Econ Exam Chapter 9

Chapter 9 Notes  Conditions or Oligopoly o Oligopoly market structures are characterized by only a few firms, each of which is large relative to the total industry.  Typical number of firms is between 2 and 10.  Products can be identical or differentiated. o An oligopoly market composed of two firms is called a duopoly. o Oligopoly settings tend to be the most difficult to manage since managers must consider the likely impact of his or her decisions on the decisions of other firms in the market. Sweezy Oligopoly o Sweezy oligopoly characteristics:  There are few firms in the market serving many consumers.  The firms produce differentiated products.  Each firm believes its rivals will cut their prices in response to a price reduction but will not raise their prices in response to a price increase.  If you raise your price, then the other producers will do nothing. But if you lower your price, the other producers will reduce their price as well.  Barriers to entry exist.  - - Demand curve 2 has higher elasticity because the curve is flatter. If the rest of the market reacts to your price change then your demand curve is going to be less elastic You reduce your price to have more demand, you expect your demand to go up from Q0 to Q1, but your demand will not go up that much if other firms also reduce their prices If you increase your price, if your demand curve is D2, demand will go down a lot more then demand cure D1 because in demand curve D1 everyone in the market increased their prices so, people will not be motivated to go to a - The demand curve where the arrivals do not match your price changes if you raise your price but do match if you increase your price. Initially more elastic, and then it is more elastic. This is the demand curve for Sweezy demand. - If the marginal cost falls from MC0 to MC1. The normal belief is that is this happens then they firm can produce it cheaper and they charge the consumers a lower price, but this isn’t always the case. - Up to Po, the demand curve is D1, so the marginal revenue curve up to Qo is the marginal revenue curve for demand D1, after that the demand curve would be D2 and the marginal revenue curve would be MR2. The actual marginal revenue curve is ACEF. -     different manufacturer. If the rest of the market reacts t0 your price change as much as you do, then your demand curve is less elastic than if the rest of the market didn’t react to your price change - Profit maximizing point is Po and Quantity maximizing point if Qo. - If Marginal cost changes in between E and C there would be no change in equilibrium price and quantity. This is because from the fear that other firms are going to react to it. So they are never going to change their prices because of this fear. Implication o As MC decreases from MC0 to MC1, there is no change in optimal output or price. Cournot Oligopoly o Cournot oligopoly characteristics  There are few firms in the market serving many consumers.  The firms produce either differentiated or homogeneous products.  Each firm believes rivals will hold their output constant if it changes its output.  Barriers to entry exist. Cournot Oligopoly: Reaction Functions o Consider a Cournot duopoly. Each firm makes an output decision under the belief that is rival will hold its output constant when the other changes its output level.  Implication: Each firm’s marginal revenue is impacted by the other firms output decision. o The relationship between each firm’s profit-maximizing output level is called a best-response or reaction function. Cournot Oligopoly: Reaction Functions Formula o Given a linear (inverse) demand function  P=a− b ( Q1+Q 2 )  and cost functions, C 1 ( Q1 ) =c 1 Q1 C 2 ( Q2 ) =c 2 Q2  the reactions functions are: a−c 1 1  Q1=r 1 ( Q2 )= − Q2 2 2b a−c 2 −1  Q2=r 2 ( Q1 )= Q 2b 2 1 P = 50 – (q1 +q2) Q = q1 + q2 Mc1 = Mc2 = 0 Firm 1: TR1 = P*q1 = (50-q1-q2)*q1 = 50q1 - q1^2 – q1q2 MR1 = TR1/q1 = 50 - 2q1 - q2 MR1 = Mc1 50 – 2q1 – q2 = 0 q1 = 50 – q2 / 2 q1 = 25 – q2/2 -> Reaction Function of Firm 1 / Best Response of Firm 1 (BR1) Firm 2: BR2 -> q2 = 25 – q1/2 - In perfect competition, you are producing the maximum and charging the minimum. - Duopoly and Oligopoly stays in between perfect competition and monopoly, they provide us variety.    Cournot Oligopoly: Equilibrium o A situation in which neither firm has an incentive to change its output given the other firm’s output. Cournot Oligopoly: Collusion o Markets with only a few dominant firms can coordinate to restrict output to their benefit at the expense of consumers.  Restricted output leads to higher market prices. o Such acts by firms is known as collusion. o Collusion, however, is prone to cheating behavior.  Since both parties are aware of these incentives, reaching collusive agreements is often very difficult Stackelberg Oligopoly o Stackelberg oligopoly characteristics:  There are few firms serving many consumers.  Firms produce either differentiated or homogeneous products.  A single firm (the leader) chooses an output before all other firms choose their outputs.  All other firms (the followers) take as given the output of the leader and choose outputs that maximize profits given the leader’s output.    