CHAPTER 11 (midterm 2) Flashcards
What are some assumptions that we relax in order to examine markets in a more realistic manner?
- allow for varying degrees of competition
- allow for differentiated products
- allow for strategic behaviour
What are the 2 different kinds of markets in imperfect competition that we talk about?
Oligopoly:
- few firms
- identical or differentiated products
- competitors are known
- allow strategic behaviour
Monopolistic Competition:
- many firms with differentiated goods
Explain how equilibrium in an oligopoly differs to equilibrium perfect competition / monopoly
Under PC and monopoly, short-run equilibrium is a price-quantity combination that results in a stabilized market clearing > there is no incentive for firms to behave any differently
More complicated in oligopoly:
- each company’s actions influence what the other companies want to do
- equilibrium occurs when each firm is doing their best given what other firms are doing - as long as other firms don’t change then they have no incentive to change themselves (Nash Equilibrium)> in order to determine this, we must determine more than just a price and quantity for the industry as a whole
Define Nash equilibrium
It is an equilibrium (oligopoly equilibrium) in which each firm is doing its best, conditional on the actions taken by other firms
> each firm knows every combination of actions and outcomes and in the equilibrium state, neither firm has an incentive to change their decision given what the other firm is doing
*this doesn’t necessarily mean that this state is the most profitable for either firm, but the key is that it is STABLE
(look over marvel and DC example)
What is Collusion?
It is economic behaviour in which all the firms in an oligopoly coordinate their production and pricing decisions to collectively act as a monopoly (form a cartel) to gain monopoly profits to be split among themselves
What are the 3 assumptions we make for a Collusion and Cartel model?
- Firms make identical products
- Industry firms agree to coordinate their quantity and pricing decisions
- No firm deviates from the agreement, even if breaking it is in the firm’s best interest
What is the main idea from the prisoner dilemma?
People’s fear of being exploited can prevent them from reaching their most beneficial outcome
Explain the problem / instability of Collusion and Cartels
The problem is that this strategy is based on *cooperation
> if firms join forces and cooperate they can act like a monopoly and earn higher profit
BUT, keeping everyone in a cartel happy is not so easy > each firm has an incentive to cheat = inherent instability
If two firms are in a cartel, what can one firm do to cheat on the agreement and make more profits?
If one firm decides to increase their individual output, then the total profits will fall, BUT their own firm’s will rise
> increased output lowers the price, so the total profit and other faithful firm’s profit will fall since they’re producing the same amt of output as before with a lower price
*the cheating firm has decided to move away from Nash equilibrium and choose the more unstable outcomes that is more beneficial for them
*if a firm cheats like this, the cartel collapses
*this incentive to cheat makes it difficult to maintain collusive agreements
How does the instability of collusion and cartels change with more or less firms in the cartel?
Increasing the number of firms in the cartel makes holding to the agreed production level more difficult > it’s harder to organize and increases the likelihood of cheating because it would be harder to catch
BUT
having more firms in a cartel reduces the damages suffered by any one firm that abides by the agreement because profit losses are spread out across more firms
- because every firm in a cartel has an incentive to cheat, this makes it very difficult to persuade any firm to collude in the first place
What are 3 things that make collusion easier/more sustainable?
- Making it easy to detect and punish cheaters
- Little variation in marginal costs across producers > since the goal is to produce at lowest cost, it is difficult to share profits if production costs vary greatly across cartel members
- Long time horizon makes defection more costly, as future monopoly profits are given more weight (while if firms are more worried about the short-term, they’re more likely to cheat for short-term benefits)
What is Bertrand competition? How does Q get split between firms depending on prices?
