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Class Assigment – Microeconomics – Oligopoly 31/10/2003 1 MicroEconomics Oligopoly Students: Ana Oliveira Fernando Vendas Miguel Carvalho Paulo Lopes Vanessa Figueiredo

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 2 Presentation Structure Introduction Competition Model –Sequential Game Quantity Leadership Price Leadership –Simultaneous Game Simultaneous Price setting Simultaneous Quantity Price setting Collude (corporate game) Resume Exercise P. Lopes and F. Vendas A.Oliveira and F. Vendas M. Carvalho V. Figueiredo

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 3 Initial Framework Market Structure Pure competition Small competitors Pure Monopoly One Large Firm However

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 4 Class Framework Monopolistic Competition Form : OLIGOPOLY Strategic interaction that arise in an industry with small number of firms. – Varian, H. (1999, 5 th ) Many Different Behavior Patterns of Behavior

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 5 Study Framework Restrict to the case of 2 firms Duopoly Simple to understand Strategic interaction Homogeneous product

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 6 Sequential Game Quantity Leadership In this case, one firm makes a choice before the other firm, according Stackelberg model, thus, our study will start from this model. Suppose, firm 1 (leader) and it chooses to produce a quantity (y 1 ) and firm 2 (follower) responds by choosing a quantity (y 2 ). Each firms knows that equilibrium price in the market depends on the total output. So we use the inverse demand function p(Y) to indicate that equilibrium, as function of industry output. Y = y 1 + y 2 The leader has to consider the follower´s profit-maximization problem, then we should think : What output should the leader choose to max its profits ?

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 7 Sequential Game The follower's Problem Assume that the follower wants to maximize its profits max p(y 1 +y 2 )y 2 – c 2 (y 2 ) The follower's profit depends on the output choice of the leader, but the leader´s output is predetermined and the follower simply views it as a constant.The follower wants to choose an output level such that marginal revenue (MR) equals marginal cost : When the follower increases its output, it increase its revenue by selling more output at the market price, but it also pushes the price down by p, and this lowers its profits on all the units that were previously sold at the higher price. MR 2 = p(y 1 +y 2 ) + y 2 = MC 2 p y2y2 y2y2

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 8 Sequential Game The follower's Problem The profit max choice of the follower will depend on the choice made by leader – the relationship is given by : y 2 = f 2 (y 1 ) - Reaction function (Profit output of the follower as a function of the leader´s choice.) How follower will react to the leaders choice of output p(y 1 +y 2 ) = a – b (y 1 +y 2 ) (consider cost (C) equal to 0) So the profit function to firm 2 (follower) is : 2 (y 1 +y 2 ) = ay 2 – b y 1 y 2 – by 2 2 So, we use this form to draw the isoprofit lines (Fig.1)Fig.1

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 9 Sequential Game The follower's Problem Fig.1 - The isoprofit lines graffic Monopolistics This reaction curve gives the profit-maximizing output for the follower

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 10 Sequential Game There are lines depicting those combination of y 1 and y 2 that yield a constant level of profit to firm 2. Isoprofit lines are comprised of all points which satisfy equations ay 2 – b y 1 y 2 – by 2 2 = 2 Firm 2 will increase profits as we move to Isoprofit lines that are further to the left. Firm 2 will make max possible profits when it's a monopolist, thus, when firm 1 chooses to produce zero units of output, as illustrated in fig 1. This point will satisfy the usual sort of tangency condition (RF). To understand it, we use : MR 2 (y 1,y 2 )= a – by 1 – 2by 2 (MR=MC ; MC=0) So, we have reaction curve of firm 2 y 2 = a-by 1 2b

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 11 Sequential Game Leadership problem It's action influence the output choice of the follower. This relationship is given by f 2 = (y 1 ) [y 2 = f 2 (y 1 ) ]. As we made, in case of the follower, the profit max problem for the leader is max p(y 1 +y 2 )y 1 – c 1 (y 1 ) Note that the leader recognizes that when it chooses output y 1, the total output produced will be y 1 + f 2 (y 1 ), its own output plus the output of the follower, so he has the influence in output of the follower. Let's see what happen : f 2 (y 1 ) = y 2 = It is the reaction function as illustrated in the previous slide y1y1 a-by 1 2b

