Lecture 2 OLIGOPOLY Copyright 2012 Pearson Education. All rights reserved.

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2 Chapter 13

3 Topics Market Structures ( A Recap). Noncooperative Oligopoly. Cournot Model. Stackelberg Model. Bertrand Model. Cartels. Comparison of Collusive/cartel, Cournot, Stackelberg, and Competitive Equilibria Copyright 2012 Pearson Education. All rights reserved.

4 Oligopoly Oligopoly - a small group of firms in a market with substantial barriers to entry. Cartel - a group of firms that explicitly agree to coordinate their activities. Monopolistic competition - a market structure in which firms have market power but no additional firm can enter and earn positive profits 13-4 Copyright 2012 Pearson Education. All rights reserved.

5 Market Structures Markets differ according to: the number of firms in the market, the ease with which firms may enter and leave the market, and the ability of firms in a market to differentiate their products from those of their rivals Copyright 2012 Pearson Education. All rights reserved.

7 What is Oligopoly derived from the Greek words Oligoi meaning few and Poleo meaning to sell a market structure characterized by small or few number of firms and where there exist a great deal of interdependence among them Copyright 2012 Pearson Education. All rights reserved.

8 Types of Oligopoly There are two types of oligopoly namely Perfect Oligopoly: this is where a few firms produce or sell homogeneous products. E.g. banking industry in Ghana. Imperfect Oligopoly: where a few firms sell differentiated products. E.g. Motor car retail outlets, cigarettes, etc Copyright 2012 Pearson Education. All rights reserved.

10 Noncooperative Oligopoly (cont.) Three restrictive assumptions: All firms are identical in the sense that they have the same cost functions and produce identical, undifferentiated products. We initially illustrate each of these oligopoly models for a duopoly The market lasts for only one period Copyright 2012 Pearson Education. All rights reserved.

11 Noncooperative Oligopoly (cont.) Duopoly equilibrium: A set of actions taken by the firms is a Nash equilibrium if, holding the actions of all other firms constant, no firm can obtain a higher profit by choosing a different action Copyright 2012 Pearson Education. All rights reserved.

12 Cournot Model Developed by French mathematician- Augustin Cournot ( ) Four assumptions: (1) there are two firms and no other firms can enter the market, i.e. duopoly model (2) the firms have identical costs, (=0) (3) they sell identical products, and (4) the firms set their quantities simultaneously Copyright 2012 Pearson Education. All rights reserved.

13 Cournot Model of an Airlines Market Example: American Airlines and United Airlines compete for customers on flights between Chicago and Los Angeles. Cournot equilibrium (Nash-Cournot equilibrium) - a set of quantities sold by firms such that, holding the quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity Copyright 2012 Pearson Education. All rights reserved.

14 The crucial behavioural assumption each duopolist in selecting his/her own rate of output assumes that the other duopolist output will remain constant. This assumption by Cournot implies a selfdelusory behaviour on the part of each duopolist. Each duopolist behaves as if he/she can act without provoking an output reaction from the other duopolist. i.e. no learning-by-doing model Copyright 2012 Pearson Education. All rights reserved.

Approach towards equilibrium 13-16 Copyright

18 Figure 13.2 American Airlines Profit- Maximizing Output (a) Monopoly (b) Duopoly p, $ per passenger p, $ per passenger MC 147 MC q U = 64 MR D MR r D r D q A, Thousand American Airlines passengers per quarter q A, Thousand American Airlines passengers per quarter Copyright 2012 Pearson Education. All rights reserved.

24 Cournot Model of an Airlines Market (cont.) Market demand function is Q = 339 p p - dollar cost of a one-way flight Q total quantity of the two airlines (thousands of passengers flying one way per quarter). Each airline has a constant marginal cost, MC, and average cost, AC, of $147 per passenger per flight Copyright 2012 Pearson Education. All rights reserved.

25 Cournot Model of an Airlines Market (cont.) Residual demand American faces is: rewriting q A = Q(p) q U = (339 p) q U. p = 339 q A q U The marginal revenue function is: MR r = 339 2q A q U Copyright 2012 Pearson Education. All rights reserved.

26 Cournot Model of an Airlines Market (cont.) American Airlines best response is the output that equates its marginal revenue, and its marginal cost: MR r = 339 2q A q U = 147 = MC and rearranging q A = 96 1/2 q U Copyright 2012 Pearson Education. All rights reserved.

27 Cournot Model of an Airlines Market (cont.) United s best-response function is q U = 96 1/2 q A This statement is equivalent to saying that the Cournot equilibrium is a point at which the bestresponse curves cross Copyright 2012 Pearson Education. All rights reserved.

28 Cournot Model of an Airlines Market (cont.) To solve the model: q A = 96 1/2 (96 1/2 q A ) and solve for q A. Doing so, we find that q A = 64; q U = 64 Q = q A + q U = 128. Cournot equilibrium price is $ Copyright 2012 Pearson Education. All rights reserved.

29 The Cournot Equilibrium and the Number of Firms We can write a typical Cournot firm s profit-maximizing condition as: MR p 1 1 n If n = 1, the Cournot firm is a monopoly, The more firms there are, the larger the residual demand elasticity, nε, a single firm faces. As n grows very large, the residual demand elasticity approaches negative infinity, and the equation above becomes p = MC, MC which is the profit-maximizing condition of a price-taking competitive firm Copyright 2012 Pearson Education. All rights reserved.

31 The Cournot Equilibrium and the Number of Firms Cournot firm s Lerner Index depends on the elasticity the firm faces p MC p 1 n Thus, a Cournot firm s Lerner Index equals the monopoly level, 1/ε, if there is only one firm Copyright 2012 Pearson Education. All rights reserved.

Application: Air Ticket Prices and Rivalry 13-32

35 Solved Problem 13.1 Derive United Airlines best-response function if its marginal cost falls to $99 per unit. Answer Determine United s marginal revenue function corresponding to its residual demand curve. Equate United s marginal revenue function and its marginal cost to determine its bestresponse function Copyright 2012 Pearson Education. All rights reserved.

36 Solved Problem 13.2 Intel and Advanced Micro Devices (AMD) are the only two firms that produce central processing units (CPUs), which are the brains of personal computers. Both because the products differ physically and because Intel s advertising Intel Inside campaign has convinced some consumers of its superiority, consumers view the CPUs as imperfect substitutes. Consequently, the two firms inverse demand functions differ: p A = q A 0.3q I, p I = q I 6q A, where price is dollars per CPU, quantity is in millions of CPUs, the subscript I indicates Intel, and the subscript A represents AMD. Each firm faces a constant marginal cost of m = $40 per unit. (For simplicity, we will assume there are no fixed costs.) Solve for the Cournot equilibrium quantities and prices Copyright 2012 Pearson Education. All rights reserved.

14.1 Comparison of Market Structures

14.1 Comparison of Market Structures 14.1 Comparison of Structures Chapter 14 Oligopoly 14-2 14.2 Cartels Cartel in Korea Oligopolistic firms have an incentive to collude, coordinate setting their prices or quantities, so as to increase their