Lecture 3 OLIGOPOLY (CONTINUED) 13-1 Copyright 2012 Pearson Education. All rights reserved.

Chapter 13

Stackelberg Model In the Cournot model, both firms make their output decisions at the same time. Suppose, however, that one of the firms, called the leader, can set its output before its rival, the follower, sets its output. 13-5 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 13.3 Use algebra to solve for the Stackelberg equilibrium quantities and market price if American Airlines were a Stackelberg leader and United Airlines were a follower. (Hint: As the graphical analysis shows, American Airlines, the Stackelberg leader, maximizes its profit as though it were a monopoly facing a residual demand function.) 13-7 Copyright 2012 Pearson Education. All rights reserved.

Why Moving Sequentially Is Essential When the firms move simultaneously, United doesn t view American s warning that it will produce a large quantity as a credible threat. If United believed that threat, it would indeed produce the Stackelberg follower output level. 13-8 Copyright 2012 Pearson Education. All rights reserved.

Strategic Trade Policy Suppose that two identical firms in two different countries compete in a world market. Both firms act simultaneously, so neither firm can make itself the Stackelberg leader. A government may be tempted to intervene to make its firm a Stackelberg leader. 13-9 Copyright 2012 Pearson Education. All rights reserved.

Problems with Intervention For government subsidies to work five conditions must hold: government must be able to set its subsidy before the firms choose their output levels. other government must not retaliate. government s actions must be credible. government must know enough about how firms behave to intervene appropriately. government must know which game the firms are playing. 13-10 Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 13.4 If governments subsidize identical Cournot duopolies with a specific subsidy of s per unit of output, what is the qualitative effect (direction of change) on the equilibrium quantities and price? Assume that the before-subsidy bestresponse functions are linear. 13-12 Copyright 2012 Pearson Education. All rights reserved.

Comparison of Collusive, Cournot, Stackelberg, and Competitive Equilibria How would American and United behave if they colluded? They would maximize joint profits by producing the monopoly output, 96 units, at the monopoly price, $243 per passenger. 13-14 Copyright 2012 Pearson Education. All rights reserved.

Bertrand Model Bertrand equilibrium (Nash-Bertrand equilibrium) - a Nash equilibrium in prices; a set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge these prices. Bertrand equilibrium depends on whether firms are producing identical or differentiated products. 13-18 Copyright 2012 Pearson Education. All rights reserved.

Best-Response Curves Suppose that each of the two price-setting oligopoly firms in a market produces an identical product and faces a constant marginal and average cost of $5 per unit. What is Firm 1 s best response if Firm 2 sets a price of p 2 = $10? 13-19 Copyright 2012 Pearson Education. All rights reserved.

Bertrand Versus Cournot Cournot equilibrium price for firms with constant marginal costs of $5 per unit by: p MC $5 1 1/( n ) 1 1/( n ) where n is the number of firms and ε is the market demand elasticity. If the market demand elasticity is ε = 1 and n = 2, the Cournot equilibrium price is $5/(1 1 2) = $10 which is double the Bertrand equilibrium price. 13-21 Copyright 2012 Pearson Education. All rights reserved.

Bertrand Equilibrium with Differentiated Products In markets with differentiated products such markets, the Bertrand equilibrium is plausible, and the two problems of the homogeneous-goods model disappear: Firms set prices above marginal cost, and prices are sensitive to demand conditions. 13-22 Copyright 2012 Pearson Education. All rights reserved.

Why Cartels Form A cartel forms if members of the cartel believe that they can raise their profits by coordinating their actions. There is therefore collusion or cooperation So cartels are basically cooperative Oligopolies 13-24 Copyright 2012 Pearson Education. All rights reserved.

P r ic e, p, $ per unit Figure 13.1 Competition Versus Cartel (a) Fi r m (b) Ma r k et p m A C MC P r ic e, p, $ per unit p m e m S p c p c e c MC m MC m Ma r k et demand MR q m q c q * Quantit y, q, Units per y ear Q m Q c Quantit y, Q, Units per y ear 13-25 Copyright 2012 Pearson Education. All rights reserved.

Laws Against Cartels Cartels persist despite these laws for three reasons: international cartels and cartels within certain countries operate legally. some illegal cartels operate believing that they can avoid detection or that the punishment will be insignificant. some firms are able to coordinate their activity without explicitly colluding and thereby running afoul of competition laws. 13-26 Copyright 2012 Pearson Education. All rights reserved.

Laws Against Cartels (cont.) In the late nineteenth century, cartels were legal and common in the United States. Examples: oil, railroad, sugar, and tobacco. Sherman Antitrust Act in 1890 and the Federal Trade Commission Act of 1914, Prohibit firms from explicitly agreeing to take actions that reduce competition. 13-27 Copyright 2012 Pearson Education. All rights reserved.

Laws Against Cartels (cont.) The Organization of Petroleum Exporting Countries (OPEC) - an international cartel that was formed in 1960 by five major oilexporting countries: Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. In 1971, OPEC members agreed to take an active role in setting oil prices. 13-28 Copyright 2012 Pearson Education. All rights reserved.

Why Cartels Fail Cartels fail if noncartel members can supply consumers with large quantities of goods. Each member of a cartel has an incentive to cheat on the cartel agreement. 13-29 Copyright 2012 Pearson Education. All rights reserved.

Maintaining Cartels To keep firms from violating the cartel agreement, the cartel must be able to detect cheating and punish violators. keep their illegal behavior hidden from customers and government agencies. 13-30 Copyright 2012 Pearson Education. All rights reserved.