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 12 Sequential Game Leadership problem Since we assume MC=0 the leader´s profit are : 1 (y 1 +y 2 )= p(y 1 +y 2 )y 1 = ay 1 – by 1 2 –by 1 y 2 But the ouput of the follower, y 2, will depend on the leader´s choice via reaction function y 2 = f 2 (y 1 ). Simplifying all the calculus and set the MC as zero and MR as (a /2) – by 1, we simple find : = In order to find the follower output we substitute y * 1 into the the reaction function: = y*1y*1 a 2b y*2y*2 a 4b

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 13 Sequential Game Leadership problem This two equations give a total industry output + = The Stackelberg solution can also be illustrated graphically using the Isoprofit curves (Fig.2). Here we have illustrated the reaction curves for both firms and the isoprofit curves for firm 1.Fig.2 To understand the graffic, firm 2 is behaving as a follower, which means that it will choose an output along its reaction curve, f 2 (y 1 ). Thus, firm 1 wants to choose an output combination on the reaction curve that gives it the highest possible profits. But, it means, picking that point on the reaction curve that touches the lowest isoprofit line (as illustrated). It follows by the usual logic of maximization that the reaction curve must be tangent to the isoprofit curve at this point. y*1y*1 y*2y*2 3a 4b

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 14 Sequential Game Leadership problem Fig.2 - Isoprofit curves (Stackelberg equilibrium)

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 15 Price Leadership What is the follower problem? In equilibrium the follower must always set the same price as the leader. Suppose that the leader has a price: The follower takes this price and wants to maximize profits: The follower wants to choose an output level where the price equals to the marginal cost. Instead of setting quantity, the leader may instead set the price, in this case the leader must forecast the follower behaviour. Profit Maximization p max(y 2 ) py 2 – c 2 (y 2 ) If one firm charged a lower price… In this model the follower takes the price as being outside of is control since it was already set by the leader. This determines the supply curve to the follower S(p);

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 16 Price Leadership What is the leader problem? The amount of output that the leader will sell will be… Supose that the leader has a a constant marginal cost of production: Then the profits that achieves for any price p are given by: In order to maximize the profits the leader wants to chose a price and a output combination... It realizes if it sets a price p the follower will supply S(p) c R(p) = D(p) – S(p) (Residual demand curve facing the leader) 1 (p)=(p-c)[D(p)– S(p)]= =(p-c)R(p) Where the marginal revenue equals the marginal cost. However, the marginal revenue should be the marginal revenue for the residual demand curve (the curve that actually measures how much output it will be able to sell at a each given price).

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 17 Price Leadership Graphical illustration The marginal revenue curve associated will have the same vertical intercept and be twice the step.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 18 Price Leadership Algebraic example 1/2 Inverse Demand Curve: Follower cost function: Leader cost function: The follower wants to operate where price is equal to marginal cost: Setting price equal to marginal cost D(p) = a - bp C 2 (y 2 ) = y 2 2 /2 C 1 (y 1 ) = cy 1 MC 2 (y 2 ) = y 2 p=y 2

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 19 Price Leadership Algebraic example 2/2 Solving for the supply curve: The demand curve facing leader (residual demand curve) is: Solving for p as function of the leaders output y 1 : This is the inverse demand function facing the leader. Setting marginal revenue equal to marginal cost: Solving for the leaders profit maximization output: y 2 =S(p)=p R(p) = D(p)-S(p)= =a-bp-p=a-(b+1)p p=a/(b+1) – y 1 /(b+1) MR 1 = a/(b+1) – 2y 1 /(b+1) MR 1 =a/(b+1)–2y 1 /(b+1)= =c=MC 1 y 1 *=(a-c(b+1))/2

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 20 Comparing Price Leadership and Quantity Leadership Weve seen how to calculate the equilibrium price and output in case of quantity leadership and price leadership. Each model determines a different equilibrium price and output combination. Quantity leadership Capacity choice Quantity Leader Price leadership Price setting Price and supply decision We have to look at how the firms actually make their decisions in order to choose the most appropriate model

