09 - Basic Oligopoly Flashcards
General definition of
Oligopoly
Relatively few but large firms in an industry. There isn’t an explicit number but usually the number is between 2 - 10.
May be differentiated or homogeneous
Manager decisions directly impact competitor’s optimal decisions and vise-versa.
Most complex and several models exist.
Rival reactions to price changes affect on demand.
If other firms match price changes, up or down, demand will be relatively inelastic.
When other firms do NOT match prices, up or down, demand is more elastic.
Firm will sell more when increasing price if other firms do match.
Firm will sell more when reducing price if other firms do not match.
Sweezy Oligopoly
Characteristics
Few firms, many customers
Differentiated products
All firms believe competitors will match reductions but do not match increases.
Barriers to entry exist.
Deadweight loss exists.
Cournot Oligopoly
Characteristics
Few firms, many customers
Differentiated or homogeneous
Each firm believes rivals will hold prices, decisions do not affect decisions of other firms. Firms are unaware of other’s decisions.
Barriers to entry exist
The underlying decision of all firms is how much to produce rather than how to price.
Cournot reaction functions
Best-Response Function
or Reaction Function
Firm 1’s MR is affected by firm 2’s output level. The greater firm 2 output, the lower firm 1 MR and lower profit maximizing output level.
Q1 = r1(Q2) Q2 = r2(Q1)
Cournot Equilibrium
The situation where neither firm has incentive to change its output given the output of competitors.
Graphically, this corresponds to the intersection of the firm’s reaction function curves.
Because equilibrium price exceeds marginal cost, industry output is below socially efficient level. As the number of firms increase, deadweight loss goes down and market approaches perfect competition if products are homogeneous.
Isoprofit Curves in a Cournot industry
Curves define the combinations of outputs of all firms that yield a given firm the same level of profits.
Characteristics:
- Every point on the same curve yields same profits.
- Curves closer to firm’s monopoly output level are associated with higher profits.
- Curves reach their peak where they cross the firm’s reaction function line.
- Isoprofit curves down the firm’s reaction function never intersect.
To maximize profits, firm 1 pushes its isoprofit curve down until tangential to expected output level of firm 2.
Changes in marginal costs Sweezy vs Cournot
If the manager believes other firms will maintain their level of output if they expand output - the Cournot model applies and it is optimal to expand output with declines in MC. This will grow market share.
If the manager believes other firms will follow price reductions but not increases - the Sweezy model applies and it may be optimal to produce the same level of output even if MC declines.
Collusion in a Cournot industry
Each firm produces less and enjoys higher profits. Total output and industry profits equal either monopoly situation.
Collusion leads to a price that exceeds MC and an output below socially optimal level introducing deadweight loss. Firms enjoy higher profit than if competing honestly as Cournot oligopolists.
Cheating against collusive partners
If firms think they can convince others to restrict output, they may cheat by expanding output to address shortage and capture market share.
This involves pushing their isoprofit curve down their reaction function line where peak profit point is tangential to the agreed collusive qty.
Firms know this and thus long standing collusive arrangements are rare.
Stackelberg Oligopoly
Characteristics
Few firms, many customers
Differentiated or homogeneous
Single leader firm chooses output level first, knowing followers will react as Cournot.
Followers choose outputs given leader’s first move. Followers behave Cournot oligopolists.
Barriers to entry exist
Stackelberg quantity strategy equilibrium
Knowing that the follower will react as a Cournot oligopolist, the leader must choose a level of output along firm 2’s reaction function line that is ideally close to firm 1’s monopolist qty.
The leader earns higher and follower lower profits than if a Cournot industry.
Price exceeds marginal cost and output is below socially desired levels leading to deadweight loss but less so than monopoly.
Bertrand Oligopoly
Characteristics
Few firms, many customers
Homogeneous products at identical MC.
Firms engage in price competition and react optimally to competitor’s price decisions.
Perfect information and zero transaction costs
Barriers to entry exist.
Bertrand Oligopoly
Outcomes
Undesirable by firms because it leads to zero economic profits. Desired by customers because it leads to same outcome as a perfectly competitive market.
Because of perfect information and zero trans costs, customers switch to firm with lowest price. Pricing > MC will be undercut. Any reduction start a price war till both firms are at P1 = P2 = MC
Socially optimal output and no deadweight loss.
Bertrand industry strategies
The Bertrand trap is when firms must price at MC. The trap is more prevalent when there are more firms.
To avoid the trap a firm has two tactics.
Introduce switching costs or lead customers to believe switching costs are greater.
Eliminate perception of homogeneity.
Both require excessive advertising costs.
