Welcome to session four of week nine. We were looking last time at monopolistic competition. Many sellers, profits that potentially can exist in the short run, not in the long run. The ability to differentiate your product, but still, in the end, end up with low margins. Profits equal to zero. One other factor, one other aspect of monopolous competition that we notice is advertising expenditures tend to be relatively high. In the case of refractive eye surgery, for example, even though the prices are $300 per eye, it's not uncommon for firms to be spending as much as $200 per surgery on advertising. To secure people like Tiger Woods or Lebron James, touting the benefits of one service versus the other. What we'll do in this session is turn to another case between perfect competition and pure monopoly. The case of oligopoly, where we have a smaller number of firms. And some barriers to entry that allow each of these firms, to earn profits in the short run as well as the long run. And look at the strategic interactions between firms, cause now we have to worry. Let's say we have a few number of automobile manufacturers. How a GM has to worry about what Ford will do in terms of its price and output decisions. And GM has to think about how do we want to anticipate, how do we want to react to what Ford does or what Toyota does? We see this, cases of oligopoly too in aircraft production, just a few number of firms globally producing aircraft that have to think about the interdependencies of their actions with the other firm action, with the other firm's actions. And we'll look at a particular model, a simple model, called the Cournot Model. To tease out some of the important implications of oligopoly. The Cournot model was developed by a French economist in the early 1800's, and starting off with the very simple case, just two producers of spring water. And we'll see what, what results we can derive from this very simple example that Augustine Cournot first came up with. And let's assume that there are only, that we have a casae of duopoly. Two producers of a particular product. They're each producing the same, water from a particular spring. And we'll look at Artesian Utopia, that's the name that we'll give to the two producers. [SOUND] And we'll want to think about what is the right output level that Artesia can choose, knowing it interacts with Utopia in this particular market. What the Cournot Model does, is it assumes that each firm in a market takes the other firm's output as given, so makes this assumption that the other firm will keep its output constant. Its a simple assumption, but there's certain results derived from making that assumption. Now one extreme, and lets say the underlying market demand is D, and the associate marginal revenue curve, MR. If Utopia produced the competitive level of output, 96, then there wouldn't be any room for Artesia to produce any amount of water in this market. On the other hand, if Utopia produced zero and Artesia had the entire demand curve to itself, the price and output it would choose would be the traditional monopoly price and output that we derived several sessions ago. Looking at where MR hits the constant marginal cost curve, 48, and then charging that monopoly price. And that's, again, if Utopia produces zero. What if Utopia, it's output, let's say Q Utopia equals 32. What if Artesia assumes that no matter what it does, Utopia will produce 32 units of output. Now, simple way to study on the decision that Artesia will face, is by taking away 32 units of output from the market. So, but in, in a sense what we can do is just move in the vertical axis by 32 units. And the demand curve that's left now originates from point B. And the marginal revenue curve is associated with that new demand curve that originates at point B. It's based on Artesia, sorry it's base on Utupia being assume to produce thirty two units of output. In this particular case, 64 total units will be produced. 32 from Utopia, and then Artesia will produce half the distance out to, the remaining demand. Half the distance being where that marginal revenue curve that has twice the slope will hit it's marginal cost curve. And total output across the two firms will be 64. Any amount that we assume, that Artesia assumes that Utopia will produce, can produce, and then if we want to figure out what the right output level is for Artesia involves the same movement of the vertical axis if Artesia assumes Utopia produces more than 32. This vertical axis shifts out even further. Less than 32, it shifts out less than that dark black line. It turns out that the Cournot outcome will involve Artesia and Utopia both producing 32 units. They have the same cost, and so it makes sense that the outputs will be symetrical. Now let's see how we can find out where we'll end up in equilibrium in the Cournot model, and let's also evaluate it. And we'll do, the determination of equilibrium through something called reaction curves. And that's on figure 13.4. Again, we're assuming, we want to figure out output of Artesia. And we're going to make certain assumptions along the way of how much Utopia's producing. So we're going to make certain assumptions for output of Utopia. RA is the reaction curve, for Artesia. It's how it reacts to any given assumed level of output from Utopia. If Utopia produces the entire market, then Artesia's reaction curve has a value of zero. And if Utopia produces zero, then another point on the reaction curve for Artesia is 48. And any point similarly in between would parallel shift out in the preceding figure, that vertical axis would go half the distance to the remaining demand curve, and that way we'd figure out the right point on the reaction curve for Artesia. These two firms are identical, so the reaction curve for Utopia is the same, has the same symmetrical intercepts. If Artesia produces 96, then it takes the entire market and Utopia would produce zero. And if Artisha produces zero then, at that opposite extreme, Utopia would produce 48 and any point between. We'll end up with each firm producing 32 at the intersection of the two curves. How will we get there if we don't start at that, equilibrium point initially? So let's say, initially, Artesia's producing 48. And then Utopia has to figure out, well what's my best ouput? If Artesia takes 48 units off the market, to figure out Utopia's best point of output, it would be half the remaining distance to the demand curve. Assuming 48 units have been taken off the market by Artesia. We can determine it off the, its reaction curve. So Utopia would produce 24. But then if Utopia produces 24 and takes that amount of output off the market, then Artesia has to figure out, look at 24, where's my reaction curve? It's here. My best output's 36. It's to shrink output from 48 to 36 because, Utopia's taking more output off the market. And where Artesia's producing 36 units, is less than before, it'll lead to a higher output from Utopia. So we'll keep making these steps until we end up at the point where each firm, it's output decision gets, and its assumption about where its rival behaves, will be validated. So Artesia, by assuming that Utopia's producing 32, will also find that profit maximizing to produce 32. Vice versa for Utopia. Across the two firms, both producing 32. Another important point is, if both produce 32, we end up with a total output of 64. Two firms in the market, making certain assumptions about how the other will behave will end up at a lower price than the monopoly price. So, more competition leads to price closer to marginal cost. But price is still not at marginal cost. How valid is the Cournot model? Well, notice that if we aren't initially at 32 units of output across the two firms, there's still adjustments that need to be made. Once we get to equalibrium we'll stay there, so it's not quite accurate away from equilibrium. But it is, once we get there. And if there are a larger number of firms than 2, then if one firm increases its output by a little bit, let's say we had 10 firms instead of just 2. That one firm's increase in output will not appear to be as large, relative to overall market demand. So not too far off base as the number of firms expand. We'll turn to other ways to formulate oligopolistic settings in the next session.