Lecture 11 oligopoly

Lecture 11HE 101

Monopolistic Competition and Oligopoly

Source: Pyndyck, Rubinfeld and Koh (2006) complemented with own materials

©2005 Pearson Education, Inc. 2

Monopolistic Competition

Characteristics

1. Many firms

2. Free entry and exit

3. Differentiated product but highly substitutable

Similar as in PerfectlyCompetitive Market

determined the degree ofmonopoly power that each firm has

(c) Y.E. Riyanto



Examples of this very common market structure include:

Toothpaste

Soap

Cold remedies

The greater the preference (degree of differentiation) the higher the price.

(c) Y.E. Riyanto

A Monopolistically CompetitiveFirm in the Short and Long Run

Quantity

$/Q

Quantity

$/QMC

AC

MC

AC

DSR

MRSR

DLR

MRLR

QSR

PSR

QLR

PLR

Short Run Long Run

4(c) Y.E. Riyanto



Short-run

Downward sloping demand – differentiated product

Demand is relatively elastic – good substitutes

MR < P

Profits are maximized when MR = MC

This firm is making economic profits

(c) Y.E. Riyanto



Long-runProfits will attract new firms to the industry (no

barriers to entry)

The old firm’s demand will decrease to DLR

Firm’s output and price will fall

Industry output will rise

No economic profit (P = AC)

P > MC some monopoly power

(c) Y.E. Riyanto

Deadweight lossMC AC

Monopolistically and Perfectly Competitive Equilibrium (LR)

$/Q

Quantity

$/Q

D = MR

QC

PC

MC AC

DLR

MRLR

QMC

P

Quantity

Perfect Competition Monopolistic Competition

7(c) Y.E. Riyanto


Monopolistic Competition & Economic Efficiency

The monopoly power yields a higher price than perfect competition Dead Weight Loss. If price was lowered to the point where MC = D, consumer surplus would increase – lower deadweight loss.

With no economic profits in the long run, the firm’s output is still below the one that minimize AC excess capacity exists.

(c) Y.E. Riyanto



If inefficiency bad for consumers, should monopolistic competition be regulated?

Market power relatively small. Usually enough firms to compete with enough substitutability between firms – deadweight loss relatively small

Inefficiency is balanced by the benefit of increased product diversity – could outweigh deadweight loss

(c) Y.E. Riyanto


Each market has much differentiation in products and try to gain consumers through that differentiation.

How much monopoly power do each of these producers have?

How elastic demand for each brand?


(c) Y.E. Riyanto


Oligopoly – Characteristics

Small number of firms

Product differentiation may or may not exist

Barriers to entry

Scale economiesPatentsTechnologyBrand name recognition/ loyaltyStrategic action by firms

(c) Y.E. Riyanto


Oligopoly

Examples

AutomobilesPC operating systemsInternet BrowsersPetrochemicalsElectrical equipment

(c) Y.E. Riyanto


Oligopoly – Equilibrium

A monopoly does not have to worry about how rivals will react to its action simply because there are no rivals.

A competitive firm potentially faces many rivals, but the firm and its rivals are price takers also no need to worry about rivals’ actions.

An oligopoly firm when deciding a strategic action (e.g. cut their price, or increase quantity, etc) must consider what the rival firms in the industry will do.

(c) Y.E. Riyanto



The oligopolist needs to choose an appropriate response to the rivals’ actions similarly, rivals also need to anticipate the firm’s response and act accordingly interactive setting.

Actions and reactions are dynamic, evolving over time

Game Theory is an appropriate tool to analyze strategic actions in such an interactive setting important assumption: firms (or firms’ managers) are rational decision makers.

