Lecture 12Slide 1 Topics to be Discussed Oligopoly Price Competition Competition Versus Collusion: The Prisoners’ Dilemma

Lecture 12Slide 2 Oligopoly Characteristics Small number of firms Product differentiation may or may not exist Barriers to entry

Lecture 12Slide 3 Oligopoly Examples Automobiles Steel Aluminum Petrochemicals Electrical equipment Computers

Lecture 12Slide 4 Oligopoly The barriers to entry are: Natural  Scale economies  Patents  Technology  Name recognition

Lecture 12Slide 5 Oligopoly The barriers to entry are: Strategic action  Flooding the market  Controlling an essential input

Lecture 12Slide 6 Oligopoly Equilibrium in an Oligopolistic Market In perfect competition and monopoly, the producers did not have to consider a rival’s response when choosing output and price. In oligopoly the producers must consider the response of competitors when choosing output and price.

Lecture 12Slide 7 Oligopoly Equilibrium in an Oligopolistic Market Defining Equilibrium  Firms doing the best they can and have no incentive to change their output or price Nash Equilibrium Each firm is doing the best it can given what its competitors are doing.

Lecture 12Slide 8 Oligopoly The Cournot Model Duopoly  Two firms competing with each other  Homogenous good  The output of the other firm is assumed to be fixed

Lecture 12Slide 9 Oligopoly The Reaction Curve A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2.

Lecture 12Slide 10 Firm 2’s Reaction Curve Q*2(Q 2 ) Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Reaction Curves and Cournot Equilibrium Q2Q2 Q1Q Firm 1’s Reaction Curve Q* 1 (Q 2 ) x x x x Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous model. In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. Cournot Equilibrium

Lecture 12Slide 11 Oligopoly An Example of the Cournot Equilibrium Duopoly  Market demand is P = 30 - Q where Q = Q 1 + Q 2  MC 1 = MC 2 = 0 The Linear Demand Curve

Lecture 12Slide 12 Oligopoly An Example of the Cournot Equilibrium Firm 1’s Reaction Curve The Linear Demand Curve

Lecture 12Slide 13 Oligopoly An Example of the Cournot Equilibrium The Linear Demand Curve

Lecture 12Slide 14 Oligopoly An Example of the Cournot Equilibrium The Linear Demand Curve

Lecture 12Slide 15 Duopoly Example Q1Q1 Q2Q2 Firm 2’s Reaction Curve Firm 1’s Reaction Curve Cournot Equilibrium The demand curve is P = 30 - Q and both firms have 0 marginal cost.

Lecture 12Slide 16 Oligopoly Generalise to n firms Compare it with perfect competition and with monopoly: Lerner index = 1/(n market elasticity)

Lecture 12Slide 17 First Mover Advantage-- The Stackelberg Model Assumptions One firm can set output first MC = 0 Market demand is P = 30 - Q where Q = total output Firm 1 sets output first and Firm 2 then makes an output decision

Lecture 12Slide 18 Firm 1 Must consider the reaction of Firm 2 Firm 2 Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q 2 = /2Q 1 First Mover Advantage-- The Stackelberg Model

Lecture 12Slide 19 Firm 1 Choose Q 1 so that: First Mover Advantage-- The Stackelberg Model

Lecture 12Slide 20 Substituting Firm 2’s Reaction Curve for Q 2 : First Mover Advantage-- The Stackelberg Model

Lecture 12Slide 21 Conclusion Firm 1’s output is twice as large as firm 2’s Firm 1’s profit is twice as large as firm 2’s Questions Why is it more profitable to be the first mover? Which model (Cournot or Shackelberg) is more appropriate? First Mover Advantage-- The Stackelberg Model

Lecture 12Slide 22 Price Competition Competition in an oligopolistic industry may occur with price instead of output. The Bertrand Model is used to illustrate price competition in an oligopolistic industry with homogenous goods.

Lecture 12Slide 23 Price Competition Assumptions Homogenous good Market demand is P = 30 - Q where Q = Q 1 + Q 2 MC = $3 for both firms and MC 1 = MC 2 = $3 Bertrand Model

Lecture 12Slide 24 Price Competition Assumptions The Cournot equilibrium:  Assume the firms compete with price, not quantity. Bertrand Model

Lecture 12Slide 25 Price Competition How will consumers respond to a price differential? (Hint: Consider homogeneity) The Nash equilibrium:  P = MC; P 1 = P 2 = $3  Q = 27; Q 1 & Q 2 = 13.5  Bertrand Model

Lecture 12Slide 26 Price Competition Why not charge a higher price to raise profits? How does the Bertrand outcome compare to the Cournot outcome? The Bertrand model demonstrates the importance of the strategic variable (price versus output). Bertrand Model

Lecture 12Slide 27 Price Competition Criticisms Even if the firms do set prices and choose the same price, what share of total sales will go to each one? It may not be equally divided. Price Competition with Differentiated Products  Market shares are determined not just by prices, but by differences in the design, performance, and durability. Bertrand Model

Lecture 12Slide 28 Competition Versus Collusion: The Prisoners’ Dilemma Why wouldn’t each firm set the collusion price independently and earn the higher profits that occur with explicit collusion?

Lecture 12Slide 29 Payoff Matrix for Pricing Game Firm 2 Firm 1 Charge $4Charge $6 Charge $4 Charge $6 $12, $12$20, $4 $16, $16$4, $20

Lecture 12Slide 30 These two firms are playing a noncooperative game. Each firm independently does the best it can taking its competitor into account. Question Why will both firms both choose $4 when $6 will yield higher profits? Competition Versus Collusion: The Prisoners’ Dilemma

Lecture 12Slide 31 An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face. Competition Versus Collusion: The Prisoners’ Dilemma

Lecture 12Slide 32 Summary In an oligopolistic market, only a few firms account for most or all of 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.

Lecture 12Slide 33 Summary The Nash equilibrium concept can also be applied to markets in which firms produce substitute goods and compete by setting price. Firms would earn higher profits by collusively agreeing to raise prices, but the antitrust laws usually prohibit this.