Lecture 15

Oligopoly I

1
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Oligopoly

u What if there are few firms in the market?

u This is the definition of an oligopoly
u A single firm is still big enough to affect
industry supply
u Hence, each firm’s own price or output
decisions affect its competitors’ profits
 3
Oligopoly
u How do we analyse markets in which
the supplying industry is oligopolistic?
u There is no dominant model of
oligopoly… we will review several
u Let’s consider the case of a duopoly in
which the two firms supply the same
(i.e., homogeneous) product
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Price Competition
u Models of duopoly differ basically on
what the firms’ decision variable is
u Models in which firms choose prices
simultaneously are called of Bertrand
competition

Joseph Louis F.
Bertrand (1822 - 1900)
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Bertrand Competition
u All firms set their prices simultaneously
and independently
u Assume that each firm’s marginal
production cost is constant at c
u Each firm takes as given the price set
by the other firm, so as to maximize
profits
 6
Bertrand Competition
u Q: Is there a stable outcome?
u A: Yes. Exactly one
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Bertrand Competition
u Q: Is there a stable outcome?
u A: Yes. Exactly one. All firms set their
prices equal to the marginal cost c.
Why?
 8
Bertrand Competition
u Homogeneity implies that consumers
will buy from the lowest-price seller
u Firms realize that the demand they face
depends both on its own price and the
price set by the other firm
 9
Bertrand Competition
u Any firm charging a higher price than its
rival will sell no output
u Any firm charging a lower price than its
rival will obtain the entire market demand
(assuming no capacity constraints)
u Hence, at equilibrium, all firms must set
the same price
 10
Bertrand Competition
u Suppose the common price set by all
firms is higher than marginal cost c
 11
Bertrand Competition
u Suppose the common price set by all
firms is higher than marginal cost c
u Then one firm can just slightly lower its
price and sell to all the buyers, thereby
increasing its profit
 12
Bertrand Competition
u Suppose the common price set by all
firms is higher than marginal cost c.
u Then one firm can just slightly lower its
price and sell to all the buyers, thereby
increasing its profit.
u The only common price which prevents
undercutting is c
u Hence, this is the only stable outcome
 13
Bertrand Paradox
u Firms price at marginal cost
u Firms make zero profits
u Two firms suffice to replicate the perfectly
competitive outcome!

…essentially, the assumption of no capacity

constraints combined with a constant average
and marginal cost works as free entry in the
long run…
 14
Quantity Competition
u Assume now that firms compete by
choosing output levels
u This is called Cournot competition
u If firm 1 produces q1 units and firm
2 produces q2 units then the total
A.A Cournot
quantity supplied is Q = q1 + q2. (1801-1877)
The market price will be p(Q)
u The firms’ total cost functions are
c1(q1) and c2(q2)
 15
Quantity Competition
u Suppose firm 1 takes firm 2’s output
level choice q2 as given. Then firm 1
sees its profit function as

1 (q1 ; q2 )  p(Q)q1  c1 (q1 ).

Given q2, what output level q1
maximises firm 1’s profit?
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Quantity Competition
£/output unit

MC(Q)
p(Q)

MR(Q)
 17
Quantity Competition
£/output unit
The blue curve is the residual
demand firm 1 faces. The orange
curve is the corresponding MR
q
2 MC(q)
p(Q)

MR(Q)
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Quantity Competition
£/output unit
The blue curve is the residual
demand firm 1 faces. The orange
curve is the corresponding MR
q2
MC(Q)
p(Q)

q1(q 2) q

MR(Q)
 19
Quantity Competition
£/output unit
The blue curve is the residual
demand firm 1 faces. The orange
curve is the corresponding MR
q’
2 MC(q)
p(Q)

q1(q’2 ) q

MR(Q)
 20
Quantity Competition; An Example
u Suppose that the market inverse
demand function is
p (Q)  60  Q = 60 – (q1 +q2)
and that the firms’ total cost functions are

c1 (q1 )  q
2
1
and c2 (q2 )  15q2  q .
2
2
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Quantity Competition; An Example
Then, for any given q2, firm 1’s profit function is

 (q ; q )  (60  q  q )q  q .
1 2 1 2 1
2
1
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Quantity Competition; An Example
Then, for any given q2, firm 1’s profit function is
 (q1 ; q2 )  (60  q1  q2 )q1  q .
2
1

So, given q2, firm 1’s profit-maximising

output level solves

 60  2q1  q2  2q1  0.
 q1
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Quantity Competition; An Example

 60  2q1  q2  2q1  0.
 q1

Firm 1’s best response to q2 is

q1  R 1(q2 )  15  .25q 2 .

