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Oligopoly
Definition-
A market structure in which there
are only a few firms each of
which is large relative to the total
industry (results in strategic
interaction)
2
Warning
Due to the complexity involved in
analyzing oligopolies and the
differences across
industries/markets, there is no
single model that is relevant to
all oligopolies.
3
Types of Oligopoly
1. Cournot Oligopoly
2. Stackelberg Oligopoly
3. Bertrand Oligopoly
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Cournot Oligopoly
1. Few firms in market serving many
customers.
2. Firms produce either differentiated
or homogeneous products.
3. Each firm believes rivals will hold
their output constant if it changes its
output.
4. Barriers to entry exist.
5
Numerical Example of Cournot Oligopoly
6
What if the firms perfectly collude?
What total output should they produce?
100
Q=40. Cant have more
90
profits than what a
80 monopolist would.
70
60
50
D
40
30
20 MC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
MR
7
Suppose firms collude where both firms
produce an output of 20 (i.e., Q1=Q2=20)
100 Firm 1s Profits = 60*20-20*20=800
90
80
Firm 2s Profits = 60*20-20*20=800
70
60
50
D
40
30
20 MC=AVC=ATC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
8
Why might you expect that the firms will not be able to
collude in this manner?
If Firm 1 thinks Firm 2 will produce 20, then Firm 1 can
increase his profits to 900 if produce 30.
100
Firm 1s Profits = 50*30-20*30=900
90
80
Firm 2s Profits = 50*20-20*20=600
70
60
50
D
40
30
20 MC=AVC=ATC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
9
What output would Firm 1 produce if Firm 1
expected Firm 2 to produce an output of 0?
Q1=40
100
Firm 1s Profits = 60*40-20*40=1600
90
80
70 D1
60
50
D
40
30
20 MC=AVC=ATC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
MR1
10
What output would Firm 1 produce if Firm 1
expected Firm 2 to produce an output of 20?
100
Q1=30
90
80
70
60
50
D
40 D1
30
20 MC=AVC=ATC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
0
Q2
10 20 30 40 50 60 70 80 Firm 1s
Output
11
MR1
What output would Firm 1 produce if Firm 1
expected Firm 2 to produce an output of 40?
100
Q1=20
90
80
70
60
50
D D1
40
30
20 MC=AVC=ATC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
0 10 20 30 40 50 60 Firm 1s
Q2 MR1 Output
12
What output would Firm 1 produce if Firm 1
expected Firm 2 to produce an output of 80?
100
Q1=0
90
80
70
60
50
D
40
30
=AVC=ATC
20
D1 MC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
0 10 20 Firm 1s
Q2 MR1 Output
13
Graphing the Reaction Function (or Best
Response Function) of Firm 1
90 Q2
80 Note: The x-axis depicts the
70 quantity produced by Firm 1
r1(Q2)
60 and the y-axis depicts the
50 quantity produced by Firm 2.
40
30
20
10
0
Q1
100
10
20
30
40
50
60
70
80
90
0
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Reaction Functions of Firm 1 and Firm 2
90 Q2
80
70
r1(Q2)
60
50
40
30
20 r2(Q1)
10
0
Q1
100
10
20
30
40
50
60
70
80
90
0
15
Cournot Equilibrium
A situation in which neither
firm has an incentive to
change its output given the
other firms output.
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Cournot Equilibrium:
Q1=26.67 and Q2=26.67
90 Q2
80
70
r1(Q2)
60
50
40
30
26.67
20 r2(Q1)
10
0
Q1
100
10
20
30
40
50
60
70
80
90
0
26.67
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Profits from Cournot Equilibrium:
Q1=26.67 and Q2=26.67 so Q=Q1+Q2=53.3
100
90 Firm 1 Profits=46.66*26.67-20*26.67= 713
80
70 Firm 2 Profits=46.66*26.67-20*26.67= 713
60
50
46.6640 D
30
20 MC =AVC=ATC
10
Q
0
0 10 20 30 40 50 60 70 80 90 100
53.33
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Cournot Equilibrium compared
to Perfect Collusion
Cournot Equilibrium
Q1=26.67 , Firm 1 Profits = 713
Q2=26.67 , Firm 2 Profits = 713
Perfect Collusion
Q1=20 , Firm 1 Profits = 800
Q2=20 , Firm 2 Profits = 800
19
Why cant achieve Perfect Collusion with
Q1=20 and Q2=20? Both Firms have
incentive to cheat!!
90 Q2
80 Note that we are assuming
70
r1(Q2) the firms interact just once.
60
50
40
30
26.67
20 r2(Q1)
10
0
26.67 Q1
100
10
20
30
40
50
60
70
80
90
0
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My All Time Favorite example of
how expectations are formed
In the June 5 memo, Summerfield K. Johnston Jr. and Henry A.
Schimberg, the chief executive and the president of Coca-Cola
Enterprises, respectively, said the bottler's plan is to "succeed
based on superior marketing programs and execution rather
than the short-term approach of buying share through price
discounting."
"This is a first step to disengagement," said Andrew Conway, an
analyst in New York for Morgan Stanley & Co. "Coke and
Pepsi are out to improve profitability for the category, not
destroy it, so this would bode for a stabilization."
For all the signals of a truce, though, Coca-Cola Enterprises'
memo could just as easily be seen as throwing down the
gauntlet. Messrs. Johnston and Schimberg said in the memo
that should "the competition" view the attempt to raise prices
"as an opportunity to gain share through predatory pricing, we
will, as we have in the past, respond immediately."
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Stackelberg Oligopoly
1. Few firms in market serving many
customers.
2. Firms produce either differentiated or
homogeneous products.
3. A single firm (the leader) chooses an
output before all other firms choose their
outputs.
4. All other firms (the followers) take as
given the output of the leader and
choose outputs that maximize profits
given the leaders output.
5. Barriers to entry exist. 25
Same numerical example as Cournot but
assume that Firm 1 is the Leader. What do
you expect to happen?
Firm 1 knows the response it will get from
90 Q2 Firm 2 (i.e. what Firm 2 will produce
80 depending on how much Firm 1
produces). Therefore, Firm 1 will select
70
r1(Q2) output to maximize profits given the
60 response function of Firm 2.
50
In this example, Firm 1 will
40
r2(Q1) produce Q1=40 so Firm 2
30 produces Q2=20. Firm 1s
20 profits are 40*40-20*40=800
10 and Firm 2s profits are
0 40*20-20*20=400.
Q1
100
10
20
30
40
50
60
70
80
90
0
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Some Conclusions
Level of Competition Depends on Many
Different Characteristics of the Industry not
just Number of Firms.
Level of Competition Depends on whether
the Firms Select Quantity or Price and
whether or not these Decisions are made
Sequentially.
Increased Competition is usually good for
Consumers (lower prices) and bad for
Firms (lower profits)
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