Barriers to entry exist.  Leader follower model, first-movers model, you decide how much you want to produce before the other firm.  Price should be less than price in Cournot and quantity should be more Stackelberg Oligopoly In Action: Problem o Suppose the inverse demand function for two firms in a homogeneous-product, Stackelberg oligopoly is given by  𝑃 = 50−(𝑄1+𝑄2)  𝑀𝐶1 = 𝑀C2 = 0 and their costs are zero. Firm 1 is the leader, and firm 2 is the follower.  What is firm 2’s reaction function?  What is firm 1’s output?  What is firm 2’s output?  What is the market price? Stackelberg Oligopoly In Action: Answer o The follower’s reaction function is: 𝑄2 = 𝑟2 (𝑄1) = 25−1/2 𝑄1. o The leader’s output is: 𝑄1 = 25. o The follower’s output is: 𝑄2 = 25−1/2 (25) = 12.5. o The market price is: 𝑃= 50−(25+12.5) = $12.5. Marginal Revenue of Firm 1 Q1 = how much the leader produces Q2 = how much they produce P = price = 12.5      Bertrand Oligopoly o Bertrand oligopoly characteristics  There are few firms in the market serving many consumers.  Firms produce identical products at a constant marginal cost.  Firms engage in price competition and react optimally to prices charged by competitors.  Consumers have perfect information and there are no transaction costs.  Barriers to entry exist.  Whoever charges the lowest price will gain the market, but then the other firm will react the same way  You end up charging the most competitive price, so this theory is the best for consumers Bertrand Oligopoly: Equilibrium o The conditions for a Bertrand oligopoly imply that firms in this market will undercut one another to capture the entire market leaving the rivals with no profit. All consumers will purchase at the low-price firm. o This “price war” would come to an end when the price each firm charged equaled marginal cost. o In equilibrium, 𝑃_1=𝑃_2=𝑀𝐶.  Socially efficient level of output.  Ensures competitive equilibrium when the price is equal to marginal cost and the quantity is as much as the competitive output Comparing Oligopoly Models o Consider the following inverse market demand function:  𝑃=1,000−(𝑄1+𝑄2) o and the cost function for each firm in this market is identical, and given by  𝐶𝑖 (𝑄𝑖) = 4𝑄𝑖 o Under these condition, the different oligopoly outputs, prices and profits are examined.  Marginal cost of both firms is M1 = M2 = 4 Comparing Oligopoly: Cournot o The Cournot oligopoly reaction functions are  𝑄1 = 498−0.5𝑄2  𝑄2 = 498−0.5𝑄1 o These reaction functions can be solved for the equilibrium output. These quantities can be used to compute price and profit.  𝑄1 = 𝑄2 = 332  𝑃 = $336  𝜋1 = 𝜋1 = $220,448 Comparing Oligopoly: Stackelberg o The Stackelberg leader’s output is 1,000+4−2× 4 o Qleader= =498 2 ×1 1 o Qfollower =498− × 498=249 2 o The market price is: P=1,000−498−249=$ 253 o π leader=$ 124,002 o π follower =$ 62,001     The leader produces more and the follower produces less, overall the price comes down and the total output is going up Comparing Oligopoly: Bertrand o Since P=MC , P=$ 4 . o Total output is found by: $ 4=1,000−Q o Solving yields: Q=996 o Given symmetric firms, each firm gets half the market, or 498 units. o π 1=π 2=$ 0  Extreme price competition, equilibrium becomes the perfect competitive equilibrium  Whenever there is more competition it always works in favor of the consumers Comparing Oligopoly: Collusion o Since the output associated with collusion is the same as monopoly output, the inverse market demand function implies that monopoly marginal revenue function is:  MR =1,000−2 Q o Setting marginal revenue equal to marginal cost yields: o 1,000−2Q=4  Solving this: Q=498 units. Each firm will produce half of these units. o Price is: P=1,000−498=$ 502 o Each firm earns profits of $ 124,002 .  Collusion is illegal in the US Contestable Markets o Contestable markets involve strategic interaction among existing firms and potential entrants into a market. o A market is contestable if:  All producers have access to the same technology.  Consumers respond quickly to price changes.  Existing firms cannot respond quickly to entry by lowering price.  There are no sunk costs. o If these conditions hold, incumbent firms have no market power over consumers. Chapter 9 Practice Problems 1) Ed just finished an empirical study of oligopoly. He found the following result: "In the examined industry, a firm's demand curve is such that other firms match price increases but do not match price reductions." What kind of oligopoly is the examined industry? D) None of the answers is correct. 2) The Bertrand model of oligopoly reveals that: C) perfectly competitive prices can arise in markets with only a few firms. 3) Both firms in a Cournot duopoly would enjoy higher profits if: D) the firms simultaneously reduced output below the Nash equilibrium level. 4) Which of the following is NOT a feature of Sweezy oligopoly? A) Each firm believes that rivals will cut their prices in response to a price reduction, but will not raise their prices in response to a price increase. B) Barriers to entry exist. C) The firms produce homogeneous products. D) There are few firms in the market serving many consumers. They can produce homogeneous or differentiated products 5) Firm A has a higher marginal cost than firm B. They compete in a homogeneous product Cournot duopoly. Which of the following results will NOT occur? B) Price A < Price B In Cournot there is only one price charged. 