Chapter 12Slide 1 Oligopoly Characteristics Small number of firms Product differentiation may or may...

Chapter 12 Slide 1

Oligopoly

CharacteristicsSmall number of firms

Product differentiation may or may not exist

Barriers to entry

Chapter 12 Slide 2

Oligopoly

ExamplesAutomobiles

Steel

Aluminum

Petrochemicals

Electrical equipment

Computers

Chapter 12 Slide 3

Oligopoly

The barriers to entry are:Natural

Scale economiesPatentsTechnologyName recognition

Chapter 12 Slide 4

Oligopoly

The barriers to entry are:Strategic action

Flooding the marketControlling an essential input

Chapter 12 Slide 5

Oligopoly

Management ChallengesStrategic actions

Rival behavior

QuestionWhat are the possible rival responses to a

10% price cut by Ford?

Chapter 12 Slide 6

Oligopoly

Equilibrium in an Oligopolistic MarketIn perfect competition, monopoly, and

monopolistic competition 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.

Chapter 12 Slide 7

Oligopoly

Equilibrium in an Oligopolistic MarketDefining Equilibrium

Firms doing the best they can and have no incentive to change their output or price

All firms assume competitors are taking rival decisions into account.

Chapter 12 Slide 8

Oligopoly

Nash EquilibriumEach firm is doing the best it can given

what its competitors are doing.

Chapter 12 Slide 9

Oligopoly

The Cournot ModelDuopoly

Two firms competing with each otherHomogenous goodThe output of the other firm is assumed

to be fixed

Chapter 12 Slide 10

MC1

50

MR1(75)

D1(75)

12.5

If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is

shifted to the left by this amount.

Firm 1’s Output Decision

Q1

P1

What is the output of Firm 1if Firm 2 produces 100 units?

D1(0)

MR1(0)

If Firm 1 thinks Firm 2 will produce nothing, its demand

curve, D1(0), is the market demand curve.

D1(50)MR1(50)

25

If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is

shifted to the left by this amount.

Chapter 12 Slide 11

Oligopoly

The Reaction CurveA firm’s profit-maximizing output is a

decreasing schedule of the expected output of Firm 2.

Chapter 12 Slide 12

Firm 2’s ReactionCurve Q*2(Q2)

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Reaction Curves and Cournot Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

Firm 1’s reaction curve shows how much itwill produce as a function of how much it thinks Firm 2 will produce. The x’s

correspond to the previous model.

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximize its own profits.

CournotEquilibrium

Chapter 12 Slide 13

Oligopoly

Questions

1) If the firms are not producing at the Cournot equilibrium, will they

adjust until the Cournot equilibrium is reached?

2) When is it rational to assume that its competitor’s output is fixed?

Chapter 12 Slide 14

Oligopoly

An Example of the Cournot EquilibriumDuopoly

Market demand is P = 30 - Q where Q = Q1 + Q2

MC1 = MC2 = 0

The Linear Demand CurveThe Linear Demand Curve

Chapter 12 Slide 15

Oligopoly

An Example of the Cournot EquilibriumFirm 1’s Reaction Curve

111 )30( Revenue, Total QQPQR

122

11

1211

30

)(30

QQQQ

QQQQ


Chapter 12 Slide 16

Oligopoly

An Example of the Cournot Equilibrium

12

21

11

21111

2115

2115

0

230

QQ

QQ

MCMR

QQQRMR

Curve Reaction s2' Firm

Curve Reaction s1' Firm


Chapter 12 Slide 17

Oligopoly

An Example of the Cournot Equilibrium

1030

20

10)2115(2115

21

1

1

QP

QQQ

Q

QQ 2:mEquilibriu Cournot


Chapter 12 Slide 18

Duopoly Example

Q1

Q2

Firm 2’sReaction Curve

30

15


15

30

10

10

Cournot Equilibrium

The demand curve is P = 30 - Q andboth firms have 0 marginal cost.

