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MicroEconomics
Oligopoly
Presented by Students: João PitaFrancisco Vilhena da Cunha
Bruno PereiraJorge Oliveira
Master in Engineering Policy and Management of Technology
Oligopoly
The regimen of oligopoly is characterized by a restricted number of agents on the offer side and a large number on the demand side.
The agents of the offer are in such number that their market share allows each one of them to affect the formation of prices and from there affect other competitors.
Master in Engineering Policy and Management of Technology
Oligopoly
This is, realistically, the regimen most current in the not controlled economies.
Easiness of communicationsInformationTransports
Technological competition
Selection of the most capable firms
Automobile Market, Energy, Microprocessors, Photograph, etc
Master in Engineering Policy and Management of Technology
Types of Oligopoly
- Cooperative OligopolyImplicit and explicit agreements about prices, amounts and types of product.Eventual barriers to the entrance of other companies in the market
- Concorrencial oligopolyWhen the companies compete between themself, having or not in consideration the reaction of the other companies in the market.
- With indifferentiated productsWith identical prices and equally available techniques of production for all the companies of the oligopoly - pure oligopoly
- With differentiated products
- When the companies differentiate its products, in order to create a search that specifically is directed them
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Cournot Model
Developed by Antoine Augustin Cournot in 1838
In a two firm oligopoly (called a duopoly), if both firms set their output levels assuming that the other firm’s strategic choice variable (quantities in Cournot competition) is fixed, the equilibrium outcome is a Cournot-Nash Non-cooperative Equilibrium.
• Static Game: Players act simultaneously
• Strategies: Any Price between 0 and infinity denoted p1 and p2
Master in Engineering Policy and Management of Technology
Cournot Model
Description:
Firm 1 excepts that firm 2 production will be y2e units of output,
Then decides to produce y1,
The total production will be
Y= y1+y2e
and market price p(Y) = p( y1 + y2
e )
Master in Engineering Policy and Management of Technology
Properties of the Cournot-Nash Equilibrium for Duopoly
When the duopolists compete in quantities, we can compare the outcome to both the monopoly and competitive outcomes.
Each duopolist produces less than a monopolist in the same market but together they produce more than the monopolist and less than the amount two competitive firms would have produced with the same cost structure and demand curves.
The sum of the economic profits of each duopolist is less than the economic profits of a monopoly in the same market.
Master in Engineering Policy and Management of Technology
Cournot Model: Water’s Reaction Curve
Firm 2q2
(litres)
Firm 1q1
(litres)
20
120
60
120
6030 50
Water´s reaction curve
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Cournot Model
Firm 2q2
(litres)
Firm 1q1
(litres)
120
60
120
40
6040
reaction curve
reaction curve
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Cournot Model
Firm 2q2
(litres)
Firm 1q1
(litres)
120
60
120
40
6040
reaction curve
reaction curve
CournotEquilibrium
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Properties of the Cournot-Nash Equilibrium for Duopoly
The profit-maximization problem
The optimal choice of firm 1 is y1 = f1(y2e )
This reaction function gives one firm’s optimal choice as a function of its beliefs about the other firm’s choice.
For arbitrary values of y1e and y2
e this won't happen - in general firm 1´s optimal level of output, y1, will be different from what firm 2 expects the output to be, y1
e.
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Bertrand-Nash equilibrium Static Game: Players act simultaneously
Strategies: Any Price between 0 and infinity denoted p1 and p2
The Bertand equilibrium is a price level for each firm such that the firm´s profits are maximized given the price level of the other firm.
Assuming that firms are selling identical products Bertrand equilibrium is the competitive equilibrium, where price equals marginal costs.
• Consider that both firms are selling output at some price > marginal cost.
• Cutting its price by an arbitrarily small amount firm 1 can steal all of the customers from firm 2.
Firm 2 can think the same way!
