Oligopoly

• Products might not be differentiated.

• Few firms account for most or all of total production.
• High barrier to entry – naturally or due to strategic actions taken
by firms to deter entry.
Oligopoly
• Think about a number between ‘0-100’. Write it down in a piece
of paper. The participant who wrote a number that is half of the
average of all numbers is the winner.
Oligopoly
• Strategic actions: Any decision taken by a firm that includes
setting price, determining production levels, undertaking
promotion campaign, or investing in new production capacity
depends on response of its competitors.

• Nash Equilibrium: Set of strategies or actions in which each firm

does the best it can given its competitor’s actions.
Game- A simple grade scheme for the class
• Write down the word ‘enemies’ or the word ‘friends’. Think of this as a grade bid. I
will randomly pair you with another person in the class.

• If you write ‘enemies’ and your pair writes ‘friends’, then you will get ‘40’. If you and
your pair both write ‘enemies’, you will get ‘10’. If you write ‘friends’ and your pair
writes ‘enemies’, you get a ‘0’ and if both of you write ‘friends’, then you get ‘15’.

Payoff Matrix Your pair

enemies friends
You enemies (a) 10, 10 40, 0
friends (b) 0, 40 15, 15

marks will be assigned to each student, based on the points made. >110= +5 ; 90-109 = 4; 70-89 = 3; 45-69= 1
The Prisoners’
Dilemma
• Prisoners’ Dilemma: Two
prisoners’ must decide
separately whether to confess to
a crime, if a prisoner confesses,
he will receive a lighter sentence
and his accomplice will receive a
heavier one, but if neither
confesses, sentences will be
lighter than if both confess.
Cournot Model- Quantity Game
• Cournot model: Oligopoly model in which firms produce homogenous
goods, each firm treats the output level of its competitor as fixed when
deciding how much to produce.

• Known variable: Market demand curve.

• Decision variable: Quantity (Both firms take the output decision

simultaneously).

• Market price: Price is dependent on total output by both the firms.

Cournot Model- Reaction curves
• Reaction curve: Firm 1’s profit-maximizing output is a Q1

decreasing schedule of how much it thinks Firm 2 100

will produce denoted by Q1*(Q2).
Firm 2’s Reaction
• We draw the reaction curve for Q2 whose MR and 75 Curve Q*2(Q1)
MC curves are different.
50
• Cournot Equilibrium: Equilibrium in the Cournot
model in which each firm correctly assumes how 25
Cournot
Equilibrium
much its competitor will produce and sets its Firm 1’s Reaction
production level accordingly. Curve Q*1(Q2)
0
25 50 75 100 Q2
• Cournot equilibrium is an example of a Nash equilibrium.
The Linear Demand Curve- Example
• Market demand curve: Q1

• P = 30-Q 30

• Here Q is the total production i.e. Q = Q1+Q2 Firm 2’s Reaction

Curve Q*2(Q1)
• MC1 = MC2 = 0
• Firm 1 and 2: 15
Cournot
Equilibrium
• Total revenue R1 = PQ1 = (30-Q)Q1 = 30Q1 - Q1Q1 - Q2Q1 10
7.5
• MR1 = ∆R1/ ∆Q1 = 30-2Q1-Q2 Firm 1’s Reaction
Curve Q*1(Q2)
• At MR1 = MC1 = 0, we get, Q1 = 15-Q2/2 0
7.5 10 15 30 Q2
• Similarly, Firm 2’s reaction curve is Q2 = 15-Q1/2
• Solving for Q1, given Q2, we get Q1 = Q2 = 10
• Market price = 30-20 = 10
• Revenue of each firm = 100
The Linear Demand Curve- Example
• Collusion: Focus on combined profit Q1

• R = PQ = (30-Q)Q = 30Q-QQ 30

• MR=∆R/ ∆Q= 30-2Q Firm 2’s Reaction

Curve Q*2(Q1)
• Q = 15, so Q1+Q2 = 15 Competitive
• Each firm produces 7.5 units Equilibrium
15
Cournot
• Competitive Output 10 Equilibrium
7.5
• MR = MC = P = 0 Collusive
Firm 1’s Reaction
curve Curve Q*1(Q2)
• P = (30-Q) = 0 0
7.5 10 15 30 Q2
• So, Q = 30
• Since, firms are identical so Q1 = Q2
• Market supply Q is summation of outputs by each firm.
• So, Q1 = Q2 = 15
First Mover Advantage- Stackelberg
Model
• Stackelberg Model- Oligopoly model in which one firm sets its output before
others firms do.
• Firms take sequential actions while expanding their capacities

