The table above has the market demand schedule in an industry that has two firms in it. The marginal cost of this product is zero because these two firms have exclusive ownership of the resource and it does not cost any additional amount to produce additional units.
a) If the firms cooperate with each other so that they operate as a monopoly, what price will they charge and what (total) output will they produce?
b) If the firms cannot cooperate but instead behave as perfect competitors, what will be the price and the (total) output they produce?
We are slightly confused about Question (b). I guess the idea is, that they have to set the price equal to marginal costs, because they are now competing. However:
1. In order for them to not incur an economic loss, they would have to have zero fixed costs. And what firms have zero fixed costs?
2. In perfect competition, the demand curve faced by the single firm is horizontal because of the fierce competition. But in an oligopoly, the individual firm can only supply part of the market demand if they are to produce at their lowest ATC. So the demand curve facing the individual firm would not be horizontal and therefore they are not pure price-takers?
3. In general, are firms in oligopoly markets earning zero economic profits in the long run if they are neither colluding nor cheating, but merely competing? It doesn’t seem to say in the book.
Intermediate and advanced microeconomic theory would distinguish different types of competition in oligopoly. When oligopolists collude, the general conclusion is similar (they share the monopoly profit). But competition can be Bertrand competition (price competition) or Cournot competition (quantity competition), and the outcome is also dependent on whether firms produce differentiated products.
Introductory microeconomic textbooks usually do not get into a detailed discussion on oligopoly. In this course, the case we have discussed is what intermediate microeconomic theory would call Bertrand competition -- oligopolists produce homogeneous products and compete by setting different prices. The students only need to know that when oligopolists collude, they share the monopoly profit; when they engage in a price war, they earn zero economic profit.
The reasoning is as follows (take duopoly as an example): when firms produce homogeneous products, they share the market demand when they set the same price, but whenever one firm sets a price lower than the other, it will get all the market demand. Therefore, the demand for an individual firm is indeed a horizontal line, but the height of the horizontal line depends on the price charged by the other firm (that is, the outcomes of the two firms are interdependent). You can visualize the situation by considering two vending machines selling identical products. If one vending machine charges a slightly lower price, then it would get all the quantity demanded by the consumers.
To get deeper into the discussion: the intensity of competition does not only depend on the number of firms in the market. It is more dependent on the substitutability of a firm’s product. Even there is only one firm in the market, but there are potential entrants that can produce the same product, this only incumbent cannot charge a high price (and potentially earn a zero economic profit).
Q1. In order for them to not incur an economic loss, they would have to have zero fixed costs. And what firms have zero fixed costs?
Firms should have positive fixed costs in this case, but fixed costs should not matter when they make production decisions. The fixed costs are forgone in the short run, so only the marginal cost would influence firms’ decisions. Fixed costs only come into play in the long run when the previous investments have run out/depreciated enough and the firm needs to make new fixed costs – but in the long run, all costs are variable costs.
The firms would suffer an economic loss when they set the price the same as the marginal cost, but that is their optimal choice if the other firm is doing so. Of course, this is a theoretical equilibrium outcome. In reality, they would charge the lowest possible price that is higher than the marginal cost, so they could make some profit out of each unit they sell so that they can cover part of the fixed costs.
Q2. In perfect competition, the demand curve faced by the single firm is horizontal because of the fierce competition. But in an oligopoly, the individual firm can only supply part of the market demand if they are to produce at their lowest ATC. So the demand curve facing the individual firm would not be horizontal and therefore they are not pure price-takers?
As mentioned above, firms can face a horizontal demand curve when they engage in a price war, but the firms’ demand curves are interdependent. In a natural oligopoly, each individual firm can only supply part of the market demand if they are to produce at their lowest ATC – but this is not true in general for all oligopoly. In the case of our question where MC is constant, ATC would never reach its minimum -- recall that MC will cross ATC at ATC’s minimum, so ATC will keep decreasing and approaching MC asymptotically.
Q3. In general, are firms in oligopoly markets earning zero economic profits in the long run if they are neither colluding nor cheating, but merely competing? It doesn’t seem to say in the book.
“Firms in oligopoly earning zero economic profits in the long run if engage in a price war.” This statement is correct based on what is discussed in the textbook and in the lecture notes, and it is enough for the students to understand this deep. But when firms engage in Cournot competition or when they produce differentiated products, they could earn a positive economic profit.
Introductory microeconomic textbooks usually do not get into a detailed discussion on oligopoly. In this course, the case we have discussed is what intermediate microeconomic theory would call Bertrand competition -- oligopolists produce homogeneous products and compete by setting different prices. The students only need to know that when oligopolists collude, they share the monopoly profit; when they engage in a price war, they earn zero economic profit.
The reasoning is as follows (take duopoly as an example): when firms produce homogeneous products, they share the market demand when they set the same price, but whenever one firm sets a price lower than the other, it will get all the market demand. Therefore, the demand for an individual firm is indeed a horizontal line, but the height of the horizontal line depends on the price charged by the other firm (that is, the outcomes of the two firms are interdependent). You can visualize the situation by considering two vending machines selling identical products. If one vending machine charges a slightly lower price, then it would get all the quantity demanded by the consumers.
To get deeper into the discussion: the intensity of competition does not only depend on the number of firms in the market. It is more dependent on the substitutability of a firm’s product. Even there is only one firm in the market, but there are potential entrants that can produce the same product, this only incumbent cannot charge a high price (and potentially earn a zero economic profit).
Q1. In order for them to not incur an economic loss, they would have to have zero fixed costs. And what firms have zero fixed costs?
Firms should have positive fixed costs in this case, but fixed costs should not matter when they make production decisions. The fixed costs are forgone in the short run, so only the marginal cost would influence firms’ decisions. Fixed costs only come into play in the long run when the previous investments have run out/depreciated enough and the firm needs to make new fixed costs – but in the long run, all costs are variable costs.
The firms would suffer an economic loss when they set the price the same as the marginal cost, but that is their optimal choice if the other firm is doing so. Of course, this is a theoretical equilibrium outcome. In reality, they would charge the lowest possible price that is higher than the marginal cost, so they could make some profit out of each unit they sell so that they can cover part of the fixed costs.
Q2. In perfect competition, the demand curve faced by the single firm is horizontal because of the fierce competition. But in an oligopoly, the individual firm can only supply part of the market demand if they are to produce at their lowest ATC. So the demand curve facing the individual firm would not be horizontal and therefore they are not pure price-takers?
As mentioned above, firms can face a horizontal demand curve when they engage in a price war, but the firms’ demand curves are interdependent. In a natural oligopoly, each individual firm can only supply part of the market demand if they are to produce at their lowest ATC – but this is not true in general for all oligopoly. In the case of our question where MC is constant, ATC would never reach its minimum -- recall that MC will cross ATC at ATC’s minimum, so ATC will keep decreasing and approaching MC asymptotically.
Q3. In general, are firms in oligopoly markets earning zero economic profits in the long run if they are neither colluding nor cheating, but merely competing? It doesn’t seem to say in the book.
“Firms in oligopoly earning zero economic profits in the long run if engage in a price war.” This statement is correct based on what is discussed in the textbook and in the lecture notes, and it is enough for the students to understand this deep. But when firms engage in Cournot competition or when they produce differentiated products, they could earn a positive economic profit.
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