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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.

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For example.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. as studied originally by Auguste Cournot in 1838.. 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. Each …rm faces the same type of (F Pj ) max qj p(q1 . 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. The assumption that each …rm takes the quantities of the others as given may seem unrealistic. Each …rm is de…ned by a cost function cj (qj ) which gives its cost for production a give quantity of goods.1 1 But a more It is also possible that there could be a boundary solution. In fact. qm ) qj cj (qj ): De…nition 1 A Cournot equilibrium consists of quantities (q1 . 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. if one or more …rms had very 262 . The market demand function p(Q) gives the market-clearing price as a function of total quantity. The formal model of Cournot competition is based on …rms 1. c00 j j the market price is decreasing in quantity sold (p0 (Q) problem: 0) and that 0). m. Crank out the …rst order conditions for each …rm. :::. Q. q2 . Assuming that all s second-order conditions are satis…ed. q2 . :::. 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. One way to proceed with equilibrium analysis is very mechanical.10. qm ) such that each …rm maximizes pro…ts given the production of other …rms. since we assume that the market price depends only on the total quantity Q and not on the quantities chosen by individual …rms. :::. We assume that production costs are strictly increasing and convex (c0 > 0.

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

each …rm recognizes that as it increases its quantity. 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. and a conjectured value q2 . This is analogous to a monopoly problem with …rm 1 as monopolist facing demand function D1 (q1 ) = A0 q1 . and thus its second-order conditions for a maximum are satis…ed. …rm 1’ …rst-order conditions are su¢ cient to identify its optimal quantity (assuming s that they identify a positive value for q1 ). each term in the numerator is (weakly) negative and each term in the denominator is (weakly) negative. it cuts the price to its existing customers. which …rm 1 takes as given. 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 . Thus. Example 3 Consider a simple linear example with linear demand and constant marginal cost for the …rms: p(Q) = A Q = A q1 q2 . thereby producing decreasing marginal pro…ts and a unique solution to its maximization problem for a given quantity produced by the other …rm. …rm 1’ marginal pro…ts are s decreasing in its quantity q1 . M C2 = c2 :Then the …rms are distinguished only by their marginal costs. Q. yielding the solution q1 (q2 ) = (A q2 c1 )=2: 264 .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 . In this respect. 2 (q1 . implying dq1 dq2 0. where A0 = A 0 0 q2 and q2 represents the conjectured value of …rm 2’ s production. with 1 (q1 . Given the parameters A. dq1 = dq2 q1 p00 (q1 + q2 ) + p0 (q1 + q2 ) q1 p00 (q1 + q2 ) + p00 (q1 + q2 ) + p0 (q1 + q2 ) c00 (q1 ) : By assumption. As in the monopoly case. q2 ) = q1 (A q1 q2 ) c1 q1 .

c2 = 2. Similarly.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. they can intersect at most once. As seen in Figure 1. …rm 2’ reaction function s 2 s atter has a slope of -1/2 (q2 (q1 ) = A c2 q1 ). so naturally …rm 2 produces a greater quantity in the resulting equilibrium at (2. which can be represented s as the inverse function q2 1 (q1 ) = A c1 2q1 . …rm 1’ reaction function is given by q1 (q2 ) = A c2 q2 . As depicted in the …gure below. s In this case. …rm 2’ reaction function is always ‡ than …rm 1’ reaction function. but q1 (q2m ) < 0. c1 = 3.for the speci…c parameter values A = 10. these reaction functions are linear as well. 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. 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. there is a unique intersection of the reaction curves in the linear example and thus a unique Cournot equilibrium with A 2c1 + c2 A . …rm 2 simply produces its monopoly quantity and …rm 1 produces nothing in equilibrium. Figure 1 graphs both reaction functions simultaneously. Note in addition that if the two reaction curves are linear.4 1 In a linear duopoly model. for this is the only way that the conjectured quantities for the …rms could match the solutions to their maximization problems. 3 265 . if for example q2 (0) = q2m is on …rm 2’ reaction curve. 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 ). which has a slope of -2. q2 = 3 2c2 + c1 : 3 q1 = In Figure 1. …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. s 4 A boundary equilibrium occurs. so there is a unique Cournot equilibrium. 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). A Cournot equilibrium is an intersection of the two reaction functions. 3). …rm 2 has lower marginal costs of production than does …rm 1. By comparison. so in graphical representation. s model3 that guarantees a unique equilibrium.

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 .

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

2. it only applies in repeated competition. First. Furthermore. 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. 10. two Cournot competitors would each produce (A k)=3 for total production of 2(A k)=3 and price of (A k)=3. They do not do so because their relationship to the product market mixes competition and monopoly.. The Cournot equilibrium is nice because it has this interpretation as the long-run dynamic outcome of some version of strategic interactions. where 2(A k)=3 consumers remain and the demand curve appears to be p(qi ) = 2A=3 k=3 qi : 268 . By contrast. Thus. the tatonnement description is dubious. Taking the production of the other competitor as …xed (competition). A monopolist in a simple linear demand economy p(Q) = A where k is the constant marginal cost of production. …rms may wish to try to develop a reputation over time in order to in‡ uence their rivals. though. 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. yet they cling to that assumption over many periods of play. each acts as a monopolist in what it perceives as the residual market. At the same time. Since the monopoly output maximizes total pro…ts for the industry.1 Comparison of Cournot and Monopoly Outcomes Q would set p = Q = (A k)=2.

