CHAPTER 6

Oligopoly Models
INTRODUCTION
Learning Objectives
• After studying this chapter you will be able to:
• Explain how strategic interaction shape optimal decisions in
oligopoly market
• Identify the conditions of oligopoly and explain how different types
of oligopoly makes price decisions, output decisions, and firm
profits
• Identify the conditions for competitive market and explain market
power and sustainability of long run profits.

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Introduction
• An oligopolistic market structure describes
the situation where a few firms dominate
the industry
• Managers select the optimal price and
quantity in the following oligopoly market
environments:
• Sweezy
• Cournot
• Stackelberg
• Bertrand 9-4
 A VIDEO ABOUT
“Oligopolies and Game Theory”:
https://www.youtube.com/watch?v=JMq059SAQ
XM
 A VIDEO ABOUT
“Oligopolies, duopolies, collusion, and cartels”
https://www.youtube.com/watch?v=N0L00FZnhtg&list=PLNz8UZHL3nk5w5
ENxAigU1MCW3AXVMNrY
Key Conditions of Oligopoly
• The main conditions for oligopoly to exist are as follows:
1. A relatively small number of firms account for the
majority of the market. Typical number of firms is
between 2 and 20.
2. There are significant barriers to entry and exit.
3. There is an interdependence in decision-making.
Products can be identical or differentiated.
Oligopoly settings tend to be the most difficult to
manage since managers must consider the likely impact
of decisions of other firms in the market.

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Oligopoly Strategy: Price Change
Response
Optimal decision on price will depend on how the
Price manager believes other managers will respond.
Demand if rivals
C match price changes

Demand if rivals do not

A
B match price changes
𝑃0

Demand2
Demand1

0 𝑄0 Output
CHAPTER 6
Oligopoly Models
THE DIFFERENT OLIGOPOLY
MARKET ENVIRONMENTS
Oligopoly Market Environments
• Oligopoly market environments:
• Sweezy
• Cournot
• Stackelberg
• Bertrand

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 A VIDEO ABOUT
“The Different Types of Oligopoly”
https://www.youtube.com/watch?v=BqAvQWIilqk
Conditions for Sweezy Oligopoly
• There are few firms in the market serving many
consumers.
• The firms produce differentiated products.
• Each firm believes its rivals will cut their prices in
response to a price reduction but will not raise their
prices in response to a price increase.
• Barriers to entry exist.

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Conditions for Cournot Oligopoly
• There are few firms in the market serving many
consumers.
• The firms produce either differentiated or
similar products.
• Each firm believes that their rivals will not
change their output if it changes its output.
• Barriers to entry exist.

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Cournot Oligopoly: Reaction
Functions
• Each firm makes an output decision assuming that rival
will hold its output constant when the other changes its
output level.
• Marginal revenue of one firm is impacted by other firms
output decision.
• Firm’s profit-maximizing output level is called a best-
response or reaction function.

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Cournot Reaction Functions
Firm has no incentive to change its output given the

Quantity2 other firm’s output.

Firm 1’s Reaction Function

𝑄1 = 𝑟1 𝑄2

𝑄2 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦
Cournot equilibrium
𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 C
Firm 2’s Reaction Function
D A 𝑄2 = 𝑟2 𝑄1
B

𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦 Quantity1

Cournot Oligopoly: Collusion
• Collusion: A few dominant firms can negotiate to restrict
output to charge higher prices in the market.
• Collusion, however, is prone to cheating behavior.
• Since both parties are aware of these incentives, reaching collusive
agreements is often very difficult.

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Incentive to Collude in a Cournot
Oligopoly
Quantity2 𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝜋2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛

Collusion outcome
𝑄2 𝑀

𝑄2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝜋1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛

𝑄1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛 𝑄1 𝑀 Quantity1
Conditions for Stackelberg
Oligopoly
• There are few firms serving many consumers.
• Firms produce either differentiated or homogeneous
products.
• Leader and follower firms: the leader (single firm) chooses
an output before all other firms choose their outputs.
• The followers (all other firms) take as given the output of
the leader and choose outputs that maximize profits given
the leader’s output.
• Barriers to entry exist.

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Stackelberg Equilibrium
Quantity Follower
𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑟 𝐿𝑒𝑎𝑑𝑒𝑟 𝜋2 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝑄2 𝑀 𝑟 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝜋1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟
𝑄1 𝑀 Quantity Leader

𝑄1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟
Conditions for Bertrand Oligopoly
• There are few firms in the market serving many
consumers.
• Firms produce identical products at a constant marginal
cost.
• Firms involve in price competition and react optimally to
prices charged by competitors.
• Consumers have perfect information and there are no
transaction costs.
• Barriers to entry exist.

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Bertrand Oligopoly: Equilibrium
• Firms can capture the entire market leaving the rivals with
no profit. All consumers will purchase at the low-price.
• The price each firm charged equaled marginal cost. This
“price war” would come to an end.
• In equilibrium, 𝑃1 = 𝑃2 = 𝑀𝐶.
• Socially efficient level of output.

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Contestable markets: Key
Conditions
• Contestable markets have strategic interaction among
existing firms and potential new firms enter into a
market.
• A market is contestable if:
• All producers have access to the same technology.
• Consumers respond quickly to price changes.
• Existing firms cannot respond quickly to entry by
lowering price.
• There are no sunk costs.
• Therefore, incumbent firms have no market power over
consumers.

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CHAPTER 6
Oligopoly Models
 2-25

RECAP
On Key Terms and Concepts
Key terms
• Oligopoly
• Collusion
• Leader and follower firms
• Reaction function
• Sunk cost
• Duopoly
• Best response function
• Cournot equilibrium

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