

L = − 1η p( )

Monopolist’s market power determined by consumers’ price sensi,vity

Summary

Summary

•  Demand constrains the monopolists behavior –  Trade-‐off between margin and sales – Need to strike a balance

•  Monopolist’s choice – Quan,ty: MC = MR –  Price: Highest possible to sell this quan,ty; P > C

•  Price is determined by –  Cost – Demand (WTP; Price sensi,vity); (3rd degree p.d.)

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Summary

•  Welfare I – Welfare loss (too small quan,ty) – Reason: One more unit lowers price of all units

•  Welfare II – Price discrimina,on can be good or bad

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Oligopoly

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Oligopoly

•  Example: Zocord – Reduces cholesterol – Produced by Merck & Co

– Patent expired in April 2003 (in Sweden) – Other companies started to sell perfect copies

(= containing exactly the same ac,ve ingredient Simvasta,n)

Examples

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Price of Zocord in Sweden

Nominal price per daily dose (SEK)

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Oligopoly

•  Ques,on –  How does compe,,on work? –  How strong is it? How does that depend on the market?

•  Compare monopoly and duopoly –  Given market (technology, demand) –  Different number of firms –  Q: How does price depend on #firms?

A duopoly model (Bertrand)

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Duopoly

•  Timing

1.  Firms set prices simultaneously

2.  Consumers decide how much to buy and from whom

NB: Firms have no ,me to react!

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Duopoly

•  Technology –  Constant marginal cost –  Firms have same marginal cost

•  Demand – Market demand: Linear (example) –  Firms’ goods homogenous

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Duopoly

•  Consumer behavior

–  All buy from cheapest firm

–  If same price: 50-‐50 split

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Duopoly Residual demand

Market demand: D(p)

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Competitors price

Market demand: D(p)

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Competitors price

Market demand: D(p)

●

Residual demand: Di(p1,p2)

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Duopoly

Profits

π i p1, p2( ) = pi − c( )Di p1, p2( )

where

D1 p1, p2( ) =

D p1( ) p1 < p212D p1( ) if p1 = p2

0 p1 > p2

#

$

%%

&

%%

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Duopoly Game Theory

•  Inter-‐dependent decisions –  Firm 1’s op,mal price depends on firm 2’s price

–  Firm 2’s op,mal price depends on firm 1’s price

•  How to analyze –  Cannot simply assume profit maximizing behavior

–  Game theory

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Duopoly Game Theory

•  Game in normal form –  Q: Elements of a game in normal form?

•  Players, Strategies, Payoffs –  Players

•  Firm 1 and Firm 2

–  Strategies •  Each firm chooses a price pi (a real number) •  Recall: Strategy profile = A price for each player

–  Payoffs •  Profits •  Recall: Payoff func,on assigns a payoff for every possible strategy profile, πi(p1, p2)

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Duopoly Game Theory

•  Nash equilibrium – A strategy profile such that no player can increase its payoff given that all other players follow their strategies

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Duopoly Game Theory

•  Nash equilibrium in duopoly game

–  A pair of prices (p1, p2) such that

•  π1(p1, p2) ≥ π1(p’1, p2) for all p’1

•  π2(p1, p2) ≥ π2(p1, p’2) for all p’2

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Duopoly Intui,ve Analysis

qm

pm

qm /2

•  Q: Will the two firms charge pm?

–  Each would sell qm/2

–  Each would earn πm/2

•  What if a firm undercuts to pm – ε?

–  It would sell ≈ qm

–  It would earn ≈ πm

•  Conclusion

–  Small reduction in price è Massive expansion of sales

–  pm not reasonable prediction

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qm

pm

qm /2


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Q: What if both charge p = c? -‐  qi = q*/2 -‐  πi = 0

p=c

q* q*/2


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No unilateral change profitable? -‐Higher price → q = 0, π = 0 -‐ Lower price → q > 0, p < c, π < 0

p=c

q* q*/2


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•  If both firms charge p = c

– No incen,ve to change behavior

– Reasonable predic,on

– Nash equilibrium


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•  Two formal proofs

– For every possible outcome, inves,gate if someone has incen,ve to deviate

– Best reply analysis

Duopoly

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Duopoly

Candidate Profitable deviation

p1 > p2 > c who? what?

