Oligopoly

Overheads

Market StructureMarket structure refers to all characteristics of a marketthat influence the behavior of buyers and sellers,when they come together to trade

Market structure refers to all features of a market that affectthe behavior and performance of firms in that market

Definition of a competitive agent

A buyer or seller (agent) is said to be competitivecompetitive if theagent assumes or believes that the market price is givenand that the agent's actions do not influence the market price

We sometimes say that a competitive agent is a price taker

Common Market Structures

Perfect (pure) competition

Agents take prices as given

Entry and exit barriers are minimal or nonexistent

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 ofone seller or one buyer

Common Market Structures

Oligopoly

Firm sets prices (faces residual demand)

Entry and exit barriers result in the existence offew sellers or buyers

Common Market Structures

Monopolistic competition

Firm sets prices (faces residual demand)

Entry and exit barriers are minimal

Strategic interdependence

When individuals make decisions in environmentscharacterized by strategic interdependence,the welfare of each decision maker depends not onlyon her own actions, but also on the actions ofthe other decision makers (firms).

Moreover, the actions that are best for her to takemay depend on what she expects the other firms to do

Formal definition of oligopolyNoncooperative oligopoly is a market structurewhere a small number of firms act independently,but are aware of each other's actions

A noncooperative oligopoly is a market structurein which a small number of firms arestrategically interdependent

Cooperative oligopoly is a market structurein which a small number of firms coordinatetheir actions to maximize joint profits

Oligopoly is an intermediate market structure in thesense that the firms are price makers as comparedto the price takers of perfect competition,but because there are others firms in the market,the firm cannot act in the independent fashionof the monopolist

A duopoly is a market with only two firms,each selling the same or similar product

Duopoly

Two firms with no additional entry

A Duopoly Model

Each firm produces a homogeneous product suchthat q1 + q2 = Q, where Q is industry outputand 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

Q q1 q2 14 12p

Demand

p 28 2Q 28 2q1 2q2

Cost (q1) 4q1

Cost (q2) 4q2

MC1 AC1 4

MC2 AC2 4

Marginal and average cost are constantand equal to $4.00

Monopoly solutionFirm 1 is the only firm in the market

Revenue is given by

Revenue (q1) pq1

(28 2q1) q1

28q1 2q 21

Using the same intercept, twice the slope rule,marginal revenue is given by

MR (q1) 28 4q1

If we set marginal revenue equal to marginal costwe can obtain the optimal level of q1

MR (q1) 28 4q1 4 MC (q1)

24 4q1

6 q1

If we substitute this into the demand equationwe can find the market price

p 28 2q1

28 (2)(6) 16

Profit for Firm 1 is given by revenue minus cost or

Profit π R C pq1 c (q1 )

(16)(6) (4)(6) 96 24 72

Zucchini MarketMonopoly

05

1015202530

0 2 4 6 8 10 12 14 16

Quantity

$ Demand/P

MC

MR

Q Price TR MR Cost MC Profit0.00 28.00 0.00 28.00 0.00 4.00 0.00

1.00 26.00 26.00 24.00 4.00 4.00 22.002.00 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 54.003.50 21.00 73.50 14.00 14.00 4.00 59.504.00 20.00 80.00 12.00 16.00 4.00 64.004.50 19.00 85.50 10.00 18.00 4.00 67.505.00 18.00 90.00 8.00 20.00 4.00 70.005.50 17.00 93.50 6.00 22.00 4.00 71.506.00 16.00 96.00 4.00 24.00 4.00 72.00 7.00 14.00 98.00 0.00 28.00 4.00 70.008.00 12.00 96.00 32.00 4.00 64.009.00 10.00 90.00 36.00 4.00 54.0010.00 8.00 80.00 40.00 4.00 40.0011.00 6.00 66.00 44.00 4.00 22.0012.00 4.00 48.00 48.00 4.00 0.00 13.00 2.00 26.00 52.00 4.00 -26.00

Competitive Solution

We set price (p) equal to marginal cost (MC)

MC 4 p

Notice that MC doesn’t depend on qi or Q

Q q1 q2 14 12p

If we substitute p = 4 in the demand equation we obtain

14 12

(4)

14 2 12

Profits will be zero

Zucchini MarketCompetition

05

1015202530

0 2 4 6 8 10 12 14 16Quantity

$ Demand/P

MC

If the two firms in this market were to coordinatetheir actions and maximize joint profit,

Cooperative (collusive) oligopoly solution

they would choose the monopoly output and price

Such cooperative agreements are called cartels

The two firms together would produce 6 unitsand charge a price of $16.00

The division of the output between the firmswould have to negotiated between them

Noncooperative Oligopoly

Joint profits maximized with Q = 6 and p = $16

Will this outcome occur?