The Bertrand competition model is an oligopoly in which each firm chooses the price of its product > strategic interaction ensues, with each firm responding to its rivals’ price decision
*firms compete by setting prices (differs from collusion, where firms focus on their output decision)
> if P of firm1 is less than P of firm2, firm1 takes the total Q in the market
> if P firm1 is bigger than P firm2, firm1’s Q is 0
> if P is equal across both firms, total Q is split evenly between firms
*this means the only way to sell anything is to match or beat the price of your competitor
What are the 4 model assumptions in Bertrand Competition with Identical Goods?
- The market has only a small # of firms
- Firms make identical products and have identical marginal costs
- Firms compete by choosing the price at which they sell their products
- Firms set their prices simultaneously
What is Nash equilibrium in a Bertrand oligopoly?
- Nash equilibrium occurs when each firm charges the marginal cost of production ***(P = MC)
- with identical firms and products, if one firm charges more than its marginal cost, the other firm always has an incentive to undercut
- SO, even though competition is imperfect, in Bertrand competition, market equilibrium is identical to PC, and P = MC
Define Cournot competition - often the case for what kind of makrets?
Cournot competition is an oligopoly model in which each firm chooses its production quantity rather than price
> often the case for producers in larger markets (ex. commodities) who have to set production because capacity constraints might keep each firm from losing all of its customers
What are the 5 model assumptions in Cournot competition?
- The market has only a small number of firms
- Firms make identical products
- Firms compete by choosing a quantity to produce
- All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market
- Firms choose quantities simultaneously
What does profit depend on in a Cournot Model?
Each firm’s profit depends on the actions (quantity decision) of the other firm
profit1 = q1 (P-c)
profit 2 = q2 (P-c)
*but since Price depends on the quantity decisions of each firm, that mean’s that there is an INTERDEPENDENCE in each firm’s profit
In Cournot competition, if there are 2 firms (A,B), and inverse demand is: P=200 - 3Q, what is the rewritten demand to include both firms?
What would firm A’s MR equation be?
P = 200 - 3q(A) - 3q(B)
MR(A) = 200 - 6q(A) - 3q(B)
*the other firm’s quantity stays as a constant because it is given simultaneously as firm A’s output decision
In Cournot Oligopoly, how do you find each firm’s profit-maximizing output equation? What is the other way to describe/name for their profit-maximizing output equations?
- You find each firm’s MR equation from the inverse demand (each should be slightly different - their own q-function should just have the doubled slope)
- make their MR equation = MC > then you will have a profit-maximizing output that has the other firm’s quantity left as a variable to substitute in
*each firm’s profit-maximizing output equations are their own firm’s best output/response functions **called their REACTION CURVE
In Cournot competition, how do you find firm A’s actual quantity produced?
You use firm A’s reaction curve and take the firm B’s reaction curve to substitute it in for firm B’S unknown quantity variable –> then you will only have firm A’s unknown variable so you can solve for it
> once you have firm A’s quantity you know that firm B produces the same amount if they have identical production costs
How would price, production, and profit differ from Cournot to Collusion and Cournot to Bertrand?
Cournot to Collusion/acting like monopoly:
- production amount is less under collusion
- price is higher under collusion
- total profit is higher under collusion
Cournot to Bertrand/acting like PC:
- production amount is higher under Bertrand
- price is lower under Bertrand
- there is less (NO) profit under Bertrand
Which imperfect industries (Cournot, Collusion, Betrand) yield the highest and lowest Output, Market price, and Profit?
Output:
Qcollusion < Qcournot < Qb
Price:
Pb <Pcournot < Pcollusion
Profit:
Pb=0 < Pcournot < Pcollusion
*Collusion looks just like monopoly, Bertrand looks just like PC (lowest price any firm could charge), and Cournot is somewhere in-between
How do outcomes change in Cournot oligopoly when the # of firms increases?
As the # of firms increases, market outcomes will still fall between the monopoly and perfectly competitive cases, but the outcome will approach the perfectly competitive case
> more competitors = higher output, lower price, and lower profit
Define Stackelberg competition
It is an oligopoly model in which firms make production output decisions sequentially (same as Cournot except one firm makes their output choice after the other > timing is different here)
What are the 5 model assumptions for Stackelberg Competition with Identical Goods?
