Introduction to Oligopoly

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Lecture 17 Introduction to Oligopoly
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Competition Among the Few

• Until now we have assumed that there are many
  firms in a market and that perfect competition
  prevails, or else we have assumed a monopolist.
• But what if there are just a few firms?
• In this case competition turns into rivalry and
  strategy becomes important.

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Competition Among the Few

• Such a setting is known as oligopoly.
• Definition
• Oligopoly is a market structure in which there
  are only a few firms. Price and output depend on
  the behavior of rivals.
• For example, Ford, Chrysler, GM, Honda and Toyota
  comprise most of the U.S. automobile market.

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Monopolistic Competition

• Monopolistic competition is an alternative
  framework that blends monopoly and competition.
• Monopolistic competitors are price setters
  because their soap, perfume, or cuisine differs
  from that of other firms.
• But in the next lecture we shall see that such
  firms make zero pure profits.

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Properties of the Different Models

• Table 1 on the next slide compares the different
  models of market structure.
• After weve finished with oligopoly youll find
  it worthwhile to return to this table, since it
  will help you to keep each theory in perspective.
• For the next two lectures we are concerned with
  the middle two models.

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Chapter 11, Table 1Properties of the
Different Models of Market Structure
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Cartels

• A cartel is just a group of firms that attempts
  to act like a monopolist and divide up the
  profits among member firms.
• After all, the monopoly solution does maximize
  industry profits.
• Cartels are illegal under U.S. anti-trust
  statutes.

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Cartels

• A perfect cartel sets industry MR equal to the
  sum of member firms MCs.
• Figure 1 below illustrates.
• The firms jointly fix price Pm instead of the Pc
  that they would have established acting as
  competitors.
• Then they divide up the profits based on their
  share in production.

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Cartels Problems of Defection

• However, at Pm notice that price exceeds MC of
  each cartel member.
• Since each firm acting alone faces a nearly
  constant Pm (a single firm comprises a small part
  of the market), each firm would like to expand
  output.
• But as all firms do this, price collapses to the
  competitive level Pc.

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Chapter 11, Figure 1Competition Versus Cartel
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Non-Cooperative Oligopoly

• Suppose that American Airlines comprises the
  entire market for commercial air travel.
• Figure 2 shows the price and output that it would
  set as a monopolist.
• Figure 3 shows what happens when United Airlines
  enters, if the firms do not cooperate. American
  lowers P and Q.

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Chapter 11, Figure 2American Airlines As
Monopolist
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Chapter 11, Figure 3The Effect of United
on American Airlines
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The Cournot Model of Non-cooperative Oligopoly

• Lets analyze how American and United set price
  and output using the Cournot model, where firms
  do not cooperate.
• Definition
• The Cournot model assumes that each firm takes
  the output of the other firm as given.
• Each of the two firms makes the same product and
  there are no other firms.

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The Cournot Model of Non-cooperative Oligopoly

• Well make very specific assumptions about demand
  and cost to solve this.
• Demand is P339-Q, where Qq Aq U, q Aoutput of
  American, q Uoutput of United. So Q is industry
  output.
• For each firm MCAC147. That is, each firm has
  a constant cost of 147 per passenger-flight.

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The Cournot Model of Non-cooperative Oligopoly

• To find the price and outputs that rule in this
  market, we have to fix ideas on each firms
  marginal revenue.
• For American the residual demand is
• (1)
• Thus Americans total revenue is
• (2)

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The Cournot Model of Non-cooperative Oligopoly

• Marginal revenue is just the derivative of (2)
• (3)
• Remember that United s output is expected to
  stay the same.
• American maximizes profits so it sets MRA equal
  to MC147.

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The Cournot Model of Non-cooperative Oligopoly

• The profit-maximizing condition for American is
  then
• (4)
• Solving (4) for q A yields Americans reaction
  function (best response curve)
• (5)

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The Cournot Model of Non-cooperative Oligopoly

• But what about United? The steps are the same.
  United s total revenue, MR, and reaction
  function are
• (6)
• (7)
• (8)

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The Cournot Model of Non-cooperative Oligopoly

• The reaction functions (5) and (8) take us close
  to the solution. All we need is the consistency
  condition,
• (9)
• Expected output equals actual output so that
  expectations make sense.
• Using this we can substitute (8) into (5). The
  result is

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The Cournot Model of Non-cooperative Oligopoly

• (10)
• The solution is q A64.
• Then take this result and substitute it into (8).
  Youll find that q U64 also.
• This is because the two firms are equal.

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The Cournot Model of Non-cooperative Oligopoly

• To find price, substitute the two outputs into
  the industry demand curve. The result is
  P339-128211.
• The result is shown in figure 4. In the Cournot
  framework the equilibrium is at the intersection
  of the two reaction functions. These are just the
  profit-maximizing conditions rearranged.

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Chapter 11, Figure 4Cournot Equilibrium For
American and United
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Comparison with Monopoly and Competition

• Lets compare the Cournot solution with monopoly.
  For one airline comprised of the two former
  firms, R339Q-Q2.
• Thus MR339-2Q. MC147, so the profit-maximizing
  condition is
• 339-2Q147
• The solution is Q m96, and P m243.
• Each division produces 48.

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Comparison with Competition

• What if American and United engaged in a price
  war and price fell to the competitive level?
  Then PMC147 and Q192. Each airline produces
  96.
• So we see that Cournot lies in between
  competition and monopoly and is really a
  different model.
• Figure 5 shows profit possibilities. Well
  discuss Stackelberg soon.

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Chapter 11, Figure 5Profit Possibilities