chapter 19

The most realistic model that we will see in this course. The buyers are price takers but the finite number of sellers are
price setters.
 Learning Objectives
• Discuss how economists use game theory to understand oligopolies and describe
the concept of Nash equilibrium.

• Describe the Bertrand model and the Cournot model, and identify the Nash
equilibrium in each model.

• Explain why product differentiation makes price competition less intense and
identify the Nash equilibrium in a market with product differentiation.

• Analyze whether collusion is sustainable in a setting with repeated price

competition.

• Determine the number of firms that will enter a market and discuss the factors that
affect this number.

• Describe the main U.S. antitrust statutes and discuss their rationales.
19-2
 Overview
• Analyze what a firm’s best actions are in oligopolies using
game theory

• Contrast models of oligopoly: Bertrand and Cournot model

• Examine the factors that determine the number of firms

that enter an oligopolistic market

• Observe strategic decisions shaping long-term competition

with rivals, along with collusion when firms compete
repeatedly

19-3
 Oligopoly and Game Theory
• Economists determine/predict/ explain the outcome
of oligopolistic competition by applying game theory.

• In particular, they focus on the Nash equilibrium.

• In a Nash equilibrium of an oligopoly market, each

firm is making a profit-maximizing choice given/
under a specific belief about the choices of its rivals

19-4
 Bertrand Model
• Suppose Duopoly, that is, two sellers in the market
• Can be trivially generalized to multiple sellers, in
which case, we shall call it an Oligopoly
• Homogeneous goods: firms sell identical products

Defining feature of Bertrand model:

Identical firms set their prices simultaneously. So in this
game the players are the firms, and their strategies are
the price which are chosen simultaneously.
19-5
 Market Demand and Firm Demand Curves
Assumption: Say customers choose between Joe and Rebecca when they charge identical prices
by tossing an unbiased coin.

19-6
 Nash Equilibrium in the Bertrand Model
When sellers are identical, both (all) sellers charge an identical price equal to their
COMMON marginal cost earning zero profits in pure strategy NE.

Or else there will be a different NE, the seller with lower marginal costs – under
some assumption of suitable discrete pricing – will charge the largest possible
price less than marginal cost of the high cost firm and sell to the whole market,
while the high cost firm will produce zero.
19-7
 Cournot Model of Oligopoly
(a model of quantity competition)
• Firms choose how much to
produce simultaneously (more
importantly, without any knowledge of
what the other is choosing),
and the
price clears the market given
the total quantity produced.

• Compared to Bertrand’s
model, everything is same
except for the choice
variable for both firms is
quantity of output. This may
be more realistic in markets
where no single firm can
cater to WHOLE MARKET at
all prices 19-8
 Residual Demand Curves
Residual demand curve: shows the relationship between a
firm’s output and the market price given the outputs of the
firm’s rivals
Joe’s residual demand
Joe’s residual demand when Rebecca
when Rebecca produces produces 4,000
2,000

Market demand Market demand

19-9
Best Responses in the Cournot Duopoly Model
(without loss of generality assume that there are two players)

P = 60
Q = 2,000 MR = MC
P = 50, Q = 1,000
Joe behaves like a
monopolist given his
MR = MC
residual demand

19-10
 Best-Response/Reaction Curves in the Cournot Duopoly

REACTION CURVE: shows a firms best choice in response to

each possible action by its rival.

19-11
Nash Equilibrium in the Cournot Duopoly

• Each chooses its

profit-maximizing
output level given
its rival’s output
• Neither firm has
an incentive to
deviate from
(2,000, 2,000)

19-12
 MATHEMATICL EXPOSITION OF COURNOT DUOPOLY

• 2 firms
• Identical products
• Output choice competition
• Simultaneous choice of production amount: that is, one does not know
the choice of the other while making own choice

For simplicity of exposition in class, assume identical CONSTANT marginal

costs ‘C’.
 Cournot Duopoly - A Linear Demand Curve
Two identical firms face the following market demand curve   𝑃=30− 𝑄
Also,   =1+2
Total REVENUE for firm 1:  𝑅 =𝑃𝑄 =( 30 −𝑄 ) 𝑄 =30 𝑄 −𝑄 2 −𝑄 𝑄
1 1 1 1 1 2 1
then MR
  1=∆ 𝑅1   /∆ 𝑄 1=30 −2 𝑄 1 − 𝑄 2
To solve for the Nash equilibrium (Q*1, Q*2) , we set MR1 = C (the firm’s marginal cost)
and we find that Firm 1’s reaction curve:   -C
By the same calculation, Firm 2’s reaction curve:
  1 -C
Cournot equilibrium strategies:: 𝑸∗
  𝟏 =𝑸∗𝟐=(𝟑𝟎 −𝑪)/𝟑
Total quantity produced in equilibrium:  
𝟐(𝟑𝟎 −𝑪)/𝟑
Equilibrium price: (30+2C)/3