- The market has only a small number of firms
- Firms make identical products
- Firms compete by choosing a quantity to produce
- All goods sell for the market price, which is determined by the sum of quantities produced by all firms in the market
- Firms choose quantities sequentially > one firm chooses quantity first, the next firm observes and then chooses theirs next
What could happen if one firm in Stackelberg competition observes the other producing more than the reaction function Cournot output?
They could punish their competitor by changing its own production
Explain each firm’s reaction curves’ slope and what does this mean for their output decisions in Cournot and in Stackelberg
Since the reaction curves are downward-sloping, the best response to the first mover is to reduce output from the Cournot equilibrium level
> the Cournot logic is that both firms are satisfied and their reaction functions are equal
> in Stackelberg, if one firm chooses their q first, the next firm’s best response will be to have a lower output because the total q is going to impact the price which therefore will impact the profit they make (basically they’re kind of trapped and at the mercy of the other firm because their reaction function remains the same no matter what)
Who has the advantage in Stackelberg competition?
There is a first-mover advantage > the first mover (initial firm to set their production quantity) has the ability to manipulate its competitor’s output instead of just having to respond and reduce their quantity
In Stackelberg Competition, how does the first-mover decide on their own optimal output?
- they find the other firm’s reaction curve
- they substitute that curve into the inverse demand curve
- solve for MR = MC to find their quantity
- then plug their own quantity into the other firm’s reaction function to find the other firm’s quantity
How do production outcomes, profit, and price change from Cournot to Stackelberg?
Cournot - both firms will produce an equal amount and split profits equally (price is higher)
Stackelberg - the first mover will capture more of the production amount and therefore more of the profits, but total industry profit will be lower, and price will be lower because of the increased quantity produced
What is the first mathematical step for either Cournot or Stackelberg oligopoly?
Find each firms best response function/reaction curves
What describes a monopolistic competition (what is different compared to oligopoly and PC)
Monopolistic competition is a market structure that has many firms selling a differentiated product and with no barriers to entry (still imperfect competition)
> key difference from PC is that they are selling a differentiated product
> difference from oligopoly is that there are many firms instead of a few, just differentiated product instead of identical or differentiated, and there are no barriers to entry instead of some
What are the 3 model assumptions in monopolistic competition?
- Industry firms sell differentiated products that consumers do not view as perfect substitutes
- Other firms’ choices affect a firm’s residual demand curve, but the firm ignores any strategic interactions between its own quantity or price choice and that of its competitors
> it will just focus on deciding its own profit-maximizing output - the market allows free entry and exit
What will equilibrium in a monopolistically competitive market look like in the short-run?
Very short-run > assuming one firm who will act like a monopoly > set MR = MC and find corresponding price on demand curve = profit-maximized output = lots of economic profit
How does equilibrium in a monopolistically competitive market change in the long-run? (effects on the demand curve for an individual firm)
*free entry + exit so new firms will enter the market in the longer-run
- Demand curve will become flatter (more elastic) because more firms offer imperfect substitutes
- Demand curve shifts inwards because the demanded output is split between more firms (new q is still set at MR = MC)
*no strategic response to behaviour of rival firms - Entry will continue to occur until economic profit is equal to 0
* this doesn’t mean price will equal marginal cost though
* *different to PC because the price will not hit at the absolute lowest ATC point - they still have some pricing power so they can set Price > Marginal Cost > this creates some inefficiency compared to PC
(whereas in PC, the horizontal demand curve indicates no pricing power at all)
* the firms will always face a downward-sloping demand curve so entry will occur until demand is tangent to the ATC curve, when economic profits are 0 (because there is no longer a gap between P and ATC, so no profit)
What is a benefit of monopolistic competition over perfect competition?
Monopolistic competition offers product differentiation/variety, and consumers like variety
