Lecture 11

• Oligopoly


  A market structure with a few large firms that produce homogeneous or differentiated goods
• The four basic market structures

  • Monopoly
  • Perfect competition
  • Oligopoly
  • Monopolistic competition
• Characteristics of an oligopolistic market


  • There are many consumers (buyers), but only "a few" firms (sellers), each "large" relative to the market
  • Consumers are price takers, but the firms are price makers
  • The firms produce homogeneous or differentiated goods
  • There are barriers to entry (but no barriers to exit)
  • The firms have market power and can choose their price or output quantity
• Examples of oligopolistic markets

  • Crude oil
  • Gasoline
  • Telecommunications
  • Computer processors
  • Credit cards
  • Airplanes
  • Cars
• Distinctive features of an oligopoly

  • Interdependence: One firm's profit depends on the other firms' choices
  • Strategic interaction: The optimal choices for one firm depend on the other firms' choices
  • Firms' beliefs about other firms' decision-making processes matter for their own choices
• Marginal revenue (MR) = Marginal cost (MC)


  The profit-maximizing output quantity for an oligopolist
• In a Cournot oligopoly, P > MC, while in a Bertrand oligopoly, P = MC
• Characteristics of a Cournot oligopoly

  • There are a few firms serving many consumers
  • The firms produce homogeneous goods
  • There are barriers to entry
  • The primary decision variable for firms is the quantity of output
  • All firms make their output decisions simultaneously
• In a Cournot oligopoly, a firm's optimal output depends on what it believes will be the other firms' output decisions
• Residual demand


  The difference between market demand and the quantities supplied by other firms
• Marginal revenue (MR) in a Cournot oligopoly

  MR = f(QA, QB) - depends on the firm's own output (QA) and the other firm's output (QB)
• Reaction function


  Shows how a profit-maximizing firm responds to other firms' choices
• In a Cournot duopoly, the firms' reaction functions are mirror images of each other
• Reaction function


  QA = RFA(QB)
• The reaction function can be shown graphically in a coordinate system with the two firms' output quantities as axes
• Firm B's reaction function is the mirror image of firm A's reaction function
• Firms choose their quantity based on what they believe is the other firm's reaction function, and this is the mirror image of their own reaction function
• Identifying the Cournot equilibrium


  1. Start at any quantity of output and ask whether there is an incentive for one of the firms to change its output

  2. When the quantity is such that there is no incentive for either firm to change, we have found the equilibrium
• Cournot equilibrium


  The quantity at which no firm has an incentive to change its own quantity, given its belief about the other firm's quantity
• The Cournot equilibrium corresponds to the intersection of the reaction functions
• The Cournot equilibrium is also the "Nash equilibrium"
• Mathematically identifying the Cournot equilibrium

  1. Solve the two reaction functions for the two unknowns

  2. Insert one reaction function into the other
• In a Cournot oligopoly, price is higher (and quantity is lower) than in perfect competition, but lower (higher) than in a monopoly if firms do not "collude"
• Collusion


  An agreement among firms about quantities to supply or prices to charge (or about other aspects of their operations) to limit competition for their mutual benefit
• Cartel


  A group of firms acting in unison
• If firms collude, they choose a linear combination (e.g., an even split) of their monopoly outputs to maximize their combined profit
• A collusive oligopoly leads to the same market result in terms of price and quantity as a monopoly
• The quantity supplied to the market with collusion is less than the quantity without collusion
• The market price with collusion is higher than the market price without collusion
• Reneging


  Breaking a collusion agreement
• There is a unilateral incentive to renege on a (non-binding) collusion agreement, because reneging raises the reneging firm's profit if the other firms do not renege
• Collusion agreements are difficult to maintain: Cartels tend to break up by themselves if the members cannot enforce the agreement, i.e., make it formal and binding
• If firms anticipate the incentive to renege and cannot enforce an agreement, they will not attempt to reach an agreement, i.e., form a cartel
• From society's perspective, firms reneging on a collusion agreement can be considered beneficial: Price is lower and quantity is higher than in the Cournot equilibrium (or under collusion)
• Bertrand oligopoly


  Competition in terms of price, where the primary decision variable for firms is the price they charge
• In a Bertrand oligopoly, all consumers buy from the firm charging the lowest price
• If several firms charge the lowest price, consumers split their purchases randomly, i.e., on average equally
• Marginal cost


  Equals average total cost
• Cournot model


  • Assumed marginal cost equals average total cost to simplify the analysis
• Bertrand model


  • Marginal cost equals average total cost is crucial