Today n Oligopoly Theory n Economic Experiment in Class

What happens when cartels won’t work? Oligopoly

Theories of Oligopoly Behavior n There are several theories of oligopoly behavior. – Many seem to explain some industries. – None seem to explain all industries. n Many share the notion of a Nash equilibrium.

Nash Equilibrium n When no firm wants to unilaterally change what it is doing. n Assumes that firms do not cooperate with each other.

Bertrand Equilibrium n Firms simultaneously choose prices. n Homogeneous product. n Perfect Information. n “Ties” split the market. n Simplification: Zero costs. n What does the equilibrium look like?

What would you charge? Q D P What will the Nash- Bertrand equilibrium look like? (No firm wants to unilaterally change its price.)

Bertrand Equilibrium Q D P With the assumption of zero costs, the equilibrium price is zero. Profits are zero. Q*

Bertrand Equilibrium Explained n Unless there are zero profits, the firms will undercut each other to get more sales. n The result is like perfect competition, but here we have only a few firms. – Zero profits – P = MC (allocatively efficient)

Cournot Equilibrium n Firms choose quantities without knowing the other firm’s quantity choice. n Equilibrium is when one firm would not have changed its quantity if it had known the other firm’s choice. This must hold for both firms.

Cournot Equilibrium, Cont’d. n Each firm sells its output for the highest price possible, given total market output. n Note there is one market price.

Cournot on graph Q D MR P Suppose a duopoly. Firm 2 guesses various quantities for firm 1. Pick any q 1 (say, 20). What is the optimal q 2 ?

Cournot on graph Q D MR P It is always optimal to “split” the difference between q1 and 100. Is this an equilibrium? (Hint: Does firm 1 regret its choice of 20 units?) $40

Cournot on graph Q D MR P Given firm 2 produces 40 units, firm 1 now wishes it had chosen 30 units (for a mkt total of 70). Firm 1 = 20 & Firm 2 = 40 units is not a Cournot equilibrium $ $30

Nash-Cournot Equilibrium n For two firms with identical costs, they will choose identical output levels in equilibrium. n In our example, each firm produces 33 1/3 units.

Nash-Cournot Equilibrium Q D MR P Each firm produces 33 1/3 units. Neither wishes to change, given the other’s output. Do these firms make profits in equilibrium? $33

Overview of Cournot Equilibrium n Firms make positive profits. n There must be barriers to entry in order for these to last in the long run. n P > MC, so deadweight loss compared to the efficient quantity.

Cournot compared to Monopoly Q D MR P Industry output is greater. Price is lower. Profits are lower. (How do we know?) Deadweight loss (compared to efficient level of output) is lower $33 50 $50 Monopoly 2 firms, Cournot Bertrand

Cournot v. Bertrand n Bertrand indicates that without cooperation, the equilibrium is the same as in perfect competition. n Cournot indicates that without cooperation, oligopolists can make profits, similar to monopolist.

Cournot v. Bertrand, Cont’d n Which is correct? Probably neither. n Firms tend to say they act as price competitors, but market outcomes typically reflect a Cournot solution.

Coming Up n Monday: Externalities n Wednesday – no class because of Thanksgiving holiday n Monday 11/27 – Prepare for 3rd exam covering chapters 22, 23, and 30. n Wednesday 11/29 – Exam 3

Group Work n A series of experiments about oligopoly behavior.