1. MicroEconomics Oligopoly Presented by Students:João Pita Francisco Vilhena da Cunha Bruno Pereira Jorge Oliveira Master in Engineering Policy and Management of Technology

2. Oligopoly The regimen of oligopoly is characterized by a restricted number of agents on the offer side and a large number on the demand side. The agents of the offer are in such number that their market share allows each one of them to affect the formation of prices and from there affect other competitors. Master in Engineering Policy and Management of Technology

3. Oligopoly This is, realistically, the regimen most current in the not controlled economies. Easiness of communications Information Transports Technological competition Selection of the most capable firms Automobile Market, Energy, Microprocessors, Photograph, etc Master in Engineering Policy and Management of Technology

4. Types of Oligopoly -Cooperative Oligopoly Implicit and explicit agreements about prices, amounts and types of product. Eventual barriers to the entrance of other companies in the market -Concorrencial oligopoly When the companies compete between themself, having or not in consideration the reaction of the other companies in the market. -With indifferentiated products With identical prices and equally available techniques of production for all the companies of the oligopoly - pure oligopoly -With differentiated products -When the companies differentiate its products, in order to create a search that specifically is directed them Master in Engineering Policy and Management of Technology

5. Cournot Model Developed by Antoine Augustin Cournot in 1838 In a two firm oligopoly (called a duopoly), if both firms set their output levels assuming that the other firm’s strategic choice variable (quantities in Cournot competition) is fixed, the equilibrium outcome is a Cournot-Nash Non-cooperative Equilibrium. Static Game: Players act simultaneously Strategies: Any Price between 0 and infinity denoted p1 and p2 Master in Engineering Policy and Management of Technology

6. Cournot Model Description: Firm 1 excepts that firm 2 production will be y 2 e units of output, Then decides to produce y 1, The total production will be Y= y 1 +y 2 e and market price p(Y) = p( y 1 + y 2 e ) Master in Engineering Policy and Management of Technology

7. Properties of the Cournot-Nash Equilibrium for Duopoly When the duopolists compete in quantities, we can compare the outcome to both the monopoly and competitive outcomes. Each duopolist produces less than a monopolist in the same market but together they produce more than the monopolist and less than the amount two competitive firms would have produced with the same cost structure and demand curves. The sum of the economic profits of each duopolist is less than the economic profits of a monopoly in the same market. Master in Engineering Policy and Management of Technology

8. Cournot Model: Water’s Reaction Curve Firm 2 q 2 (litres) Firm 1 q 1 (litres) 20 120 60 120 603050 Water´s reaction curve Master in Engineering Policy and Management of Technology

9. Cournot Model Firm 2 q 2 (litres) Firm 1 q 1 (litres) 120 60 120 40 6040 reaction curve Master in Engineering Policy and Management of Technology

10. Cournot Model Firm 2 q 2 (litres) Firm 1 q 1 (litres) 120 60 120 40 6040 reaction curve Cournot Equilibrium Master in Engineering Policy and Management of Technology

11. Properties of the Cournot-Nash Equilibrium for Duopoly The profit-maximization problem The optimal choice of firm 1 is y1 = f1(y 2 e ) This reaction function gives one firm’s optimal choice as a function of its beliefs about the other firm’s choice. 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. Master in Engineering Policy and Management of Technology

12. Bertrand-Nash equilibrium Static Game: Players act simultaneously Strategies: Any Price between 0 and infinity denoted p1 and p2 The Bertand equilibrium is a price level for each firm such that the firm´s profits are maximized given the price level of the other firm. Assuming that firms are selling identical products  Bertrand equilibrium is the competitive equilibrium, where price equals marginal costs. 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 think the same way! Any price higher than marginal cost cannot be an equilibrium The only equilibrium is the competitive equilibrium Master in Engineering Policy and Management of Technology

13. Bertrand-Nash equilibrium Graphical demonstration of Why P1=P2> MC is not a Nash Equilibrium Master in Engineering Policy and Management of Technology

14. Sequential Models  Companies act sequentially, as opposed to simultaneously (Cournot and Bertrand models)  Competitors decisions are taken into account  Dominant player or Leader (first mover) and Follower – anticipation strategy from the Leader  Perfect information: Follower has complete information on Leader’s actions – Competitive Intelligence  Examples: IBM, Microsoft Master in Engineering Policy and Management of Technology

15. Stackelberg Model  Heinrich Freiherr von Stackelberg 1905 (Germany) – 1946 (Spain) Theory of competition  Model Duopoly where both firms have market power with undifferentiated products First model to assume asymmetries between companies Cournot-like competition on quantity/output followed by Bertrand-like competition on price 1 st mover’s decision remains constant and follower decides based on that (otherwise it’s a Cournot model) Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg

