Oligopoly Part 2 Flashcards
What will happen in cournot oligopoly if new firms are free to enter the market, given symmetric firms and no fixed costs?
Firms will keep entering until P=MC (as we found earlier, as n increases)
Recall quantity and price expressions for a firm ‘i’ in cournot oligopoly with symmetric costs
Qi = v-c / n+1
P = v+nc / n+1
where P>MC, so keep entering till P=MX
What does this tell us about the sustainability of oligopoly in the long run
b) why would fixed costs preserve oligopoly
Oligopoly only sustainable if firms face fixed costs, since would otherwise approach perfect competition!
b)
With fixed costs, entry continues so n firms earns positive profits, but n+1 firms in the market now earns negative profits.
So show fixed cost effects!
Qi = v-c / n+1
P = v+nc / n+1
πi = (P-c)qi - F
Sub in our values to get profit (pg 40 own working)
B) why is this expression useful
𝜋𝑖 = [𝑣-𝑐 / 𝑛 + 1]² − 𝐹
B) if rearrange to make n gives us optimal number of firms in the market that make profit>=0
Rearrange 𝜋𝑖 = [𝑣-𝑐 / 𝑛 + 1]² − 𝐹 to find n (working pg41)
Final expression:
n* = v-c /√F - 1
If a decimal, round up to the lower integer e.g if 5.7, 5 firms, 6 would make negative profits
So when will more firms be allowed to operate profitably in cournot oligopoly (use expression)
(2)
Larger markets (higher v)
Lower fixed costs (F)
allows more firms to operate profitably under cournot oligopoly
Is entry good for welfare in cournot oligopoly (no fixed costs vs fixed costs)
With no fixed costs entry is always good for welfare , each firm nears toward perfect comp (increases CS and sum of profits)
But with fixed costs, it may make profitable entry inefficient for social welfare (see why next)
Shows welfare gains going from n firms to n+1 firms under cournot oligopoly with no fixed costs
identify
gain in CS
profit of new entrant
welfare gain
Cournot oligopoly - adding one more firm (n+1) creates welfare gains a+b
Gain in CS: a+d (d is stolen from producers)
Profits of new entrant: b+c (c is stolen from existing firms, since split even!)
Overall welfare gain is a+b, since dc are just transferred amonst producers and consumers
Now add fixed costs: when will a new firm enter now?
New firm enters as long as b+c (its profits) is bigger than its fixed costs
Important result:
What if fixed cost is bigger than a+b but smaller than b+c
So fixed cost is bigger than welfare gain, but less than b+c (profit for new firm)
So it is profitable to enter, but welfare reducing! thus shows how in cournot oligopoly with fixed costs, profitable entry can reduce social welfare!
So profitable entry can be welfare reducing (free entry means they exceed the socially optimal number)
Mankiw and Whinston: evidence on whether this happens in real life
The find number of firms always exceeds the socially optimal number.
i.e b+c > fixed costs, hence they enter. however, also fixed cost > a+b so welfare reducing!)
So what should policymakers do (2 options)
Restrict entry to prevent reduced social-welfare
or alternatively allow mergers
What if firms have different asymmetric costs?
Is entry still welfare-reducing?
No - if low-cost firms enter, it is likely welfare improving, as price falls and sales stolen from inefficient firms
and entry by high cost firms is STILL less damaging compared to the symmetric case, since they’ll be less effective at stealing sales and may result in increased market share for existing low-cost firms, beneficial for welfare as reasoning above
Why do firms sizes differ in reality (4)
Cost differences (MC)
Cost breakdown (high fixed low MCvs low fixed high MC)
Endogenous entry costs (higher S = higher F)
Homogeneous vs differentiated products
1st reason why firm size differs: Cost differences
what model can we use to explain this
Recall general case for firm i in cournot oligopoly
𝑞𝑖 = 𝑣−𝑐𝑖 +𝑛(𝑐bar−𝑐𝑖) / 𝑛+1
if Ci<Cbar they produce more! (thus larger)
2nd reason for firm size differences: cost breakdown
what are the cost breakdowns for large vs small firms
Large firms tend to have high fixed cost and low MC
Small firms have low fixed cost high MC.
Both small and large firms could operate, why? (3)
Large plants (high fixed, low MC) are more profitable
but smaller plants (low fixed, high MC) are cheaper to set up, so firms with less access to finance can afford entry
Differentiation - small can still exist with large plants
Example of large and small plants coexisting
Beer market - 3 large firms, and large number of small breweries (differentiation!)
Notably, only large and small, medium size breweries have disappeared
Endogenous entry costs:
𝑛∗ = 𝑣−𝑐 √𝑆/𝐹− 1
Or n* = v-c /√F - 1
Shows us number of firms depends on fixed costs and market size (V or S). But F can depend on S!
How?
b) what does this help us explain (paradoxical result)
F can depend on S E.g in an industry where advertising is important so they have to do it, so will cost more in a larger country
b) Explains why large market may not have as many firms as we would expect (since even if S increases, increases F as well, offsetting thus n* doesnt rise much/at all)
Beer market example again to show endogenous entry costs (F depending on S)
US beer market is 30-50x larger than Portugal, but only has 1 more (3) dominant firm than Portugal (2)
Shows us large markets do not have as many firms as would expect, advertising costs can explain this! More expensive to market for a large country/market
Homogenous vs differentiated products
Which has higher entry costs and why
Entry costs higher for differentiated products, since advertising more important!
Thus do we expect for advertising-intensive industries to be more concentrate or less?
More concentrated (firms dominate) since higher entry costs of advertising deters entry
Market structure (how many firms) influences conduct (pricing, advertising etc) which influences performance.
This implies more concentrate industries should be more profitable as fewer firms so less competition.
However evidence shows link between concentration and profitability is weak. Why?
Causality unclear, as conduct and performance can also cause structure (not the other way round)
E.g more competitive market with less profitability deters entry, thus determining structure!
Thus shows us structure-conduct-performance is useful but limited
