15 Oligopoly (Imperfect Competition)

Dr. A. M. Tanvir Hussain

ECO467: Intermediate Microeconomic Theory - II

Department of Economics
East West University
Chapter 15

Introduction

The Bertrand model

The (non-cooperative) Cournot model

Collusion and cartel

Numerical example

Varying the number of firms

Long run decision making

2
15.1 Introduction
15.1.1 Definition and preliminaries

I Perfect competition and monopoly are two extreme market forms

no firm has an incentive to account for other firms’ output choices when
choosing its own output (⇒ choices are independent)

I Oligopoly is a market with more than one but relatively few firms

each firm exercises some market power, but, also faces competition

strategic thinking is advantageous for each firm (⇒ interdependent)

Game theory is a useful tool for analyzing firm behavior in such markets

Duopoly: a market with two firms

3
15.1 Introduction
15.1.1 Definition and preliminaries

I Final market outcome (equilibrium) often depends on ...

... how aggressively firms compete ...

I ... what variables firms choose

I ... how much firms know about each other
I ... how often firms interact with each other in the market

I Firms might find it beneficial to collude and create a “cartel” or they may
behave in a non-collusive manner

collusion is illegal in many countries

4
15.1 Introduction
15.1.2 Market interaction and final outcome (overview)

MR(qm) = MC(qm)
Price, costs qs(p)
p(q
Figure 15.1: Firms in
this oligopolistic market
can form a cartel andSupply (S)
act
M as a monopoly
PM (equilibriumqmat M ); firmsDemand (D)
PA A can get involved in a
“price war” by constantly AC
E
C MC undercutting| each
PC (q)|<1
other’s
prices and act as (pé,qé)
perfectly competitive
MR D (equilibrium at C)
Q Qé
| |>1
QM QA QC
| (q)|
| |<

5
15.2 The Bertrand model
15.2.1 Summary

I A game with two identical firms producing an identical good

firm i chooses price pi in a single-move simultaneous game, where i = 1, 2

each firm has constant marginal cost c (also constant average cost)

I Output is sold in a common market with demand D(p)

only Nash equilibrium strategy for each firm is to set p?i = c

each firm earns zero profit (as in perfect competition)

I Bertrand paradox: even with two firms, competition is so intense that they
end up at a perfectly competitive equilibrium

6
15.3 The (non-cooperative) Cournot model
15.3.1 Preliminaries

I Imagine a market with two firms producing a homogeneous good

qi is output produced by firm i, where i = 1, 2

aggregate output is Q = q1 + q2

firm i’s cost function is Ci (qi ), where i = 1, 2

usual cost function: Ci0 > 0 and Ci00 > 0, where i = 1, 2

I Output is sold in a common market

market price depends on aggregate output

inverse market demand function is P = P (Q) = P (q1 + q2 )

7
15.3 The (non-cooperative) Cournot model
15.3.2 Firm’s output choice problem

I Profit maximization problem for firm 1

Maximize: π1 (q1 , q2 ) = P (Q)q1 − C1 (q1 )

q1

= P (q1 + q2 )q1 − C1 (q1 ) (15.1)

where each firm’s profit depends on its own as well as the other’s

I Output choice (q1? , q2? ) is a non-cooperative Cournot-Nash equilibrium if qi?

maximizes πi given that ...

... each firm predicts (or “forms a belief”) about the other; and

... each firm’s beliefs are correct

8
15.3 The (non-cooperative) Cournot model
15.3.3 Optimality conditions

I First order conditions for an interior optimum are

∂π1
= P (Q? ) + P 0 (Q? )q1? − C10 (q1? ) = 0 (15.2)
∂q1
∂π2
= P (Q? ) + P 0 (Q? )q2? − C20 (q2? ) = 0 (15.3)
∂q2

I Second order conditions for profit maximum

∂ 2 π1
= 2P 0 (Q? ) + P 00 (Q? )q1? − C100 (q1? ) ≤ 0 (15.4)
∂q12
∂ 2 π2
= 2P 0 (Q? ) + P 00 (Q? )q2? − C200 (q2? ) ≤ 0 (15.5)
∂q22

9
15.3 The (non-cooperative) Cournot model
15.3.4 Intuition behind the optimality conditions

I Looking at the FOCs, we find M R = M C for each firm; recall chapter 12,
M R for an imperfectly competitive firm

M R(Q) = P (Q? ) + P 0 (Q? )q1? (15.6)

intuition: if firm increases output above market price will fall by P 0 (Q? )
q1? ,
and hence marginal revenue will be reduced by the amount P 0 (Q? )q1?

recall our discussion about the “adjustment term” in chapter 14

I Each firm’s profit is maximized when equations (15.2) and (15.3) hold

10
15.3 The (non-cooperative) Cournot model
15.3.5 Solution using best-response functions

I Each firm’s FOC defines its reaction (or best-response) function

e.g., firm 1’s reaction function shows its optimal (or profit maximizing)
output choice in response to what it believes firm 2 will produce

linear downward-sloping reaction functions for linear market demand curve

I Simultaneous solution of the FOCs or the best-response functions yields

the Cournot-Nash equilibrium (q1? , q2? )