Chapter 12 Slide 19

Oligopoly

MCMRMR

QQRMR

QQQQPQR

and 15 Q when 0

230

30)30( 2

Profit Maximization with CollusionProfit Maximization with Collusion

Chapter 12 Slide 20

Oligopoly

Contract Curve

Q1 + Q2 = 15

Shows all pairs of output Q1 and Q2 that maximizes total profits

Q1 = Q2 = 7.5

Less output and higher profits than the Cournot equilibrium

Profit Maximization with CollusionProfit Maximization with Collusion

Chapter 12 Slide 21



Duopoly Example

Q1

Q2

30

30

10

10

Cournot Equilibrium15

15

Competitive Equilibrium (P = MC; Profit = 0)

CollusionCurve

7.5

7.5

Collusive Equilibrium

For the firm, collusion is the bestoutcome followed by the Cournot

Equilibrium and then the competitive equilibrium

Chapter 12 Slide 22

First Mover Advantage--The Stackelberg Model

AssumptionsOne 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

Chapter 12 Slide 23

Firm 1Must consider the reaction of Firm 2

Firm 2Takes Firm 1’s output as fixed and

therefore determines output with the Cournot reaction curve: Q2 = 15 - 1/2Q1


Chapter 12 Slide 24

Firm 1

Choose Q1 so that:

122

1111 30

0

Q - Q - QQ PQ R

MC, MC MR

0 MR therefore


Chapter 12 Slide 25

Substituting Firm 2’s Reaction Curve for Q2:

5.7 and 15:0

15

21

1111

QQMR

QQRMR

211

112

111

2115

)2115(30

QQ

QQQQR


Chapter 12 Slide 26

ConclusionFirm 1’s output is twice as large as firm 2’sFirm 1’s profit is twice as large as firm 2’s

QuestionsWhy is it more profitable to be the first

mover?Which model (Cournot or Shackelberg) is

more appropriate?


Chapter 12 Slide 27

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.

Chapter 12 Slide 28

Price Competition

AssumptionsHomogenous goodMarket demand is P = 30 - Q where

Q = Q1 + Q2

MC = $3 for both firms and MC1 = MC2 = $3

Bertrand ModelBertrand Model

Chapter 12 Slide 29

Price Competition

AssumptionsThe Cournot equilibrium:

Assume the firms compete with price, not quantity.


$81 firms both for

12$P

Chapter 12 Slide 30

Price Competition

How will consumers respond to a price differential? (Hint: Consider homogeneity)The Nash equilibrium:

P = MC; P1 = P2 = $3Q = 27; Q1 & Q2 = 13.5


0

Chapter 12 Slide 31

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).


Chapter 12 Slide 32

Price Competition

CriticismsWhen firms produce a homogenous good,

it is more natural to compete by setting quantities rather than prices.

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.


Chapter 12 Slide 33

Price Competition

Price Competition with Differentiated ProductsMarket shares are now determined not just

by prices, but by differences in the design, performance, and durability of each firm’s product.

Chapter 12 Slide 34

Price Competition

AssumptionsDuopolyFC = $20VC = 0

Differentiated ProductsDifferentiated Products

Chapter 12 Slide 35

Price Competition

AssumptionsFirm 1’s demand is Q1

= 12 - 2P1 + P2

Firm 2’s demand is Q2 = 12 - 2P1 + P1

P1 and P2 are prices firms 1 and 2 charge respectively

Q1 and Q2 are the resulting quantities they sell


Chapter 12 Slide 36

Price Competition

Determining Prices and OutputSet prices at the same time

202-12

20)212(

20$ :1 Firm

212

11

211

111

PPPP

PPP

QP


Chapter 12 Slide 37

Price Competition

Determining Prices and Output

Firm 1: If P2 is fixed:

12

21

2111

413

413

0412

'

PP

PP

PPP

curve reaction s2' Firm

curve reaction s1' Firm

price maximizing profit s1 Firm


Chapter 12 Slide 38

Firm 1’s Reaction Curve

Nash Equilibrium in Prices

P1

P2

Firm 2’s Reaction Curve

$4

$4

Nash Equilibrium

$6

$6

Collusive Equilibrium

Chapter 12 Slide 39

Nash Equilibrium in Prices

Does the Stackelberg model prediction for first mover hold when price is the variable instead of quantity?

Hint: Would you want to set price first?

Chapter 12 Slide 40

A Pricing Problem for Procter & Gamble

Scenario

1) Procter & Gamble, Kao Soap, Ltd., and Unilever, Ltd were entering the market for Gypsy Moth Tape.

2) All three would be choosing their prices at the same time.


Chapter 12 Slide 41

Scenario

3) Procter & Gamble had to consider competitors prices when setting their price.