Note the demand by Hyundai chairman to reduce GST to help tide over the current auto
industry crisis. So what he is saying is that auto sales are down (for very
specific political and economic reasons beyond the scope of this course) so that the value
’30’ in demand curve has now become ‘20‘ leading to reduction in output produced and
hence, labour employed. If taxes are reduced sufficiently, then the output will increase again
as ‘C’ will reduce to say, ‘C-10’, and the initial output and employment levels would be
regained – albeit at a significant loss of Government revenue.
 Deadweight Loss from Duopoly versus
Monopoly
• The deadweight loss
of monopoly is
larger because the
monopoly price is
further above
marginal cost than is
the oligopoly price

19-16
 Price Competition with Differentiated
Products
• Differentiated products: when consumers do not
view similar products as perfect substitutes

19-17
 Bertrand Competition with Differentiated
Products
Coke’s Best Responses

Coke’s residual demand

Coke’s residual demand

19-18
Bertrand Competition with Differentiated
Products

19-19
 Collusion
Competing firms could merge become monopoly and earn monopoly profits that are
divided equally among shareholders of all firms. The is formation of CARTEL such as
OPEC. However, in domestic markets most countries have made such HORIZONTAL
MERGERS to be ILLEGAL.

So firms, if they want to collude in a domestic market must do so without any legal or
public declaration. This causes a problem because two separate production
technologies not integrated to each other need to agree to charge HIGH price – that
is, not cheat each other by charging LOW price while the other charges HIGH price.

Unfortunately, they can view their interaction to be an infinitely repeated game so use
special NE strategies (as the GRIM strategies) to sustain cooperation. That is, firms
may adopt a strategy in which they charge the monopoly price if no one has yet
undercut that price; otherwise they charge a price near or at their marginal cost.

OF COURSE, FOR THIS COLLUSIVE/COOPERTATIVE OUTCOME TO BE EQUILIBRIUM EACH FIRM MUST BE

ABLE TO VERIFY THE PRICES CHARGED BY OTHER FIRM SO AS TO ENSURE SHE HAS BEEN CHEATED OR
NOT. In that case, collusion will work if firms value the future highly enough (that is, if the
interest rate is low enough) EVEN when regulatory framework is robust and efficient.
19-20
 Imperfect Price Observation
(A STRATEGIC OBSTACLE TO COLLUSION)

In many real-world settings a firm observes its rivals’ prices imperfectly,

if at all. This makes collusion harder to sustain because a firm will
doubt whether its rivals have abided by the collusive agreement.

The Matt Damon movie called “Informant” actually documents such an

example “TACIT COLLUSION” between lysine manufacturers in US from
1992-95.
Interestingly, they start by fixing prices together – imperfect price observation led to
failure.

So the next step was for them to fix market share to each firm – if any firm sold
more leading to less sales from other fellow cartel members, she had to buy lysine
from them at the cartel decided price.

This eliminated the incentive to cheat among members and led to sustaining of
cooperation until FBI arrested all CEOs.
19-21
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY or NOMINAL ENTRY COSTS)

• Markets where firms sell differentiated products at a markup, that is,

such that price of these products is greater than the marginal cost of
producing total sales.

• In spite of that each firm makes almost negligible (almost zero)

economic profit in long run.

• It occurs in a market with free entry when there is a large number of

firms – sunk cost to entry are very less.

• In long run, each firm produces a level of output that is NOT minimum
of LAC curve level.

• Example: petrol pumps or supermarkets.

19-22
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT RUN

Suppose that the Nash

equilibrium price of the
competitor firm 2 at any value
P*2.
Because the firm is the only
producer of its brand, it faces a
downward-sloping demand
curve.
Then, given the fixed P*2, the
profit maximizing (and hence,
Nash equilibrium) price of firm
1 must be PSR:= P*1.

