Chapter 13 Imperfect Competition: A Game-Theoretic Approach Monopolistic Competition 13 -1

The Chamberlin Model ü Assumption: a clearly defined “industry group, ” which consists of a large number of producers of products that are close, but imperfect substitutes for one another. ü Two implications: 1. Because the products are viewed as close substitutes, each firm will confront a downward-sloping demand schedule. 2. Each firm will act as if its own price and quantity decisions have no effect on the behavior of other firms in the industry. That is, its competitors do not respond to its pricing and output decisions. But symmetry makes sense for other firms to respond to this behavior. Thus, the firm faces 2 demand curves: (a) when the firm alone changes price, and (b) when prices change in unison. Since the goods are perceived as close substitutes, each firm perceives the demand curve facing it as highly elastic. 13 -2

The Chamberlin Model (a) The firm alone changes the price (dd) and (b) when all firms change prices (DD) Gain when ALL firms change prices along DD Advantage of being 1 st mover alone along the dd curve Figure 13. 11: The Monopolistic Competitor’s Two Demand Curves Figure 13. 12: Short-Run Equilibrium for the Chamberlinian Firm üAt the initial price, P’, each firm sells Q’. If the firm lowers P to P”, it sells Q”’ along dd curve. üBUT if ALL prices change, then each firm sells only Q” along DD curve Figure 13. 12: In the SR, assume the firm has dd curve and the equilibrium is Q* at P* with ATCQ*. Since P* > ATCQ*. , it follows that the green rectangle is short-term profits. As in PC, profits invites entry into the industry (free entry & exit) 13 -3

Figure 13. 13: Long-Run Equilibrium in the Chamberlin Model Entry leads to a leftward shift of the demand curve, i. e. after entry, each firm contributes proportionately less to industry output. In the LR, entry drives profits to zero (just as in PC). Recall: PC = Perfect Competition E PPC E’ QPC 13 -4

Perfect Competition Versus Chamberlinian Monopolistic Competition ü Competition meets the test of allocative efficiency(P=MC), while monopolistic competition does not (P>MC). ü Monopolistic competition is less efficient than perfect competition because in the former case firms do not produce at the minimum points of their long-run average cost (LAC) curves (E > E’) ü In terms of long-run profitability the equilibrium positions of both the perfect competitor and the Chamberlinian monopolistic competitor are precisely the same (P = ATC in both) 13 -5

Criticisms of the Chamberlin Model 1. Arbitrary definition of an “industry group. ” Chamberlin thought of group of products that are different from each other and providing variety (Stigler) 2. It complicates PC without changing its fundamental results (Friedman) 3. Too closely resembles the PC especially its assumption that any firm can attract any buyers in an industry. These criticisms have lead to the development of models that yield different results than the Chamberlin model.

EXAMPLE Suppose each of the 20 firms in monopolistic competition faces a dd curve of the form: P = 10 – 0. 001 Q. What is each firm’s dd curve following the entry of 5 firms? Before Entry: MR = 10 – 0. 002 Q and set = 0 and solve for Q = 5, 000. Divide 5000 by 20 firms to get a firm’s share: 5000/20 = 250. Thus, in % terms, each firm has 250/5000 = 1/20 = 5%. P=10, and Q = 10, 000 After entry: Divide 5000 by 25 = 200 and in % terms, the share is 200/5000 =1/25 = 4%. Thus, at each price, quantity demanded will be 20% less, i. e. P = 10 – 0. 00125 Q so that P =10 but Q = 8, 000 (where 0. 000125 = 1/8000) P=10 8, 000 10, 000

Criticisms of the Chamberlin Model 1. Arbitrary definition of an “industry group. ” Chamberlin thought of group of products that are different from each other and providing variety (Stigler) 2. It complicates PC without changing its fundamental results (Friedman) 3. Too closely resembles the PC especially its assumption that any firm can attract any buyers in an industry. These criticisms have lead to the development of models that yield different results than the Chamberlin model.

Figure 13. 14: An Industry in Which Location is the Important Differentiating Feature 4 equally space outlets (green); circumference = 1 mile Distance as reducing substitutability The Optimal Number of Locations The number of outlets that emerges from the independent actions of profit-seeking firms will in general be related to the optimal number of outlets in the following simple way Any environmental change that leads to a change in the optimal number of outlets (here, any change in population density, transportation cost, or fixed cost) will lead to a change in the same direction in the equilibrium number of outlets. 13 -9

Figure 13. 16: The Optimal Number of Outlets Optimal N* = where the slopes of the 2 curves are equal # CMtrans – total transportation costs ; declines with the number of outlets (restaurants in this case)(N) # CMMeals – total cost of meals served ; increases with the number of outlets N) #N* - optimal number of restaurants, i. e. the one that minimizes the sum of these costs. At t (transportation costs ) rises, so do N as people economize on transportation by going to nearer restaurants. Similarly, if L (population) rises, high density in the area increases N (see Natomas). If restaurant start-up costs (F) increase, N decreases (e. g. zoning costs) 13 -10

Figure 13. 17: A Spatial Interpretation of Airline Scheduling 5 P. M. Preference for a 5 PM flight can be easily accommodated by the closet substitute – flight at 6 P. M. in the airline ‘product space. ’ üWhy not have a flight leaving every 5 minutes, so that no one would be forced to travel at an inconvenient time? ØThe larger an aircraft is, the lower its average cost per seat is. v. If people want frequent flights, airlines are forced to use smaller planes and charge higher fares (commuter airlines) 13 -11

Figure 13. 18: Distributing the Cost of Variety üDesire for variety increases with income; those with a preference for a wide variety have the income to back-up their demands, i. e. automobile market. üBuyers who care more about special features will buy the higher priced Cadillac while the opposite is true of those who might care but have low incomes üNote that by charging more for Cadillac's, the producer is able to recoup the cost of “variety” even if the MC of both types are hardly different. üNote that the cost of ‘variety’ is not evenly distributed across consumers 13 -12

Consumer Preferences And Advertising ü Because products are differentiated, producers can often shift their demand curves outward significantly by advertising. ü The revised sequence -- the corporation decides which products are cheapest and most convenient to produce, and then uses advertising and other promotional devices to create demand for them. 13 -13