Chapter 13

best response

A firm's profit-maximizing choice of output given the level of output by rival firms.

reaction function

A graph that shows a firm's best response (i.e., profit- maximizing choice of out- put or price) for each possible action of a rival firm.

duopoly market .

A market in which there are just two firms

What are the characteristics of a monopolistically competitive industry? Provide an example of a monopolistically competitive industry.

A monopolistically competitive market has three key features. First, the market is fragmented, meaning it consists of many buyers and many sellers. Second, there is free entry and exit into the market. Third, firms produce horizontally differentiated products.The restaurants in a city might represent a monopolistically competitive market. There are likely many restaurants, and many consumers who want to eat at a restaurant; entrepreneurs can easily enter the restaurant market; and consumers likely view the restaurants as imperfect substitutes. Clothing retailers might represent another monopolistically competitive market.

What is a reaction function? Why does the Cournot equilibrium occur at the point at which the reaction functions intersect?

A reaction function represents a firm's best response to each possible choice of another firm. For example, in a Cournot model a reaction function represents the firm's profit-maximizing level of output given another firm's choice of output.At the point where the reaction functions intersect, both firms are choosing a level of output that maximizes its profit given the output choice of the other firm. Thus, neither firm would choose to deviate from this point since doing so would reduce its profit. This point, therefore, represents an equilibrium since neither firm would choose to change what it is doing given the other firm's choice.

Cournot equilibrium

An equilibrium in an oligopoly market in which each firm chooses a profit- maximizing output given the output chosen by other firms.

Bertrand equilibrium

An equilibrium in which each firm chooses a profit- maximizing price given the price set by other firms.

Explain why, in the Bertrand model of oligopoly with differentiated products, a greater degree of product differentiation is likely to increase the markup between price and marginal cost.

As the degree of product differentiation increases, the firm gains more market power for its product. This occurs because with greater product differentiation there are fewer close substitutes for the product to compete with. As the firm gains market power for its product, it is able to charge a higher price for the product. Viewing this from the opposite standpoint, if there was less product differentiation, there would be more close substitutes and price increases would send consumers to other products. In the limit, if there were no product differentiation in the Bertrand model, prices would fall to marginal cost and all producers would charge the same price.

monopolistic competition

Competition in a market in which many firms produce differentiated products that are sold to many buyers.

residual demand curve

In a Cournot model, the curve that traces out the relationship between the market price and a firm's quantity when rival firms hold their outputs fixed.

Explain why, at a Cournot equilibrium with two firms, neither firm would have any regret about its output choice after it observes the output choice of its rival.

In a Cournot setting, each firm chooses a level of output that maximizes its own profit given the output choice of the other firm. In equilibrium each firm is choosing the profit-maximizing level of output given the other firm's output choice. Thus, neither firm will have any regret since it is doing the best it can given the other firm's choice.

Why is it the case in a long-run monopolistically competitive equilibrium that the firm's demand curve is tangent to its average cost curve? Why could it not be a long-run equilibrium if the demand curve "cut through" the average cost curve?

In a monopolistically competitive market, each firm's demand curve will be tangent to its average cost curve because there is free entry and exit of firms, so firms will enter if there are any economic profits to be earned. This entry will occur until economic profits are driven to zero, much like the perfectly competitive environment. When economic profits are zero, it must be the case that price is equal to average cost since profit can be written as r = (P - AC)Q . If price is equal to average cost, then the demand curve must touch the average cost curve at the optimal quantity. This is seen as a tangency between demand and average cost in the long run. If demand 'cut through' the average cost curve, then there would be a range of outputs over which economic profit would be positive. This would entice new firms to enter, driving profits down. Therefore, the demand curve 'cutting through' the average cost curve cannot be an equilibrium in the long run since new firms will enter.

Explain the difference between the Bertrand model of oligopoly and the Cournot model of oligopoly. In a homogeneous products oligopoly, what predictions do these models make about the equilibrium price relative to marginal cost?