Will be covered in more detailed in lecture 11(c) Y.E. Riyanto


Oligopoly – An Intermezzo Consider the following story (taken from Dixit and Skeath (1999), Games of

Strategy)

…”There were two friends taking Chemistry at Duke. Both had done pretty well on all of the quizzes, the labs, and the midterm, so that going to the final they had a solid A. They were so confident that the weekend before the final exam they decided to go to a party at the University of Virginia. The party was so good that they overslept all day Sunday, and got back too late to study for the Chemistry final that was scheduled for Monday morning. Rather than take the final unprepared, they went to the professor with a sob story. They said they had gone to the University of Virginia and had planned to come back in good time to study for the final but had had a flat tire on the way back. Because they did not have a spare, they had spent most of the night looking for help. Now they were too tired, so could they please have a make-up final the next day? the professor was so kind to agree with this

The two studied all of Monday evening and came well prepared on Tuesday morning. The professor placed them in separate rooms and handed the test to each. Each of them wrote a good answer, and greatly relieved, but …

when they turned to the last page. It had just one question, worth 90 points. It was: “Which tire?”….

(c) Y.E. Riyanto



Defining Equilibrium

Firms are doing the best they can and have no incentive to change their strategy (e.g. output or price)

All firms assume competitors are taking rival decisions into account.

Nash Equilibrium John Nash (remember Russel Crowe’s movie “A Beautiful Mind”)

Each firm is doing the best it can given what its competitors are doing no incentive to deviate.

We will focus on duopoly Markets in which two firms compete

(c) Y.E. Riyanto


Oligopoly

The Cournot Model

With a homogenous good Oligopoly model in which firms produce a homogeneous good.

Firm will adjust its output based on what it thinks the other firm will produce

(c) Y.E. Riyanto


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

D1(0)

MR1(0)

Firm 1’s demand curve, D1(0), if it thinks that Firm 2 produces nothing.

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.

(c) Y.E. Riyanto


Oligopoly

The Reaction Curve

The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce.

A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2.

(c) Y.E. Riyanto


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


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.

(c) Y.E. Riyanto



Reaction Curves and Cournot Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100


x

x

x

x

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximize its own profits.

CournotEquilibrium

(c) Y.E. Riyanto


Cournot Equilibrium

Each firms reaction curve tells it how much to produce given the output of its competitor.

Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.

(c) Y.E. Riyanto


Oligopoly

Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium)

(c) Y.E. Riyanto


The Linear Demand Curve

An Example of the Cournot Equilibrium

Two firms face linear market demand curve

We can compare competitive equilibrium and the equilibrium resulting from collusion

Market demand is P = 30 - Q

Q is total production of both firms:

Q = Q1 + Q2

Both firms have MC1 = MC2 = 0

(c) Y.E. Riyanto


Oligopoly Example

Firm 1’s Reaction Curve derived from firm 1’ profit max problem MR=MC

1 1 1 1(30 )TR PQ Q Q

122

11

1211

30

)(30

QQQQ

QQQQ

(c) Y.E. Riyanto


Oligopoly Example

An Example of the Cournot Equilibrium

11 1 2 1

1

1 1 1 2

1 2

2 1

30 2 and 0

0 30 - 2 0

Firm 1's Reaction Curve

15 1 2

Similarly, firm 2's Reaction Curve can be derived

15 1 2

TRMR Q Q MC

Q

MR MC Q Q

Q Q

Q Q

(c) Y.E. Riyanto


Oligopoly ExampleAn Example of the Cournot Equilibrium

1 2

1 1 1

2 1 1 2

2

1 2 1 1 1 2

Cournot Equilibrium:

1 1 115 15 10 2.5 10

2 2 4

115 10 20 30 10

2

If fixed costs for both firms = 0

30 100

Q Q

Q Q Q

Q Q Q Q Q P Q

Q Q QQ

(c) Y.E. Riyanto


Duopoly ExampleQ1

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.

(c) Y.E. Riyanto


Oligopoly Example

Profit Maximization with Collusion

2

2

1 2

(30 ) 30

30 2

0

30 - 2 0 15

If fixed costs for both firms = 0

=30 15 15 225

225112.5

2

TR PQ Q Q Q Q

TRMR Q

Q

MR MC

Q Q

(c) Y.E. Riyanto


Profit Maximization w/Collusion

Collusion 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

(c) Y.E. Riyanto




Duopoly ExampleQ1

Q2

30

30

10

10

Cournot Equilibrium

CollusionCurve

7.5

7.5

Collusive Equilibrium

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

Equilibrium and then the competitive equilibrium

15

15

Competitive Equilibrium (P = MC; Profit = 0)

(c) Y.E. Riyanto


First Mover Advantage – The Stackelberg Quantity Competition Model

Oligopoly model in which one firm sets its output before other firms do.

