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1 11. Oligopoly Literature: Pindyck and Rubinfeld, Chapter 12 Varian, Chapter Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 1

2 Chapter Outline Oligopoly Quantity Competition Price Competition Competition versus Collusion: The Prisoner s Dilemma Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 2

3 Oligopoly Properties Small number of firms. The products may or may not be differentiated. Barriers to market entry. Example Automobiles Steel Aluminum Petrochemicals Electrical Equipment Computers Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 3

4 Oligopoly We have the following barriers to entry: Natural entry barriers Economies of scale Patents Technology Name recognition and market reputation Strategic actions to deter entry Flooding the market with goods, product dumping. Controlling essential factors of production Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 4

5 Oligopoly Equilibrium for an oligopolistic market In perfect competition, monopoly, and monopolistic competition, the producers do not have to take into account the response of their rival s choice of output and price. However, in the case of an oligopoly, producers must take into account their rival s response when choosing output and prices Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 5

6 Oligopoly Equilibrium for an oligopolistic market Definition of a market equilibrium When a market is in equilibrium, firms are doing the best they can and have no reason to change their prices or output levels. All firms set prices or output based partly on strategic considerations regarding the behavior of their respective competitors. Nash Equilibrium: Set of strategies or actions in which each firm does the best it can given its competitors actions Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 6

7 Oligopoly The Cournot Model Duopoly Market in which two firms compete with each other. Homogeneous good. Each firm treats the output of its competitors as fixed. All firms decide simultaneously how much to produce Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 7

8 Firm 1 s Output Decision P 1 If Firm 1 thinks Firm 2 will produce nothing, its demand curve, labeled D 1 (0), is the market curve. D 1 (50) D 1 (0) If Firm 1 thinks that Firm 2 will produce 50 units, its demand curve, D 1 (50), is shifted to the left by this amount. MR 1 (50) D 1 (75) MR 1 (0) If Firm 1 thinks that Firm 2 will produce 75 units, its demand curve, D 1 (75), is shifted to the left by this amount. MR 1 (75) MC Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 8

9 Oligopoly Reaction curve: Relationship between a firm s profit-maximizing output and the output level it thinks its competitor will produce. Firm 1 s profitmaximizing output is thus a decreasing schedule of how much it thinks Firm 2 will produce Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 9

10 Reaction Curves and Cournot Equilibrium Q 1 Firm 1 s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce Firm 2 s Reaction Curve Q 2 *(Q 1 ) Firm 2 s reaction curve shows its output as a function of how much it thinks Firm 1 will produce x Firm 1 s Reaction Curve Q* 1 (Q 2 ) x Cournot Equilibrium x In Cournot equilibrium, each firm correctly assumes the amount that its competitor will produce and thereby maximizes its own profits. Therefore, neither firm will move from this equilibrium x Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 10

11 Duopoly Example The Linear Demand Curve An example of Cournot equilibrium Duopoly: two firms facing the following market demand curve P = 30 Q, where Q is total production of both firms (i.e. Q = Q 1 + Q 2 ) Suppose also that MC 1 = MC 2 = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 11

12 Duopoly Example The Linear Demand Curve An example of Cournot equilibrium Firm 1 s reaction curve Total revenue : R = PQ = (30 Q) Q = 30Q 1 = 30Q 1 ( Q Q Q 2 2 ) Q Q Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 12

13 Duopoly Example The Linear Demand Curve An example of Cournot equilibrium MR = R Q = 30 2Q Q MR = 0 = MC 1 1 Firm 1's reaction curve Q = Q 1 2 Firm 2's reaction curve Q = Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 13

14 Duopoly Example The Linear Demand Curve An example of Cournot equilibrium Firm 1 s reaction curve: Cournot equilibrium Q = ( Q ) Q = 10 = Q Q= Q + Q = P= 30 Q= Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 14

15 Duopoly Example Q 1 30 Firm 2 s Reaction Curve The demand curve is P = 30 Q, and both firms have zero marginal cost. 15 Cournot Equilibrium 10 Firm 1 s Reactions Curve Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 15