Any price higher than marginal cost cannot be an equilibrium
The only equilibrium is the competitive equilibrium
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Bertrand-Nash equilibriumGraphical demonstration of Why P1=P2> MC is not a Nash Equilibrium
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Sequential Models
Companies act sequentially, as opposed to simultaneously (Cournot and Bertrand models)
Competitors decisions are taken into account
Dominant player or Leader (first mover) and Follower – anticipation strategy from the Leader
Perfect information: Follower has complete information on Leader’s actions – Competitive Intelligence
Examples: IBM, Microsoft
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Stackelberg Model Heinrich Freiherr von Stackelberg
1905 (Germany) – 1946 (Spain) Theory of competition
Model Duopoly where both firms have market power with
undifferentiated products First model to assume asymmetries between companies Cournot-like competition on quantity/output followed by
Bertrand-like competition on price 1st mover’s decision remains constant and follower
decides based on that (otherwise it’s a Cournot model)
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Sequential Models - Stackelberg
Firm 1 (leader) decides on quantity to produce (y1), assuming that Firm 2 (follower) will react to maximise its profits, producing y2:
Total output: Y = y1 + y2 = f(y1) Equilibrium price P is a function of total output, Y
What will be the quantity produced by Firm 1 (Leader)?Look forward and reason back
Firm 1 knows that: It has influence over Firms2’s output and Firm 2 will react in order to maximise its profit
Leading to…
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Sequential Models - Stackelberg
Follower's profit-maximization problem Firm 2 will choose y2 in order to maximise its
profit, 2
2 = P(y1+y2)(y2) - w2(y2), where w2 is Firm 2’s unit costs
To Firm 2 and considering profit maximization:• y1=constant and it will have to define y2 from:
• MR(y1,y2*)=MC(y2) y2
* = f2(y1)
y2* = f2(y1): Firm 2 reaction function
• y2* is a function of Firm 1’s decision
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Sequential Models - Stackelberg
Follower's profit-maximization problem
y’1
Reaction Curve f2(y1)
Isoprofit lines – Firm 2
y2 = f2(y’1)
y2
2 max
(Monopolist)
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y1
+
-
Sequential Models - Stackelberg
Leader’s Problem
Assuming Firm 2’s reaction to its output, Firm 1 now aims at maximizing it profit:
1 = P[y1+f(y1)](y1) - w1(y1), since y2 = f(y1)
Leader knows that his actions influence the output choice of the follower,
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Sequential Models - Stackelberg
Isoprofit lines – Firm 1
Stackelberg model - EquilibriumMathematical deduction: http://josemata.org/ee/17/stackelberg2/
y*1
Reaction Curve Firm 2 f2(y1)
y*2
y2
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y1
+
-
Sequential Models - Stackelberg
Reaction Curve Firm 1
Cournot Equilibrium
Stackelberg Equilibrium
Stackelberg model compared
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Sequential Models - Stackelberg
PriceBertrand < Stackelberg < Cournot
Competitive < Stackelberg < Monopoly
Total OutputMonopoly < Stackelberg < Competitive
Cournot < Stackelberg < Bertrand
Consumer Surplus Cournot < Stackelberg < Bertrand
Identifying the leader Stackelberg model based on Cournot with an
anticipation strategy from one of the companies on setting its output
The model doesn’t explain what is the asymmetry neither in what it is based on
There can be several reasons, e.g.: Company already in the market and new entrant
• 1st can decide on the installed capacity• If installed capacity irreversible, 2nd can assume capacity of the
1st as an input for decision Depending on fixed costs, 2nd may not be able to enter
the market (monopoly) If seond enters the market Stackelberg model
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Sequential Models - Stackelberg
Collusion Model
When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion.
• Explicit collusion occurs when firms ostensibly agree to maintain their joint-profit-maximizing output. Cartels -- such as DeBeers and OPEC -- are obvious examples.
•Tacit collusion occurs when firms act without explicit agreement to achieve the cooperative outcome. Can take the form of a verbal ‘gentleman’s agreement’ to fix prices and output.
Types of Cooperative Behaviour
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Factors that affect the ability to collude:
Number and size distribution of sellers Similar easier to collude
Product heterogeneity Homogeneous easier to collude
Cost structures Similar easier to collude
Size and frequency of orders Frequent smaller easier to collude
Secrecy and retaliation Less secrecy, easier retaliation easier to collude
Social structure of the industry Social interaction easier to collude
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Tacit CollusionPrice Leader (Barometric Firm)
Largest, dominant, or lowest cost firm in the industry
Demand curve is defined as the market demand curve less supply by the followers
Followers Take market price as given and behave as
perfect competitors
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Price Leadership
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Oligopoly isn’t a problem unless it becomes a Cartel
Cartel – a formal or informal agreement among firms in an oligopolistic industry
Cartel members may agree on such issues as prices, total industry output, market shares, and division of profits
Cartels or collusive agreements are illegal in most cases.
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Cartels
OPECColombian Drug CartelMafia or Crime SyndicateIvy League SchoolsGovernment enforced cartels: market
intervention to raise prices!
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Cartel as a Monopolist D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel).
Cartel profits are maximized when the industry produces quantity Q and charges price p.
