Presentation on theme: "The World of Oligopoly: Preliminaries to Successful Entry"— Presentation transcript:
1 The World of Oligopoly: Preliminaries to Successful Entry Chapter 19The World of Oligopoly:Preliminaries to Successful Entry
2 The profit-maximizing output for the gadget monopoly Price,CostMCACDMRcdabQuantityIf there are no other market entrants, the entrepreneur can earn monopoly profits that are equal to the area dcba.
3 Cournot Theory of Duopoly & Oligopoly Oligopoly marketFew sellers of a product that are interdependentMay produce the same good or a differentiated productEntry barriers allows the oligopoly to make a profitDuopolyTwo firmsOne product
4 Cournot Theory of Duopoly & Oligopoly Cournot modelTwo firmsChoose quantity simultaneouslyPrice - determined on the marketCournot equilibriumNash equilibrium
5 The demand curve facing firm 1 Price, CostDM(q1)AP=A-b(q1+q2)MCMRMD1(q1,q2)A-bq2MR1D2(q1,q2’)A-bq2’MR2qMq11q12Quantityq1 declines as firm 2 enters the market and expands its output
6 Profit Maximization in a duopoly market Inverse demand function – linearP=A-b(q1+q2)Maximize profitsπ1= [A-b(q1+q2)]·q1 - C(q1)π2= [A-b(q1+q2)]·q2 - C(q2)
7 Reaction functions (best-response) Profit maximization:Set MR=MCMR now depends on the output of the competing firmSetting MR1=MC1 gives a reaction function for firm 1Gives firm 1’s output as a function of firm 2’s output
8 Reaction functions (best-response) Output of firm 2 (q2)q1=f1(q2)Output of firm 1 (q1)Given firm 2’s choice of q2, firm 1’s optimal response is q1=f1(q2).
9 Reaction Functions Points on reaction function Reaction functions Optimal/profit-maximizing choice/outputOf one firmTo a possible output level – other firmReaction functionsq1= f1(q2)q2 = f2(q1)
10 Reaction functions (best-response) Output of firm 2 (q2)q2=f2(q1)Output of firm 1 (q1)Given firm 1’s choice of q1, firm 2’s optimal response is q2=f2(q1).
11 Alternative Derivation -Reaction Functions Isoprofit curvesCombination of q1 and q2 that yield same profitReaction function (firm 1)Different output levels – firm 2Tangency points – firm 1
12 Reaction Function Output of firm 2 (q2) Firm 1’s Reaction Function y xq’2q’1Output of firm 1 (q1)q1m
13 Deriving a Cournot Equilibrium Intersection of the two Reaction functionsSame graph
14 Using Game Theory to Reinterpret the Cournot Equilibrium Simultaneous-move quantity-setting duopoly gameStrategic interactionFirms choose the quantity simultaneously
15 Using Game Theory to Reinterpret the Cournot Equilibrium Strategies: two output levelsPayoffsπ1= [A-b(q1+q2)]·q1 - C(q1)π2= [A-b(q1+q2)]·q2 - C(q2)Equilibrium CournotNash equilibrium
16 Criticisms of the Cournot Theory: The Stackelberg Duopoly Model Asymmetric modelStackelberg modelFirst: firm 1 – quantityThen: firm 2 – quantityFinally:Price – marketProfits
17 Criticisms of the Cournot Theory: The Stackelberg Duopoly Model Stackelberg leaderFirm - moves firstStackelberg followerFirm - moves secondStackelberg equilibriumEquilibrium prices and quantitiesStackelberg game
18 The Stackelberg solution Output of firm 2 (q2)Firm 1’s Reaction Functionπ1Firm 2’s Reaction FunctionEπ2π3π4Output of firm 1 (q1)Firm 1 (the leader) chooses the point on the reaction function of firm 2 (the follower) that is on the lowest attainable isoprofit curve of firm 1: point E.
19 Criticisms of the Cournot Theory: The Stackelberg Duopoly Model First-mover advantageLeader has a higher level of output and gets greater profits
20 Wal-Mart and CFL bulbs market In 2006 Wal-Mart committed itself to selling 1 million CFL bulbs every yearThis was part of Wal-Mart plan to be more socially responsibleAhmed(2012) shows that this commitment can be an attempt to raise profit.
21 Wal-Mart and CFL bulbs market When the target is smallWal-MartCommit to output targetDo not commit1Small firmSmall firm23commitDo notCommitDo not904550040806010050The outcome is similar to a prisoners dilemma
22 Wal-Mart and CFL bulbs market When the target is largeWal-MartCommit to output targetDo not commit1Small firmSmall firm23commitDo notCommitDo not8030500359010010050When the target is large enough, we have a game of chicken
24 The monopoly solution with zero marginal costs PriceDxp=a-bqMRypmA/2bDeadweight lossMC=0QuantityThe monopolist will choose output A/2b, at which the marginal revenue equals the marginal cost of zero. At the welfare-optimal output level, x, the price equals zero. The deadweight loss is area (A/2b)xy under the demand curve and between the monopoly and welfare-optimal output levels.
26 Criticisms of the Cournot Theory: The Bertrand Duopoly Model Bertrand modelOligopolistic competitionFirms compete - setting pricesDemand functionPayoff to each firm
27 Criticisms of the Cournot Theory: The Bertrand Duopoly Model The Nash equilibrium: P1=P2=MCProof: At each of the following an individual firm has an incentive to deviateP1=P2>MCP1>P2The equilibrium is socially optimal
28 Criticisms of the Cournot Theory: The Bertrand Duopoly Model Bertrand equilibriumNash equilibriumPrice-setting gameCompetitionPrice - down to marginal costWelfare-optimal price, quantity
29 Collusive Duopoly Collusive duopoly Firms collude and set price above marginal costArrangements – unstableGreat incentive to cheatPrice – driven down to marginal cost
30 Collusive DuopolyMatrix of the payoffs from a game involving a collusive pricing arrangementFirm 2Honor AgreementCheatFirm 1$1,000,000$200,000$1,200,000$500,000
31 Collusive DuopolyExample: The European voluntary agreement for washing machines.The agreement requires firms to eliminate from the market inefficient modelsAhmed and Segerson (2011) show that the agreement can raise firm profit, however, it is not stableFirm 2eliminateKeepFirm 1$1,000$200$1,200keep$500