Assumptions

One firm can set output first

MC = 0

Market demand is P = 30 - Q where Q is total output

Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1 output

(c) Y.E. Riyanto


First Mover Advantage – The Stackelberg ModelFirm 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: Q2 = 15 - ½(Q1)

Firm 1 sets Q1, anticipatingFirm 2’s best response quantity Q2.

Firm 2 sets it best responsequantity Q2, against Q1.

period 1 period 2

(c) Y.E. Riyanto


First Mover Advantage – The Stackelberg Model

By backward induction: Using Firm 2’s Reaction Curve for Q2:

Firm 1:

2 1

115

2Q Q

21 1 2 1 1 1 1 1 2

2 21 1 1 1 1 1 1

11 1

1

1 1 1 1

2

2

30 30

1 130 15 15

2 2

15

15 0 15

115 15 15 7.5 7.5

2

TR Q Q Q TR Q Q QQ

TR Q Q Q Q Q Q

TRMR Q

Q

MR MC Q Q

Q P

(c) Y.E. Riyanto


An Intermezzo: Backward Induction

Consider the following ‘immunity challenge’ in the reality TV game show ‘Survivor’ (Survivor Thailand (season 5) - episode 6)

This is a sequential move game, use backward induction to find what is the best strategy for the first mover (thinking ahead and see the implication for your action now).

Player A

Player B

21 FlagsA moves first must pick1 or2 or 3 flags.

B moves second must Also pick 1 or2 or 3 flags.

The player who removes the last remaining flag(s) (1, or 2, or 3 last flag(s) isthe winner of the challenge.

(c) Y.E. Riyanto



Profits:

21 1 1 1 1 2

2

1

Suppose that Fixed Cost for both firms = 0

30

30 15 15 15 7.5 112.5

TR Q Q QQ

22 2 2 2 1 2

2

1

30

30 7.5 7.5 15 7.5 56.25

TR Q Q QQ

(c) Y.E. Riyanto



Conclusion

Going first gives firm 1 the advantage

Firm 1’s output is twice as large as firm 2’s

Firm 1’s profit is twice as large as firm 2’s

Going first allows firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless wants to reduce profits for everyone

(c) Y.E. Riyanto


Price Competition

Competition in an oligopolistic industry may occur with price instead of output.

The Bertrand Model is used instead of Cournot Model.

Oligopoly model in which each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge

(c) Y.E. Riyanto


Price Competition – Bertrand Model

Assumptions

Homogenous good

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

MC1 = MC2 = $3

If we have Cournot competition Q1 = Q2 = 9 and P=$12 giving each firm a profits of $81.

(c) Y.E. Riyanto



Assume here that the firms compete with price, not quantity.

Since good is homogeneous consumers will buy from lowest price seller

If firms charge different prices, consumers buy from lowest priced firm only

If firms charge same price, consumers are indifferent who they buy from

(c) Y.E. Riyanto



Bertrand-Nash equilibrium: firms have incentive to cut prices below rivals

Both firms set P=MC like in compt. Mkt.

P = MC; P1 = P2 = $3

Q = 27; Q1 & Q2 = 13.5

Both firms earn zero profit

(c) Y.E. Riyanto


Price Competition – Bertrand Model – A real example

(c) Y.E. Riyanto



Why not charge a different price (P>MC)?

If charge more, sell nothing

If charge less, lose money on each unit sold

The Bertrand model demonstrates the importance of the strategic variable

Price versus output

(c) Y.E. Riyanto


Bertrand Model – Criticisms

When 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 e.g. brand name loyalty product differentiation.

(c) Y.E. Riyanto


Price Competition – Differentiated Products

Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product products are no longer homogeneous but instead differentiated.