In the Cournot model of oligopoly, firms choose a level of output given the output choices of rival firms. In the Bertrand model of oligopoly, firms choose a price given the prices set by rival firms. In the Bertrand model it is assumed that the firm with the lowest price will achieve 100% market share. Therefore, firms will undercut the prices of rival firms until price is driven down to the firm's marginal cost.In a homogenous products oligopoly, Cournot firms exhibit market power and set a price above the perfectly competitive price and provide a level of output below the perfectly competitive level. Bertrand firms, by undercutting prices of rival firms, drive the price down to the level of marginal cost, achieving the perfectly competitive solution. Thus, in the Cournot model price is above the perfectly competitive price and in the Bertrand model price is equal to the perfectly competitive price.

differentiated products oligopoly markets

Markets in which a small number of firms sell prod- ucts that are substitutes for each other but also differ from each other in significant ways, including attributes, performance, packaging, and image.

dominant firm markets

Markets in which one firm possesses a large share of the market but competes against numerous small firms, each offering identical products

Profit Maximization by Cournot Firms

The Cournot model pertains to a homogeneous products oligopoly. we need the overall global demand . we are no longer price taker we are just quantity takes

Beryllium oxide is a chemical compound used in pharmaceutical applications. Beryllium oxide can only be made in one particular way, and all firms produce their version of beryllium oxide to the exact same standards of purity and safety. The largest firms have market shares given in the table below: Firm Market share Mercury 80% Mars 1% Jupiter 1% Saturn 1% ----------------------- a. What is the four-firm (4CR) concentration ratio for this industry? b. What is the Herfindahl-Hirschman Index (HHI) for this industry? c. Of the market structures described in Table 13.1, which one best describes the Beryllium oxide industry?

a) 4CR = 80+1+1+1 = 84 b) HHI = 802 + 12 +12 +12 = 6,403 (ignoring the effect of smaller firms in the industry). c) This is an example of a dominant firm industry. The firms sell homogeneous products, and the industry is dominated by a single large firm.

1. Identify the truthfulness of the following statements. I. Cournot competitors behave less aggressively than Bertrand competitors because a Cournot firm cannot expect to "steal" customers from a rival whereas a Bertrand firm can. II. Two firms are enough to replicate perfectly competitive outcomes in a Bertrand market, whereas a Cournot market only approaches perfectly competitive outcomes when the number of competitors becomes large. a) Both I and II are true. b) Both I and II are false. c) I is true; II is false. d) I is false; II is true.

a) Both I and II are true.

1. In the Cournot model of oligopoly, a) each firm chooses simultaneously and non-cooperatively how much to produce to maximize its own profit. b) each firm chooses simultaneously and non-cooperatively its own product's price to maximize its own profit. c) one firm acts as a quantity leader, choosing its quantity first, while all other firms act as followers, choosing their quantities second and in reaction to the first. d) each firm makes its profit-maximizing decision while considering the entire market demand, the same as a monopolist.

a) each firm chooses simultaneously and non-cooperatively how much to produce to maximize its own profit.

1. Perfect competition a) in its purest form is probably difficult to observe in the real world because even such factors as location can lead to some market power. b) is only observed where there are some barriers to entry in the industry. c) requires each of the few firms in the industry to behave in the same profit-maximizing fashion. d) only exists in differentiated product markets

a) in its purest form is probably difficult to observe in the real world because even such factors as location can lead to some market power.

1. The Cournot reaction function a) maps out the best response a firm could take for each possible action of the rival firm. b) maps out how firms work together to maximize profits. c) is most applicable to monopoly markets. d) shows how each firm makes its profit-maximizing decision while considering the entire market demand, the same as a monopolist.

a) maps out the best response a firm could take for each possible action of the rival firm.

1. A differentiated products oligopoly market consists of a) only a few firms producing similar, but differentiated products. b) only a few firms producing the same products. c) many firms producing differentiated products. d) a single, large firm producing differentiated products.

a) only a few firms producing similar, but differentiated products.

1. All of the following statements are true except: a) Perfect competition can only exist in industries with a large number of firms. b) A monopoly market structure cannot exist in an industry with an undifferentiated product. c) Monopolistic competition implies that each firm has some ability to differentiate its product. d) Oligopoly can exist in industries with differentiated and undifferentiated products.

b) A monopoly market structure cannot exist in an industry with an undifferentiated product.