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Some illegal Cartels get caught:
Electrical equipment manufacturers in the 1950s
Pharmaceutical companies more recently
Some don’t…
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Cheating
Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement
By offering a price slightly below the established price, a firm can usually increase its sales and economic profit
Because oligopolists usually operate with excess capacity, some cheat on the established price
Master in Engineering Policy and Management of Technology
How can either of the firms be sure that the other firm isn’t cheating on their agreement, and selling the product for lower price?
“BEAT ANY PRICE”
One way is to offer to beat any price a costumer can find. That way, the costumer report any attempt to cheat on the collusive arrangement
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OPEC Illustrates Cartel Difficulties
Incentive to CheatCheating increases individual profitsCheating decreases cartel profits
Different Members Have Different GoalsHigh prices encourage substitutes
Supply expansion by non-membersDevelopment of alternative products
More important to some members than to others
Master in Engineering Policy and Management of Technology
OPEC and CIPEC OPEC is the Organization of Petroleum Exporting Countries CIPEC is the French acronym for Int’l Council of Copper Exporting Countries Why has OPEC been successful in raising its price, but CIPEC has not? OPEC as a dominant firm
PriceMCnon-opec
P1
P2
Popec
Qc+c
Pcomp
Output
DmktMRopec
MCopec
QopecQfringeQtotal
Oil Market
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OPEC and CIPEC CIPEC (Chile, Peru, Zambia, Zaire) MCCIPEC is not much less than MCnon-cipec
Why has OPEC been successful in raising its price, but CIPEC has not?
CIPEC as a dominant firm
Output
Price
Dmkt
MCnon-cipec
P1
P2
MRopec
MCcipec
Qcipec
Pcipec
Qfringe
Qtotal
Qc+c
Pcomp
Why can’t CIPEC increase
copper prices much? D for copper is more elastic
(aluminum is a good substitute) Comp’ve supply more elastic than for
oil (if P rises, simply go to scrap heap) Successful cartel needs relatively inelastic
D.
Copper Market
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Obstacles to Collusion
Demand and cost differences between firms.Higher numbers of firms, particularly if a
number of firms outside collusive agreement.Incentives to cheat.Recession.Legislative obstacles: Trade Practices Law.
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COMPARISON OF THE SOLUTIONS
OLIGOPOLY MODELS
Stackelberg(Quantity-
leader)
One firm leads by setting its output, and the other firm follows. When the leader chooses an output, it will take into account how the follower will respond
Cournot(Price-leader)
One firm sets its price and the firm chooses how much it wants to supply at that price. Again the leader has to take into account the behavior of the follower when it takes its decision
Bertrand(Simultaneous price setting)
Each firm chooses its prices given its beliefs about the price that the other firm will choose. The only equilibrium price is the competitive equilibrium
Collusion(Cartel)
A number of firms colluding to restrict output and to maximize industry profit. A cartel will typically be unstable in the sense that each firm will be tempted to sell more than its agreed upon output if it believes that the other firms will not respond
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Sweezy Model- It tries to explain the rigidity
of the price, many times observed in oligopolistc markets;
- If a companie increases its price, the other companies will not, making the first one to lose its customers;
- On the other hand, if a company lower the prices, the other companies also will lower the price, for that it will not have advantage to do that.
P
Q
D
mC
mC’
mR
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Conclusions - Balance in the Long Run
Profits, equilibrium or damage
In the long run, the oligopolist will leave the industry if has no profits.
It prepares its company to present the very best level of production in the long run.
If it will have some profits, other companies will try to enter in the sector, if the entrance will not be restricted.
Competition based on strategy, quality, product project, advertisement, services, innovation
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Bibliography
Lipsey & Chrystal
Mata, José, “Economia da empresa”, Fund. Calouste Gulbenkian, Lisboa, 2nd edition, 2002
Mata, José in http://josemata.org/ee, 2006
Pindyck, Robert S., Rubinfield, Daniel L., “Microeconomics”, 5th edition, ch. 12, pgs. 429 to 451
Samuelson
Salvatore, Dominick, “Microeconomy”, Schaum, MacGraw-Hill, 1984
Sousa, Alfredo de, “Análise Económica”, Universidade Nova de Lisboa, Faculdade de Economia, 1988
“The Home of Economics on the Internet” in www.tutor2u.net, 2006
Varian, Hal R., “Intermediate Microeconomics”, 6th edition, ch. 26, pgs. 459 to 479
Master in Engineering Policy and Management of Technology