Market Power. Economics II: Microeconomics. December Aslanyan (VŠE) Oligopoly 12/09 1 / 39

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1 Market Power Economics II: Microeconomics VŠE Praha December 2009 Aslanyan (VŠE) Oligopoly 12/09 1 / 39

2 Microeconomics Consumers: Firms: People. Households. Monopoly. Oligopoly Now Perfect Competition. Equilibrium: Holds. Does not hold. Aslanyan (VŠE) Oligopoly 12/09 2 / 39

3 Monopoly Revision Inverse Demand function: p = D (q) e.g. linear: p = A bq Optimal production max π. MR = MC. Can it sustain perpetually? Aslanyan (VŠE) Oligopoly 12/09 3 / 39

4 De nition De nition Oligopoly is a market characterised with more than one producer where their individual decision on production has a non-negligible e ect on the price of the good. De nition Duopoly is a version of Oligopoly with only two producers. Aslanyan (VŠE) Oligopoly 12/09 4 / 39

5 Cournot Model Simultaneously choosing the quantity to produce. Aslanyan (VŠE) Oligopoly 12/09 5 / 39

6 Cournot Model Simultaneously choosing the quantity to produce. Acknowledging the existence of the other producer. Aslanyan (VŠE) Oligopoly 12/09 5 / 39

7 Cournot Model Simultaneously choosing the quantity to produce. Acknowledging the existence of the other producer. In equilibrium neither rm has incentive to change its output decision (Nash equilibrium). Aslanyan (VŠE) Oligopoly 12/09 5 / 39

8 Cournot Model: Best-response Demand: p = A b (q 1 + q 2 ) Problem Given rm 2 s decision rm 1 should choose an output level that maximises its pro t subject to the market demand. Aslanyan (VŠE) Oligopoly 12/09 6 / 39

9 Cournot Model: Best-response Demand: p = A b (q 1 + q 2 ) Cournot conjecture: invariable q 2 Problem Given rm 2 s decision rm 1 should choose an output level that maximises its pro t subject to the market demand. Aslanyan (VŠE) Oligopoly 12/09 6 / 39

10 Cournot Model: Best-response Demand: p = A b (q 1 + q 2 ) Cournot conjecture: invariable q 2 Residual demand: p = (A q 2 ) bq 1 Problem Given rm 2 s decision rm 1 should choose an output level that maximises its pro t subject to the market demand. Aslanyan (VŠE) Oligopoly 12/09 6 / 39

11 Cournot Model: Best-response Demand: p = A b (q 1 + q 2 ) Cournot conjecture: invariable q 2 Residual demand: p = (A q 2 ) bq 1 Pro t: π 1 = (A b (q 1 + q 2 )) q 1 C (q 1 ). Problem Given rm 2 s decision rm 1 should choose an output level that maximises its pro t subject to the market demand. Aslanyan (VŠE) Oligopoly 12/09 6 / 39

12 Cournot Model: Best-response Demand: p = A b (q 1 + q 2 ) Cournot conjecture: invariable q 2 Residual demand: p = (A q 2 ) bq 1 Pro t: π 1 = (A b (q 1 + q 2 )) q 1 C (q 1 ). Optimum: MR = MC Problem Given rm 2 s decision rm 1 should choose an output level that maximises its pro t subject to the market demand. Aslanyan (VŠE) Oligopoly 12/09 6 / 39

13 Cournot Model: Best-response Demand: p = A b (q 1 + q 2 ) Cournot conjecture: invariable q 2 Residual demand: p = (A b q 2 ) bq 1 Pro t: π 1 = (A b (q 1 + q 2 )) q 1 C (q 1 ). Optimum: MR = MC Aslanyan (VŠE) Oligopoly 12/09 7 / 39

14 Cournot Model: Best-response Reaction (Best Response) Function Problem Optimise: max π 1 = ((A bq 2 ) bq 1 ) q 1 C (q 1 ) Solution BR function: q 1 = f 1 (q 2 ) Aslanyan (VŠE) Oligopoly 12/09 8 / 39

15 Cournot Model: Best-response in Normal Form π 1 = p (q 1 + q 2 ) q 1 C (q 1 ) a i, b i, c i, d i π 1 ( q 2 ) Normal Form x x x x a 1 b 1 c 1 d 1 x x x x a 2 b 2 c 2 d 2 x x x x a 3 b 3 c 3 d 3 x x x x a 4 b 4 c 4 d 4 Aslanyan (VŠE) Oligopoly 12/09 9 / 39

16 Cournot Model: Best-response in Normal Form π 1 = p (q 1 + q 2 ) q 1 C (q 1 ) a i, b i, c i, d i π 1 ( q 2,i ) x x x x a 1 π 1 (q 2,1) c 1 d 1 x x x x π 1 (q 2,2) b 2 c 2 d 2 x x x x a 3 b 3 c 3 π 1 (q 2,3) x x x x a 4 b 4 π 1 (q 2,4) d 4 π 1 (q 2,i ) = max fa i, b i, c i, d i g Aslanyan (VŠE) Oligopoly 12/09 10 / 39