4) FC = $480,000/month and VC = $1/unit for all firms



Chapter 12 Slide 42

Scenario

5) P&G’s demand curve was:

Q = 3,375P-3.5(PU).25(PK).25

Where P, PU , PK are P&G’s, Unilever’s, and Kao’s prices respectively



Chapter 12 Slide 43

ProblemWhat price should P&G choose and what is

the expected profit?



P&G’s Profit (in thousands of $ per month)

1.10 -226 -215 -204 -194 -183 -174 -165 -155

1.20 -106 -89 -73 -58 -43 -28 -15 -2

1.30 -56 -37 -19 2 15 31 47 62

1.40 -44 -25 -6 12 29 46 62 78

1.50 -52 -32 -15 3 20 36 52 68

1.60 -70 -51 -34 -18 -1 14 30 44

1.70 -93 -76 -59 -44 -28 -13 1 15

1.80 -118 -102 -87 -72 -57 -44 -30 -17

Competitor’s (Equal) Prices ($) P&G’sPrice ($)1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80

Chapter 12 Slide 45

What Do You Think?

1) Why would each firm choose a price of $1.40? Hint: Think

Nash Equilibrium

2) What is the profit maximizing price with collusion?


Chapter 12 Slide 46

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?

Chapter 12 Slide 47

Assume:

16$ 6$ :Collusion

12$ 4$ :mEquilibriuNash

212 :demand s2' Firm

212 :demand s1' Firm

0$ and 20$

12

21

P

P

PPQ

PPQ

VCFC


Chapter 12 Slide 48

Possible Pricing Outcomes:

4$204)6)(2(12)6(

20

20$206)4)(2(12)4(

20

4$ 6$

$16 6$ :2 Firm 6$ :1 Firm

111

222

QP

QP

PP

PP


Chapter 12 Slide 49

Payoff Matrix for Pricing Game

Firm 2

Firm 1

Charge $4 Charge $6

Charge $4

Charge $6

$12, $12 $20, $4

$16, $16$4, $20

Chapter 12 Slide 50

These two firms are playing a noncooperative game.Each firm independently does the best it

can taking its competitor into account.

QuestionWhy will both firms both choose $4 when

$6 will yield higher profits?


Chapter 12 Slide 51

An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.


Chapter 12 Slide 52

ScenarioTwo prisoners have been accused of

collaborating in a crime.

They are in separate jail cells and cannot communicate.

Each has been asked to confess to the crime.


Chapter 12 Slide 53

-5, -5 -1, -10

-2, -2-10, -1

Payoff Matrix for Prisoners’ Dilemma

Prisoner A

Confess Don’t confess

Confess

Don’tconfess

Prisoner B

Would you choose to confess?

Chapter 12 Slide 54

Payoff Matrix forthe P & G Prisoners’ Dilemma

Conclusions: Oligipolistic Markets

1) Collusion will lead to greater profits

2) Explicit and implicit collusion is possible

3) Once collusion exists, the profit motive to break and lower price is significant

Chapter 12 Slide 55

Charge $1.40 Charge $1.50

Charge$1.40

Unilever and Kao

Charge$1.50

P&G

$12, $12 $29, $11

$3, $21 $20, $20

Payoff Matrix for the P&G Pricing Problem

What price should P & G choose?

Chapter 12 Slide 56

Implications of the Prisoners’Dilemma for Oligipolistic Pricing

Observations of Oligopoly Behavior

1) In some oligopoly markets, pricing behavior in time can create a

predictable pricing environment and implied collusion may occur.

Chapter 12 Slide 57

Observations of Oligopoly Behavior

2) In other oligopoly markets, the firms are very aggressive and collusion is not possible.

Firms are reluctant to change price because of the likely response of their competitors.

In this case prices tend to be relatively rigid.

Implications of the Prisoners’Dilemma for Oligipolistic Pricing

Chapter 12 Slide 58

The Kinked Demand Curve

$/Q

Quantity

MR

D

If the producer lowers price thecompetitors will follow and the

demand will be inelastic.

If the producer raises price thecompetitors will not and the

demand will be elastic.

Chapter 12 Slide 59

The Kinked Demand Curve

$/Q

D

P*

Q*

MC

MC’

So long as marginal cost is in the vertical region of the marginal

revenue curve, price and output will remain constant.

