Oligopoly

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Oligopoly Overheads
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Market Structure
Market structure refers to all characteristics of
a market that influence the behavior of buyers
and sellers, when they come together to trade
Market structure refers to all features of a
market that affect the behavior and performance
of firms in that market
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Definition of a competitive agent
A buyer or seller (agent) is said to be
competitive if the agent assumes or believes that
the market price is given and that the agent's
actions do not influence the market price
We sometimes say that a competitive agent is a
price taker
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Common Market Structures
Perfect (pure) competition
Agents take prices as given
Entry and exit barriers are minimal or nonexistent
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Common Market Structures
Monopoly (seller) or Monopsony (buyer)
Firm sets price (faces market demand or supply
curve)
Entry and exit barriers result in the existence
of one seller or one buyer
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Common Market Structures
Oligopoly
Firm sets prices (faces residual demand)
Entry and exit barriers result in the existence
of few sellers or buyers
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Common Market Structures
Monopolistic competition
Firm sets prices (faces residual demand)
Entry and exit barriers are minimal
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Strategic interdependence
When individuals make decisions in
environments characterized by strategic
interdependence, the welfare of each decision
maker depends not only on her own actions, but
also on the actions of the other decision makers
(firms).
Moreover, the actions that are best for her to
take may depend on what she expects the other
firms to do
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Formal definition of oligopoly
Noncooperative oligopoly is a market
structure where a small number of firms act
independently, but are aware of each other's
actions
A noncooperative oligopoly is a market
structure in which a small number of firms
are strategically interdependent
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Cooperative oligopoly is a market structure in
which a small number of firms coordinate their
actions to maximize joint profits
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Oligopoly is an intermediate market structure in
the sense that the firms are price makers as
compared to the price takers of perfect
competition, but because there are others firms
in the market, the firm cannot act in the
independent fashion of the monopolist
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Duopoly
A duopoly is a market with only two firms, each
selling the same or similar product
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A Duopoly Model
Two firms with no additional entry
Each firm produces a homogeneous product
such that q1 q2 Q, where Q is industry
output and qi is the output of the ith firm
There is a single period of production sales
(zucchini)
The market demand and inverse demand are linear
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Demand
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Marginal and average cost are constant and equal
to 4.00
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Monopoly solution
Firm 1 is the only firm in the market
Revenue is given by
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Using the same intercept, twice the slope
rule, marginal revenue is given by
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If we set marginal revenue equal to marginal
cost we can obtain the optimal level of q1
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If we substitute this into the demand equation we
can find the market price
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Profit for Firm 1 is given by revenue minus cost
or
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Zucchini Market
Monopoly
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25
20
15
10
5
0
0
2
4
6
8
10
12
14
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Quantity
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Q Price TR MR Cost MC Profit 0.00 28.00 0.00
28.00 0.00 4.00 0.00 1.00 26.00 26.00
24.00 4.00 4.00 22.00 2.00 24.00 48.00
20.00 8.00 4.00 40.00 2.50 23.00 57.50
18.00 10.00 4.00 47.50 3.00 22.00 66.00
16.00 12.00 4.00 54.00 3.50 21.00 73.50
14.00 14.00 4.00 59.50 4.00 20.00 80.00
12.00 16.00 4.00 64.00 4.50 19.00 85.50
10.00 18.00 4.00 67.50 5.00 18.00 90.00
8.00 20.00 4.00 70.00 5.50 17.00 93.50
6.00 22.00 4.00 71.50 6.00 16.00 96.00
4.00 24.00 4.00 72.00 7.00 14.00 98.00
0.00 28.00 4.00 70.00 8.00 12.00 96.00
32.00 4.00 64.00 9.00 10.00 90.00 36.00
4.00 54.00 10.00 8.00 80.00 40.00 4.00
40.00 11.00 6.00 66.00 44.00 4.00
22.00 12.00 4.00 48.00 48.00 4.00 0.00
13.00 2.00 26.00 52.00 4.00 -26.00
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Competitive Solution
We set price (p) equal to marginal cost (MC)
Notice that MC doesnt depend on qi or Q
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If we substitute p 4 in the demand equation we
obtain
Profits will be zero
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Zucchini Market
Competition
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25
20
15
10
5
0
0
2
4
6
8
10
12
14
16
Quantity
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Cooperative (collusive) oligopoly solution
If the two firms in this market were to
coordinate their actions and maximize joint
profit,
they would choose the monopoly output and price
Such cooperative agreements are called cartels
The two firms together would produce 6 units and
charge a price of 16.00
The division of the output between the
firms would have to negotiated between them
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Noncooperative Oligopoly
Joint profits maximized with Q 6 and p 16
Will this outcome occur?
