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Oligopoly

10.1 Overview

Oligopoly is the study of interactions between multiple …rms. Because the actions of any one …rm may depend on the actions of others, oligopoly is the …rst topic which requires us to consider interactive decision making. In our study of supply and demand, we assumed that …rms and consumers took market conditions to be given and did not realize their decisions a¤ected the other side of the market. In our study of monopoly pricing, we allowed the monopolist to

account for the interdependence of quantity and price, but still assumed that consumers took market prices as given. That is, monopoly amounted to a single person strategic decision

problem where the …rm had complete control of the market outcome. But oligopoly requires a serious assumption of some sort about the interactions between the decisions of the …rms because each …rm has partial e¤ect on the market price. The standard models of oligopoly fall partway between the models of monopoly and perfect competition. Each …rm accounts for its own e¤ect on prices, and maximizes pro…ts, while taking the actions of other …rms to be …xed according to some prevailing conjecture about what those …rms will do. An equilibrium requires that the prevailing conjectures about the actions of

all …rms actually correspond to their pro…t-maximizing decisions given these conjectures. This de…nition of equilibrium matches the de…nition of Nash equilibrium in game theory.

261

q2 . The assumption that each …rm takes the quantities of the others as given may seem unrealistic. the informational requirements for a Cournot equilibrium can be somewhat relaxed – any …rm needs only to know the aggregate production of others to determine its pro…t-maximizing quantity in equilibrium. Each …rm faces the same type of (F Pj ) max qj p(q1 .1 1 But a more It is also possible that there could be a boundary solution. qm ) qj cj (qj ): De…nition 1 A Cournot equilibrium consists of quantities (q1 . check that the combination of cost function cj (qj ) and price function p(Q) satisfy the second-order conditions so that the FOC’ for each …rm. The formal model of Cournot competition is based on …rms 1. qm ) such that each …rm maximizes pro…ts given the production of other …rms. m. then the combination of …rst-order conditions for all the …rms produce a system of m equations with m unknowns (the quantities of the …rms) and should generally produce an interior solution which is a Cournot equilibrium.2 Classical Cournot Outcomes The most prominent model of competition among a small number of …rms is Cournot competition. Each …rm decides on a quantity to produce and the total quantity of production sets the market price. Each …rm is de…ned by a cost function cj (qj ) which gives its cost for production a give quantity of goods. :::. For example. Q. We assume that production costs are strictly increasing and convex (c0 > 0. since we assume that the market price depends only on the total quantity Q and not on the quantities chosen by individual …rms. Assuming that all s second-order conditions are satis…ed. :::. Crank out the …rst order conditions for each …rm. The market demand function p(Q) gives the market-clearing price as a function of total quantity. as studied originally by Auguste Cournot in 1838.. :::. One way to proceed with equilibrium analysis is very mechanical.10. for a …rm may have many competitors and is unlikely to know about the speci…c production plans of each and every one of them. c00 j j the market price is decreasing in quantity sold (p0 (Q) problem: 0) and that 0). q2 . In fact. if one or more …rms had very 262 .

q2 such that q1 (q2 ) = q1 . both p and c are linear functions. c00 0. which we discuss at length below. (The We illustrate this result by totally di¤erentiating the …rst-order conditions for q1 . q2 (q1 ) = q2 . but is not su¢ ciently positive to o¤set the two other negative terms in the sum.intuitive approach is to analyze the reaction curves of each …rm. ^ ^ ^ ^ For …xed and known q2 . so that p00 = c00 = 0 and j the second-order conditions are guaranteed to hold. analysis for q2 is similar. In the simplest example. We have assumed that p0 0. and will also hold in some cases where p00 > 0.) high costs of production that they would only lose money by setting qj > 0. De…ne s q2 (q1 ) similarly. Reaction Curves De…ne q1 (q2 ) as the optimal production for …rm 1 as a function of …rms 2’ production. then these …rms should not produce anything in equilibrium. q2 . the …rst-order conditions for …rm 1’ maximization problem are s p(q1 + q2 ) + q1 p0 (q1 + q2 ) c0 (q1 ) = 0: 1 The second-order conditions for a maximum are given by 2p0 (q1 + q2 ) + q1 p00 (q1 + q2 ) c00 (q1 ) 1 0: The …rst and second-order conditions for …rm 2 are exactly parallel to the conditions identi…ed above for …rm 1. which describe each …rm’ s optimal quantity as a function of the total quantity produced by others. so the second-order conditions always hold if p00 is non-positive. We begin by studying reaction curves in the case of duopoly (two …rms) and then extend our analysis to the case of many …rms. Proposition 2 Suppose that the …rst-order conditions characterize the reaction functions for each …rm2 and that p00 (q) 0. 2 This is equivalent to assuming that there is a unique solution to (FOC) and that the second-order conditions hold as well. 263 . Then q1 (q2 ) is decreasing in q2 and q2 (q1 ) is decreasing in q1 . An equilibrium consists of quantities q1 .

