Chapter 9

Basic Oligopoly Models

 Learning Objectives

Explain Explain how beliefs and strategic interaction shape optimal decisions in oligopoly environments .

Identify the conditions under which a firm operates in a Sweezy, Cournot, Stackelberg, or
Identify Bertrand oligopoly, and the ramifications of each type of oligopoly for optimal pricing decisions,
output decisions, and firm profits.

Apply reaction (or best-response) functions to identify optimal decisions and likely competitor
Apply responses in oligopoly settings.

Identify the conditions for a contestable market and explain the ramifications for market power
Identify and the sustainability of long-run profits.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-2

 Conditions for Oligopoly
• Oligopoly market structures are characterized by only a few firms, each
of which is large relative to the total industry.
– Typical number of firms is between 2 and 10.
– Products can be identical or differentiated.
• An oligopoly market composed of two firms is called a duopoly.
• Oligopoly settings tend to be the most difficult to manage since
managers must consider the likely impact of his or her decisions on the
decisions of other firms in the market.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-3

Strategic Interaction: A Firm’s Demand Depends on
Actions of Rivals (Figure 9-1)

Price
Demand if rivals
C match price changes

Demand if rivals do not

A
B match price changes
𝑃0

Demand2
Demand1

0 𝑄0 Output

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-4

 Sweezy Oligopoly
The Sweezy model is based on a very specific assumption regarding how
other firms will respond to price increases and price cuts.
Sweezy oligopoly characteristics:
• There are few firms in the market serving many consumers.
• The firms produce differentiated products.
• Each firm believes its rivals will cut their prices in response to a price
reduction but will not raise their prices in response to a price increase.
• Barriers to entry exist.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-5

 Sweezy Oligopoly (Figure 9-2)
Price

Sweezy Demand MC0

A
B
𝑃0
MC1
C Demand1
(rival holds price
constant)

E MR1
MR Demand2
(rival matches price change)
0 𝑄0 F Output
MR2

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-6

 Cournot Oligopoly
Cournot oligopoly characteristics
• There are few firms in the market serving many consumers.
• The firms produce either differentiated or homogeneous products.
• Each firm believes rivals will hold their output constant if it changes its
output.
• Barriers to entry exist.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-7

 Cournot Oligopoly: Reaction Functions
Consider a Cournot duopoly. Each firm makes an output decision under
the belief that its rival will hold output constant when the other
changes its own output level.
– Implication: Each firm’s marginal revenue is impacted by the other firm’s output
decision.

The relationship between each firm’s profit-maximizing output level is

called a best-response or reaction function.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-8

 Cournot Oligopoly:
Reaction Functions Formula
Given a linear (inverse) demand function

and cost functions,

the reaction functions are:

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-9

 Cournot Reaction Functions (Figure 9-3)
Quantity2

Firm 1’s Reaction Function

𝑄2 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦
𝐶𝑜𝑢𝑟𝑛𝑜𝑡
Cournot equilibrium
𝑄2 C
Firm 2’s Reaction Function
D A
B

𝑄1𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦 Quantity1

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-10

 Cournot Oligopoly: Equilibrium

A situation in which neither firm has an incentive to change its output

given the other firm’s output.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-11

 Cournot Oligopoly: Isoprofit Curves

A function that defines the combinations of outputs produced by all firms

that yield a given firm the same level of profits.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-12

Isoprofit Curves for Firm 1 (Figure 9-4)
1. Every point on a given isoprofit curve
yields Firm 1 the same level of
profits.
2. Isoprofit curves that lie closer to Firm
1’s monopoly output are associated
with higher profits for that firm.
3. The isoprofit curves for Firm 1 reach
their peak where they intersect Firm
1’s reaction function.
4. The isoprofit curves do not intersect
one another.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-13

Firm 1’s Best Response to Firm 2’s Output
(Figure 9-5)
Quantity2

(Firm 1’s reaction function)

A B C D
∗
𝑄2 𝐴
is the output firm 1 thinks firm 2 will choose
𝜋1
𝜋1 𝐵
𝜋 1𝐶

𝑀
𝑄1 𝐴𝑄1 𝐵 𝑄
𝑄1𝐶 1
𝑄1
𝐷
Quantity1

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-14

 Firm 2’s Reaction Function and Isoprofit Curves
(Figure 9-6)

Quantity2

Monopoly point
for firm 2
𝑄2 𝑀
C G Firm 2’s profit increases as isoprofit
B curves move toward

A
𝜋 3𝐶
𝜋 2𝐵 (Firm 2’s reaction function)
𝜋1 𝐴 F
Quantity1

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-15

 Cournot Equilibrium (Figure 9-7)
Quantity2
𝜋 2𝐶𝑜𝑢𝑟𝑛𝑜𝑡
r1

𝑄2 𝑀 Cournot Equilibrium

𝑄2𝐶𝑜𝑢𝑟𝑛𝑜𝑡

𝜋 1𝐶𝑜𝑢𝑟𝑛𝑜𝑡

r2

𝑄1𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀 Quantity1

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-16

 Effect of Decline in Firm 2’s Marginal Cost
on Cournot Equilibrium (Figure 9-8)