The firm's profit maximizing action as a function

of the action by the rival firm is the firm's best
response (or reaction) function
 24
Quantity Competition; An Example
q2
Firm 1’s reaction function
60
q1  R 1(q2 )  15  .25q 2 .

24

9 15 q1
 25
Quantity Competition; An Example
Similarly, given y1, firm 2’s profit function is

 (q2 ; q1 )  (60  q1  q2 )q2  15q2  q .

2
2
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Quantity Competition; An Example
Similarly, given q1, firm 2’s profit function is

Π(q2 ; q1 )  (60  q1  q2 )q2  15q 2  q .

2
2

So, given q1, firm 2’s profit-maximising

output level solves


 60  q1  2q2  15  2q2  0.
 q2
 27
Quantity Competition; An Example

 60  q1  2q2  15  2q2  0.
 q2
Firm 2’s best response to q1 is

45  q1
q2  R2 (q1 )  .
4
 28
Quantity Competition; An Example
q2

Firm 2’s reaction function

45  q1
q2  R2 (q1 )  .
4
45/4
6
21 45 q1
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Cournot Equilibrium
u An equilibrium occurs when each firm’s
output level is a best response to the
other firm’s output level
u Hence no firm wants to deviate from its
output level
u A pair of output levels (q1*,q2*) is a
Cournot equilibrium if
q1  R1 (q2 ) and q2  R2 (q1 ).
* * * *
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Quantity Competition; An Example
q1*  R 1(q2* )  15  .25q 2* and q2*  R 2 (q1* )  .25(45  q1* )
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Quantity Competition; An Example
q  R 1(q )  15  .25q
*
1
*
2
*
2 and q2*  R 2 (q1* )  .25(45  q1* )

Substitute for q2* to get

q  15  .25 45  q
*
1
2
 *
1 
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Quantity Competition; An Example
q  R 1(q )  15  .25q
*
1
*
2
*
2 and q2*  R 2 (q1* )  .25(45  q1* )

Substitute for q2* to get

1 
q  15  .25 45  q
* 2 *
1   q  13
*
1
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Quantity Competition; An Example
q  R 1(q )  15  .25q
* * *
and q  R 2 (q )  .25(45  q )
* * *
1 2 2 2 1 1

Substitute for q2* to get

1 
q  15  .25 45  q
* 2 *
1   q  13
*
1

Hence
q  .25(45  13)  8.
*
2
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Quantity Competition; An Example
q1*  R 1(q2* )  15  .25q 2* and q2*  R 2 (q1* )  .25(45  q1* )

Substitute for q2* to get

q  15  .25 45  q
*
1
2
 *
1   q  13
*
1

Hence q  .25(45  13)  8.

*
2

So the Cournot equilibrium is (q , q )  (13,8). *

1
*
2
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Quantity Competition; An Example
q2 Firm 1’s “reaction curve”

60 q1  R 1(q2 )  15  .25q 2 .

Firm 2’s “reaction curve”

45  q1
q2  R2 (q1 )  .
45/4 4

15 45 q1
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Quantity Competition; An Example
q2
60 q1  R 1(q2 )  15  .25q 2 .

Cournot equilibrium
45  q1
q2  R2 (q1 )  .
8 4

13 48 q1
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Cournot Paradox?
u The equilibrium price is thus:
p* = 60 -13 - 8 = 39
u Plugging this prices and firms’ outputs in
each firm’s profit function yields
1* = 338, 2* = 126
u Profits are positive in equilibrium!
u Firms have market power!
u Only when the number of firms approaches
infinity would profits approach zero
 38
Bertrand with differentiated products
Product Differentiation between two or more
products exists when the products possess
attributes that, in the minds of consumers, set
the products apart from one another and
make them less than perfect substitutes