16. Firm 1 (leader) decides on quantity to produce (y 1 ), assuming that Firm 2 (follower) will react to maximise its profits, producing y 2 : Total output: Y = y 1 + y 2 = f(y 1 ) Equilibrium price P is a function of total output, Y What will be the quantity produced by Firm 1 (Leader)? Look forward and reason back  Firm 1 knows that: It has influence over Firms2’s output and Firm 2 will react in order to maximise its profit Leading to… Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg

17. Follower's profit-maximization problem  Firm 2 will choose y 2 in order to maximise its profit,  2  2 = P(y 1 +y 2 )(y 2 ) - w 2 (y 2 ), where w 2 is Firm 2’s unit costs To Firm 2 and considering profit maximization: y 1 =constant and it will have to define y 2 from: MR(y 1,y 2 * )=MC(y 2 )  y 2 * = f 2 (y 1 )  y 2 * = f 2 (y 1 ): Firm 2 reaction function y 2 * is a function of Firm 1’s decision Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg

18. Follower's profit-maximization problem y’ 1 Reaction Curve f 2 (y 1 ) Isoprofit lines – Firm 2 y 2 = f 2 (y’ 1 ) y2y2  2 max (Monopolist) Master in Engineering Policy and Management of Technology y1y1 +-+- Sequential Models - Stackelberg

19. Leader’s Problem  Assuming Firm 2’s reaction to its output, Firm 1 now aims at maximizing it profit:  1 = P[y 1 +f(y 1 )](y 1 ) - w 1 (y 1 ), since y 2 = f(y 1 )  Leader knows that his actions influence the output choice of the follower, Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg

20. Isoprofit lines – Firm 1 Stackelberg model - Equilibrium Mathematical deduction: http://josemata.org/ee/17/stackelberg2/http://josemata.org/ee/17/stackelberg2/ y* 1 Reaction Curve Firm 2 f2(y1) y* 2 y2y2 Master in Engineering Policy and Management of Technology y1y1 +-+- Sequential Models - Stackelberg Reaction Curve Firm 1 Cournot Equilibrium Stackelberg Equilibrium

21. Stackelberg model compared Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Price Bertrand < Stackelberg < Cournot Competitive < Stackelberg < Monopoly Total Output Monopoly < Stackelberg < Competitive Cournot < Stackelberg < Bertrand Consumer SurplusCournot < Stackelberg < Bertrand

22. Identifying the leader  Stackelberg model based on Cournot with an anticipation strategy from one of the companies on setting its output  The model doesn’t explain what is the asymmetry neither in what it is based on  There can be several reasons, e.g.: Company already in the market and new entrant 1st can decide on the installed capacity If installed capacity irreversible, 2nd can assume capacity of the 1st as an input for decision Depending on fixed costs, 2nd may not be able to enter the market (monopoly) If seond enters the market  Stackelberg model Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg

23. Collusion Model When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion. Explicit collusion occurs when firms ostensibly agree to maintain their joint-profit-maximizing output. Cartels -- such as DeBeers and OPEC -- are obvious examples. Tacit collusion occurs when firms act without explicit agreement to achieve the cooperative outcome. Can take the form of a verbal ‘gentleman’s agreement’ to fix prices and output. Types of Cooperative Behaviour Master in Engineering Policy and Management of Technology

24. Factors that affect the ability to collude : Number and size distribution of sellers  Similar  easier to collude Product heterogeneity  Homogeneous  easier to collude Cost structures  Similar  easier to collude Size and frequency of orders  Frequent smaller  easier to collude Secrecy and retaliation  Less secrecy, easier retaliation  easier to collude Social structure of the industry  Social interaction  easier to collude Master in Engineering Policy and Management of Technology

25. Tacit Collusion Price Leader (Barometric Firm)  Largest, dominant, or lowest cost firm in the industry  Demand curve is defined as the market demand curve less supply by the followers Followers  Take market price as given and behave as perfect competitors Master in Engineering Policy and Management of Technology

26. Price Leadership Master in Engineering Policy and Management of Technology

27. Oligopoly isn’t a problem unless it becomes a Cartel Cartel – a formal or informal agreement among firms in an oligopolistic industry Cartel members may agree on such issues as prices, total industry output, market shares, and division of profits Cartels or collusive agreements are illegal in most cases. Master in Engineering Policy and Management of Technology

28. Cartels OPEC Colombian Drug Cartel Mafia or Crime Syndicate Ivy League Schools Government enforced cartels: market intervention to raise prices! Master in Engineering Policy and Management of Technology

29. Cartel as a Monopolist D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel). Cartel profits are maximized when the industry produces quantity Q and charges price p. Master in Engineering Policy and Management of Technology