MR

Quantity

Chapter 12 Slide 60

Implications of the Prisoners’Dilemma for Oligopolistic Pricing

Price Signaling

Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit

Price Signaling & Price LeadershipPrice Signaling & Price Leadership

Chapter 12 Slide 61


Price Leadership

Pattern of pricing in which one firm regularly announces price changes that other firms then match

Price Signaling & Price LeadershipPrice Signaling & Price Leadership

Chapter 12 Slide 62


The Dominant Firm ModelIn some oligopolistic markets, one large

firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market.

The large firm might then act as the dominant firm, setting a price that maximized its own profits.

Chapter 12 Slide 63

Price Setting by a Dominant Firm

Price

Quantity

D

DD

QD

P*

At this price, fringe firmssell QF, so that total

sales are QT.

P1

QF QT

P2

MCD

MRD

SF The dominant firm’s demandcurve is the difference between

market demand (D) and the supplyof the fringe firms (SF).

Chapter 12 Slide 64

Cartels

Characteristics

1) Explicit agreements to set output and price

2) May not include all firms

Chapter 12 Slide 65

Cartels

Examples of successful cartels

OPEC International

Bauxite Association

Mercurio Europeo

Examples of unsuccessful cartels

Copper Tin Coffee Tea Cocoa

Characteristics

3) Most often international

Chapter 12 Slide 66

Cartels

Characteristics

4) Conditions for successCompetitive alternative sufficiently

deters cheatingPotential of monopoly power--inelastic

demand

Chapter 12 Slide 67

Cartels

Comparing OPEC to CIPECMost cartels involve a portion of the market

which then behaves as the dominant firm

Chapter 12 Slide 68

The OPEC Oil Cartel

Price

Quantity

MROPEC

DOPEC

TD SC

MCOPEC

TD is the total world demandcurve for oil, and SC is the

competitive supply. OPEC’s demand is the difference

between the two.

QOPEC

P*

OPEC’s profits maximizingquantity is found at the

intersection of its MR andMC curves. At this quantity

OPEC charges price P*.

Chapter 12 Slide 69

Cartels

About OPECVery low MC

TD is inelastic

Non-OPEC supply is inelastic

DOPEC is relatively inelastic

Chapter 12 Slide 70

The OPEC Oil Cartel

Price

Quantity

MROPEC

DOPEC

TD SC

MCOPEC

QOPEC

P*

The price without the cartel:•Competitive price (PC) where DOPEC = MCOPEC

QC QT

Pc

Chapter 12 Slide 71

The CIPEC Copper Cartel

Price

Quantity

MRCIPEC

TD

DCIPEC

SC

MCCIPEC

QCIPEC

P*PC

QC QT

•TD and SC are relatively elastic•DCIPEC is elastic•CIPEC has little monopoly power•P* is closer to PC

Chapter 12 Slide 72

Cartels

ObservationsTo be successful:

Total demand must not be very price elastic

Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic

Chapter 12 Slide 73

The Cartelizationof Intercollegiate Athletics

Observations

1) Large number of firms (colleges)

2) Large number of consumers (fans)

3) Very high profits

Chapter 12 Slide 74

QuestionHow can we explain high profits in a

competitive market? (Hint: Think cartel and the NCAA)

The Cartelizationof Intercollegiate Athletics

Chapter 12 Slide 75

The Milk Cartel

1990s with less government support, the price of milk fluctuated more widely

In response, the government permitted six New England states to form a milk cartel (Northeast Interstate Dairy Compact -- NIDC)

Chapter 12 Slide 76

The Milk Cartel

1999 legislation allowed dairy farmers in Northeastern states surrounding NIDC to join NIDC, 7 in 16 Southern states to form a new regional cartel.

Soy milk may become more popular.

Chapter 12 Slide 77

Summary

In a monopolistically competitive market, firms compete by selling differentiated products, which are highly substitutable.

In an oligopolistic market, only a few firms account for most or all of production.

Chapter 12 Slide 78

Summary

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.

Chapter 12 Slide 79

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.

Chapter 12 Slide 80

Summary

The Prisoners’ Dilemma creates price rigidity in oligopolistic markets.

Price leadership is a form of implicit collusion that sometimes gets around the Prisoners Dilemma.

In a cartel, producers explicitly collude in setting prices and output levels.

End of Chapter 12

Monopolistic Competition and

Oligopoly

Monopolistic Competition and

Oligopoly

Chapter 12Slide 1 Oligopoly Characteristics Small number of firms Product differentiation may or may...

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