EC111LectNG7

EC111LectNG7 - University of Essex Department of Economics...

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1 University of Essex Session 2011/12 Department of Economics Autumn Term EC111: INTRODUCTION TO ECONOMICS IMPERFECT COMPETITION Under imperfect competition each firm has some market power (i.e. it faces a downward sloping demand curve for its product) but it is constrained by the existence of actual or potential competitors. Monopolistic Competition The key assumptions for imperfect competition are: Many small firms (we assume they have U shaped long run average costs). Free (costless) entry and exit in the long run. Product differentiation, so each firm faces a downward sloping demand curve. No strategic interaction: each firm assumes that its decisions do not affect the decisions of other firms. This situation is like perfect competition except that each of the (tiny) firms faces a downward sloping demand curve. Q: Examples? The diagram (next page) looks like monopoly. With D 1 and MR 1 the firm is making super-normal profits producing the profit maximising output q 1 . But there is free entry so that new firms will enter in the long run. Because the products of entrants are close substitutes, their entry shifts the demand curve to the left, eventually shifting demand to D 2 and MR 2 . At this point MR = MC, so the firm is maximising its profit, but that point (q 2 ) is directly below where the demand curve is tangent to average cost, so profit is zero, and there is no further incentive to enter.
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2 Note that: In equilibrium, firms are not producing at the minimum of long run average cost. Q: why is this? In a sense there is a trade off between variety and efficiency. Restricting entry to the industry would allow each firm to produce closer to the minimum of LRAC, but then there will be less variety (fewer firms). Thus the welfare implications are unclear. LRAC D 1 MR 1 D 2 MR 2 MC P P 1 P 2 q 2 q 1 q
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3 Oligopoly There are a few firms in the industry, so they are less anonymous; each firm recognises that it will be affected by what the other firms do. Because there are few firms each of them has some market power (i.e. can affect the price, even in a market where the good is homogenous. Cournot Dupoly Assumptions: Two firms (A and B), no entry to the industry A homogenous product Each firm takes the other firm’s output as given. Here, we shall also assume that each firm has identical average and marginal costs. MR R P q A q B Q MR D MC = AC
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4 Suppose firm A produces the monopoly output. What would firm B do? Firm B takes Firm A’s output, q A , as given, so it looks at the residual demand curve and the associated Marginal Revenue, MR R . It produces output q B . This is the ‘best response’ for firm B, but is it now optimal from the point of view of firm A? If firm B is producing q B, firm A would want to produce less than the monopoly output in order to maximise its profits. Q: how do we know that?
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EC111LectNG7 - University of Essex Department of Economics...

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