17 Cournot Model: Cournot (Nash) Equilibrium in Normal Form π 1 = p (q 1 + q 2 ) q 1 C (q 1 ) π 2 = p (q 1 + q 2 ) q 2 C (q 2 ) (v, x) (π 1 (q 2,1), x) (v,π 2 (q 1,3)) (v, x) (π 1 (q 2,2), x) (v,π 2 (q 1,2)) (v, x) (v, x) (v, x) (v, x) (v, x) (π 1 (q 2,3), π 2 (q 1,4)) (v,π 2 (q 1,1)) (v, x) (π 1 (q 2,4), x) (v, x) π 1 (q 2,i ) = max fπ 1 (q 2,i )g π 2 (q 1,i ) = max fπ 2 (q 1,i )g Aslanyan (VŠE) Oligopoly 12/09 11 / 39

18 Cournot Model: Cournot Equilibrium Graphical interpretetion Convergence of the Cournot equilibrium Aslanyan (VŠE) Oligopoly 12/09 12 / 39

19 Cournot Model: Cournot Equilibrium Graphical interpretetion Convergence of the Cournot equilibrium Does it always converge? Aslanyan (VŠE) Oligopoly 12/09 12 / 39

20 Cournot Model: Unstable Cournot Equilibrium Aslanyan (VŠE) Oligopoly 12/09 13 / 39

21 The Big Assumption of Cournot Model Firms Treat the Rivals as Equals. Aslanyan (VŠE) Oligopoly 12/09 14 / 39

22 The Big Assumption of Cournot Model: Firms treat the rivals as equals. Aslanyan (VŠE) Oligopoly 12/09 15 / 39

23 The Big Assumption of Cournot Model: Firms treat the rivals as equals. Aslanyan (VŠE) Oligopoly 12/09 16 / 39

24 The Big Assumption of Cournot Model: Firms treat the rivals as equals. Aslanyan (VŠE) Oligopoly 12/09 17 / 39

25 The Big Assumption of Cournot Model: Firms treat the rivals as equals. What is Next? Aslanyan (VŠE) Oligopoly 12/09 18 / 39

26 Do rms treat the rivals as equals? Aslanyan (VŠE) Oligopoly 12/09 19 / 39

27 Stackelberg Duopoly: An Asymmetric Model De nition Stackelberg leader decides on the production quantity acknowledging the existence of the second producer in the market. De nition Stackelberg follower decides on the production quantity after observing what the leader rm has done. Aslanyan (VŠE) Oligopoly 12/09 20 / 39

28 Stackelberg Model De nition Cournot Model is a simultaneous-move quantity-setting oligopoly (duopoly) game. De nition Stackelberg Model is a sequential-move quantity-setting oligopoly (duopoly) game. Aslanyan (VŠE) Oligopoly 12/09 21 / 39

29 Stackelberg Model: The Algebra Example (Cournot) Problem (Firm 1) max π 1 = (A b (q 1 + q 2 )) q 1 C (q 1 ) solution: q 1 = f 1 (q 2 ) Problem (Firm 2) max π 2 = (A b (q 1 + q 2 )) q 2 C (q 2 ) solution: q 2 = f 2 (q 1 ) Demand: p = A bq Example (Stackelberg) Problem (Firm 2: Follower) max π 2 = (A b (q 1 + q 2)) q 2 C (q 2 ) solution: q 2 = f 2 (q 1 ) Problem (Firm 1: Leader) max π 1 = (A b (q 1 + f (q 1 ))) q 1 C (q 1 ) solution: q 1 Aslanyan (VŠE) Oligopoly 12/09 22 / 39

30 Stackelberg Model: The Algebra Example (Stackelberg) Problem (Firm 2: Follower) max π 2 = (A b (q 1 + q 2)) q 2 C (q 2 ) solution: q 2 = f 2 (q 1 ) Problem (Firm 1: Leader) max π 1 = (A b (q 1 + f (q 1 ))) q 1 C (q 1 ) First-mover advantage solution: q 1 Demand: p = A bq Aslanyan (VŠE) Oligopoly 12/09 23 / 39

31 Cournot and Stackelberg Questions and Comments! Aslanyan (VŠE) Oligopoly 12/09 24 / 39

32 Price competition De nition Bertrand model of price competition for oligopolies is a simultaneous-move price-setting market-sharing game. Aslanyan (VŠE) Oligopoly 12/09 25 / 39

33 Bertrand Model: The demand The producer on the market faces the following demand function: 8 < D (p i ) if p i < p j 1 D i (p i, p j ) = : 2 D (p i ) if p i = p j 0 if p i > p j Aslanyan (VŠE) Oligopoly 12/09 26 / 39

34 Bertrand Model: The Equilibrium De nition Bertrand (Nash) equilibrium is a pair of prices that, once set, are such that neither rm has any incentive to change its price given the price of its opponent. Lemma In case of Bertrand equilibrium the prices are equal to the marginal cost. Proof. If p j > c, p i = p j ε > c will capture all the market. Aslanyan (VŠE) Oligopoly 12/09 27 / 39