I See solved example 15.1 from textbook (S-N)

11
15.3 The (non-cooperative) Cournot model
15.3.6 Best-response diagram for Cournot model

p(qé)
qs(p)
q2
A 45o-line (q1=q2) MR(qé
BR1(q2) p(q)
Supply
D Figure 15.2: Pé
Dem
Best-response functions
and Cournot Nash E Q
q 2 é E
equilibrium for a general
model q é
BR2(q1)
Reac/on func/on
of firm 2, f2(q1)
q1
q 1 é B C
|
<1
12
15.3 The (non-cooperative) Cournot model
15.3.7 Deriving the best-response functions
p(qé)
BR1(q2)
q 2 é qs(p)
q2 ⇡1m > ⇡15 > ⇡14 > ⇡13 > ⇡12 > ⇡11 q2
MR(qé) = MC(qé)
A
BR1(q2) p(q)
⇡11 Supply (S)
C A A 1
1

Pé
2
Demand (D)
D B 1

B qé E Qé
⇡12
q 1 é
3 C q é
⇡13 1
D (pé,qé)
⇡14
Reac/on func/on
⇡15 of firm 2, f2(q1)
q1 q1
⇡1m M1

a: Iso-profit curves b: Best-response lines | (q)|

<1

Figure 15.3: Deriving best-response lines from iso-profit curves

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15.4 Collusion and cartel
15.4.1 Joint output choice problem

I The cartel’s objective is to maximize joint profit (Π)

Maximize: π1 + π2 = P (Q)(q1 + q2 ) − C1 (q1 ) − C2 (q2 ) (15.7)

q1 ,q2

I First order condition for q1 :

P 0 (Q)Q + P (Q) − C10 = 0 (15.8)

where the adjustment term P 0 (Q)Q is larger than the corresponding

adjustment term in equation (15.2)

I Intuition: any increase beyond q1? decreases market price and thus revenue
for all firms; therefore Q is multiplied in the adjustment term

in the Cournot model, firm 1 was only considering its own revenue reduction

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15.5 Numerical example
15.5.1 Basic structure of the model

I Two firms (1 and 2) producing q1 and q2

I Market demand function

P (Q) = a − Q, a>0 (15.9)

where Q = q1 + q2

I Firms have identical cost functions are

C1 (q1 ) = cq1 and C2 (q2 ) = cq2 (15.10)

I Marginal cost is c > 0 for each firm (assume a > c)

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15.5 Numerical example
15.5.2 The (non-cooperative) Cournot problem

I Profit maximization problem for firm 1

Maximize: π1 (q1 , q2 ) = (a − Q)q1 − cq1

q1

= (a − q1 − q2 )q1 − cq1
= aq1 − q12 − q1 q2 − cq1 (15.11)

I First order condition for choosing q1 is

a − 2q1 − q2 − c = 0
a−c q2
q1 = − (15.12)
2 2

I Equation (15.12) is firm 1’s best-response function: BR1 (q2 )

16
15.5 Numerical example
15.5.2 The (non-cooperative) Cournot problem

I Profit maximization problem for firm 2

Maximize: π2 (q1 , q2 ) = (a − Q)q2 − cq2

q2

= (a − q1 − q2 )q2 − cq2
= aq2 − q1 q2 − q22 − cq2 (15.13)

I First order condition for choosing q2 is

a − q1 − 2q2 − c = 0
a−c q1
q2 = − (15.14)
2 2

I Equation (15.14) is firm 2’s best-response function: BR2 (q1 )

17
15.5 Numerical example
15.5.2 The (non-cooperative) Cournot problem

I Simultaneous solution of BR1 and BR2 yields Cournot Nash equilibrium

I Substitute for q2 in (15.12) from (15.14)

a−c 1a − c q1 
q1 = − −
2 2 2 2
a−c a−c q1
q1 = − −
2 4 4
3 a−c
q1 =
4 4
? a−c
q1 =
3

I Substituting in (15.14) and rearranging then yields

a−c
q2? =
3

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15.5 Numerical example
15.5.2 The (non-cooperative) Cournot problem

I We can further calculate

a(a − c) (a − c)2 (a − c)2 c(a − c)
π1 = π2 = − − −
3 9 9 3
(a − c)2 2(a − c)2 (a − c)2
= − =
3 9 9
(a − c)2 (a − c)2 2(a − c)2
Π? = π1 + π2 = + =
9 9 9
a−c a−c 2(a − c)
Q? = + =
3 3 3
2(a − c) 3a − 2a + 2c a + 2c
P? = a− = =
3 3 3

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15.5 Numerical example
15.5.2 The (non-cooperative) Cournot problem
p(qé)
qs(p
q2 A
a c 45o-line (q1=q2) MR(q
D p(q)
BR1(q2)
Suppl
a c Figure 15.4:q2é
Cournot
2 Nash equilibrium at the Pé De
intersection of qBR
1 1 (q2 )
é

a c ? ? and BR2 (q1 ); Nash E

E (q1 , q2 )
3 equilibrium coincides with
the 45◦ -line, because, q é
BR2(q1) firms have identical cost
functions Reac/on func/on
of firm 2, f2(q1)
q1
a c a c a c
3 2
|
<