where A0 = A 0 0 q2 and q2 represents the conjectured value of …rm 2’ s production. In this respect. q2 ) = q1 (A q1 q2 ) 1= c2 q2 @q1 = A c1 The derivative of …rm 1’ pro…t with respect to its quantity is then @ s q2 2q1 .p00 (q1 +q2 )dq1 +p00 (q1 +q2 )dq2 +p0 (q1 +q2 )dq1 +q1 p00 (q1 +q2 )dq1 +q1 p00 (q1 +q2 )dq2 c00 (q1 )dq1 = 0: 1 dq1 Rearranging terms to isolate the ratio dq2 . Given the parameters A. M C2 = c2 :Then the …rms are distinguished only by their marginal costs. Example 3 Consider a simple linear example with linear demand and constant marginal cost for the …rms: p(Q) = A Q = A q1 q2 . This is analogous to a monopoly problem with …rm 1 as monopolist facing demand function D1 (q1 ) = A0 q1 . Q. q2 ) = q1 (A q1 q2 ) c1 q1 . and a conjectured value q2 . …rm 1’ …rst-order conditions are su¢ cient to identify its optimal quantity (assuming s that they identify a positive value for q1 ). …rm 1’ marginal pro…ts are s decreasing in its quantity q1 . 2 (q1 . with 1 (q1 . M C1 = c1 . we can view each …rm in a Cournot duopoly as a residual monopolist for customers who are not served by the other …rm. dq1 = dq2 q1 p00 (q1 + q2 ) + p0 (q1 + q2 ) q1 p00 (q1 + q2 ) + p00 (q1 + q2 ) + p0 (q1 + q2 ) c00 (q1 ) : By assumption. each …rm recognizes that as it increases its quantity. which …rm 1 takes as given. and thus its second-order conditions for a maximum are satis…ed. Thus. yielding the solution q1 (q2 ) = (A q2 c1 )=2: 264 . thereby producing decreasing marginal pro…ts and a unique solution to its maximization problem for a given quantity produced by the other …rm. each term in the numerator is (weakly) negative and each term in the denominator is (weakly) negative. As in the monopoly case. implying dq1 dq2 0. it cuts the price to its existing customers.