Suppose that PSR exceeds

average cost at the output sold
QSR . That is, in the short run,
the firm earns profits shown by
the yellow-shaded rectangle.
 Monopolistic Competition
(DIFFERENTIATED PRODUCT OLIGOPOLY WITH FREE ENTRY)

A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN

In the long run, these profits
attract new firms with competing
brands. The firm’s market share
falls in the new Nash equilibria
with larger number of firms, and
this is gets reflected in a
downward shift of its product’s
demand curve.
In long-run equilibrium,
described in figure (b), price
equals average cost, so the firm
earns zero profit even though it
has monopoly power.

So free entry and exit in

market eliminates any
monopoly profits in long run.
 COMPARISON OF MONOPOLISTICALLY COMPETITIVE LONG RUN EQUILIBRIUM AND
PERFECTLY COMPETITIVE LONG RUN EQUILIBRIUM

Under monopolistic
competition, price exceeds
marginal cost, and
production is carried out at
an inefficient level where
costs are not minimized.
Thus there is a deadweight
loss, as shown by the
yellow-shaded area.
The demand curve is
downward-sloping, so the
zero profit point is to the left
In both types of markets, entry occurs until profits are driven to
of the point of minimum
zero.
average cost.
 Back to Oligopoly - Raising Rival’s Costs

Options range from lobbying, to buying critical input in bulk, to fomenting labour trouble a
competitors’ plant. There is much documentary and punishment evidence in US itself. 19-26
How to Raise a Rival Firm’s Marginal Cost

• Lobbying
– Imposing stringent environmental regulations
– Imposing a tariff
• Increasing the cost of a rival’s inputs

• Buying a lot of the supply of a critical input and not

supplying it to rivals (example: De Beers)

19-27
 Strategic Precommitment in Oligopoly
When a firm commits to certain actions before rivals take
theirs, with the aim of affecting rivals’ later choices

• Examples
– Output choice by a first-mover (by signing a big labour contract
in advance or setting up a large plant whose technology requires it to
run at almost full capacity – like alumina refining plants)
– Spanish Conquistador (CORTES’) in 1519 burning ships to
eliminate option retreat while invading Aztec city of
Tenochtitlan
– Entry deterrence (making a large enough output choice, in the
manner mentioned above which makes profits consequent to entry so
low for the competitor that she does not enter)

19-28
 Output Choice by a First-Mover
(UNDER THE ASSUMPTION THAT SECOND MOVER ENTERS THE MARKET AT A LATER DATE)

• Stackelberg model of quantity competition: two firms

choose their outputs sequentially

If the entry cost of Joe is 15000$, then Rebecca will choose to produce (or commit to
produce) 4000 units, which will deter Joe from entering (as post entry profits would be
10000$, and thus, yield Rebecca a profit of 80000$. 19-29
 Entry Deterrence
(OUT PUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE
MARKET AT A LATER DATE)

Commitment versus flexibility: Though a firm can sometimes gain by pre-

committing to future actions, there is a potential downside to the strategy if market
conditions are uncertain.

Put simply, pre-committing limits the firm’s ability to respond to changing market conditions.
For example, DuPont once tried to deter rivals from producing titanium dioxide (a whitener
used in paints and plastics) by committing to an extensive expansion of its facilities.
Unfortunately for DuPont, an unexpected recession struck, and market demand turned out to
be much lower than DuPont forecasted, causing the firm’s clever strategy to yield a
disappointing loss. HENCE THE NEED FOR PROFESSIONAL STATISITICIANS/ ECONOMISTS WHO
CAN PREDICT BUSINESS CYCLES.

19-30
 Entry Deterrence
(OUTPUT CHOICE UNDER THE ASSUMPTION THAT SECOND MOVER MAY NOT ENTER THE MARKET
AT A LATER DATE)
• By expanding one’s output sufficiently, a firm may reduce the profit
its rival foresees enough to deter them from entering the market.

• However, often firms prefer to set up the excess capacity (by signing a
labour contract or setting up a plant) but not actually increase
production prior to possible entry of competitor.

• Effectively, the existing firms are threatening the entrant that they
will render this decision to enter a financially COSTLY decision if they
DARE to enter.

• Such THREATS increase output and cause losses to a potential entrant

will only have an effect if the threat is credible. The exact meaning of
this credibility in terms of COMMITMENT is beyond the current course 19-31