20
15.5 Numerical example
15.5.3 (Collusive) Cartel problem

I Recall: cartel’s problem is to maximize joint profit

Maximize: Πc = (a − Q)q1 − cq1 + (a − Q)q2 − cq2

Q

= (a − Q)Q − cQ (15.15)

I First order condition for choosing optimal Q

∂Πc a−c
: a − 2Q − c = 0 ⇒ Qc = (15.16)
∂Q 2

I Only cartel output Qc is to be decided

individual firms’ quantities, (q1c , q2c ), are as agreed in the cartel agreement

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15.5 Numerical example
15.5.3 (Collusive) Cartel problem

I Substituting in the objective function in (15.15) yields

 a − c a − c c(a − c)
Πc = a− −
2 2 2
a − c a−c 
= a− −c
2 2
2
(a − c)
=
4

I Using the market demand function yields

a−c a+c
Pc = a − =
2 2

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15.5 Numerical example
15.5.4 The Bertrand game

I Zero-profit perfect competition-like equilibrium

π1b = π2b = Πb = 0
Pb = c
Qb = a − c

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15.5 Numerical example
15.5.5 Summary of results

Table 15.1: Summarizing and comparing results

Cartel Cournot Bertrand

a−c a−c
Firm output (q1 , q2 ) 3
, 3
(a−c)2 (a−c)2
Firm profit (π1 , π2 ) 9
, 9 0
(a−c)2 2(a−c)2
Total profit (Π) 4 9
0
a−c 2(a−c)
Market output (Q) 2 3
a−c
a+c a+2c
Market price (P ) 2 3
c

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15.6 Varying the number of firms
15.6.1 A more general model

I A general model with n identical firms with same cost function C(qi )

in Nash equilibrium: each firm will produce equal share of market output
qi = Q
n
(recall Nash equilibrium along the 45◦ -line)

I The adjustment term from (15.6) now becomes

Q
P 0 (Q)q1 = P 0 (Q) (15.17)
n
if n = 1: adjustment term becomes P 0 (Q)Q; see (15.9) for cartel

if n → ∞: adjustment term approaches zero; firms become competitive

I See solved example 15.3 from textbook (S-N)

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15.7 Long run decision making
15.7.1 Preliminaries

I Nature and scope of strategic interaction fundamentally differ in long run

a car manufacturer making slight changes year-to-year but making major

design innovations only every 3-5 years

I When making major long run commitments, firm often think about ...

... will it increase or decrease competition with rival firms?

... is commitment reversible and flexible?

... will it give first-mover advantage?

... what are the sunk costs involved?

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15.7 Long run decision making
15.7.2 The Stackelberg model

I Recall the setup from the Cournot model

two identical firms selling output q1 and q2 in a common market with inverse
demand function P = P (Q) where Q = q1 + q2

cost functions are C1 (q1 ) and C2 (q2 )

I Sequential game: firm 1 is “leader” (first-mover) and firm 2 is “follower”

I Equilibrium concept known as subgame-perfect Nash equilibrium found

through a process of “backward induction”

start at the end and “work your way back”

27
15.7 Long run decision making
15.7.2 The Stackelberg model

1 Leader starts with follower firm 2’s problem first

following (15.1), write the follower firm’s problem

Maximize: π2 (q1 , q2 ) = P (q1 + q2 )q2 − C2 (q2 ) (15.18)

q2

which defines the follower’s reaction function BR2 (q1 ); given perfect
information, leader already then knows how the follower will react

2 Leader firm 1 incorporates follower’s reaction function in its problem

Maximize: π1 (q1 , q2 ) = P (q1 + BR2 (q1 ))q1 − C1 (q1 ) (15.19)

q1

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15.7 Long run decision making
15.7.2 The Stackelberg model

I Take first order condition for leader’s choice of q1L

P (Q) + P 0 (Q)q1 + P 0 (Q)BR20 (q1 )q1 = C10 (q1 ) (15.20)

I Comparing with (15.2) indicates the additional term capturing the

strategic effect firm 1’s output has on firm 2’s decision

Leader firm 1 can produce more than its Cournot level and force follower
firm 2 to produce less by the amount of BR20 (q1 )

a larger q1 must accompany a smaller q2 (firm 1’s threat/commitment to

produce more must be credible/believable)

I In general, first-mover advantage dictates that q1L > q1? and q2F < q2?
(⇒ see solved example 15.8 from textbook)

29
15.7 Long run decision making
15.7.2 The Stackelberg model
p(qé)
a c a c
q2 2 A
45o-line M
BR1 D p(q)
S
Figure 15.5: q 2
é
Stackelberg
BR2 equilibrium at S and Pé
q1
é
Cournot Nash equilibrium
E (q1? , q2? )
at E; note that leader’s
output (and therefore
S profit) is higher at S than
at E q é
Reac/on func/o
of firm 2, f2(q1)
q1
a c a c
a c 3 2
30