• Firm 1 sets its output first

• Firm 2 follows Firm 1 (it reacts based on Firm 1’s decision) – Follows the reaction
curve

• While making output decision, Firm 1 knows how Firm 2 will react

• Firm 1 sets its output after taking into account Firm 2’s reaction curve
First Mover Advantage- Stackelberg Model
• Market demand curve:
• P = 30-Q
• Firm 2 takes Firm 1’s output decision as fixed.
• Firm 2’s profit-maximizing output is given by Cournot reaction curve, Q2 = 15-
Q1/2
• Firm 1 Chooses Q1 which maximize its profit so that MR=MC=0
• R1= PQ1 = (30-Q)Q1 = 30Q1 - Q1Q1 - Q2Q1
• R1 depends on Q2, so put Q2 from Cournot reaction curve, R1 = 30Q1-Q1Q1-
(15-Q1/2)Q1 = 15Q1-(1/2)Q1Q1
• MR1= ∆R1/ ∆Q1 = 15-Q1. Since, MR=0, so Q1=15. Solving for Q2=7.5
• Firm 1 enjoys first mover advantage.
Bertrand Model- Price game
• Bertrand competition: Oligopoly model in which each firm treats
the price of its competitors as fixed, and all firms decide
simultaneously what price to charge.
Cournot and Bertrand Model compared
• Cournot and Bertrand competition takes place over different time frames.
• Cournot model is a long-run capacity competition.
• Cournot is a “two-stage” competition (first choose capacities and then
choose prices).
• In contrast, the Bertrand model is a short-run price competition
• both firms have more than enough capacity to satisfy market demand at any price
greater than or equal to marginal cost.
• Which is a more aggressive form of competition?
• Cournot equilibrium results in positive profits and a price that exceeds
marginal cost.
Price game in homogenous goods
• Market demand curve: P = 30-Q
• Supply is Q = Q1+Q2 is total production of homogenous good.
• We assume, MC1 = MC2 = Rs.3
• R1 = PQ1 = (30-Q)Q1 = 30Q1-Q1Q1-Q1Q2
• MR 1 = MC 1 = 30-2Q1-Q2, similar is the case for Q2.
• Hence Q1 = Q2 and they are equal to 9.
• Market supply = Q1+Q2 = 18 and price = Rs. 12
• Profit = Q(P-MC) = 9*(12-3) = Rs. 81
Nash equilibrium in Bertrand Competition
• If any of the firm reduces prices upto MC, then it will capture the whole
market because the products are homogenous.

• Nash equilibrium: It is the competitive equilibrium i.e. P = MC = Rs. 3

• Output Q = Q1+Q2 would increase upto 27 .
• Q1 = Q2 = 13.5

• Competition with homogenous Products

• Consumers will purchase only from the lowest price seller.
• If the prices are same, consumers will be indifferent and each firm will
supply half the market.
Price competition with differentiated
products
• Price competition with differentiated Products
• Firms compete on prices rather than quantities.

• Two duopolists have fixed cost of Rs. 20 but zero MC.

• Firm 1’s demand: Q1 = 12-2P1+P2
• Firm 2’s demand: Q2 = 12-2P2+P1
• Quantity produced by each firm decreases when price of the good produced by it
increases and increases when price of the good produced by its competitor increases.
• Choosing Prices: Both firms set their prices at the same time and takes its competitor's
price as fixed.
Price competition with differentiated
products
• Firm 1: π1= P1Q1-20 = P1 (12-2P1+P2) -20 = 12P1-2P1P1+P1P2 -20
• Profit is maximized at P1 given P2 as fixed. Also, it is maximized when
incremental increase in price leads to zero profit.
• ∆ π1/ ∆P1 = 12-4P1+P2 = 0
• Firm 1’s reaction curve: P1 = 3+P2/4
• Firm 2’s reaction curve: P2 = 3+P1/4
• Solving for P1 and P2, we get P1 = P2 = Rs. 4
• Q1 = Q2 = 8.
• Profit Firm 1 and 2 = 32-20 = Rs. 12
Price competition with differentiated
Products
• Collusion: Both the firms decide to charge P1
the same price instead of independently.
0
Firm 2’s Reaction
• πT = π1+ π2 = 24P -2PP-40 Curve Q*2(Q1)

