1

OLI GOPOLY
1
Lectures 23 and 24
A. Madestam
OLI GOPOLY
Whenfirmsareawarethat thepriceor output choicesmadeby
any one of them affects the profits of all, they are said to
recognizetheir mutual interdependence
Therecognition of mutual interdependencehas two important
consequences:
i) hfi i d i h h i i l
2
i) eachfirmisconcernedwithwhat itsrivalsareupto
ii) each firmknows that the other producers are watching it
andwill respondtoit actions
Thus thefirmmust takeits rivals reactions into account when
deciding what to do; when afirmtakes thepotential reactions
of other firms into account in choosing its best course of
action, thisfirmissaidtobehavestrategically
Fundamental assumptions
Oligopolyreliesonfour keyassumptions:
1) Sellersarepricemakers
2) Sellersbehavestrategically
3
3) Buyersarepricetakers
4) The conditions of entry may range from completely
blockedtoperfectlyfree
2
Market Structure
i) There are relatively few firms, and they face a downward
slopingfirm-specific demandcurve
ii) There are many buyers, and no one is large enough to
influencetheprice
iii) Oligopoly allows for products that range from perfect
b i d h hi hl diff i d d
4
substitutes to products that are highly differentiated; products
just have to be close enough substitutes such that producers
recognizetheir influenceononeanother
iv) Oligopoly is a broad enough model to encompass both
well-informedandpoorlyinformedbuyers
v) Oligopoly allows for conditions of entry ranging from
completelyblockedtoperfectly free
Cournot Duopoly
Let us consider the simplest oligopoly model, known as
Cournot duopoly and based on the following additional
assumptions:
i) Thereareonly two firms in theindustry, who choosetheir
output levelssimultaneously
5
ii) Further entryintothemarket iscompletelyblocked
iii) Thefirmsproducehomogenousgoods
iv) Thefirmshaveidentical andconstant marginal costsequal
toc
Theseassumptions areclearly restrictive, but help us to bring
out manyimportant featuresof oligopolisticbehavior
Equilibrium in the Cournot Duopoly
An oligopolistic market is in equilibrium when every firm
pursues a strategy that is a best response to the strategies of
theother firmsinthemarket
Inother words, amarket is inequilibriumwhenno firmwants
tochangeitsbehavior unilaterally
6
Does this definition remind you of something? YES, this
remindsusof thedefinitionof theNashequilibrium
A Cournot duopoly is in equilibrium when each firm is
producingtheoutput level that maximizes its profits giventhe
output level chosenbytheother firm
Wecall thisaCournot-Nashequilibrium
3
How to find a Cournot equilibrium
Proceed using graphs
In sum: given that Cheapskates output is 200 seats/day,
Sometimes on Timecan sell:
200 seats/day at a price of 200
400 seats/day at a price of 100
7
This corresponds to two points on Sometimes on Times
firm-specific demand curve, given that Cheapskates output
is 200 seats/day
More generally we could write D(p)-200 to express
Sometimes on Timesdemand schedule or residual
demand curve
How to find a Cournot equilibrium contd
If Cheapskates output changes to 250 seats/day, Sometimes
on Timesresidual demand curve becomes D(p)-250
Intuition: the more Cheapskates produces the smaller the
residual left toSometimes on Time
8
What is the profit-maximizing output level for Sometimes on
Time?
Need the marginal revenue and the marginal cost
curve
Each best response of Sometimes on Time can be summarized
by a best-response curve or reaction curve
How to find a Cournot equilibrium contd
The output y*(z) corresponds to Sometimes on Timesprofit-
maximizing output level, given Cheapskates production level
z
Similarly, output z*(y) corresponds to Cheapskates profit-
maximizing output level, given Sometimes on Times
9
g p , g
production level y
Putting the two reaction curves in the same diagramenables us
to find the Cournot-Nash equilibrium
4
Graphically, theCournot-Nash equilibriumis identified by the
intersection of thetworeactioncurves:
z
Cournot-Nash equilibrium
Cheapskates
outputin
/d
SometimesonTime
reactionfunction, ( ) y z
-
f
' z
h
10
y y
z