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 21 Simultaneous Game Simultaneous Quantity Setting Leader – follower model is necessarily asymmetric. Cournot Model Each firm has to forecast the other firm´s output choice. Given its forecasts, each firm then chooses a profit-maximizing output for itself. Each firm finds its beliefs about the other firm to be confirmed.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 22 Simultaneous Quantity Setting Assuming: Firm 1decides to produce y 1 units of output, and believes that firm will produced y 2 e Total output produced will be Y = y 1 + y 2 e Output will yield a market price of p(Y) = p( y 1 + y 2 e ) The profit-maximization problem of firm 1 is them max p( y 1 + y 2 e ) y 1 – c(y 1 ) y1y1 For any given belief about the output of firm 2 (y 2 e ), there will be some optimal choice of output for firm 1 (y 1 ). y 1 = f 1 (y 2 e ) This reaction function gives one firm´s optimal choice as a function of its beliefs about the other firm´s choice.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 23 Simultaneous Quantity Setting Similarly, we can write: y 2 = ƒ 2 (y 1 e ) Which gives firm2´s optimal choice of output for a given expectation about firm 1´s output, y 1 e. Each firm is choosing its output level assuming that the other firm´s output will be at y 1 e or y 2 e. For arbitrary values of y 1 e and y 2 e this won´t happen - in general firm 1´s optimal level of output, y 1, will be different from what firm 2 expects the output to be, y 1 e. Seek an output combination (y 1 *, y 2 * ) Optimal output level for firm1 (assuming firm 2 produces y 2 * ) is y 1 * Optimal output level for firm2 (assuming firm 1 produces y 1 * ) is y 2 * So the output choices (y 1 *, y 2 * ) satisfy y 1 * = ƒ 1 (y 2 * ) y 2 * = ƒ 2 (y 1 * ) Cournot equilibrium

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 24 Cournot Equilibrium Each firm is maximizing its profits, given its beliefs about the other firm´s output choice. The beliefs that optimally chooses to produce the amount of output that the other firm expects it to produce are confirmed in equilibrium. In a Cournot equilibrium neither firm will find it profitable to change its output once it discovers the choice actually made by the other firm. Cournot Equilibrium Reaction curve for firm 1 Reaction curve for firm 2 y1 y2 Figure - Cournot Equilibrium Is the point at which the reaction curves cross.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 25 Adjustment to Equilibrium Firm 1 choice in period t +1 will be: Y 1 t+1 =ƒ 1 (y 2 t ) Firm 2 can reason the same way, so firm 2 choice next period will be: Y 2 t+1 =ƒ 2 (y 1 t ) These two equations describe how each firm adjusts its output in the face of the other firm´s choice At time t the firm are producing outputs (y 1 t, y 2 t ), not necessarily equilibrium outputs. If firm 1 expects that firm 2 is going to continue to keep its output at y 2 t, then next period firm 1 would want to choose the profit– maximizing output given that expectation, namely ƒ 1 (y 2 t ). Grafico livro pag 480 fig27.4

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 26 Adjustment to Equilibrium The Cournot equilibrium is a stable equilibrium when the adjustment process converges to the Cournot equilibrium. Some difficulties of of this adjustment process: Each firm is assuming that the other´s output will be fixed from one period to the next, but as it turns out, both firms keep changing their output. Only in equilibrium is one firm´s output expectation about the other firm´s output choice actually satisfied.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 27 Many firms in Cournot Equilibrium More than two firms involved in a Cournot equilibrium Each firm has an expectation about the output choices of the other firms in the industry and seek to describe the equilibrium output. Suppose that are n firms: Total industry output The marginal revenue equals marginal cost condition for firm is Using the definition of elasticity of aggregate demand curve and letting s i =y i /Y be firm i´s share of total market output Like the expression for the monopolist, except (s i )

