Microeconomics, 2 Edition David Besanko and Ron Braeutigam

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Microeconomics, 2nd Edition
                                                            Market structures differ on four important dimensions:

    David Besanko and Ron Braeutigam                                   The number of sellers
                                                                        The number of buyers
                                                                        Entry conditions
Chapter 13: Market Structure and Competition
                                                                        The degree of product differentiation

        Prepared by Katharine Rockett                       Definition: Product Differentiation between two or
                                                            more products exists when the products possess
              Dieter Balkenborg                             attributes that, in the minds of consumers, set the
                 Todd Kaplan                                products apart from one another and make them less
               Miguel Fonseca                               than perfect substitutes.

                                                            Examples: Pepsi is sweeter than Coke, Brand Name
                                                            batteries last longer than "generic" batteries.
                                                        1                                                                                       2
           2006 John Wiley & Sons




 Two types of differentiation:
                                                                      Table 1: A Taxonomy of Market Structures
       "Superiority" (Vertical Product
       Differentiation) i.e. one product is viewed as
                                                                                                      Number of firms (sellers)
       unambiguously better than another so that,
       at the same price, all consumers would buy                   Degree of
                                                                    Product
                                                                                      Many          Few             One
                                                                                                                    Dominant
                                                                                                                                  One

       the better product                                           Differentiation
                                                                    Firms produce     Perfect      Oligopoly with Dominant      Monopoly
                                                                    identical         Competition  homogeneous firm
       "Substitutability" (Horizontal Product                      products
                                                                    Firms produce
                                                                                                   products
                                                                                      Monopolistic Oligopoly with
       Differentiation) i.e. at the same price, some                differentiated    Competition differentiated   ------------  ------------
                                                                    products                       products
       consumers would prefer the characteristics of
       product A while other consumers would
       prefer the characteristics of product B.


                                                        3                                                                                       4




                                                               1. Bertrand Oligopoly (Homogeneous)


Assume: Many Buyers
        Few Sellers                                            Assume: Firms set price*
                                                                       Homogeneous product
        Each firm faces downward-sloping demand                        Simultaneous
      because each is a large producer compared to                     Noncooperative
      the total market size

        There is no one dominant model of                                   *Definition: In a Bertrand oligopoly, each
      oligopoly... we will review several.                                  firm sets its price, taking as given the
                                                                            price(s) set by other firm(s), so as to
                                                                            maximize profits.


                                                        5                                                                                       6




                                                                                                                                                    1
                                                                                    How will each firm set price?
Definition: Firms act simultaneously if each firm makes its
strategic decision at the same time, without prior observation                           Homogeneity implies that consumers
of the other firm's decision.                                                          will buy from the low-price seller.

                                                                                          Further, each firm realizes that the
Definition: Firms act noncooperatively if they set strategy                            demand that it faces depends both on its
independently, without colluding with the other firm in any                            own price and on the price set by other
way                                                                                    firms

                                                                                         Specifically, any firm charging a higher
                                                                                       price than its rivals will sell no output.

                                                                                          Any firm charging a lower price than its
                                                                                       rivals will obtain the entire market
                                                                                       demand.
                                                               7                                                                            8




        Definition: The relationship between the price                      Price
                                                                                    Example: Residual Demand Curve, Price Setting
        charged by firm i and the demand firm i faces is
        firm i's residual demand
                                                                                       Market Demand
        In other words, the residual demand of firm i is the
        market demand minus the amount of demand
        fulfilled by other firms in the market: Q1 = Q - Q2
                                                                                                    Residual Demand Curve (thickened
                                                                                                   line segments)




                                                                            0                                              Quantity
                                                               9                                                                           10




                                                                          Example: Reaction Functions, Price Setting and Homogeneous Products

                                                                   Price charged by firm 2                          45 line
        Assume firm always meets its residual
        demand (no capacity constraints)
                                                                                Reaction function of firm 1
        Assume that marginal cost is constant at c
        per unit.

        Hence, any price at least equal to c ensures
                                                                                                      Reaction function of firm 2
        non-negative profits.

                                                                   p 2*                  



                                                              11     0                   p 1*                                  Price charged
                                                                                                                                          12
                                                                                                                               by firm 1




                                                                                                                                                2
 Thus, each firm's profit maximizing response to the
 other firm's price is to undercut (as long as P > MC)

 Definition: The firm's profit maximizing action as a          If we assume no capacity constraints and that all firms
 function of the action by the rival firm is the firm's        have the same constant average and marginal cost of c
 best response (or reaction) function                          then...