seats/day
SometimesonTime
outputinseats/day
Cheapskates
reactionfunction, ( ) z y
-
' y
g
z
Let us now study the situation algebraically. The market
demandcurvedependsonthejoint output of bothfirms:
( ) ( )
C S
p p y p y y = = +
FromCheapskates point of view, theoutput of Sometimes on
Timeisgiven(andunobservable); hence:
( )
11
( )
C S
p p y y = +
representsCheapskates residual demand curve, i.e. itsfirm-
specific demand curvegiventheconjectured output strategy
chosenbyitsrival - SometimesonTime
Theresidual demandcurvespecifiesthepricethat Cheapskates
would face, as a function of its own output level, given the
conjecturedoutput level chosenbySometimesonTime
Total revenuefor Cheapskates, based on its own output level
andtheconjecturedstrategy followedbyitsrival, isequal to:
( ) ( )
C C C S C
R y p y y y +
Marginal revenuebecomesthefollowing:
( ) ( ) R y dp y c
12
( ) ( )
C
( ) ( )
C
C C C S C
C
R y dp y
MR y p y y y
y dy
c
= + +
c
( ) ( )
C S
C
p y y dp y
y dy
c +
=
c
since:
5
Given the conjectured output strategy of Sometimes on Time,
Cheapskates maximizes profit on its residual demand; the
usual optimalityconditionapplies:
( ) ( )
C C C C
MR y MC y =
Inour specificcase, theconditionbecomes:
( )
( )
C S C
dp y
p y y y c + + =
13
( )
C S C
p y y y
dy
Intuitively, Cheapskates behaves as a monopolist on the
market shareit expects not tobenot coveredby Sometimes on
Time
This optimality condition implicitly defines Cheapskates best
response to each output level that Sometimes on Time might
choose; hence, it isknownasCheapskates reactionfunction
Symmetrically, given the conjectured output strategy of
Cheapskates, Sometimes on Time maximizes profit on its
residual demand too; again, the usual optimality condition
applies:
( ) ( )
S S S S
MR y MC y =
or:
( )
( )
dp y
p y y y c + + =
14
( )
S C S
p y y y c
dy
+ + =
Sometimes on Time behaves as a monopolist on the market
shareit expectsnot tobenot coveredbyCheapskates
As before, the optimality condition implicitly defines
Sometimes on Time best response to each output level that
Cheapskates might choose, and is Sometimes on Times
reactionfunction
Self-enforcing agreements
An agreement among firms is self-enforcing when it is in
each firms self-interest to abideby theagreement, given that
theother firmsarealsoabidingbyit
Thenotionof Cournot-Nashequilibriumcaptures theideathat
anagreement must beself-enforcingtobeviable
If the firms agree that each will produce its Cournot Nash
15
If the firms agree that each will produce its Cournot-Nash
equilibrium output level, then it will be in each firms self-
interest to abide by the agreement, given that it believes the
other firmisdoingsoaswell
Of course the kind of agreement we are considering are tacit
agreements, whereby each firm deduces what the implicit
agreement among themis without actually discussing it with
theother firms
6
Cartels
A cartel is an arrangement under which suppliers join
together toact asamonopolist, i.e. torestrict output andraise
market price; explicit cartel agreements inproduct markets are
rarebecausetheir aregenerallyillegal
A full cartel outcomeis representedby thepriceandquantity
at which suppliers joint profit is maximized; at the industry
16
at which suppliers joint profit is maximized; at the industry
level, the full cartel outcome corresponds to the monopoly
outcome
Tobesuccessful, acartel must beable:
i) to prevent its members fromcheating ontheagreement by
producingtomuchoutput
ii) tolimit entrybynewsuppliers
Can the full cartel outcome be supported by a self-enforcing
agreement intheCournot duopolymodel?
Suppose the airlines in our previous example agree to split
output (and profits) equally between them; if Cheapskates
believes that Sometimes on Time is going to sell y
M
/2 units
(wherey
M
is themonopoly output), is it in Cheapskates self-
interest tohonor theagreement bysellingy
M
/2unitsaswell?
17
Cheapskates incentive to raise output above y
M
/2 is the
changeinitsprofitswhenit sellsonemoreunit, i.e. MR
C
-MC
C
At y
M
, the industrys profit maximizing output level, industry
marginal revenue equals industry marginal cost:
MR=MC
C
=MC
S
Thekeyquestionsis: at y
M
/2, isMR
C
=MRor not?
Theanswer is: NO!
Theindustry marginal revenuehasthreecomponents:
i) arevenuegainfromtheadditional unit that issold
ii) a revenue loss because the increase in industry output
lowers thepricereceivedby Cheapskates for theunits it was
sellingbeforetheoutput change
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iii) arevenueloss becausethetheincreasein industry output
lowersthepricereceivedby Sometimeson Timefor theunits
it wassellingbeforetheoutput change
Thefirm-specific marginal revenues haveonly two of these
threecomponents
Cheapskates marginal revenuetakes (i) and (ii) into account,
whileSometimesonTimesmarginal revenuetakes(i) and(iii)
intoaccount
7
Comparing the industry and firm-specific marginal revenues,
weseethat:
i) Cheapskates ignores the adverse effect that its output
expansion has on Sometimes on Time when calculating its
marginal revenue
ii) Similarly, Sometimes on Time ignores the negative effect
h i i h h k
19
that itsexpansionhasonCheapskates
Thus, ineachcase, themarginal revenueto afirmexceeds the
marginal revenuetotheindustry
It would be in the self-interest of each of the two firms to
cheat onacartel agreement
Thus, thefull cartel outcomeisnot aself-enforcingagreement,
andcertainlynot aCournot-Nashequilibrium
Cournot-Nash vs. perfect competition
Let us now consider a Cournot model with more than two
firms, i.e. a Cournot oligopoly, and focus on a generic firms
reactionfunction(generic means atypical firmintheindustry,
for examplefirmj):
( )
c y
dy
y dp
y p
j
= + ) (
20
Thisreactionfunctioncanberewrittenas:
( )
( )
c
s
y p
y
y
y p
y
dy
y dp
y p
j j
=
|
|
.
|