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 28 Many firms in Cournot Equilibrium Think of Є(Y)/s i as being the elasticity of the demand curve facing the firm: elastic the demand curve it faces If its market share is 1 Demand curve facing the firm is the market demand curve Condition just reduces to that of the monopolist. If its market is a very small part of a large market market share is effectively 0 Demand curve facing the firm is effectively flat condition reduces to that of the pure competitor: price equals marginal cost. If there are a large number of firms, then each firm´s influence on the market price is negligible, and the Cournot equilibrium is effectively the same as pure competition.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 29 Simultaneous Price Setting Cournot Model described firms were choosing their quantities and letting the market determine the price. Firms setting their prices and letting the market determine the quantity sold Bertrand competition. What does a Bertrand equilibrium look like? Assuming that firms are selling identical products Bertrand equilibrium is the competitive equilibrium, where price equals marginal cots. Consider that both firms are selling output at some price > marginal cost. Cutting its price by an arbitrarily small amount firm 1 can steal all of the customers from firm 2. Firm 2 can reason the same way! Any price higher than marginal cost cannot be an equilibrium The only equilibrium is the competitive equilibrium ^

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 30 Collusion Key Findings Companies collude so as to jointly set the price or quantity of a certain good. This way it is possible to maximize total industry profits. The output produced by multiple firms that are colluding will be equal to the one produced by one firm that has a monopoly. When firms get together and attempt to set prices and outputs so as to maximize total industry profits, they are known as a Cartel. A cartel will typically be unstable in the sense that each firm will be tempted to sell more than its agreed upon output if it believes that the other firms will stick to what was agreed. EXAMPLES OF COLLUSION: De Beers Organization of the Petroleum Exporting Countries (OPEC) Port Wine Institute (IVP)

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 31 Collusion Profit-maximization when colluding max y1, y2 p(y1, y2)[y1+y2] – c 1 (y1) – c 2 (y2) p(y1 *, y2 * ) + (p/Y)[y1 * +y2 * ] = MC 1 (y 1 * ) p(y1 *, y2 * ) + (p/Y)[y1 * +y2 * ] = MC 2 (y 2 * ) MC 1 (y 1 * ) = MC 2 (y 2 * ) The optimality quantity is given by From there we may conclude that in equilibrium If one firm has a cost advantage, so that its marginal cost curve always lies bellow that of the other firm, then it will necessarily produce more output in the equilibrium in the cartel solution.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 32 Collusion Incentives not to respect the deal (1) The profit-maximizing point is D but if firm 1 assumes that firm 2 will stick with the deal, it will have incentives to produce G because it will produce more and will therefore produce more revenue. Worse, if firm 1 thinks that firm 2 isnt going to stick with the deal, it will want to start to produce G as fast as possible so as to gain the maximum profits it can.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 33 Collusion Incentives not to respect the deal (2) Algebraically π 1 / y 1 = p( y * 1 + y * 2 ) + (p/ y) Y * 1 – MC 1 (y * 1 ) p( y * 1, y * 2 ) + (p/y) y * 1 + (p/y) y * 2 – MC 1 (y * 1 ) = 0 Which rearranging gives π 1 / y 1 = p( y * 1, y * 2 ) + (p/y) y * 1 – MC 1 (y * 1 ) = - (p/y) y* 2 Following π 1 / y 1 > 0 So that are always incentives for firm 1 individually to cheat firm 2 if it thinks that firm 2 will stick to the agreement.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 34 Collusion Game Theory – Brief example Prisoner B ConfessDont confess Prisoner A Confess 5 5 0 20 Dont confess 20 0 1 1 PRISONERS DILEMMA Firm B Keep Prices Lower prices Firm A Keep Prices 100 10 140 Lower prices 140 10 50 Each prisoner is in a different cell and may assume that the other one is not going to talk. The dominant strategy in this example is to confess. But if both stay silent they will only get 1 year each.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 35 Collusion Example of failed collusion OPEC has tried and succeeded to maintain a cartel for the oil market. However they had some drawbacks, like in 1986 when Saudi Arabia dropped the price from $28 to $10 for barrel.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 36 Collusion How to maintain a Cartel? (1) Monitor others participants behavior Beat any price strategy Threat participants to respect the deal If you stay at the production level that maximizes joint industry profits, fine. But if i discover that you are cheating by producing more than this amount, i will punish you by producing the Cournot level of output forever.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 37 Collusion How to maintain a Cartel? (2) Punish disrespects to the deal tit-for-tat - Ill do this time what you did last time Regulation Government Regulation Examples Instituto do Vinho do Porto Πm – monopoly profits Πd – one time profit Πc – Cournout profit Present value of cartel behaviour - Πm + (Πm/r) Present value of cheating - Πd + (Πc/r) Πd > Πm > Πc r < (Πm - Πc) / (Πd - Πm) As long as the prospect of future punishment is high enough, it will pay the firms to stick to their quotas.

