# Chapter 12. Oligopoly. Oligopoly Characteristics. Oligopoly Equilibrium

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1 Chapter Oligopoly Oligopoly Characteristics Small number of firms Product differentiation may or may not eist Barriers to entry Chapter Oligopoly Equilibrium Defining Equilibrium Firms are doing the best they can and have no incentive to change their output or price Nash Equilibrium Each firm is doing the best it can given what its competitors are doing. Chapter 3

2 Duopoly The Cournot Model Oligopoly model in which firms produce a homogeneous good, each firm treats the output of its competitors as fied, and all firms decide simultaneously how much to produce Firm will adjust its output based on what it thinks the other firm will produce Chapter 4 Firm s Output Decision P D (0) Firm and market demand curve, D (0), if Firm produces nothing. If Firm thinks Firm will produce 50 units, its demand curve is shifted to the left by this amount. D (75) MR (0) If Firm thinks Firm will produce 75 units, its demand curve is shifted to the left by this amount. MR (75) MC MR (50) D (50) Q Chapter 5 Oligopoly The Reaction Curve The relationship between a firm s profitmaimizing output and the amount it thinks its competitor will produce. A firm s profit-maimizing output is a decreasing schedule of the epected output of Firm. Chapter 6

3 Reaction Curves and Cournot Equilibrium Q Firm s reaction curve shows how much it will produce as a function of how much it thinks Firm will produce. The s correspond to the previous model. Firm s Reaction Curve Q*(Q ) Firm s reaction curve shows how much it will produce as a function of how much it thinks Firm will produce. 5 Firm s Reaction Curve Q* (Q ) Q Chapter 7 Reaction Curves and Cournot Equilibrium Q Firm s Reaction Curve Q*(Q ) In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maimize its own profits Firm s Reaction Curve Q* (Q ) Cournot Equilibrium Q Chapter 8 Cournot Equilibrium Each firms reaction curve tells it how much to produce given the output of its competitor. Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly. Chapter 9

4 Oligopoly Cournot equilibrium is an eample of a Nash equilibrium (Cournot-Nash Equilibrium) The Cournot equilibrium says nothing about the dynamics of the adjustment process Chapter 0 Oligopoly: Eample An Eample of the Cournot Equilibrium Two firms face linear market demand curve Market demand is P = 30 - Q Q is total production of both firms: Q = Q + Q Both firms have MC = MC = 0 Chapter Oligopoly Eample Firm s Reaction Curve MR=MC Total Revenue : R PQ 30 Q) 30Q Q ( Q 30Q ( Q Q ) Q Q Q Chapter

5 Oligopoly Eample An Eample of the Cournot Equilibrium MR R Q 30 Q Q MR 0 MC Q 5 Q Q 5 Q Firm' s Reaction Curve Firm ' s Reaction Curve Chapter 3 Oligopoly Eample An Eample of the Cournot Equilibrium Cournot Equilibrium : 5 (5 Q ) 0 Q Q Q 0 P 30 Q 0 Q Q Chapter 4 Duopoly Eample Q 30 Firm s Reaction Curve The demand curve is P = 30 - Q and both firms have 0 marginal cost. 5 Cournot Equilibrium 0 Firm s Reaction Curve Q Chapter 5

6 Oligopoly Eample Profit Maimization with Collusion R PQ (30 Q) Q 30Q Q MR R Q 30 Q MR 0 when Q 5 and MR MC Chapter 6 Profit Ma with Collusion Contract Curve Q + Q = 5 Shows all pairs of output Q and Q that maimizes total profits Q = Q = 7.5 Less output and higher profits than the Cournot equilibrium Chapter 7 Duopoly Eample Q 30 Firm s Reaction Curve For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium 5 0 Competitive Equilibrium (P = MC; Profit = 0) Cournot Equilibrium Collusive Equilibrium 7.5 Collusion Curve Firm s Reaction Curve Q Chapter 8

7 First Mover Advantage The Stackelberg Model Oligopoly model in which one firm sets its output before other firms do. Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q is total output Firm sets output first and Firm then makes an output decision seeing Firm output Chapter 9 First Mover Advantage The Stackelberg Model Firm Must consider the reaction of Firm Firm Takes Firm s output as fied and therefore determines output with the Cournot reaction curve: Q = 5 - ½ (Q ) Chapter 0 First Mover Advantage The Stackelberg Model Firm Choose Q so that: MR MC 0 R PQ 30 Q - Q - Q Q Firm knows that firm will choose output based on its reaction curve. We can use firm s reaction curve as Q Chapter

8 First Mover Advantage The Stackelberg Model Using Firm s Reaction Curve for Q: R 30Q Q 5Q Q Q (5 Q ) MR R Q 5 Q MR 0 : Q 5 and Q 7.5 Chapter First Mover Advantage The Stackelberg Model Conclusion Going first gives firm the advantage Firm s output is twice as large as firm s Firm s profit is twice as large as firm s Going first allows firm to produce a large quantity. Firm must take that into account and produce less unless it wants to reduce profits for everyone Chapter 3 Competition Versus Collusion: The Prisoners Dilemma Nash equilibrium is a noncooperative equilibrium: each firm makes decision that gives greatest profit, given actions of competitors Chapter 4

9 Competition Versus Collusion: The Prisoners Dilemma The Prisoners Dilemma illustrates the problem that oligopolistic firms face. Two prisoners have been accused of collaborating in a crime. They are in separate jail cells and cannot communicate. Each has been asked to confess to the crime. Chapter 5 Payoff Matri for Prisoners Dilemma Prisoner B Confess Don t confess Confess Prisoner A -6, -6 0, -0 Would you choose to confess? Don t confess -0, 0 -, - Chapter 6 Oligopolistic Markets Conclusions. Collusion will lead to greater profits. Eplicit and implicit collusion is possible 3. Once collusion eists, the profit motive to break and lower price is significant Chapter 7

10 Price Leadership The Dominant Firm Model In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. The large firm might then act as the dominant firm, setting a price that maimizes its own profits. Chapter 8 Price Setting by a Dominant Firm Price D S F The dominant firm s demand curve is the difference between market demand (D) and the supply of the fringe firms (S F). P MC D P* P D D At this price, fringe firms sell Q F, so that total sales are Q T. Q F Q D Q T MR D Quantity Chapter 9

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