35 Model of Collusion: Cartels Fact In order to make extra-normal (half monopoly level) pro t, the producers may collude on price. Example Honour Agreement Cheat Honour Agreement Cheat Simultaneous game Sequential game Aslanyan (VŠE) Oligopoly 12/09 28 / 39

36 The Edgeworth Model Problem Assume Bertrand price-competition while neither of the rms can satisfy the market demand alone (they are capacity-constrained) Fact Game de ned by the Edgeworth model does not have an equilibrium: Prices cycle endlessly and never settle at any particular level. Industry will go through periods when prices fall ("price wars") and periods when prices rise (if prices reach marginal cost, they always move back to a higher level). Aslanyan (VŠE) Oligopoly 12/09 29 / 39

37 Thank you! Aslanyan (VŠE) Oligopoly 12/09 30 / 39

38 Microeconomics Consumers: Firms: People. Households. Market Power Now Monopoly. Oligopoly Perfect Competition Internal organisation Equilibrium: Holds. Does not hold. Aslanyan (VŠE) Oligopoly 12/09 31 / 39

39 Firm s problem Revision Optimal production max π π = R C MR = MC Aslanyan (VŠE) Oligopoly 12/09 32 / 39

40 Firm s problem Revision Revenue: R = p(q) q Marginal revenue: MR = p Q q + q q p MR = p 1 + p Q Q p s MR = p 1 jεj p = MR 1 q Q s jεj Pricing: p = MC s 1 jεj Aslanyan (VŠE) Oligopoly 12/09 33 / 39

41 Firm s problem Pricing Markup Pricing: Monopoly: Oligopoly (Cournot): p = MC 1 s jεj s = 1 : p = MC 1 1 jεj s = q/q : p = MC 1 s jεj Competition: s = 0 : p = MC Aslanyan (VŠE) Oligopoly 12/09 34 / 39

42 Market power Lerner Index De nition Lerner Index, = p MC, p is a measure of market power: the rm s ability to raise price above marginal cost. Lemma Lerner Index: Monopoly: = 1 jεj Oligopoly: = s jεj Competitive rm: = 0 Aslanyan (VŠE) Oligopoly 12/09 35 / 39

43 Market Organisation Competitive rm De nition An industry consisting of many rms, each if which has an insubstantial share if the market, constitutes a perfectly competitive market. Characteristics: Aslanyan (VŠE) Oligopoly 12/09 36 / 39

44 Market Organisation Competitive rm De nition An industry consisting of many rms, each if which has an insubstantial share if the market, constitutes a perfectly competitive market. Characteristics: The rms are price-takers Aslanyan (VŠE) Oligopoly 12/09 36 / 39

45 Market Organisation Competitive rm De nition An industry consisting of many rms, each if which has an insubstantial share if the market, constitutes a perfectly competitive market. Characteristics: The rms are price-takers No barriers for entry Aslanyan (VŠE) Oligopoly 12/09 36 / 39

46 Market Organisation Competitive rm De nition An industry consisting of many rms, each if which has an insubstantial share if the market, constitutes a perfectly competitive market. Characteristics: The rms are price-takers No barriers for entry Homogeneous product Aslanyan (VŠE) Oligopoly 12/09 36 / 39

47 Market Organisation Competitive rm De nition An industry consisting of many rms, each if which has an insubstantial share if the market, constitutes a perfectly competitive market. Characteristics: The rms are price-takers No barriers for entry Homogeneous product Perfect factor mobility Aslanyan (VŠE) Oligopoly 12/09 36 / 39

48 Market Organisation Competitive rm De nition An industry consisting of many rms, each if which has an insubstantial share if the market, constitutes a perfectly competitive market. Characteristics: The rms are price-takers No barriers for entry Homogeneous product Perfect factor mobility Perfect information Aslanyan (VŠE) Oligopoly 12/09 36 / 39

49 Competitive Firm Supply Lemma (Output Rule 1) Produce when the price is above the average variable cost: p > AVC Proof. Follows from the shutdown condition: FC > pq VC FC Lemma (Output rule 2) Produce at a level where the price is equal to the marginal cost: p = MC Proof. Follows from the zero marginal pro t condition: π 0 = 0 Aslanyan (VŠE) Oligopoly 12/09 37 / 39

50 Competitive rm Short-Run Equilibrium for a Competitve Industry De nition A price-quantity combination constitutes a short-run equilibrium for a competitive market if it is such that: 1 no individual rm wishes to change the amount of own supply 2 no individual consumer wishes to change the amount demanded 3 the excess demand is zero in the market. Aslanyan (VŠE) Oligopoly 12/09 38 / 39

51 Competitive rm Short-Run Pro t and Zero Long-Run Pro t Fact In the short-run equilibrium some rms may make (extra-normal, non-zero) pro t due to short-run constraints. Fact In the long-run due to free entry and exit: 1 rm leaves the market if LR pro t is negative, π < 0 2 rm enters the market if LR pro t is positive, π > 0 Fact All rms in the market operating at minimum LR average cost. Aslanyan (VŠE) Oligopoly 12/09 39 / 39