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Duopoly


p1 > p2 > c Firm i pi = pj – ε (max pm)

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Duopoly



p1 = p2 > c who? what?

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Duopoly



p1 = p2 > c Firm i pi = pj – ε (max pm)

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Duopoly




p1 > p2 = c who? what?

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Duopoly




p1 > p2 = c Firm 2 p2 = p1 – ε (max pm)

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Duopoly





p1 = p2 = c who? what?

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Duopoly





p1 = p2 = c - -

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Duopoly Best-‐reply analysis

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p2

p1

p2 = p1

c

c

pm

pm

Set of all strategy profiles

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p2

p1

p2 = p1

c

c

pm

pm

Q: Firm 2’s best reply func,on? A: Profit maximizing p2 for every possible p1

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p2

p1

p2 = p1

c

c

pm

pm

Q: Firm 2’s best reply func,on? A: Profit maximizing p2 for every possible p1

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p2

p1

p2 = p1

c

c

pm

pm

What if p1 > pm

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p2

p1

p2 = p1

c

c

pm

pm

Firm 2’s best reply

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p2

p1

p2 = p1

c

c

pm

pm


What if c < p1 ≤ pm

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p2

p1

p2 = p1

c

c

pm

pm


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p2

p1

p2 = p1

c

c

pm

pm


What if p1 = c

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p2

p1

p2 = p1

c

c

pm

pm


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p2

p1

p2 = p1

c

c

pm

pm


What if p1 < c

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p2

p1

p2 = p1

c

c

pm

pm


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p2

p1

p2 = p1

c

c

pm

pm


Selec,on

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Duopoly

p2

p1

p2 = p1

c

c

pm

pm


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Duopoly

p2

p1

p2 = p1

c

c

pm

pm



Nash equilibrium A (p1, p2) that lies on both best reply func,ons

What is price compe,,on? Compare monopoly and duopoly

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What is price compe,,on?

•  Predic,on – More firms è Lower prices

•  Is this predic,on true?

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•  Extreme predic,on (“Bertrand paradox”) –  2 firms => p = c & π = 0

•  Q: Reason for extreme predic,on? –  Reduce price one cent, get all customers

–  Always profitable to reduce price below compe,tor

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•  More o�en

– More firms: p > c & π > 0

–  Reason: Don’t get all customers

–  Examples: Product differen,a,on


•  Es,mated Lerner indexesmark-‐ups in automobiles •  Compe,,on does not eliminate all markups •  Pricing to market

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Model Belgium France Germany Italy UK

Fiat Uno 7.6 8.7 9.8 21.7 8.7

Ford Escort 8.5 9.5 8.9 8.9 11.5

Peugeot 9.9 13.4 10.2 9.9 11.6

Mercedes 14.3 14.4 17.2 15.6 12.3

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•  Theore,cally robust – Many other models of oligopoly give same qualita,ve predic,on

•  Empirically “confirmed” – Many empirical studies suggest that compe,,on leads to lower prices

124

Does Compe,,on Mager?

Consumer surplus

p=c

q*

DWL

qm

pm

Profit

Consumer surplus

Duopoly Monopoly

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Sources of market power 1.  Few firms & Entry barriers 2.  Product differen,a,on: horizontal & ver,cal

3.  Quan,ty compe,,on/Capacity constraints

4.  Cost advantage 5.  Uninformed customers

6.  Customer switching costs

7.  Price discrimina,on: informa,on & arbitrage

8.  Carteliza,on

Economic Methodology •  Economic model = An imaginary economy

–  Include key features for issues at hand –  Remove all complica,ons (eg compe,,on) –  Add features sequen,ally (eg compe,,on)

•  Pros –  Easy to see principles –  Can do experiments (eg What is the effect of compe,,on)

•  Cons –  Not the full picture –  Are conclusions true or ar,facts?

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