By comparison. 3 265 . for this is the only way that the conjectured quantities for the …rms could match the solutions to their maximization problems. if for example q2 (0) = q2m is on …rm 2’ reaction curve.4 1 In a linear duopoly model. c2 = 2. but q1 (q2m ) < 0. which has a slope of -2. Firm 1’ reaction curve q1 (q2 ) is more steeply s This is a general property of a linear duopoly sloping than …rm 2’ reaction curve q2 (q1 ). The negative value for …rm 1’ reaction function indicates that …rm 1’ production costs are so high that it cannot s s compete pro…tably with …rm 2 in equilibrium. …rm 2’ reaction function to s s …rm 1’ reaction function is given by the equation s q2 (q1 ) = (A q1 c2 )=2: Given the assumption of linear costs and prices. …rm 2 simply produces its monopoly quantity and …rm 1 produces nothing in equilibrium.This equation identi…es …rm 1’ reaction function to …rm 2’ production since it identi…es an s s optimal quantity as a function of …rm 2’ production.for the speci…c parameter values A = 10. Note in addition that if the two reaction curves are linear. Figure 1 graphs both reaction functions simultaneously. there is a unique intersection of the reaction curves in the linear example and thus a unique Cournot equilibrium with A 2c1 + c2 A . c1 = 3. so in graphical representation. q2 = 3 2c2 + c1 : 3 q1 = In Figure 1. …rm 2’ reaction function is always ‡ than …rm 1’ reaction function. which can be represented s as the inverse function q2 1 (q1 ) = A c1 2q1 . As depicted in the …gure below. so naturally …rm 2 produces a greater quantity in the resulting equilibrium at (2. these reaction functions are linear as well. they can intersect at most once. either at an intersection of the reaction curves or (if there is no intersection of the reaction curves) at a boundary with only one …rm producing a positive quantity. 3). …rm 2 has lower marginal costs of production than does …rm 1. so there is a unique Cournot equilibrium. A Cournot equilibrium is an intersection of the two reaction functions. …rm 2’ reaction function s 2 s atter has a slope of -1/2 (q2 (q1 ) = A c2 q1 ). …rm 1’ reaction function is given by q1 (q2 ) = A c2 q2 . Similarly. s In this case. s model3 that guarantees a unique equilibrium. s 4 A boundary equilibrium occurs. As seen in Figure 1. note that …rm 1’ production is repres sented as a function from the vertical axis (…rm 2’ quantity) to the horizontal axis (…rm 1’ s s quantity).

Duopoly Reaction Curves 8 7 6 Firm 2 quantity 5 4 q1(q2) q2(q1) 3 2 1 0 0 1 2 3 4 5 6 7 8 9 Firm 1 quantity 266 .

is that sophisticated …rms should come to expect equilibrium actions from each other.t ). there is some t ( ) so that after t or more periods. but for any distance from the equilibrium point . If we allow this dynamic process to continue for many periods. where …rm i produces qi. Suppose that the …rms compete over time in many consecutive periods. the …rms use last period’ output as the best prediction of this period’ output for its s s rival. the …rms are always within of their equilibrium quantities. and so on. The basis for this answer in Cournot competition is based on what is known as a tatonnement (slight adjustment) process. then they will move to point C in the second period. 267 . One extreme answer. For example. where both …rms are producing less than their equilibrium quantities. but this leaves the question of how they might come to these conjectures. to point D in the third period.t+1 = q2 (q1. where both …rms are producing more than their equilibrium quanities. the equilibrium values for the two …rms converge to the same value (A k)=3. Further. the tatonnement process leads to "cobweb" dynamics that converge towards the equilibrium point. the …rms switch their production from one side of the equilibrium point to the other (alternating between producing relatively more and relatively less than the equilibrium quantities). if we start at an arbitrary point B. while moving ever closer to equilibrium. then they would certainly produce their equilibrium quantities.t in period t. Each period.t ): As shown in Figure 2 for a linear duopoly example. If each …rm makes the right conjecture about what the other will produce. they will not actually reach equilibrium.In a symmetric case with c1 = c2 = k.t+1 = q1 (q2. q2. the …rms will move asymptotically closer and closer to the Cournot equilibrium over time –for any …nite number of periods t. suggested by Cournot. Tatonnement One challenge is that the equilibrium analysis above does not provide a description of why …rms would produce the equilibrium quantities in a Cournot duopoly. That gives a dynamic process for the outputs over time based on the equations q1.

First.1 Comparison of Cournot and Monopoly Outcomes Q would set p = Q = (A k)=2. the tatonnement description is dubious. we cannot really rely on the tatonnement story provided by Cournot and are left without a justi…cation of the Cournot equilibrium as the result of a dynamic convergence process. the Cournot …rms would do better to reduce their production. By contrast.. But more worrying is the fact that the assumption of each …rm that their competitor is acting as in the previous period is clearly false. yet they cling to that assumption over many periods of play. Thus. Furthermore.2. it only applies in repeated competition. The Cournot equilibrium is nice because it has this interpretation as the long-run dynamic outcome of some version of strategic interactions. 10. Taking the production of the other competitor as …xed (competition). where 2(A k)=3 consumers remain and the demand curve appears to be p(qi ) = 2A=3 k=3 qi : 268 . though. two Cournot competitors would each produce (A k)=3 for total production of 2(A k)=3 and price of (A k)=3. Since the monopoly output maximizes total pro…ts for the industry. each acts as a monopolist in what it perceives as the residual market. At the same time. …rms may wish to try to develop a reputation over time in order to in‡ uence their rivals. A monopolist in a simple linear demand economy p(Q) = A where k is the constant marginal cost of production. They do not do so because their relationship to the product market mixes competition and monopoly.

