E312. Lecture 11
29 September 2005
Assignments
Problem Set #5 (Due today) Begin ch. 3.
Test: 1 week from Today
Review
F. Dominant Firm Pricing.
1. Overview
2. Analysis
a. Assumptions
b. Residual Demand and “Kinked” Demand
c. Possible outcomes:
i. Limit Pricing
ii Pricing that allows entry
A dynamic consequence of entry
Preview
III. Imperfect Competition, Virtual Products and Network Industries
A. Motivation
B. Static Oligopoly
1. Sweezy
2. Cournot
3. Bertrand
LECTURE______
III. Imperfect Competition, Virtual Products and Network Industries
A. Introduction. What explains the “.com” bubble or “bandwagon effects’. Concurrent with the Asian financial crises of the late 1990’s was an incredible run-up in stock prices for “.com”.s. Stock prices, of course, are supposed to reflect the net present value of a firm, dot-com prices were increasing so rapidly that Larry Summers argued that Asian countries might append a dot com to their name to recover.
Of course the bubble burst, and the patina associated with the dot.com title disappeared. The remaining question is the following: What characteristics of internet exchange led to such a run up in prices. We study this, along with continued patterns f interactions between firms in this chapter.
We start with to industrial structures between monopoly and perfect competition
B. Oligopoly. Suppose it’s the case that a particular firm enjoys some reasonable level of protection from rivals. The may be, for example, substantial economies of scale in operation. However, a limited number of rivals persist in the market.
This sort of industrial scenario is referred to as oligopoly. An example regards the production of anti-virus software. Only two producers persist in the market Symantec (which markets Norton AntiVirus software) and Network Associates (McAfee and Dr. Solomon’s). Anti-virus packages are expensive to develop and maintain, since new viruses appear frequently, and competitors must have the resources to quickly offer defenses for these viruses.
The rivals used to sell a considerable volume of software through “bricks and mortar” outlets. Increasingly, however, these firms sell products online. This has the advantage of allowing customers more current protection. It also encourages a degree of “lock-in”. That is, consumers will be reluctant to switch brands once they’ve installed a package.
The critical observation here, is that Symantec and Network Associates are undoubtedly strategically aware of each others actions. A reduction in the price of Norton AntiVirus, for example, will lead to a response in the price of McAfee. Similarly, a Network Associate Strategy of selling “real time” versions of its software (that update automatically) would lead Symantec to do the same. These are classical oligopolists.
1. Oligopoly Characteristics
a. A limited number of firms, who are strategically aware of others’ actions.
b. Barriers to entry and exit
c. No price discrimination.
d. Uniform products (for simplicity – not essential)
2. Static Oligopoly Predictions. The Theory of Oligopoly is among the richest in all of economics. Outcomes depend critically on the way that rivals interact. We illustrate this by illustrating the two most standard models of oligopoly interactions in a very simple two competitor case, with constant unit costs, and with a linear demand curve with unitary slope.
a. An Informal Theory: Sweezy Oligopoly: One way to approach the problem is to consider prices relative to an arbitrarily specified existing level. Suppose the following reactions
- Sellers do not respond to price increases.
b. Sellers match price reductions
Such assumptions generate a “kinked” demand curve very similar to that in the case of dominant firm pricing (the only difference is that there is no competitive fringe.
Predictions: In this case, oligopolists will price at their current level. That is, sellers will not reduce prices in response to a cost reduction (at least over a range of prices), and they will not find a price increase profitable.
PP* /
Q
Analysis: This model is very simple, and it has important deficiencies. In particular, it does not explain how prices are set. But it has the distinct advantage of showing how consumers may fail to enjoy the benefits of cost reductions.
This model also has some relevance to the world of E-Commerce. A longstanding conjecture is that the availability of price information available online would be a panacea for consumers, driving prices to costs. Will this happen? It depends on whether consumers can monitor and respond to price changes more rapidly than firms. If firms monitor and respond to price changes more rapidly, then a Sweezy type structure might emerge.
Now let us consider some more complete characterizations of oligopoly performance. There are two leading models, Cournot Competition and Bertrand Competition.
b. Cournot Competition. This approach to the problem is as an extension of the residual firm analysis. Competitors select quantities, with each Competitor selecting the quantity that maximizes profits, given the quantity choices of his rival.
Now, consider the limits of these choices. On the one hand, the rival might produce nothing, in which case a firm enjoys a monopoly over the market. In another case, the firm might produce a competitive quantity. In this case, the rival has no choice but to withdraw from competition. If these are the incentives for a seller 1, then seller 2 faces just symmetrical incentives. We could plot these relationships on an axis with the quantity choices for x1 and x2.
Notice that the two “reaction functions” intersect when the two sellers select exactly the same quantity.