16 Duopoly Example Profit maximization with collusion RR = PPPP = 30 QQ QQ = 30QQ QQ 2 MMMM = = 30 2QQ MMMM = 0 = MMMM, iiii QQ = 15 aaaaaa MMMM = MMMM Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 16

17 Duopoly Example Profit maximization with collusion Collusion curve Q 1 + Q 2 = 15. Gives all the output combinations of Q 1 and Q 2 for which the total profit is maximized. Q 1 = Q 2 = 7.5. Smaller production quantity and higher profits in comparison to Cournot equilibrium Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 17

18 Duopoly Example Q 1 30 Firm 2 s Reaction Curve For the firm, the best solution is collusion; the next best solution is Cournot equilibrium, after that is competitive equilibrium, i.e., P = MC, Profit = 0. Competitive Equilibrium (P = MC, Profit = 0) Cournot Equilibrium Collusive Equilibrium Firm 1 s Reaction Curve Collusion Curve Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 18

19 First Mover Advantage- The Stackelberg Model Assume that we have two duopolists: A firm can set its output before other firms do. MC = 0. The market demand is P = 30 Q, where Q = total amount produced. Suppose Firm 1 sets its output first; then Firm 2, after observing Firm 1 s output, makes its output decision Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 19

20 Firm 1 Firm 2 First Mover Advantage- The Stackelberg Model In setting output, Firm 1 must consider how Firm 2 will react. Takes Firm 1 s output as fixed and, accordingly, determines its production quantity using the Cournot reaction curve: Q 2 = 15-1/2Q Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 20

21 First Mover Advantage- The Stackelberg Model Firm 1 chooses Q 1 so that its marginal revenue equals its marginal cost of zero: MMMM = MMMM, MMMM = 0, cccccccccccccccccccccccc MMMM = 0 Recall Firm 1 s revenue is: RR 1 = PPQQ 1 = 30QQ 1 QQ 1 2 QQ 2 QQ Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 21

22 First Mover Advantage- The Stackelberg Model By inserting the reaction curve of Firm 2 for Q 2 we get R = 30 Q Q Q( Q) = 15Q 1 2Q MR = R Q = 15 Q MR= 0 Q = 15 und Q = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 22

23 First Mover Advantage- The Stackelberg Model We conclude that Firm 1 produces twice as much as Firm 2. Firm 1 makes twice as much profit as Firm 2. Going first gives Firm 1 an advantage Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 23

24 Price Competition In an oligopolistic market, the competition may consist of choosing a price instead of a quantity. Bertrand model: Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 24

25 Price Competition Bertrand Model Let s return to the duopoly example: Homogeneous Good Market demand is P = 30 Q, with Q = Q 1 + Q 2. This time, however, assume that MC = 3 for both firms and therefore MC 1 = MC 2 = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 25

26 Price Competition Bertrand Model in Cournot equilibrium: P = 12 Q = Q = π for both firms = 81 Now suppose that these two duopolists compete by simultaneously choosing a price instead of a quantity Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 26

27 Price Competition Bertrand Model What price will each firm use, and how much profit will each earn? (Hint: assume homogeneous products, meaning that consumers will purchase only from the lowest-price seller.) The Nash Equilibrium P = MC; P 1 = P 2 = 3 Q = 27; Q 1 = Q 2 = 13.5 Since P=MC, both firms earn zero profit Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 27

28 Price Competition Bertrand Model Why shouldn t a firm set prices higher in order to increase profits? How does the result in the Bertrand model differ from that of the Cournot model? The Bertrand model shows the meaning of strategic variables (price versus quantity produced) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 28

29 Price Competition Bertrand Model Criticism When a firm produces homogeneous goods, it is more common that it competes by the quantity produced rather than the selling price. And, even if firms set prices equal to each other, what share of total sales will go to each one? Eventually, the quantity produced by the two firms will not be the same Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 29

30 Price Competition with differentiated Products Differentiated Products Suppose we have the following: Two duopolists FC = 20 VC = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 30

31 Price Competition Differentiated Products Assume they face the same demand curve: Firm 1 s demand curve is Q 1 = 12-2P 1 + P 2 Firm 2 s demand curve is Q 2 = 12-2P 2 + P 1 P 1 and P 2 are the prices that Firms 1 and 2 charge, respectively. Q 1 and Q 2 are the resulting quantities that they sell Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 31