This example demonstrates the earlier statement that as the number of …rms increases (from 1). Instead. Formally. If …rm 1 can somehow commit to a more aggressive production policy. If the …rms recognize that point (and they will).5 A q1 2 k q2 (q1 ) = 5 : Note that …rm 1’ decision precedes …rm 2’ decision in time. p ! k and we reach the state of perfect competition. Firm 1 can attempt to commit to more production in several ways. Ultimately. …rm 1 can anticipate …rm 2’ production as a function of its own s decision. one …rm moves …rst. Then. based on the logic above. As …rm 1 produces more. …rm 2’ optimal reaction s is to produce less. 10. total quantity Q increases and p decreases. With more …rms. giving it a …rstmover advantage.3 Incentives and the Market The reaction curves illustrate a simple point. the behavior of the …rms moves further away from monopoly and towards perfect competition. they may try to in‡ uence their rival’ action. Q = (A k) n=(n + 1).1 Stackleberg Competition In the Stackelberg version of competition. so only …rm 1 can view the problem in this s s manner. qi = (A k)=(n 1).3. each …rm incorporates the e¤ect of its production on the prices of its own goods. it will produce more. as n ! 1.g. but it ignores the e¤ect on the sales of the other …rm. the pattern continues as each has less and less of a residual market to monopolize. 10. This …rm must be at least as well o¤ as its rival because it can always choose the earlier level of production (e. p = A=(n + 1) + nk=(n + 1): As n increases. Note that the strategic interaction between the actions of the …rms is s dismissed in the de…nition of Cournot equilibrium.As a result. 269 . it could improve its lot from the original equilibrium because …rm 2 would produce correspondingly less than before. (A k)=3 with two …rms).

Example: Suppose that p(Q) = 9 Q. Although we have only solved for a special case here. faster (but expensive) machinery. Each …rm produces 3 units of the good at a total cost of 6. Firm 1 increased its production to constrain …rm 2. building new. Of course. What …rm 1 would really like to do is 1) pretend to commit to (A to q2 = (A k)=2. k1 = k2 = 3: The …rms are identical.3. each with marginal costs of 3 and no …xed costs. Firm 2 is responding optimally to …rm 1. it is easy to demonstrate that both of these properties carry over when the demand function is more general (not necessarily so simple and linear) and marginal costs are increasing rather than constant: …rm 1 increases output if it can move …rst. 270 .(F P1 ) max q1 p(Q) = q1 (A q1 q1 q2 (q1 )): k)=2. with a market price of 5. 10. The Stackelberg equilibrium is not an equilibrium of the original Cournot simultaneousmoves game. e.2 Fixed and Marginal Costs: Another way to become more aggressive is to shift costs from marginal costs to …xed costs. 3) actually respond optimally k)=4 by producing 3(A k)=8. What happens if we allow this process to of thought to continue? We will inevitably end up back at the symmetric Cournot equilibrium because this is exactly the tatonnement process. q2 = (A k)=4: Total output Substituting and taking the derivative gives q1 = (A has increased from the Cournot equilibrium. but it cannot do that and choose the best response to …rm 2 simultaneously. The natural extension of this result is that it might be desirable to choose a more costly technology which is weighted towards …xed costs over a cheaper one weighted towards marginal costs. while incurring a cost of 3*2 = 6. but …rm 1 is better o¤. but …rm 1’ is producing too much to be s optimal. With lower marginal costs of production. Again. then …rm 2 would wish to increase its production a bit from (A k)=4 and so on. 2) induce …rm 2 to produce (A k)=4. because of production in‡ uence on rivals. a …rm hits the point M C = M R at higher production level than before (in its monopoly calculations for its residual market). increases pro…ts from the symmetric equilibrium because …rm 2 reduces its output in response. it is possible to improve pro…ts by shifting towards a …xed cost production technology.g. The Cournot equilibrium is for each to produce (A k)=3 or 2 each.