\
|
=
(

+
c
1 ) ( 1 ) (
wheres
j
=y
j
/ yisthemarket shareof thegenericfirmj, i.e. the
firmsshareintotal industryoutput
Notethat:
OLIGOPOLY 1 0
N COMPETITIO PERFECT 0
MONOPOLY 1
< <

=
j
j
j
s
s
s
) ( = c y p 1 ) ( =
|
|
|

j
c
s
y p
1
1 ) ( = |
|

|
c y p
21

n competitio Perfect
0
) (

=
j
s
c y p

Oligopoly
1 0
1 ) (
< <
=
|
|
.

\

j
s
c y p
c

Monopoly
1
1 ) (
=
= |
.

\

j
s
c y p
c
Hence:
n Competitio Oligopoly Monopoly
y y y < <
8
Bertrand competition
In theCournot model, firms choosequantities and themarket
setstheequilibriumprice
In many instances, it is more appropriate to model firms as
choosingpricesrather thanquantities
Firms choose prices and consumers can buy as much as they
22
Firms choose prices and consumers can buy as much as they
want at that price
Bottom-line: If firms sell homogenous goods, competition in
pricewill leadtoprice=marginal cost
Bertrand?
Bertrand competition intro contd
The model in which firms choose prices while the market
determines the equilibriumquantities is known as Bertrand
competition, andsuchfirmsarecalledBertrandrivals
Suppose that our two firms simultaneously have to set the
23
Suppose that our two firms simultaneously have to set the
prices that they will charge during the time under
consideration; assumefurthermorethat thetwo firms facethe
same, constant marginal cost c, and that the two firms sell a
homogeneousgood
The Bertrand duopoly can be represented as a simultaneous
gameof imperfect information(remember our gametheory
lecture)
Thebasicelementsof thisgamewouldbe:
24
i) Players: thetwofirmsCheapskatesandSometimesonTime
ii) Actions: theset of possibleprices
iii) Strategies: theset of possibleprices
iv) Payoffs: theprofitsassociatedtoeachset of prices
9
Themarket demand, D(p), depends onthepriceat whichthe
(homogenous) goodissoldonthemarket
FromCheapskates point of view, the price set by Sometimes
on Time is given (and unobservable); hence Cheapskates
residual demand, i.e. its firm-specific demand given the
conjectured pricestrategy chosenby itsrival, canassumeone
of thefollowingthreeforms:
1) If p <p then D (p )=D(p ) and D (p )=0 since nobody
25
1) If p
C
<p
S
, then D
C
(p
C
)=D(p
C
) and D
S
(p
S
)=0, since nobody
will buy Sometimes on Times output (both firms produce the
samehomogenousgood)
2) If p
C
>p
S
, then D
S
(p
S
)=D(p
S
) and D
C
(p
C
)=0, since nobody
will buyCheapskates output
3) If p
S
=p
C
=p, then D
C
(p)=D(p)/2 and D
S
(p)=D(p)/2 by
assumption, i.e. customers equally dividethemselves between
CheapskatesandSometimesonTime
Hence, givenany strategy p
S
>c chosenbySometimesonTime,
Cheapskates best responsewould beto chargeapricep
C
just
slightly below p
S
, i.e. to slightly undercut Sometimes on
Times price, in order to drive the rivals sales and profits to
zero
Unfortunately for Cheapskates, its rival has exactly the same
reaction function: if p
C
>c, Sometimes on Time can slightly