32 Price Competition Differentiated Products Choosing price and quantity Assume both firms set prices at the same time: Firm 1's profit : π = PQ π = P(12 2 P + P) 20 π = 12P-2P + PP Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 32

33 Price Competition Differentiated Products Choosing price and quantity Firm 1 assumes P 2 to be fixed: -Firm 1 s profit maximizing price : π P = 12 4P + P = Firm 1 s reaction curve : P = 3+ 14P 1 2 -Firm 2 s reaction curve : P = 3+ 14P 2 1 -P = 4 π = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 33

34 Choosing Prices in Collusive Equilibrium Set the price in a way such that both firms maximize their profits. If firms cooperatively set price they choose P = 6; π = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 34

35 Nash Equilibrium in Prices P 1 Firm 2 s Reaction Curve Collusive Equilibrium 6 4 Firm 1 s Reaction Curve Nash Equilibrium 4 6 P Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 35

36 Competition versus Collusion: The Prisoner s Dilemma Nash-equilibrium is a non-cooperative equilibrium. Cooperation would have led to higher profits. Why don t firms cooperate without explicity colluding? In particular, if you and your competitor can both figure out the profit-maximizing price you would agree to charge if you were to collude, why not just set that price and hope your competitor will do the same? Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 36

37 Competition versus Collusion: The Prisoner s Dilemma Let s go back to our example: FC= 20 and VC= 0 Firm 1's demand curve: Q= 12 2P+ P 1 2 Firm 2's demand curve: Q= 12 2P + P Nash Equilibrium: P= 4, π = 12 Collusion: P= 6, π = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 37

38 Competition versus Collusion: The Prisoner s Dilemma Possible pricing options and respective results: If they collude, both ask 6 and ππ = 16. In Nash equilibrium: -if P = 6 and P = then π = PQ π = 4 [ 12 (2)(4) + 6] 20 = π = PQ π = 6 [ 12 (2)(6) + 4] 20 = Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 38

39 Payoff Matrix for a Pricing Game Firm 2 Charge 4 Charge 6 Charge 4 12, 12 20, 4 Firm 1 Charge 6 4, 20 16, Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 39

40 Competition versus Collusion: The Prisoner s Dilemma Both firms play in a non-cooperative game (a game in which negotiation and enforcement of binding contracts is not possible). Question Each firm optimizes profits given its decision and the decision of its competitor (payoff matrix). Why do both firms set a price equal to 4, when they could gain more profit with a price equal to 6? Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 40

41 Competition versus Collusion: The Prisoner s Dilemma A classical example in game theory, called the prisoner s dilemma, illustrates the problem faced by oligopolistic firms Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 41

42 Scenario Competition versus Collusion: The Prisoner s Dilemma Two prisoners have been accused of collaborating in a crime. They are in separate jail cells and cannot communicate with each other. Each has been asked to confess Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 42

43 Payoff Matrix for Prisoner s Dilemma Confess Prisoner B Don t confess Confess -5, -5-1, -10 Prisoner A Don t confess -10, -1-2, Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 43

44 Payoff Matrix for Prisoner s Dilemma Conclusion: Oligopolistic markets Collusion yields higher profits. Explicit, secret, and implicit agreements are all possible. If there is a price agreement, then there is a motivation to deviate from this agreement Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 44

45 Concluding Remarks In an oligopolistic market, few firms account for most or all of the production. In the Cournot model of oligopoly, firms make their output decisions at the same time, each taking the other s output as fixed. In the Stackelberg model, one firm sets its output first Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 45

46 Concluding Remarks The Nash equilibrium concept can also be applied to markets in which firms produce substitute goods and compete by setting price. Firms can earn higher profits through price collusion (pricing agreements made in private), however this is prohibited by Antitrust laws. The prisoner s dilemma creates price rigidity in oligopolistic markets Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 11 Slide 46

Chapter 12. Oligopoly. Oligopoly Characteristics. ) of firms Product differentiation may or may not exist ) to entry. Chapter 12 2

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