Between Competition and Monopoly, Part 2

9 Between Competition and Monopoly Part 2 ? The Kinked Demand Curve Model ● Resolve puzzle 3 –why do P in oligopolistic markets (cars or appliances) change less often than P of commodities (wheat or gold)? ● Firms think that other firms will match any P cut, but not any P increase. If true, firms face an inelastic D curve with P cuts and an elastic curve with P increases. ? The Kinked Demand Curve Model ● In Fig. 4, pt A is firm’s initial P = $8. ● 2 D curves pass through pt A. ♦ DD is more elastic → rivals’ P are fixed ♦ dd is less elastic → rivals match ∆P ● If firm ↓P to $7 (and rivals don’t match ↓P) → large ↑customers, so new Qd = 1,400. ● If rivals match ↓P → ↑Qd is small, so new Qd = 1,100. ● If firm ↑P (and rivals don’t match ↑P) → large ↓Qd. ? The Kinked Demand Curve Model ● The firm’s true demand curve in Fig. 4 is DAd –a kinked demand curve. ● P tend to “stick” to their original level because ↑P → lose many customers and ↓P → gain very few customers. ● Firm will only ∆P if costs change enormously. FIGURE 4. The Kinked Demand Curve Price d $8 7 D Typical oligopoly fears the worst. If firm cuts P then rivals will match P cut → relevant demand curve is dd. But if firm raises P then rival will not match the P increase → relevant demand curve is DD. Thus, the firm’s true demand curve is the red line “DAd.” A D (Competitors’ prices are fixed) (Competitors d respond to price changes) 0 1,000 1,100 Quantity per Year 1,400 ? ● ● ● ● The Kinked Demand Curve Model MR is associated with DD and mr is associated with dd. Overall marginal revenue curve is DBCmr. MC = MR at pt E which shows Π-max Q for oligopolist. Since relevant MR curve is kinked, even a moderate shift in MC will leave Q and thereby P unchanged. ● Oligopoly prices are “sticky” and do not respond to minor cost changes. FIGURE 5. The Kinked Demand Curve and Sticky Prices d MC Price D A $8 B D E MR C 1,000 Quantity Supplied per Year mr d The Game-Theory Approach ● Most widely used approach to analyze oligopoly behavior. ● Each oligopolist is seen as a competing player in a game of strategy. ● Optimal strategies are determined by examining a payoff matrix showing Π of each firm depending on P strategy that each firm follows. Games with Dominant Strategies ● Dominant strategy = one that gives the bigger payoff to the firm that selects it, no matter which of the two strategies the competitor selects. ♦ E.g., Table 1., both firms have an incentive to pick low P strategy regardless of what other firm does. If B picks high P, then A receives largest payoff choosing low P. Or if B picks low P, then A receives the largest payoff by choosing low P. ♦ “Low Price” is the dominant strategy for both firms, so both charge a low P and each earns $3m. TABLE 1. Payoff Matrix with Dominant Strategies Firm B Strategy High Price Low Price High Price A gets $10m B gets $10m A gets -$2m B gets $12m Low Price A gets $12m B gets -$2m A gets $3m B gets $3m Firm A Strategy Games with Dominant Strategies ● A market with a duopoly serves public interest better than a monopoly because of the competition created between two firms. ♦ Both firms would be better off if they could charge high P. But the presence of a competitor, forces each firm to protect itself by charging low P. ● It is damaging to the public to allow rival firms to collude on what prices to charge for their products. ♦ E.g., if two firms collude in Table 1, then we end up with high P and each earning $10m. Games without Dominant Strategies ● Maximin = select the strategy that yields the max payoff assuming your rival does as much damage to you as he can. ● In Table 2, A’s maximin strategy is to pick low P and earn $5m. ♦ Firm A thinks: if I chose a high P → worst outcome is B picks a low P and I get $3m. If I chose a low P → worst outcome is B picks a low P and I get $5m. ♦ Firm A picks the strategy that offers the best of those bad outcomes. TABLE 2. A Payoff Matrix without a Dominant Strategy Firm B Strategy Firm A Strategy High Price Low Price High Price A gets $10m A gets $3m Low Price A gets $8m A gets $5m Repeated Games ● Repeated games give players the opportunity to learn something about each other’s behavior patterns and, perhaps, to arrive at mutually beneficial arrangements. ● Table 1 shows a single round of the game. Each firm picked low P. But if games are repeated, players can escape this trap. ♦ E.g., Firm A could cultivate a reputation of “tit for tat.” Each time B charges a high P → A would charge a high P. After a few repetitions, B learns that A always matches its P decisions. So B will see that it’s better to stick with a high P. Threats and Credibility ● Use threats to induce rivals to change their behavior. ♦ E.g., retailer could threaten to double Q and ↓P to $0 if a rival imitates its product. But this is not credible, because it hurts the retailer who is making the threat. ● A credible threat is a threat that does not harm the threatener if it is carried out. ● Old firms often use credible threats to prevent new firms from entering the industry. ♦ E.g., old firm will build a larger factory than it would otherwise want. Large factory lowers cost of ↑Q –even at low P. FIGURE 6. Entry and Entry-Blocking Strategy Possible Choices of Old Firm Possible Reactions of New Firm Profits (millions $) Old Firm New Firm –2 –2 4 0 2 2 6 0 Threats and Credibility ● In Fig. 6, best outcome for old firm is to have a small factory and no rivals. ♦ But if old firm builds a small factory, it can count on new firm entering to earn $2m. So old firm’s ↓Π to $2m. ● If old firm builds a big factory, its ↑Q will ↓P and ↓Π. Old firm now earns $4m if new firm stays out. ♦ Clearly, new firm will stay out to avoid loses of $2m. ● Thus, old firm should build big factory to keep rivals out. Monopolistic Competition, Oligopoly, & Public Welfare ● Oligopolistic behavior is so varied that it is hard to come to a simple conclusion about welfare implications. ● In many circumstances, the behavior of monopolistic competitors and oligopolists falls short of the social optimum. ● Excess capacity theorem suggests monopolistic competition can lead to inefficiently high production costs. ● Oligopolists may organize into successful cartels to ↓Q and ↑P. Monopolistic Competition, Oligopoly, & Public Welfare ● When an oligopolistic market is perfectly contestable –if firms can enter and exit without losing $ they invested –then (P,Q) of firms is likely to be socially efficient. ♦ ● E.g., airplanes, trucks, and barges can easily be moved. Constant threat of entry forces oligopolists to keep their prices down and their costs low. Comparing the Four Market Forms ● Perfect competition and pure monopoly are rare. ● Most firms are monopolistically competitive, but oligopoly firms account for largest share of economy’s output. ● Π = 0 in LR under perfect competition and monopolistic competition because of free entry and exit. ♦ Thus, P = AC in LR under these 2 market forms. ● Π-max firm under any market form selects Q by setting MR = MC. ♦ However, oligopolists may not set MC = MR when choosing Q –e.g., if firm max sales. Comparing the Four Market Forms ● Perfectly competitive firm and industry ⇒ efficient allocation of resources. ● Monopoly ⇒ inefficient allocation of resources by ↓Q and ↑P. ● Monopolistic competition ⇒ inefficient allocation of resources through excess capacity. ● Under oligopoly, almost anything can happen, ⇒ impossible to generalize about its vices or virtues. TABLE 3. Attributes of the Four Market Forms