1. When one firm possesses a large share of the market but competes against numerous small firms each offering identical products, such markets are called a) Oligopoly markets b) Dominant firm markets c) Differentiated markets d) Homogenous product markets

b) Dominant firm markets

1. Under monopolistic competition, the firm optimizes a) by setting MC = MR = P. b) by setting MC = MR, but P > MC. c) by setting MC greater than MR. d) by setting MC = MR, but P < MC.

b) by setting MC = MR, but P > MC.

1. In a Bertrand oligopoly, a) each firm chooses simultaneously and non-cooperatively how much to produce to maximize its own profit. b) each firm chooses simultaneously and non-cooperatively its own product's price to maximize its own profit. c) one firm acts as a quantity leader, choosing its quantity first, while all other firms act as followers, choosing their quantities second and in reaction to the leader. d) each firm makes its profit-maximizing decision while considering the entire market demand, the same as a monopolist.

b) each firm chooses simultaneously and non-cooperatively its own product's price to maximize its own profit.

1. Suppose that firms A and B are Cournot duopolists in the computer industry. Firm A's best response function a) lists firm B's profit-maximizing choice of output given any level of output by firm A. b) lists firm A's profit-maximizing choice of output given any level of output by firm B. c) lists firm B's profit-maximizing choice of price given any level of price by firm A. d) lists firm B's profit-maximizing choice of price given any level of price by firm B.

b) lists firm A's profit-maximizing choice of output given any level of output by firm B.

1. A monopolistically competitive market consists of __________ firms selling _________ to many buyers. a) a small number; differentiated products b) many; differentiated products c) many; identical products d) a small number; identical products

b) many; differentiated products

1. Which of the following is not a characteristic of monopolistic competition? a) The market is fragmented. b) There is free entry and exit. c) In the long-run equilibrium, firms earn positive profits. d) Firms produce horizontally differentiated products.

c) In the long-run equilibrium, firms earn positive profits.

1. In the Cournot model, the curve that traces out the relationship between the market price and a firm's quantity when rival firms hold their outputs fixed is called ______________ a) Reaction function b) Best response c) Residual demand curve d) Cournot equilibrium

c) Residual demand curve

1. In the Cournot model, the firm chooses a) its optimal price, holding the price of its competitors constant. b) its best response to the price changes of the competitor firm. c) its optimal level of output, holding the output of the other firm constant. d) the level of output that would optimize profits for all firms.

c) its optimal level of output, holding the output of the other firm constant.

What is the role played by the competitive fringe in the dominant firm model of oligopoly? Why does an increase in the size of the fringe result in a reduction in the dominant firm's profit-maximizing price?

n a dominant firm market, one dominant firm splits the market with a competitive fringe. This competitive fringe is some number of producers that act as perfect competitors: each chooses a quantity of output taking the market price as given. The market price is set by the dominant firm who chooses a price to maximize its own profit. As more firms enter the competitive fringe, the supply of the competitive fringe increases. As this supply increases, the dominant firm's residual demand - market demand less fringe supply - falls. As this residual demand falls, marginal revenue declines and the firm will maximize its own profits at a lower price.

How Firms Achieve a Cournot Equilibrium

the Cournot equilibrium is a natural outcome when both firms fully understand their interdependence and have confidence in each other's rationality. e.g samsung If they are clever, Samsung's managers would then conclude: Given that LG will not produce more than 45, we should produce at least 22.5. Why? Because we see from RS that any quantity less than 22.5 could never be profit maximizing for us given that LG will never produce more than 45. But Samsung can go even deeper: We should assume that LG has reasoned the same way we have—after all, they are just as clever as we are. But if LG realizes that we will produce at least 22.5, LG would never produce more than 33.75, as we see from RLG. But, of course, Samsung's managers can reason more deeply still: Given that LG will produce no more than 33.75, we should produce at least 28.125. Why? Because we see from RS that any quantity smaller than 28.125 could never be profit maximizing for us given that LG will never produce more than 33.75.