• Profit is maximized when ∆ π / ∆P = 0

• ∆ πT / ∆P = 24 - 4P Collusive
6 equilibrium
• P = Rs. 6 Firm 1’s Reaction
Curve Q*1(Q2)
• Profit (total)= Rs. 32, π1= π2= Rs. 16 4
Nash Equilibrium
(Bertrand Equilibrium)
• Whether we have first mover advantage in this case like 0
Stackelberg Model? 4 6 P2
Competition Versus Collusion: The
Prisoner’s Dilemma
• This profit is higher than the competitive outcome but lower than collusive
outcome.
• Then why don’t the firms collude?
Competition Versus Collusion: The
Prisoner’s Dilemma
• Competitor may set a lower price and capture the whole market.
• Firm 1’s demand: Q1 = 12-2P1+P2
• Firm 2’s demand: Q2 = 12-2P2+P1
• At Bertrand equilibrium, firms charge Rs. 4 and earn a profit of Rs. 12 whereas if
they collude, they will charge a price of Rs. 6 and earn profit of Rs. 16
• If Firm 2 decide to charge Rs. 4 instead.
• Π2 = P2Q2-20 = (4) (12-2(4)+6) -20 = Rs. 20
• Π1 = P1Q1-20 = (6) (12-2(6)+4) -20 = Rs. 4
• Hence, profit of firm 2 increases at the cost of profit of firm 1.
• Noncooperative game: Game in which negotiation and enforcement of binding
contracts are not possible.
The Prisoners’ Dilemma
Payoff Matrix for Pricing Game Firm 2
Charge Rs 4 Charge Rs 6
Firm 1 Charge Rs 4 Rs. 12, Rs. 12 Rs. 20, Rs. 4
Charge Rs 6 Rs. 4, Rs. 20 Rs. 16, Rs. 16
Implications of the Prisoners’ dilemma for
Oligopolistic Pricing
• In oligopolistic competition, firms have many opportunity to set output
and price by observing the behavior of their competitors unlike the
prisoners’ dilemma case.
• Firms develop reputation from which trust can arise.
• Price wars lower profits in the long run.

• Price rigidity: Characteristic of oligopolistic markets by which firms are

reluctant to change prices even if costs or demand changes.
• Change in prices may send a wrong signal to the competitors.
Kinked demand curve model
• Kinked demand curve: Each firm faces a demand curve
kinked at the currently prevailing price.
• At higher price demand is very elastic
• At lower price demand is inelastic

Rs. Per unit of output

MC’
• At a higher price than the prevailing one, the firms might
MC
not follow its suit and the firm would lose sales and
market share. P*

• At a lower price, other firms would follow its suit

because they do not want to loose their market share.
D
• Sales would increase upto the extent of increase in 0
market demand due to lower prices. Q* Output

• Marginal Cost can change without

change in prices.
Price Signaling and Price Leadership
• Price Signaling: Form of implicit collusion in which a firm announces a price
increase in the hope that other firms will follow suit.

• Price leadership: Pattern of pricing in which one firm regularly announces price
changes that other firms then match.
• The announcing firm is the price leader.
• Other firms are price followers.

• It’s a solution to the co-ordination problem.

• Price signaling can be detrimental due to deadweight loss. So, there are antitrust
laws.
The Dominant Firm Model

Price
Sf
D
• Dominant firm: Firm with a large market share of total sales
that sets price to maximize profits, taking into account the
supply response of smaller firms. P1 MC
dominant
• Smaller firms then take price set by dominant firm as given. P*
• They act as perfect competition where prices are given.
Dd

• Market demand curve is given. P2

• Supply curve of small firms is determined as aggregate 0

Qf Qd Qt Output
sum of marginal cost curves.
MR
dominant
• Supply curve of fringe firm is the difference between • Dominant firm produces Qd where
market demand and demand curve of dominant firm. MRd=MCd at price P*.
• At P1, supply of fringe firms is the market demand. At
P2, supply of fringe firms is zero. • Total quantity is Qd+Qf = Qt
Equilibrium in Markets
Type of Market Equilibrium Price
Perfect Competition Demand = Supply
Monopoly Marginal revenue = Marginal cost
Monopolistic Competition Marginal revenue = Average cost
Oligopoly - Bertrand Strategic consideration of the
behavior of competitors