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

10. 3) actually respond optimally k)=4 by producing 3(A k)=8. but it cannot do that and choose the best response to …rm 2 simultaneously. 2) induce …rm 2 to produce (A k)=4. k1 = k2 = 3: The …rms are identical. faster (but expensive) machinery. increases pro…ts from the symmetric equilibrium because …rm 2 reduces its output in response. 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. but …rm 1’ is producing too much to be s optimal. The Cournot equilibrium is for each to produce (A k)=3 or 2 each. 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.3. Again. each with marginal costs of 3 and no …xed costs. With lower marginal costs of production. with a market price of 5. q2 = (A k)=4: Total output Substituting and taking the derivative gives q1 = (A has increased from the Cournot equilibrium. The Stackelberg equilibrium is not an equilibrium of the original Cournot simultaneousmoves game. then …rm 2 would wish to increase its production a bit from (A k)=4 and so on.g. building new. Firm 2 is responding optimally to …rm 1. Example: Suppose that p(Q) = 9 Q. 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. because of production in‡ uence on rivals. Of course.2 Fixed and Marginal Costs: Another way to become more aggressive is to shift costs from marginal costs to …xed costs. e. while incurring a cost of 3*2 = 6. 270 . What …rm 1 would really like to do is 1) pretend to commit to (A to q2 = (A k)=2. a …rm hits the point M C = M R at higher production level than before (in its monopoly calculations for its residual market). Firm 1 increased its production to constrain …rm 2. Although we have only solved for a special case here. but …rm 1 is better o¤.(F P1 ) max q1 p(Q) = q1 (A q1 q1 q2 (q1 )): k)=2. it is possible to improve pro…ts by shifting towards a …xed cost production technology. Each …rm produces 3 units of the good at a total cost of 6.

which is at the core of Cournot competition. constant and identical marginal costs k. The …rms choose prices simultaneously and the …rm which charges a lower price will 271 .2 develops this idea further. Paradoxically. But let’ see what happens. It is pro…table to spend up to 12 to change technologies. Once again. That is quite unusual because most contracting issues involve attempts to align the incentives of employees with those of the …rm. Note that …xed costs play no role in the market competition because they are taken to be sunk costs at that point. In fact. …rm 1’ optimal reaction to …rm 2 is to produce (9 9q2 )=2. Then the Cournot equilibrium is q1 = 4. but that he felt that it was too di¢ cult that way. even though that shift could increase the production costs in the relevant range of possibilities. …rms cannot choose their market shares. s With c1 = 0.4 Price Competition It may seem that price rather than quantity competition is a more natural model. That in turn causes other …rms to be more conservative. F C and s its pro…t is 16 F C. It is the e¤ect on other …rms that is paramount here.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.3. 10. After all. p = 4. which is an increase s from the earlier value of 3 (q2 =2). Kreps problem 16. By shifting to a lower marginal cost technology. Price competition is known as Bertrand competition. 10. q2 = 1. oligopoly competition is one instance where it can improve pro…ts of the …rm to have its managers value something else. the commitment to aggressiveness can increase pro…ts. If the managers value market share. the …rms have unlimited capacity of production. then they will always choose to produce more output than suggested by the reaction curve. and undi¤erentiated goods.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. …rm 1 in‡ uences …rm 2 to cut production by 50%! Now …rm 1’ production costs are given by the …xed cost. it is said that Cournot wished to study a situation in which the strategic choice of …rms was the price rather than the quantities. In its extreme form.

it cannot o¤er such good service to them. Allow for a cost of congestion. even if it allows you to capture the whole market. Unfortunately. then this reduces your incentives to cut the price. As one …rm gains more customers. In this case. 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. either because of long lines or because it is straining its production limits. we would like to resolve their seeming clash.capture the whole market. If the initial price is above marginal cost. the best response for …rm 2 to any price p1 > k is a price just less than p1 . If the capacity of the …rms are not large enough to meet the full market demand individually. The …rms o¤er slightly di¤erentiated products. yielding no pro…ts whatsoever. whenever you cut the price. Similarly. then they could charge di¤erent prices and yet each still have some market share. 2. some customers will still buy Pepsi. 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.1 Linking Bertrand and Cournot Results Since Bertrand and Cournot each o¤er such di¤erent conclusions about the results of market pricing. and they will continue cutting prices until price reaches marginal cost. 10. tatonnement takes s the form of continual undercutting of prices. Price equals marginal cost equals k is the only way both can be simultaneously playing best responses to the other’ action. They split the market at equal prices. 3. Any of these adjustments produces an equilibrium which resembles pure Cournot competi272 . 1.4. With slightly more realistic assumptions. 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. 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 . If all the …rms o¤er minimum price guarantees. Even if Coke is considerably cheaper than Pepsi. 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 . the Bertrand model adjusts to produce results close to Cournot outcomes.

tion more than it resembles pure Bertrand outcomes. 273 .

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