1. INTERMEDIATE MICROECONOMICS Topic 9 Oligopoly: Strategic Firm Interaction These slides are copyright © 2010 by Tavis Barr. This work is licensed under a Creative Commons Attribution- ShareAlike 3.0 Unported License. See http://creativecommons.org/licenses/by-sa/3.0/ for further information.http://creativecommons.org/licenses/by-sa/3.0/

2. Topic Outline ● Introduction ● Cournot Competition ● Bertrand Competition ● Sequential Oligopoly Decisions ● Collusion ● Positioning ● Entry, Exit, Deterrence, Accommodation ● Oligopolies, Competition, and Efficiency

3. Introduction What it is ● An industry dominated by a handful of firms ● More than one firm has enough market share to affect the price ● Firms know their competitors by name Source: Gartner

4. Introduction Oligopoly and Strategy ● Ignoring competitors (each firm acts like monopolist) ● Colluding with competitors and forming a cartel (industry acts like one big monopolist ● Complex strategies Source: Beverage Marketing Corporation

5. Introduction Oligopoly and Strategy ● Complex strategies – Price wars – Market niches – Collusion – Etc. – How to model?

6. Introduction Oligopoly and Strategy ● Competition is a game – Players are firms (and potentially also consumers) – Strategies are pricing and quantity/quality decisions – Outcomes are profits

7. Introduction Cooperative and Non- Cooperative Games ● Cooperation: Strategies and Outcomes coincide – Bargaining game ● Non-cooperation: Outcome depends on interaction of strategies – Prisoner's dilemma

8. Introduction Cooperative and Non- Cooperative Games ● Cooperation: Strategies and Outcomes coincide – Bargaining game ● Non-cooperation: Outcome depends on interaction of strategies – Prisoner's dilemma

9. Cournot Competition What it is ● Firms choose quantity ● Market determines price that combined quantities can be sold at ● Equilibrium is Nash: Each player takes best option given other player's strategy ● Strategies are quantities ● “Best” is most profitable

10. Cournot Competition Cournot Duopoly ● Firm 1 chooses Q 1, Firm 2 chooses Q 2 ● Price is P(Q 1 +Q 2 ) from market demand curve ● Firm 1 takes Q 2 as given, sets Q 1 so that MR=MC ● Firm 2 takes Q 1 as given, sets Q 2 so that MR=MC

11. Cournot Competition Cournot Duopoly ● Example: – Market: Q D = 5000 – 500P – Constant MC = 1 ● Firm 1 takes Q 2 as given: – P = 10 – Q/500 or P = 10 – (Q 1 + Q 2 )/500 ● Can calculate MR given Q 2 : – MR = (10 – Q 2 /500) - Q 1 /250

12. Cournot Competition Cournot Duopoly ● Firm 1 takes MR given Q 2 : – MR = (10 – Q 2 /500) – Q 1 /250 ● Then maximizes profits by MR=MC (here MC = 1) – 1 = (10 – Q 2 /500) – Q 1 /250 – Q 1 = 2250 - Q 2 /2

13. Cournot Competition Cournot Duopoly ● Firm 1 calculates best response to Q 2 : – Q 1 * = 2250 – Q 2 /2 ● Firm 2 makes completely symmetrical calculations: – MR 2 = (10 –Q 1 /500) – Q 2 /250 – 1 = (10 – Q 1 /500) – Q 2 /250 – Q 2 * = 2250 - Q 1 /2

14. Cournot Competition Cournot Duopoly ● Nash equilibrium: – Q 1 * = 2250 - Q 2 /2 – Q 2 * = 2250 – Q 1 /2 – So, Q 1 = Q 2 = 1500 ● Price can be obtained from the (inverse) demand curve: – P(Q 1 +Q 2 ) = 10 – (Q 1 +Q 2 )/500 = 10 - (1500+1500)/500 = 4

15. Cournot Competition Cournot Duopoly ● What would a monopolist do? – Q D = 5000 – 500P so P = 10 – Q D /500 so MR = 10 – Q/250 – MC = 1 – Set output where MR=MC: 1 = 10 – Q/250 or Q = 2250 – P = 10 – 2250/500 = 5.5

16. Cournot Competition Cournot Duopoly ● What would a perfect competitor do? ● Setting P=MC really only makes sense with a flat demand curve, but let's pretend it did

17. Cournot Competition Cournot Duopoly ● What would a perfect competitor do? P = MC – Q D = 5000 – 500P so P = 10 – Q D /500 – MC = 1 – Set output where P=MC: 1 = 10 – Q/500 or Q = 4500 – P = 10 – 4500/500 = 1

18. Cournot Competition Cournot Duopoly ● Monopoly: Q = 2250 P=5.50 ● Cournot: Q = 3,000 P = 4 ● Perf. Comp.:Q = 4500 P = 1 ● So Cournot price/output is somewhere between monopoly and perfect competition

19. Bertrand Competition What It Is ● Firms choose price, market demand determines quantity ● Firms can sell at different prices ● Standard assumption: Consumers will buy from lower-priced producer

20. Bertrand Competition Features ● Result: Revenue increases dramatically from one-penny price drop ● So firms will drop price as long as P ≥ MC ● Results in P=MC, same price and quantity as perfect competition

21. Bertrand Competition Features ● If some consumers buy from more expensive producer, result not as severe ● Key point: It matters whether firms choose price or quantity

22. Collusion What It Is ● Firms may agree to raise price and lower quantity to monopoly level, and split profits ● Illegal in U.S. since 1889 ● May be done by tacit collusion: Firms “follow the golden rule” Cournot Game: Output 1500 Price $4, Cost 1 Profits: $4,500 Monopoly: Output 2250 Price $5.50, Cost 1 Profits: $10,125

23. Collusion ● Firms have incentive to cheat: If other firm chooses collusive output and you choose high output, you may get windfall profit

24. Collusion ● Incentive to cheat: – Best response to Q 2 is Q 1 =2250 – Q 2 /2 – Best response to 1125: 1687.5 – Total output: 1125+1687.5 = 2812.5 – Market price: P = 10 – 2812.5/500 = $4.375 – Profit: 1687.5(3.375) = $5695.31

25. Collusion ● Incentive to cheat: – Profit from cheating: 1687.5(3.375) = $5695.31 – Profit to firm that didn't cheat: 1125(3.375) = $3796.87 – Collusive profit: $5,062.5 – Non-collusive profit: $4,500

26. Collusion ● Incentive to cheat: – Profit from cheating: 1687.5(3.375) = $5695.31 – Profit to firm that didn't cheat: 1125(3.375) = $3796.87 – Collusive profit: $5,062.5 – Non-collusive profit: $4,500 ● Creates a prisoner's dilemma