ECN 2115: Lecture 4. 4.

Oligopoly

4.5.1: Introduction

Another form of market structure is oligopoly. Let us look at the market structures we have
discussed. These are monopoly and perfect competition. We can actually classify market
structures into two groups. These are perfect markets giving us perfect competition and
imperfect markets giving us an array of markets. Among these are monopoly, oligopoly and
monopolist competition. Perfect competition and monopoly are at either extreme.

Figure 4.5.1: Market Models

Oligopoly belongs to the group of imperfect markets. Several important points emerge in the study
of imperfectly competitive markets.

Game theory is a valuable tool for studying oligopoly and other imperfect market
models. Small changes in details on the variables that firms choose, the timing of
their moves, information about market conditions or information about their rival's
actions can have dramatic effect on market outcomes.
Predicting outcomes in imperfectly competitive markets is difficult if this is based on
theory alone. Here, we have to combine theory and empirical evidence to predict
market outcomes.
In imperfect markets, firm worry about three types of decisions. These are in the short term ,
the medium term and the long term. The short-term decisions are price and output

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 outcomes. In the medium terms, firms worry about product design, advertising and
investment. In the long term, firms worry about entry and exist in the market.

4.5.2: Characteristics of Oligopoly.

In an oligopoly, there are a few firms, but more than one firm. There may be many reasons for
this. Economies of scale is one. Low costs cannot be achieved in some markets unless a few firms
are producing outputs that account for substantial percentage of the total available market.
Conseuently, there will be a few firms.

There might be economies of scale in sales promotion as well as production. This can promote a
oligopolistic market structure.

There may also be barriers to entry to the market. This would make it difficult for new firms to enter
the industry. Furthermore, the number of firms in an industry may decrease over time. This might
be because the participating firms in the industry will always want to weaken rivals and competitive
pressures in the industry through various means like mergers and acquisitions.

The major features of an oligopoly is the small number of firms in the market, the interdependence
of decision-making, barriers to entry and the indeterminate price and output outcomes.

4.5.3: Cournot Model

Assumptions

i) The market is perfectly competitive on the demand side. i.e., It is assumed that there are
many demanders, each of whom is a price taker.
There are no transactions or information costs.
The good is homogenous
There are two firms in the market
v) Each firm must decide how much to produce and the two firms make their decisions at the
same time.
Each firm treats the output level of its competitor as fixed and then decides how much to
produce.
Both firms have the same cost functions.
Both firms want to maximize their profits.

Suppose we have two firms; A and B. This will actually be a duopoly. Let us take an example of
costless production. In this case we shall have MC= O. The common example we can take is that of
two firms operating natural springs . These produce water and are costless.

The two firms will simultaneously choose and units of water to supply during a specific period.
Clearly, spring water is a homogenous product.

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The total market quantity will be Q = qA + thousand litres of water produced by the two firms.

If the market demand is given by;

Q = 120 — P where Q= total demand and P= market price.

We can use our inverse demand rule to determine the market price. This is given by,

P: 120- Q.

In this case, we can look at the two firms as playing a game. This is a game of which the players are
the two firms, actions are quantities, and payoffs are profits.

Nash Equilibrium in the Cournot Model.

For a pair of quantities, and q g, to be Nash Equilibrium, must be a best response to q B and
viceversa.

This will give us the best response functions. Let us compute the best response function for firm A.
Its best response function tells us the value of that maximizes A's profits given each possible choice
of by firm B.

We know that profits are maximized by the quantity where MR =MC.

Firm A

So for Firm A we have ; MC = O, since production is costless.

To calculate MRA, We have,

TRA = P q A (120-Q)

( 120- ) 120 qA — q 2 A-

Therefore, MIRA = /ö q A = 120 —

The best response function for firm A can therefore be derived from,

MRA = MC

120 - - % -o

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Similarly, we can find the best response function for firm B. This can be calculated as follows;

Firm B.

We have MC = O, To calculate MRB We have ,

TRB (120- Q) (120 -qB)

= 120 qa —q A qg— q 2 B

Therefore MR TRB / 120 -qA

We therefore have the best response function from setting MR -MC

MR B = MC

120 - 2 qg-q - O
120 - % = 2
(120 - CIA) / 2

This is the best response function for firm B. This is sometimes called the reaction function.

We can solve the equilibrium solution for the two firms when we solve the response
functions or reaction functions simultaneously. Thus we have; (120- qB)/ 2 and

= (120-qA) / 2.

Once we solve the two equations simultaneously, we

get; q A = 40 and % = 40.
This equilibrium solution is called a Nash Equilibrium. So in Nash Equilibrium both firms produce 40
units and total output is 80 units.

40 +40 = 80

To get the market price, we go to the demand function. We take the inverse demand function;

120 = Q

= 120 - + % ) = 120- (40 +40)

40
So the equilibrium solution is q F 40 qg=40 and P=40 and Q: 80.

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 We can graphically depict the Nash Equilibrium below.

( (Iffy )
Figure 4.5.2: Reaction Curves and Nash Equilibrium for Firm A and B.

We can further determine each firm's total profits in equilibrium. Thus;

= TR. TCF P. - TCA = (40 x 40) -

TRB -TCF P.%-TC (40 x 40) -o = 1,600
Total Industry profit is + n B = 1,600 + 1,600 = 3,200
It is important to note that the cournot model solution for equilibrium price and quantity is between
perfect competition and monopoly. This is depicted in figure 4.5.3. The equilibrium of the cournot
game might occur at point A.

Figure 4.53: Equilibrium for perfect competition, oligopoly and monopoly

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The cournot model can be extended to cases involving more complex demand and cost conditions
or situations involving three or more firms. As the number of firms grows large, it can be shown
that the nash equilibrium approaches the competitive case, with the price approaching marginal
cost.

General Case.

Let us generalize our discussions. Let us consider the case of an industry composed of two firms.
Total market out

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