Ch 10

Oligopoly

Oligopoly
There are many models describes an oligopolists output and pricing decision:
The Cournot Model The Stackelbery Model Dominant Firm Model The Collusion Model

The Cournot Model

Assumption:
Only two firms, firm A and firm B in the market (Duopoly) They produce homogenous good the goods of the two firms are perfect substitutes. Only one price exists for the two products. The two firms have the same cost structures all the cost curves are the same. The firms choose its profit-maximizing output and the price will be determined by the market.

The Cournot Model

1. Before setting its own output, firm A assumes P the output being produced by firm B as Q1. 2. As Q1 is produced by B, only the remaining part of the demand will buy As product. This is the demand facing firm A residual demand curve.
Residual demand of firm A

DA
D MR Q1 Q

The Cournot Model

3. Facing the residual P demand, DA, the firm derives its MR curve, MRA. 4. Given the MC of firm A, Firm A should produce Q2, where MRA = MCA.

MCA

MRA
Q2

MR

DA

D Q

The Cournot Model

6. As there are Q1 + Q2 units of output in the P market, the equilibrium price will be at Pe. Remark: Firms cannot Pe simply set their own prices according to its residual demand, as its competitor is selling the homogenous good, ie, only one price exits in the market.

D MR Q1+Q2 Q

The Cournot Model

Question: Is firm B going to product Q1 as predicted by firm A? Uncertain! As firm Bs output decision depends on the output level of firm A. To determine the market equilibrium by the Cournot model, we use the reaction curve of the firms.

Shows the relationship between a firms profitmaximizing output level and the output level of another firm. Reaction curve of firm A: QB
If QB = 0, QA = Qm (firm A Q PC becomes a monopoly) If QB = QPC, QA = 0 (as an additional unit can only be Qm sold lower than the MC).

Reaction Curve

Reaction curve of firm B:

If QA = 0, QB = Qm If QA = QPC, QB = 0

Qm

QPC QA

Reaction Curve
Steps in finding the equilibrium outputs: If QB = Q1, QA = Q2 If QA = Q2, QB = Q3 If QB = Q3, QA = Q4
QA = Q*, QB = Q* QB
QPC Qm Q* Q3 Q1 Q* 4 2 Qm QPC QQ

QA

PC vs Mono vs Oligopoly
Assumption: a firm takes over all the competitive firms without changing their costs and then split into two firms.
P PM P* PPC MR MRA Q*QM 2Q* QPC DA D Q S =MCM =MCA+B

PC vs Mono vs Oligopoly
Price:

PPC < Poligopoly < Pmono

Output:

QPC > Qoligopoly > Qmono

E. Profit: PC < oligopoly < mono Efficiency: DWLPC < DWLoligopoly < DWLmono

Stackelberg Model
In the Cournot model, firms are assumed to make output decisions simultaneously. However, in some market, a firm (leader) makes output decision first and other firms (followers) do this afterwards. The Stackelberg model uses this assumption. Firm A is the leader; Firm B is the follower.

Stackelberg Model
Parkin Shops promotion: $88 / 2 on 2nd July. Wellcomes promotion: $88 / 2 on 3rd July. Parkin Shop is the leader and Wellcome is the follower.

Stackelberg Model
As firm A is the leader, it does not need to response to firm Bs action. There is no reaction curve for firm A.
QB
QPC Qm

Qm

QPC QA

Stackelberg Model
To determine the firm As (leader) profitmaximizing output and price level, we check its cost curves and its residual demand curve. Firm As residual demand curve is derived by adjusting firm Bs output level according to firm Bs reaction function instead of having it fixed at a certain level.

Stackelberg Model
1. 2. 3. 4. 5. If QA = Q3, QB = Q4. Q m If QA = Q5, QB = Q6. Q4 QB Residual demand = DAQ6 P It derives MR = MRA QPC Firm A produces QA and firm B produces P* QB . 6. As there are QA + QB units in the market, P = P*.
QB

QPC QA Q4 MCA Q6 DA D MRA Q3 QA Q5 QPC Q QA +QB

Stackelberg Model
Question: Are the two firms get their profit maximized? Firm A (leader) produces at QA, where MRA = MCA. Firm B (follower) produces at QB. It is the best response to QA but this does not necessary maximize its profit. The leader sets its output and the market price to maximize its profit at the expense of the follower. The first-mover advantage.

Dominant Firm Model

There is a single giant firm (Dominant firm), which take a very large market share. It is the leader in the market. All the remaining firms are all small independent firms with small market share. The small firms act as price takers. The dominant firm sets the price and output to maximize its profit and take the

Dominant Firm Model

1. The market is divided into two groups:
The small firms with Supply = S The dominant firm with MCA

S MCA Q2
MRA

2. 3. 4. 5. 6.

If P = P2, QA = 0 P2 If P = P1, QS = Q2, P1 QA = Q1 Demand to firm A = DAP3 As firm A is the leader, it will produce Q1 where MRA = MCA 7. Total supply = Q1+ Q2

DA

Q2Q1 Q1+Q2

The Collusion Model

As the profit of a monopolist is greater than the combined profit of the oligopolists, they have an incentive to form a Cartel, in which the firms act together as a Monopoly. A cartel is an agreement among individual firms to cooperate and set their output and price jointly.