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Individual firm conjectures and market equilibrium
Conjecture
A supposition or guess
Each firm makes a conjecture about the action of
the other firm and then chooses its own action
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Story
Firm 1 conjectures that Firm 2 will produce 3
units
Why?
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Inverse demand given the conjecture
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Revenue for Firm 1 given the conjecture
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Marginal revenue is given by
because
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If we set marginal revenue equal to marginal
cost we can obtain the optimal level of q1
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If Firm 2 produced 3 units, price would be
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Profit for Firm 1 is given by revenue minus cost
or
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Profit for Firm 2 is given by
Total profit for the two firms is 67.50
Monopoly profit was 72
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Is Firm 2 happy?
Is Firm 2 content?
Is Firm 2 going to keep producing 3 units?
Lets See
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Suppose Firm 2 conjectures that Firm 1 will
produce 4.5 units
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Inverse demand given the conjecture
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Marginal revenue is given by
because
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If we set marginal revenue equal to marginal
cost we can obtain the optimal level of q2
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If Firm 1 produces 4.5 units and Firm 2 produces
3.75 units, price will be
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Profit for Firm 1 is given by
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Profit for Firm 2 is given by
Total profit for the two firms is 61.875
Monopoly profit was 72
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Because Firm 2 is producing 3.75 and not 3 units
Firm 1 will want to adjust its output level
And then Firm 2 will want to change its output
This silly game could go on forever
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We can compute the best response for each
firm given the action of the other firm to see
this
Other q q1 q2 3.00 4.500 4.500 3.25
4.375 4.375 3.50 4.250 4.250 3.75
4.125 4.125 4.00 4.000 4.000 4.25
3.875 3.875 4.50 3.750 3.750 4.75
3.625 3.625 5.00 3.500 3.500
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What if Firm 1 conjectures that Firm 2 will bring
4 units to market?
Other q q1 q2 3.75 4.125 4.125 4.00
4.000 4.000 4.25 3.875 3.875 4.50 3.750 3.750
Firm 1 will bring 4 units to market!
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What if Firm 2 conjectures that Firm 1 will bring
4 units to market?
Other q q1 q2 3.75 4.125 4.125 4.00
4.000 4.000 4.25 3.875 3.875 4.50 3.750 3.750
Firm 2 will bring 4 units to market!
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Both firms are happy and content
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Graphically
Zucchini Market Response Functions
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A situation in which all economic actors
(firms) interacting with one another choose
their best strategy, given the strategies that
all other actors have chosen, is called a Nash
Equilibrium
A market outcome is a Nash Equilibrium if no
firm would find it beneficial to deviate from its
output level provided that all other firms do not
deviate from their output levels at this market
outcome
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The market outcome of this noncooperative oligopol
y market is an output of 8 units with a price of
12.00.
The output is lower than the competitive output
but higher than the monopoly output
The price is lower than the monopoly price but
higher than the competitive one
This is a result that holds generally
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Results
Total Firm 1 Firm 2 P Total Firm 1 Firm 2
Q q q B B B
Monopoly 6 6 -- 16 72 72 --
Perfect Competition 12 ? ? 4 0 0 0
Cooperative Oligopoly 6 ? ? 16 72 ? ?
Noncooperative Oligopoly 8 4 4 12 64 32 3
2
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Oligopoly and the number of firms
Small number of firms ? large price impact of
individual
Larger number of firms ? less price impact
As the number of firms in an oligopoly rises, the
impact of any one firm on price falls
As numbers keep getting larger, firms start to
act more and more like price takers
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The End