Examples: Pepsi is sweeter than Coke, brand

name batteries last longer than generic ones
 39
Bertrand with differentiated products
u Two types of differentiation:
1. Vertical (Superiority): one product is
viewed as unambiguously better
than another
2. Horizontal (Substitutability): at the
same price, some consumers would
prefer product A while others would
prefer product B
 40
Bertrand with differentiated products
u We will consider Substitutability

u Lowering your price below your rival’s

will not result in capturing the entire
market, nor will raising price mean
losing the entire market
 41
An Example
q1 = 100 – 2p1 + p2 "Coke's demand"
q2 = 100 – 2p2 + p1 "Pepsi's demand"

MC1 = MC2 = 5
 42
An Example
u Given the rival’s price, firms again
behave as monopolists over their
residual demands
u In our example, what is firm 1's residual
demand when firm 2 sets price 10? 0?

q110 = 100 – 2p1 + 10 = 110 – 2p1

q10 = 100 – 2p1 + 0 = 100 – 2p1
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An Example
Each firm maximizes profits based
on its residual demand by setting its
Coke’s price residual MR = MC
100

Pepsi’s price = £0 for D0 and £10 for D10

D0

0
Coke’s quantity
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An Example

Coke’s price

110
100 Pepsi’s price = £0 for D0 and £10 for D10

D10
D0

0
Coke’s quantity
 45
An Example

Coke’s price

110
100 Pepsi’s price = £0 for D0 and £10 for D10

D10
D0

MR0
0
Coke’s quantity
 46
An Example

Coke’s price

110
100 Pepsi’s price = £0 for D0 and £10 for D10

D10
D0
MR10

MR0
0
Coke’s quantity
 47
An Example

Coke’s price

110
100 Pepsi’s price = £0 for D0 and £10 for D10

D10
D0
MR10
5

MR0
0
Coke’s quantity
 48
An Example

Coke’s price

110
100 Pepsi’s price = £0 for D0 and £10 for D10

30
27.5
D10
D0
MR10
5

MR0
0
45 50 Coke’s quantity
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An Example
Analytically, the best response price of Firm 1 is the
one that solves the problem:
Maxp1 π1 = p1q1(p1,p2) – 5q1(p1,p2) = (p1 - 5)q1(p1,p2)
= (p1 - 5)(100 – 2p1 + p2)
The solution is then given by the equation:
∂π1 / ∂p1 = 100 – 2p1 + p2 - 2(p1 - 5) = 0
Which leads to expression
p1 = R1*(p2 ) = 27.5 + p2 / 4
Because the problem is symmetric
p2 = R2*(p1 ) = 27.5 + p1 / 4
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Best Response (Reaction) Functions
Pepsi’s price (p2)

R2*(p1) = 27.5 + p1/4

(Pepsi’s R.F.)

27.5

Coke’s price (p1)

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The Equilibrium
u As before, equilibrium occurs when all firms
simultaneously choose their best response to
each others' actions
u That is, we are looking for a pair of prices
(p1*,p2*) such that
p1* = R1*(p2*) and p2* = R2*(p1*)
u Solving these two equations (see slide 49)
with two unknowns yields
p1* = p2* = 110 / 3
u Graphically again, the market equilibrium is
the point where the best response functions
intersect
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Best Response (Reaction) Functions
Pepsi’s price (p2) R1*(p2) = 27.5 + p2/4 (Coke’s R.F.)

R2*(p1) = 27.5 + p1/4

(Pepsi’s R.F.)

27.5

27.5 p = 110/3 Coke’s price (p1)

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Best Response (Reaction) Functions
Pepsi’s price (p2) R1*(p2) = 27.5 + p2/4 (Coke’s R.F.)

Bertrand R2*(p1) = 27.5 + p1/4

Equilibrium (Pepsi’s R.F.)
p2 =
110/3 •

27.5

27.5 p1 = 110/3 Coke’s price (p1)

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Bertrand Paradox anymore?
u Plugging the equilibrium prices in the profit
function we get:
1* = 2* = 2005.55
u Profits are positive in equilibrium since both
prices are above marginal cost!
u Why? A firm cannot capture all demand by
undercutting its rival
u Only when the number of firms approaches
infinity would price approach marginal cost
u Note! Prices need not be equal in equilibrium
if firms are not identical