The Collusion Model

Eg. Organization of Petroleum Exporting Countries (OPEC) OPEC's mission is to coordinate and unify the petroleum policies of Member Countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital to those investing in the petroleum industry.

The Collusion Model

created at the Baghdad Conference on September 1014, 1960, by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. The five Founding Members were later joined by nine other Members: Qatar (1961); Indonesia (1962) -suspended its membership from January 2009; Socialist Peoples Libyan Arab Jamahiriya (1962); United Arab Emirates (1967); Algeria (1969); Nigeria (1971); Ecuador (1973) -suspended its membership from December 1992-October 2007; Angola (2007); and Gabon (19751994).

The Collusion Model

Only two identical firms, A & B, in the markets They joint together without changing their Firm A Firm B costsMarket structure.
MCCartel
PCartel =PA =PB =MCA +MCB

MCA A ACA DA
QA QB

MCB
B ACB DB

DMarket =Dcartel MRCartel

QCartel =QA + QB

The Collusion Model

As the two firms joint together to form the cartel, the cartel behaves like a monopoly. It maximizes the combined profit by setting output level where MRCartel = MCCartel. At QCartel, MRA MCA & MRB MCB. The price of the two firms must be the same and equal to PCartel. The cartel will allocate the output until MCA =MCB

The Collusion Model

Question: Can the Cartel be sustained for a long time? No! There are three reasons for the failure of cartel 1.Incentive to cheat 2.Disagreement over cartel policy 3.Potential new entrants

Failure of cartel
1. Incentive to cheat: PCartel > POligopoly once the agreement on higher price has been achieved, each cartel member has an incentive to cheat by increasing their own production and lowering its own price below the agreed price.

Failure of cartel
Market Firm A Firm B

MCCartel
PCartel

MCA A ACA
P* B B

MCB ACB DB

DMarket MRCartel
QCartel =QA + QB QA

MRB
QB Q*

(given QA)

> B

Firm B has an incentive to cheat

Failure of cartel
Actually, both firm A and firm B will make more profit if they cheat. Will the cartel break-down?
Firm B cooperate cheat cooperate Mono/2; Mono/2 Mono/2-; Mono/2+ Firm A cheat Mono/2+; Mono/2- olig; olig

Cartel

Nash Equilibrium:olig; olig Finally, the cartel will break-down and the firms will compete among themselves.

Failure of cartel
2. Disagreement over cartel policy In the previous example, we assume that the two firms have the identical cost curves and the cartel shares the combined profit eqully. But, in reality, it is very likely that the costs of the two firms are different. That implies that the ability in making profit should be different. The more capable one may be unhappy cheat with the sharing policy.

Failure of cartel
3. Potential new entrants As the combined profit is huge, it creates incentive for potential entrants to enter the market. It will driven down the cartel price and hence the Economic Profit. With new entrants, the incentive to cheat of the existing firms increases.

Failure of cartel
Because of the above reason, cartel is not common in reality. Why is there still cartel existing in the real world? It is a continuous game!

Repeated Game
cooperate Firm A cheat Firm B cooperate cheat 50; 50 20; 80 80; 20 40; 40

If it is a one-shot game (only one round is run), both firms will cheat. However, if they cheat in the first round, they cannot cooperate anymore in the future. If the game last for 5 rounds, how will the firms behave?

Repeated Game
One firm decides to cheat
Firm As Payoff 80 (cheat)
40 (cheat) 40 (cheat) 40 (cheat) 40 (cheat) Payoffs in 5 rounds: 240

No firm decides to cheat

Firm Bs Firm As Firm Bs payoff Payoff payoff 20 (cooperate) 50 (cooperate) 50 (cooperate)

40 (cheat) 40 (cheat) 40 (cheat) 40 (cheat) Payoffs in 5 rounds: 180 50 (cooperate) 50 (cooperate) 50 (cooperate) 50 (cooperate) 50 (cooperate) 50 (cooperate) 50 (cooperate) 50 (cooperate) Payoffs in 5 rounds: 250 Payoffs in 5 rounds: 250

As the total profit for them to cooperate is larger, they will cooperate in a continuous game.

Repeated Game
If the two firms have to make their decisions repeatedly, they will maximize their total profit from each round. If this is a finite game (with ending), they have an incentive to cheat in the last round. If this is an infinity game (no ending), they will cooperate forever.

Conclusion
In an oligopoly market, firms are strategic interdependent. Each firm has to make pricing and output decisions by taking the behaviour of its competitors into account. To deal with this characteristic, we use game theory. Accounting to the assumptions we hold, different models are used to describe the behaviour of the firms.

Conclusion
The Cournot model assumes both firms make their decisions simultaneously. The Stackelberg model assumes that there is a leader in the market. The dominant firm model assumes that the leader is a dominant firm in the market. As the combined profit of oligopolists is smaller than that of a monopolists, firms have incentive to cooperate the collusion model.