d Ch k i d d i h l l d
26
undercut Cheapskates price and drive the latters sales and
profitstozero
Thisreciprocal priceundercuttinghastostopwhenp
C
=p
S
=c,
becauseno profit-maximizingfirmwill ever operateat aprice
belowthemarginal cost
Evidently no pricecombinationsuchthat p
C
>c or p
S
>c canbe
aNash equilibrium, sincetheoptimal responseof at least one
of thefirmswouldbetoundercut therivalsprice
This implies that, when all firms havemarginal costs that are
constant at c, there is a unique Bertrand-Nash equilibrium
that entailsall firmssettingtheir pricesequal toc
The Bertrand-Nash equilibrium has a very interesting
characteristic: it perfectlyreplicatesthecompetitiveallocation
(i.e. generatesthesameoutput, price, profit, andsurpluslevels)
Infact, notethat:
27
0 = H =
B
j j
c p
Two(interesting) questions:
i) Canyouidentifythebasicassumptionthat drivesthisresult?
ii) What if thefirmsfacedifferent marginal costs, withc
C
<c
S
?
10
Cournot vs. Bertrand
Why are Cournot oligopolists able to keep the price above c
whileBertrandrivalsarenot?
In the Cournot model, if Cheapskates cheats and increases
output, the price at which both firms sell their output
decreases, and therefore Cheapskates does not get the whole
market just byloweringitspricealittle
28
In the Bertrand model, if Cheapskates cheats by lowering its
price slightly, Sometimes on Time does not lower its price to
match (Sometimes on Time cannot observe its rivals move);
consequently, Cheapskates could get the whole market at
almost thesameprice
The incentive to cheat is therefore MUCH larger under
Bertrandthanunder Cournot
Cournot vs. Bertrand contd
Which model should we use? Sometimes Cournot sometimes
Bertrand
If firms in an industry find it difficult to adjust their output,
Cournot isthenameof thegame. That is, if firmshavefixed
production plans, it is hard to adjust themonce they are in
place. Examples include supermarket chains (no of checkout
) h l bli h ( f b d ) i ( f
29
counters), hotel establishments(noof beds), gasstations(noof
pumps)
OnceCournot-likefirmshavechosentheir capacity (e.g. noof
roomsinahotel), theyarelikelytostick withit for awhile
If firmsinanindustry findit easy toadjust quantityandgoods
arehomogenous, Bertrandprovidesabetter fit
Cournot vs. Bertrand contd
Examplesincludemail-order companieswhichneedtostick to
their price once the catalogue is printed and mailed out or
companiesthat submit bidsfor aanorder. Other applications?
Is the Bertrand conjecture reasonable, that is, do we observe
price=marginal cost withjust twofirms?
If we remove the assumption that goods are homogenous the
30
If we remove the assumption that goods are homogenous the
predictions of the Bertrand model changes. For example,
Ferrari vs. SkodaOctavia(obvious) or Perrier vs. Pellegrino
despiteseemingly similar products, consumers viewthemas
different
Inthesecases, priceisNOT equal tomarginal cost. Why?