Quantity2
𝑟1

∗∗
F
𝑄2
Due to decline in
firm 2’s marginal cost

E
𝑄2∗ 𝑟2 𝑟 2∗ ∗
𝑄1∗ ∗ 𝑄1∗ 𝑄1 𝑀 Quantity1

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-17

 Cournot Oligopoly: Collusion

• Markets with only a few dominant firms can coordinate to restrict

output to their benefit at the expense of consumers.
- Restricted output leads to higher market prices.

• Such acts by firms are known as collusion.

• Collusion, however, is prone to cheating behavior.
- Since both parties are aware of these incentives, reaching collusive agreements is often very
difficult.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-18

Incentive to Collude in a Cournot Oligopoly (Figure 9-9)

9-19
Incentive to Renege on Collusive Agreements in Cournot
Oligopoly (Figure 9-10)

9-20
 Stackelberg Oligopoly
Stackelberg oligopoly characteristics:
• There are few firms serving many consumers.
• Firms produce either differentiated or homogeneous products.
• A single firm (the leader) chooses an output before all other firms
choose their outputs.
• All other firms (the followers) take as given the output of the leader and
choose outputs that maximize profits given the leader’s output.
• Barriers to entry exist.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-21

 Stackelberg Equilibrium (Figure 9-11)
Quantity Follower
𝜋 2𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑟 1𝐿𝑒𝑎𝑑𝑒𝑟 𝜋 2𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝑟 2𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟
𝑄2 𝑀
C
.

𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝜋 1𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟
S

𝜋 1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟
𝑄1 𝑀𝑄1𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟 Quantity Leader

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-22

 Stackelberg Oligopoly:
Equilibrium Output Formulae
Given a linear (inverse) demand function

and cost functions and .

– The follower sets output according to the reaction function

– The leader’s output is

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-23

 Stackelberg Oligopoly In Action: Problem
Suppose the inverse demand function for two firms in a homogeneous-product, Stackelberg
oligopoly is given by

Cost functions for the 2 firms are

Firm 1 is the leader, and firm 2 is the follower.

– What is firm 2’s reaction function?

– What is firm 1’s output?
– What is firm 2’s output?
– What is the market price?

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-24

 Stackelberg Oligopoly In Action: Answer

The follower’s reaction function is:

The leader’s output is:
The follower’s output is:
The market price is:

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-25

 Bertrand Oligopoly
Bertrand oligopoly characteristics
• There are few firms in the market serving many consumers.

• Firms produce identical products at a constant marginal cost.

• Firms engage in price competition and react optimally to prices charged
by competitors.
• Consumers have perfect information and there are no transaction costs.
• Barriers to entry exist.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-26

 Bertrand Oligopoly: Equilibrium
• The conditions for a Bertrand oligopoly imply that firms in this market will
undercut one another to capture the entire market leaving the rivals with
no profit. All consumers will purchase at the low-price firm.

• This “price war” would come to an end when the price each firm charged
equaled marginal cost.

• In equilibrium, .
– Socially efficient level of output.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-27

 Comparing Oligopoly Models
Consider the following inverse market demand function:

and the cost function for each firm in this market is identical, and given
by

Under these condition, the different oligopoly outputs, prices and profits
are examined.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-28

 Comparing Oligopoly: Cournot
The Cournot oligopoly reaction functions are

These reaction functions can be solved for the equilibrium output. These
quantities can be used to compute price and profit.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-29

 Comparing Oligopoly: Stackelberg
The Stackelberg leader’s output is

• The market price is:

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-30

 Comparing Oligopoly: Bertrand
Since ,

Total output is found by:

– Solving yields:
– Given symmetric firms, each firm gets half the market, or 498 units.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-31

 Comparing Oligopoly: Collusion
Since the output associated with collusion is the same as monopoly output, the
inverse market demand function implies that monopoly marginal revenue
function is:

Setting marginal revenue equal to marginal cost yields:

– Solving this: units. Each firm will produce half of these units.

Each firm earns profits of

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-32

 Contestable Markets
Contestable markets involve strategic interaction among existing firms and potential
entrants into a market.

A market is contestable if:

– All producers have access to the same technology.
– Consumers respond quickly to price changes.
– Existing firms cannot respond quickly to entry by lowering price.
– There are no sunk costs.

*If these conditions hold, incumbent firms have no market power over consumers. P=MC and firms
earn zero economic profits.

© 2022 by McGraw-Hill Education. All Rights Reserved. 9-33