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 38 Resume 1 Few firms Homogeneous or different products Strategic interactions (the decisions of one firm influence the results of the others) It is not possible to describe the oligopoly behavior in just one model The oligopoly behavior depends on the characteristics of the market

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 39 Resume 2 Example: Television broadcasting in Portugal RTP, SIC, TVI Questions: - What if they change the price? -What if they change amount produced? -What if they introduced a new product? Sequential, Simultaneous or Cooperative game

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 40 Resume 3 Example: Computer firm, IBM Stackelberg Model – Quantity Leadership A firm (leader) decides its own production before the others – dominant firm or natural leader The others firms (followers) decide after they know the leaders decision When the leader chooses an output, it will take into account how the follower will respond

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 41 Resume 4 Example: McDonalds Price Leadership A firm (leader) sets the price and the others choose how much they will produce at that price When the leader chooses a price, it will take into account how the follower will respond

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 42 Resume 5 Example: Banking business Cournot Model – Simultaneous Quantity Setting Each firm believes that a change in its output will not lead to followers to change their productions It is supposed that both firms make their output choices simultaneously and the expectations about the other firms choices are confirmed Each firm has a small market share, that implies that price will be very close to the marginal price – nearly competitive

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 43 Resume 6 Example: Pump Gas Bertrand Competition – Simultaneous Price Setting Each firm chooses its price based on that it expects the price of the other firms will be Competitive equilibrium

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 44 Resume 7 Example: Cartel Collusion Group of firms that jointly collude to set prices and quantities that maximize the sum of their profits Typically unstable Problem: temptation to cheat to make higher profits (may break the cartel) Firms need a way to detect and punish cheating Behave like a single monopolist Punish Strategies (clients, governments…)

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 45 Comparing Oligopoly models... Assuming demand function P=a-by and marginal cost = 0 ModelsFirm 1 Quantity Q 1 Firm 2 Quantity Q 2 Total Quantity Q 1 +Q 2 Market Price Firm 1 profit 1 Firm 2 profit 2 Total profit 1 + 2 Colludea/4b a/2ba/2a 2 /8b a 2 /4b Cournota/3b 2a/3ba/3a 2 /9b 2a 2 /9b Bertranda/2b a/b0000 Stackelberga/2ba/4b3a/4ba/4a 2 /8ba 2 /16b3a 2 /16b Evidences... The Firm 1 profit in the Stackelberg Model. From Stackelberg Model to Bertrand Model. In the model Stackelberg the total output is bigger than in Cournot model; In Shared Monopoly model: smallest output and highest price; In Bertrand model: highest output and smallest price;

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 46 Exercise Stackelberg model 1/2 The Demand Curve is: Marginal cost for Leader and Follower: P = 10 - Q = 2 Questions: What will be the equilibrium price for both? What will be the equilibrium quantity for both?

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 47 Exercise Stackelberg model 2/2 The Marginal Revenue Curve is: Marginal cost: The Firm 2 Reaction Function: Replacing in the Firms1 demand function: The Marginal Revenue for firm 1 is: MR 2 =P(Q 1 +Q 2 )+(P/Q 2 )*Q 2 MR 2 = 10-Q 1 -2Q 2 MR = MC = 2 Anwsers: What will be the equilibrium price for both: = 4 What will be the equilibrium quantity for both? Q 1 = 4; Q 2 =2 R 2 (Q 1 ) = Q 2 * = = 4-(Q 1 /2) P 1 =10 – Q 1 – 4 + (Q 1 /2) = = 6 - (Q 1 /2) MR 1 = 6-Q 1 And MR 1 = MC = 2

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Class Assigment – Microeconomics – Oligopoly 31/10/2003 48 MicroEconomincs Oligopoly Bibliografy: Intermediate Microeconomics- Varian, H. Price Theory and Apllications- Landsburg, S.

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