Individual firm conjectures and market equilibrium

Conjecture

A supposition or guess

Each firm makes a conjecture about the actionof the other firm and then chooses its own action

Story

Firm 1 conjectures that Firm 2 will produce 3 units

Why?

Inverse demand given the conjecture

p 28 2q1 2q2

28 2q1 (2)(3)

22 2q1

Revenue for Firm 1 given the conjecture

Revenue (q1 , q2) pq1

(22 2q1) q1

22q1 2q 21

MR (q1) 22 4q1

Marginal revenue is given by

because

p 22 2q1

If we set marginal revenue equal to marginal costwe can obtain the optimal level of q1

MR (q1) 22 4q1 4 MC (q1)

18 4q1

4.5 q1

If Firm 2 produced 3 units, price would be

p 28 2q1 2q2

28 (2)(4.5) (2)(3) 28 9 6 13

Profit for Firm 1 is given by revenue minus cost or

Profit π R C pq1 c (q1 )

(13)(4.5) (4)(4.5) 58.5 18 40.5

Profit for Firm 2 is given by

Profit pq2 c (q2 )

(13)(3) (4)(3) 39 12 27

Total profit for the two firms is $67.50

Monopoly profit was $72

Is Firm 2 happy?

Is Firm 2 content?

Is Firm 2 going to keep producing 3 units?

Let’s See

Suppose Firm 2 conjectures thatFirm 1 will produce 4.5 units

Inverse demand given the conjecture

p 28 2q1 2q2

28 2(4.5) (2)q2

19 2q2

MR (q2) 19 4q2

Marginal revenue is given by

because

p 19 2q2

If we set marginal revenue equal to marginal costwe can obtain the optimal level of q2

MR (q2) 19 4q2 4 MC (q2)

15 4q2

3.75 q2

If Firm 1 produces 4.5 units and Firm 2produces 3.75 units, price will be

p 28 2q1 2q2

28 (2)(4.5) (2)(3.75) 28 9 7.5 11.5

Profit for Firm 1 is given by

Profit pq1 c (q1 )

(11.5)(4.5) (4)(4.5) 51.75 18 33.75

Profit for Firm 2 is given by

Profit pq2 c (q2 )

(11.5)(3.75) (4)(3.75) (7.5)(3.75) 28.125

Total profit for the two firms is $61.875

Monopoly profit was $72

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

We can compute the best response for each firmgiven the action of the other firm to see this

Other q q1* q2

3.00 4.500 4.5003.25 4.375 4.3753.50 4.250 4.2503.75 4.125 4.1254.00 4.000 4.0004.25 3.875 3.8754.50 3.750 3.7504.75 3.625 3.6255.00 3.500 3.500

What if Firm 1 conjectures thatFirm 2 will bring 4 units to market?

Firm 1 will bring 4 units to market!

Other q q1* q2

3.75 4.125 4.1254.00 4.000 4.0004.25 3.875 3.8754.50 3.750 3.750

What if Firm 2 conjectures thatFirm 1 will bring 4 units to market?

Firm 2 will bring 4 units to market!

Other q q1* q2

3.75 4.125 4.1254.00 4.000 4.0004.25 3.875 3.8754.50 3.750 3.750

Both firms are happy and content

We have an equilibrium!!

0

2

4

6

8

10

12

14

0 2 4 6 8 10 12 14 16

q2

q1

Zucchini MarketResponse Functions

q1*

q2*

Graphically

A situation in which all economic actors (firms)interacting with one another choose theirbest strategy, given the strategies that all other actorshave chosen, is called a Nash Equilibrium

A market outcome is a Nash Equilibrium if no firmwould find it beneficial to deviate from its output levelprovided that all other firms do not deviate from theiroutput levels at this market outcome

The market outcome of this noncooperativeoligopoly market is an output of 8 unitswith a price of $12.00.

The output is lower than the competitiveoutput but higher than the monopoly output

The price is lower than the monopoly pricebut higher than the competitive one

This is a result that holds generally

Monopoly 6 6 -- 16 $72 $72 --Perfect Competition 12 ? ? 4 $0 $0 $0Cooperative Oligopoly 6 ? ? 16 $72 ? ?Noncooperative Oligopoly 8 4 4 12 $64 $32 $32

Total Firm 1 Firm 2 P Total Firm 1 Firm 2 Q q q

Results

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 actmore and more like price takers

The End