In fact. which is at the core of Cournot competition. The …rms choose prices simultaneously and the …rm which charges a lower price will 271 . q2 = 1. p = 4. but that he felt that it was too di¢ cult that way. 10. s With c1 = 0. and undi¤erentiated goods.3 Managerial Contracts A …nal method to become more aggressive is to pay your managers a bonus based on marketshare rather than total pro…ts. …rm 1 in‡ uences …rm 2 to cut production by 50%! Now …rm 1’ production costs are given by the …xed cost.How much would …rm 1 pay to reduce its marginal cost to 0? You would not think that it would ever pay more than its current production costs of 6. constant and identical marginal costs k. After all. It is pro…table to spend up to 12 to change technologies. which is an increase s from the earlier value of 3 (q2 =2). In its extreme form. Note that …xed costs play no role in the market competition because they are taken to be sunk costs at that point.2 develops this idea further. the commitment to aggressiveness can increase pro…ts. then they will always choose to produce more output than suggested by the reaction curve. F C and s its pro…t is 16 F C. Kreps problem 16. But let’ see what happens. …rms cannot choose their market shares. It is the e¤ect on other …rms that is paramount here. By shifting to a lower marginal cost technology. …rm 1’ optimal reaction to …rm 2 is to produce (9 9q2 )=2. even though that shift could increase the production costs in the relevant range of possibilities. That is quite unusual because most contracting issues involve attempts to align the incentives of employees with those of the …rm. Once again. Then the Cournot equilibrium is q1 = 4. it is said that Cournot wished to study a situation in which the strategic choice of …rms was the price rather than the quantities. That in turn causes other …rms to be more conservative. Paradoxically. the …rms have unlimited capacity of production.4 Price Competition It may seem that price rather than quantity competition is a more natural model. 10.3. oligopoly competition is one instance where it can improve pro…ts of the …rm to have its managers value something else. Price competition is known as Bertrand competition. If the managers value market share.

whenever you cut the price. 10. we would like to resolve their seeming clash.capture the whole market. then they could charge di¤erent prices and yet each still have some market share. this model produces an astonishing and somewhat unbelievable result: the only equilibrium is for both …rms to choose a price equal to their marginal cost. yielding no pro…ts whatsoever. If the initial price is above marginal cost. If the capacity of the …rms are not large enough to meet the full market demand individually. In this case. They split the market at equal prices. If all the …rms o¤er minimum price guarantees. tatonnement takes s the form of continual undercutting of prices. it cannot o¤er such good service to them. The proof of this result is really quite simple: the best response for …rm 1 to any price p2 > M C = k is a price just less than p2 . Allow for a cost of congestion. Comment: This actual story of price competition is an explanation of why it might be that …rms o¤er “minimum price guarantees” If you have to o¤er rebates to previous customers . As one …rm gains more customers.4. 1. Even if Coke is considerably cheaper than Pepsi. Price equals marginal cost equals k is the only way both can be simultaneously playing best responses to the other’ action. Unfortunately. and they will continue cutting prices until price reaches marginal cost. With slightly more realistic assumptions. Any of these adjustments produces an equilibrium which resembles pure Cournot competi272 .1 Linking Bertrand and Cournot Results Since Bertrand and Cournot each o¤er such di¤erent conclusions about the results of market pricing. the best response for …rm 2 to any price p1 > k is a price just less than p1 . 2. then this reduces your incentives to cut the price. either because of long lines or because it is straining its production limits. Let the …rms choose capacities in period 1 (building expenses are increasing in capacity) and then choose prices in period 2. the …rms will reduce those prices ruthlessly to attempt to take the whole market. 3. Similarly. even if it allows you to capture the whole market. the Bertrand model adjusts to produce results close to Cournot outcomes. then they may be able to maintain a pro…table price and escape from the cutthroat competition that drove the price down to marginal cost. The …rms o¤er slightly di¤erentiated products. some customers will still buy Pepsi.

273 .tion more than it resembles pure Bertrand outcomes.

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