 Example:                                                      For each firm's response to be a best response to the
                                                               other's each firm must undercut the other as long as P>
 2 firms                                                       MC
 Bertrand competitors
                                                               Where does this stop? P = MC (!)
 Firm 1's best response function is P1=P2- e
 Firm 2's best response function is P2=P1- e

                                                          13                                                        14




So...

   1. Firms price at marginal cost

   2. Firms make zero profits

   3. The number of firms is irrelevant to the price level
   as long as more than one firm is present: two firms is
   enough to replicate the perfectly competitive outcome!




                                                          15                                                        16




                                                          17                                                        18




                                                                                                                         3
     Hotelling's (1929) linear city                                            Hotelling (voting version)
 Why do all vendors locate in the same                                        Voters vote for the closest party.
  spot?
                                                                          L                                                           R
 For instance, on High Street many shoe                                               Party A                    Party B
  shops right next to each other. Why do
                                                                               If Party A shifts to the right then it gains voters.
  political parties (at least in the US) seem
  to have the same agenda?                                                L                                                           R
                                                                                                  Party A         Party B
 This can be explained by firms trying to
  get the most customers.
                                                                               Each has incentive to locate in the middle.
                                                                 19                                                                       20




                                                                                 Further considerations:
                  Hotelling Model
                                                                                        Hotelling
                                                                        Firms choose location and then prices.
 L                                                           R
                      Party A     Party B                               Consumers care about both distance and
                                                                         price.
      Average distance for voter is  total. This isn't "efficient"!
                                                                        If firms choose close together, they will
                                                             R
                                                                         eliminate profits as in Bertrand
 L
              Party A                    Party B                         competition.
                                                                        If firms choose further apart, they will be
       Most "efficient" has average distance of 1/8 total.
                                                                         able to make some profit.
                                                                 21
                                                                        Thus, they choose further apart.            22




                                                                              Example:

                                                                              Q1 = 100 - 2P1 + P2 "Coke's demand"
                                                                              Q2 = 100 - 2P2 + P1 "Pepsi's demand"
     Assume: Firms set price*
             Differentiated product                                           MC1 = MC2 = 5
             Simultaneous
                                                                              What is firm 1's residual demand when
             Noncooperative
                                                                              Firm 2's price is $10? $0?
     As before, differentiation means that lowering price
                                                                              Q110 = 100 - 2P1 + 10 = 110 - 2P1
     below your rivals' will not result in capturing the
                                                                              Q10 = 100 - 2P1 + 0 = 100 - 2P1
     entire market, nor will raising price mean losing the
     entire market so that residual demand decreases
     smoothly


                                                                 23                                                                       24




                                                                                                                                               4
      Example: Residual Demand, Price Setting, Differentiated Products                Example: Residual Demand, Price Setting, Differentiated Products
      Each firm maximizes profits based on its residual demand by                     Each firm maximizes profits based on its residual demand by
      setting MR (based on residual demand) = MC                                      setting MR (based on residual demand) = MC



 Coke's price                                                                    Coke's price

                                                                                110
100                          Pepsi's price = $0 for D0 and $10 for D10          100                 Pepsi's price = $0 for D0 and $10 for D10




                                                                                                                    D10
                                                                                                                  D0


                                 MR0
 0                                                                       25      0                                                              26
                                         Coke's quantity                                                               Coke's quantity




             Example: Residual Demand, Price Setting, Differentiated Products         Example: Residual Demand, Price Setting, Differentiated Products
             Each firm maximizes profits based on its residual demand by              Each firm maximizes profits based on its residual demand by
             setting MR (based on residual demand) = MC                               setting MR (based on residual demand) = MC
                 Pepsi's price = $0 for D0 and $10 for D10                                Pepsi's price = $0 for D0 and $10 for D10

       Coke's price                                                              Coke's price

      110                                                                       110
      100                                                                       100




                                            D10                                                                   D10
                                           D0                                                                      D0
                                  MR10                                                                     MR10
                                                                                 5

                                   MR0                                                                      MR0
        0                                                                27      0                                                              28
                                            Coke's quantity                                                            Coke's quantity




             Example: Residual Demand, Price Setting, Differentiated Products                Example:
             Each firm maximizes profits based on its residual demand by
             setting MR (based on residual demand) = MC
                                                                                             MR110 = 55 - Q110 = 5
                 Pepsi's price = $0 for D0 and $10 for D10
                                                                                               Q110 = 50
       Coke's price                                                                            P110 = 30

      110                                                                             Therefore, firm 1's best response to a
      100
                                                                                      price of $10 by firm 2 is a price of $30

       30
      27.5
                                         D10
                                           D0
                                  MR10
       5

                                   MR0
        0                                                                29                                                                     30
                            45    50        Coke's quantity




                                                                                                                                                         5
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