In these markets, more likely to compete using price instead of quantity

(c) Y.E. Riyanto



Example

Duopoly with fixed costs of $20 but zero variable costs

Firms face the same demand curves

Firm 1’s demand: Q1 = 12 - 2P1 + P2

Firm 2’s demand: Q2 = 12 - 2P1 + P1

Quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price

(c) Y.E. Riyanto



Firms set prices simultaneously

1 1 1

1 1 2

21 1 1 2

2 2 2

22 2 1 2

Firm 1: $20

(12 2 ) 20

12 2 20

Firm 2: $20

12 2 20

PQ

P P P

P P PP

PQ

P P PP

(c) Y.E. Riyanto



Reaction Curves can be derived:

11 2

1

1 2

2 1

Firm 1's profit maximizing price

12 4 0

Firm 1's reaction curve :

1 3

4Likewise Firm 2's reaction curve

can be derived:

1 3

4

P PP

P P

P P

(c) Y.E. Riyanto

©2005 Pearson Education, Inc.

Bertrand Nash equilibrium:

Profit

49


1 2 2 1

1 1 1

1 2

1 13 and 3

4 41 1 15 1

3 34 4 4 16

4 and 4

P P P P

P P P

P P

21 1 1 1 2

1 2

12 2 20

12 & 12

P P PP

(c) Y.E. Riyanto


Nash Equilibrium in PricesA digression What if both firms collude?

They both decide to charge the same price that maximized both of their profits

Firms will charge $6 and will be better off colluding since they will earn a profit of $16

1 2

1 2

2 21 1 1 2 2 2 1 2

2

1 2

=

= 12 2 20 12 2 20

24 2 40

24 4 0 6 16

P P P

P P PP P P PP

P P

P PP

(c) Y.E. Riyanto


Firm 1’s Reaction Curve

Nash Equilibrium in Prices

P1

P2

Firm 2’s Reaction Curve

$4

$4

Nash Equilibrium

$6

$6

Collusive Equilibrium

Equilibrium at price of $4 and profits of $12

(c) Y.E. Riyanto


Nash Equilibrium in Prices

What if they move sequentially in A Stackelberg fashion? If Firm 1 sets price first and then firm 2 makes pricing decision

Firm 1 would be at a distinct disadvantage by moving first

The firm that moves second has an opportunity to undercut slightly and capture a larger market share

(c) Y.E. Riyanto


Collusion with competitors will give larger profits.

If all agree to charge $6, each earn profit of $16.

Collusive agreement hard to enforce temptation to undercut the rival and charge slightly below $6 gets the whole market.

Competition Versus Collusion:The Prisoners’ Dilemma

(c) Y.E. Riyanto



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

(c) Y.E. Riyanto



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

(c) Y.E. Riyanto


Payoff Matrix for Pricing GameFirm 2

Firm 1

Charge $4 Charge $6

Charge $4

Charge $6

$12, $12 $20, $4

$16, $16$4, $20

Dominant Strategy

Nash Eq.($4;$4)

better outcomes(c) Y.E. Riyanto



We can now answer the question of why firm does not choose cooperative price.

Cooperating means both firms charging $6 instead of $4 and earning $16 instead of $12

Each firm always makes more money by charging $4, no matter what its competitor does

Unless enforceable agreement to charge $6, will be better off charging $4

(c) Y.E. Riyanto



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

Two 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.

(c) Y.E. Riyanto


-5, -5 -1, -10

-2, -2-10, -1

Payoff Matrix for Prisoners’ Dilemma

Prisoner A

Don’t confess

Don’tconfess

Prisoner B

Would you choose to confess?

Confess

Confess

Dominant Strategy

Nash Eq.(confess;confess)

better outcomes(c) Y.E. Riyanto


Intermezzo:

(c) Y.E. Riyanto

• Is this a PD game?

©2005 Pearson Education, Inc.

• It is indeed difficult for them to cooperate!! The matrix form representation of the game shown in the movie clip.

• Stealing is a ‘weakly dominant’ strategy.

• (Splitting; Splitting) does not constitute as a Nash-equilibrium unilateral incentive to deviate.

(c) Y.E. Riyanto 61

Female

Male

50 , 50

Split(Sp)

Steal(St)

Split(Sp)

Steal(St)

0 , 0100 , 0

0 , 100

Prisoner’s Dilemma (PD)

Multiple Nash Equilibrium


Collusion

Do the same analysis for the Cournot competition we derived earlier! (Homework ).