30. Some illegal Cartels get caught: Electrical equipment manufacturers in the 1950s Pharmaceutical companies more recently Some don’t… Master in Engineering Policy and Management of Technology

31. Cheating Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement By offering a price slightly below the established price, a firm can usually increase its sales and economic profit Because oligopolists usually operate with excess capacity, some cheat on the established price Master in Engineering Policy and Management of Technology

32. How can either of the firms be sure that the other firm isn’t cheating on their agreement, and selling the product for lower price? “BEAT ANY PRICE” One way is to offer to beat any price a costumer can find. That way, the costumer report any attempt to cheat on the collusive arrangement Master in Engineering Policy and Management of Technology

33. OPEC Illustrates Cartel Difficulties Incentive to Cheat Cheating increases individual profits Cheating decreases cartel profits Different Members Have Different Goals High prices encourage substitutes Supply expansion by non-members Development of alternative products More important to some members than to others Master in Engineering Policy and Management of Technology

34. OPEC and CIPEC OPEC is the Organization of Petroleum Exporting CountriesOrganization of Petroleum Exporting Countries CIPEC is the French acronym for Int’l Council of Copper Exporting CountriesInt’l Council of Copper Exporting Countries Why has OPEC been successful in raising its price, but CIPEC has not? OPEC as a dominant firm Price MC non-opec P1P1 P2P2 P opec Q c+c P comp Output D mkt MR opec MC opec Q opec Q fringe Q total Oil Market Master in Engineering Policy and Management of Technology

35. OPEC and CIPEC CIPEC (Chile, Peru, Zambia, Zaire) MC CIPEC is not much less than MC non- cipec Why has OPEC been successful in raising its price, but CIPEC has not? CIPEC as a dominant firm Output Price D mkt MC non-cipec P1P1 P2P2 MR opec MC cipec Q cipec P cipec Q fringe Q total Q c+c P comp Why can’t CIPEC increase copper prices much?  D for copper is more elastic (aluminum is a good substitute)  Comp’ve supply more elastic than for oil (if P rises, simply go to scrap heap) Successful cartel needs relatively inelastic D. Copper Market Master in Engineering Policy and Management of Technology

36. Obstacles to Collusion Demand and cost differences between firms. Higher numbers of firms, particularly if a number of firms outside collusive agreement. Incentives to cheat. Recession. Legislative obstacles: Trade Practices Law. Master in Engineering Policy and Management of Technology

37. COMPARISON OF THE SOLUTIONS OLIGOPOLY MODELS Stackelberg (Quantity-leader) One firm leads by setting its output, and the other firm follows. When the leader chooses an output, it will take into account how the follower will respond Cournot (Price-leader) One firm sets its price and the firm chooses how much it wants to supply at that price. Again the leader has to take into account the behavior of the follower when it takes its decision Bertrand (Simultaneous price setting) Each firm chooses its prices given its beliefs about the price that the other firm will choose. The only equilibrium price is the competitive equilibrium Collusion (Cartel) A number of firms colluding to restrict output and to maximize industry profit. 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 not respond Master in Engineering Policy and Management of Technology

38. Sweezy Model -It tries to explain the rigidity of the price, many times observed in oligopolistc markets; -If a companie increases its price, the other companies will not, making the first one to lose its customers; -On the other hand, if a company lower the prices, the other companies also will lower the price, for that it will not have advantage to do that. P Q D mC mC’ mR Master in Engineering Policy and Management of Technology

39. Conclusions - Balance in the Long Run Profits, equilibrium or damage In the long run, the oligopolist will leave the industry if has no profits. It prepares its company to present the very best level of production in the long run. If it will have some profits, other companies will try to enter in the sector, if the entrance will not be restricted. Competition based on strategy, quality, product project, advertisement, services, innovation Master in Engineering Policy and Management of Technology

40. Bibliography Lipsey & Chrystal Mata, José, “Economia da empresa”, Fund. Calouste Gulbenkian, Lisboa, 2 nd edition, 2002 Mata, José in http://josemata.org/ee, 2006 http://josemata.org/ee Pindyck, Robert S., Rubinfield, Daniel L., “Microeconomics”, 5th edition, ch. 12, pgs. 429 to 451 Samuelson Salvatore, Dominick, “Microeconomy”, Schaum, MacGraw-Hill, 1984 Sousa, Alfredo de, “Análise Económica”, Universidade Nova de Lisboa, Faculdade de Economia, 1988 “The Home of Economics on the Internet” in www.tutor2u.net, 2006www.tutor2u.net Varian, Hal R., “Intermediate Microeconomics”, 6th edition, ch. 26, pgs. 459 to 479 Master in Engineering Policy and Management of Technology