6) Two firms compete in a Stackelberg fashion. If firm 2 is the leader, then: C) firm 1 views the output of firm 2 as given. 7) Two identical firms compete as a Cournot duopoly. The demand they face is P = 100 − 2Q. The cost function for each firm is C(Q) = 4Q. The equilibrium output of each firm is: B) 16. 8) Two firms compete as a Stackelberg duopoly. The demand they face is P = 100 − 3Q. The cost function for each firm is C(Q) = 4Q. The profits of the two firms are: A) πL = $384; πF = $192. 9) From a consumer's point of view, which type of oligopoly is most desirable? A) Bertrand 10) Which of the following is true? A) If there are only two firms in a market, prices must be above marginal cost. B) Both if there are only two firms in a market, prices must be above marginal cost and if there is only one firm in a market, prices must be above marginal cost are correct. C) If there is only one firm in a market, prices must be above marginal cost. D) None of the answers is correct. If there are two firms then price can be AT marginal cost. If there is one firm you can still be charging marginal cost. Can be due to federal regulations, these would be called non-profit companies. 11) When firm 1 acts as a Stackelberg leader: A) Firm 1's profit is less than its profit if they compete in a Cournot fashion. B) Firm 2 produces the monopoly output. C) Firm 2 will earn more than if they compete in a Cournot fashion. D) None of the answers is correct. As the firms compete more and more, the consumers benefit more and more. Homework- Chapter 9 Question 1 1 / 1 pts A new firm enters a market which is initially serviced by a Bertrand duopoly charging a price of $20. What will the new price be should the three firms coexist after the entry? $20 Question 2 1 / 1 pts A market is NOT contestable if: there are sunk costs. Question 3 1 / 1 pts If firms compete in a Cournot fashion, then each firm views the: Correct! output of rivals as given. Question 4 1 / 1 pts With linear demand and constant marginal cost, a Stackelberg leader's profits are ________ the follower. greater than Question 5 1 / 1 pts The market demand in a Bertrand duopoly is P = 10 − 3Q, and the marginal costs are $1. Fixed costs are zero for both firms. Which of the following statement(s) is/are true? P = $1. Producer's surplus of firm 1 = producer's surplus of firm 2. Profits of firm 1 = profits of firm 2. All of the statements associated with this question are correct. Question 6 1 / 1 pts Two identical firms compete as a Cournot duopoly. The demand they face is P = 100 − 2Q. The cost function for each firm is C(Q) = 4Q. Each firm earns equilibrium profits of: $512. Question 7 1/ 1 pts In a Sweezy Oligopoly, a decrease in a firm's marginal cost generally leads to: You Answered reduced output and a higher price. higher output and a higher price. increased output and a lower price. None of the answers is correct. Question 8 1 / 1 pts Two firms compete as a Stackelberg duopoly. The demand they face is P = 100 − 3Q. The cost function for each firm is C(Q) = 4Q. The outputs of the two firms are: QL = 16; QF = 8. Question 9 1 / 1 pts The spirit of equating marginal cost with marginal revenue is NOT held by: oligopolistic firms. perfectly competitive firms. perfectly competitive firms and oligopolistic firms. None of the answers is correct. Question 10 1 / 1 pts Which of the following is NOT a type of market structure? Monopolistic oligopoly Question 11 1 / 1 pts Which firm would you expect to make the lowest profits, other things equal? Bertrand oligopolist Question 12 1 / 1 pts Firm 1 and firm 2 compete as a Cournot oligopoly. There is an increase in marginal cost for firm 1. Which of the following is NOT true? Both firm 1's and firm 2's reaction functions are shifted. Question 13 1 / 1 pts Two firms produce different goods. Firm 1 has a positive-sloped reaction function. This can be explained best by: heterogeneous product Bertrand oligopoly. Question 14 1 / 1 pts A duopoly in which both firms have a Lerner index of monopoly power equal to 0 is probably a: Bertrand oligopoly. Question 15 1 / 1 pts Which of the following are quantity-setting oligopoly models? Stackelberg and Cournot. Question 16 1 / 1 pts Both firms in a Cournot duopoly would experience lower profits if: there was an increase in marginal production costs. Question 17 1 / 1 pts Which of the following are price-setting oligopoly models?! Bertrand. Question 18 1 / 1 pts A new firm enters a market which is initially serviced by a Cournot duopoly charging a price of $20. What will the new market price be should the three firms coexist after the entry? Correct! Below $20 Question 19 1 / 1 pts Sue and Jane own two local gas stations. They have identical constant marginal costs, but earn zero economic profits. Sue and Jane constitute: a Bertrand oligopoly. Question 20 1 / 1 pts Which of the following is a profit-maximizing condition for a Cournot oligopolist?! MR = MC.