Conclusions

1. Collusion will lead to greater profits

2. Explicit and implicit collusion is possible need a ‘binding’ agreement cartel agreement.

(c) Y.E. Riyanto


Collusion (Price Fixing)BA and Virgin: Flying in formation

Aug 2nd 2007From The Economist print edition

It takes two to fix prices

FOR years British Airways (BA) described itself as “the world's favorite airline”. It no longer looks so popular in London and Washington. On August 1st the firm was hit with a transatlantic double whammy after it was found guilty of colluding with a rival, Virgin Atlantic, to fix prices on long-haul passenger routes. Britain's Office of Fair Trading (OFT) handed down a record fine of £121.5m ($246m). A few hours later, America's Department of Justice (DoJ) imposed a $300m penalty of its own. The severity of the American fine also reflected BA's role in a different international conspiracy involving Korean Air and Lufthansa.

A clearer example of illegal price-fixing than that between BA and Virgin would be hard to imagine. The two firms discussed “fuel surcharges” at least six times between August 2004 and January 2006, during which time they rose from £5 to £60 on a return ticket.

A transatlantic bust was particularly fitting for the OFT. During Labour's period in office, it has introduced American-style, cartel-busting sanctions on companies that prefer cozy deals with rivals to the bracing winds of competition. But despite many protracted investigations into sectors such as banking and supermarkets that attract consumers' ire, the OFT has struggled to find the kind of smoking-gun evidence of collusion it needed to look as terrifying as it and the government wished. That is partly the nature of the beast. Collusion is difficult to prove: as Mr Collins observes, the tricky thing about colluders is that they do their business in secret. Indeed, the airlines' price-fixing came to light only after Virgin's legal department alerted the authorities.

This was no selfless dedication to consumers' welfare. Virgin hoped to benefit from the “leniency policy”, which was introduced in the 1998 Competition Act and copied from similar laws in America, granting immunity to firms that blow the whistle. Virgin was just as complicit as BA in the price-fixing and has, presumably, benefited from it financially. Not only was the airline saving itself from the risk of prosecution, but it was also grassing up a rival with whom it has had a bruising relationship in the past. It grates to see one firm get away with something while another is punished, but leniency policies are, probably, a good thing. The ability to claim immunity gives a powerful incentive for businesses to police their own industries, which ought to improve things for consumers. After all, half a victory is better than none.

(c) Y.E. Riyanto


Collusion (Price Fixing)

(c) Y.E. Riyanto


Price Rigidity

Firms have strong desire for stability

Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change

Fear lower prices will send wrong message to competitors leading to price war

Higher prices may cause competitors to raise theirs

(c) Y.E. Riyanto


Price Signaling and Price Leadership

Price Signaling

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

Price Leadership

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

(c) Y.E. Riyanto



(c) Y.E. Riyanto



The Dominant Firm Model

In 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 maximizes its own profits.

(c) Y.E. Riyanto


Source: http://apple20.blogs.fortune.cnn.com/2008/01/29/beyond-the-incredible-shrinking-ipod-market/


(c) Y.E. Riyanto



source: Hitwise and http://www.marketingpilgrim.com/2007/05/google-market-share-up-again.html

(c) Y.E. Riyanto



(c) Y.E. Riyanto


Collusive Agreement Cartels

Producers in a cartel explicitly agree to cooperate in setting prices and output.

Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel

If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels

(c) Y.E. Riyanto


Cartels

Examples of successful cartels

OPEC

De Beers (Diamond Cartel)

Examples of unsuccessful cartels

CopperTinCoffeeTeaCocoa

(c) Y.E. Riyanto


Cartels – Conditions for Success

1. Stable cartel organization must be formed – price and quantity settled on and adhered to sometimes difficult because;

Members have different costs, assessments of demand and objectives

Tempting to cheat by lowering price to capture larger market share

(c) Y.E. Riyanto


Cartels – Conditions for Success

2. Potential for monopoly power

Even if cartel can succeed, there might be little room to raise price if faces highly elastic demand

If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work

(c) Y.E. Riyanto


Cartels

To 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

(c) Y.E. Riyanto


Cartels

(c) Y.E. Riyanto

Lecture 11 oligopoly

Education

Transcript of Lecture 11 oligopoly