15: Oligopolistic firm behavior

Question 1

What aspect is different in this chapter?

Answer 1

So far, we have analyzed firm behavior in markets with perfect competition (many firms) and monopolistic markets (only one firm).

Now, we consider a situation in between:
In an oligopoly, only few firms supply a good.

Question 2

What do the firms now in oligopolistic markets?

Answer 2

These firms are aware that they are large enough such that they can affect the market price (in contrast to perfect competition).
However, each firm also knows that not only its own behavior that is, the quantities it produces or the price it sets, affects its own profit, but also the decision of the (few) other firms in the market.

Question 3

What is the consequence of firms knowing that they are not alone in this market?

Answer 3

Thus, firms in an oligopolistic market consider their strategic interaction.

Question 4

Which variables can firms use to determine their strategy?

Answer 4

In general, firms can use two variables to determine their strategy:
They can decide to charge a particular price or they produce a particular quantity.

Question 5

Why does choosing between the two variables not make a difference for the monopolist?

Answer 5

If the monopolist determines one of these two variables, the other one is automatically determined by the demand curve.

Question 6

What is Cournot competition?

Answer 6

In a market with Cournot competition, firms simultaneously decide which quantities they want to produce.

The total quantity in the market then determines (together with the demand function) the market price.

Therefore, firms play a simultaneous game in which the quantities are the strategies.

Question 7

What is Bertrand competition?

Answer 7

In a market with Bertrand competition, firms simultaneously decide which price they want to change.
The quantities are then determined together with the demand function.

Therefore, firms play a simultaneous game in which the prices are strategies.

Question 8

What does the market demand function look like (two firms = i = 1, 2)?

Answer 8

p(X) = A-BX with X = x1 + x2

p(x1, x2) = A - B(x1 + x2)

Question 9

What is different between the market demand function in an oligopoly (duopoly) with cournot competition than in our norma, linear (inverse) demand function?

Answer 9

The main difference is that we directly write that the total quantity in the market X is the sum of the two individual quantities, x1 + x2.

==> If a firm wants to find its production x1, that maximizes its profits, it also must consider the effect of the other firm’s production on the market price.

Question 10

What does the profit function of firms look like?

Answer 10

max profit(x1) = p(X)x1 - C(x1)

(Revenue - costs)

= A - B (x1 + x2)) x1 - C(x1)

Question 11

How do we determine the own production x1 that maximizes our profit for given x2?

Answer 11

We must differentiate profit 1 with respet to x1 and treat x2 as a constant parameter.
==> this is the first-order condition

0 = A - Bx2 - 2Bx1 - C’(x1)

A - Bx2 - 2Bx1 = Marginal revenue

C’ (x1) = Marginal cost

Question 12

When is the profit maximized? What is the difference here in comparison to the other markets?

Answer 12

The profit is maximized if the marginal revenue is equal to marginal costs.
==> The main difference to the previous markets is that the marginal revenue depends not only on the own quantity, but also the quantity of the other firm.

Question 13

What is the “reaction function”?

Answer 13

An equatoin that shows us the optinal quantity of firm 1 conditional on the quantity of firm 2.

Example:
x1 = 9 - 0.5x2

Question 14

What is a cournot equilibrium? Where do we find the cournot equilibrium?

Answer 14

If both firms choose a quantity that is a best response to the quantity of the other firm, the firms are in the Cournot equilibrium (which is simply the Nash equilibrium of a Cournot duopoly).

We can find the Cournot equilibrium at the intersection of both reaction functions.

Question 15

How do we compute the Cournot equilibrium?

Answer 15

We can compute this intersection by substituting the reaction function of one firm into the reaction function of the other firm.

Question 15

What is an important condition of a market with Bertrand competition?

Answer 15

In a market with Bertrand competition, customers only buy from the firm with the lowest price.

We assume that with Bertrand competition, customers react very elastically to changes in the price of individual firms.

In other words: If a firm charges a higher price than its competitor, it cannot sell any products!

Question 15

When can a “Bertrang Paradox” occur?

Answer 15

• Both firms have identical marginal costs
• Both firms can produce an infinite amount of goods

Question 15

When can we use the Bertrang model?

Answer 15

We can use the Bertrang model to analyze markets in which firms compete via prices such as gas stations or at least to some extent, internet providers.

It shows that if competition is strong enough, even very few firms can give rise to a market equilibrium that is close (or even identical) to the one of perfect competition.

Question 15

When can we use the Cournot model?

Answer 15

The Cournot model is more suited to analyze markets with less competition (but more than one firm).

We can interpret it as a situation between a monopoly and perfect competition.

Moreover it can be shown that with an increasing number of firms, the Cournot-Nash equilibrium converges to the equilibrium under perfect competition.

Question 16

What is the problem of collusion?

Answer 16

The quantity that is produced in a Cournot duopoly is larger than the quantity of a monopoly in the same market.

Thus, the prices in a Cournot duopoly are lower than with a monopoly.
==> This also means that both firms combined make lower profits in the duopoly than a similar monopolist could make.

This gives the firms in the duopoly an incentive to cooperate:
If they decide to basically act like one big monopolist and produce each half of the quantity such a monopolist would produce, they could increase their profit.
==> This behavior is called collusion.

Question 17

Why does collusion often not constitute a stable equilibrium?

Answer 17

Each individual has an incentive to deviate and increase its quantity according to its reaction function.
If both do this, they converge back to the Cournot equilibrium.
In principle, this situation is just like the prisoner’s dilemma.

Question 18

By what could collusive behavior might be stabilized?

Answer 18

• explicit contracts between firms: usually illegal
• implicit contracts between firms: reputatoin and punishment in repeated games

Question 19

What does the theory of monopolistic competition analyze?

Answer 19

It analyzes markets that lie between monopoly and perfect competition, where firms produce differentiated goods that are not perfectly homogenous from the customer’s perspective.

Question 20

In monopolistic competition, what happens when a firm increases its price?

Answer 20

The firm loses customers, but not all of them, unlike in perfect competition.

Question 21

What happens in the long run in a monopolistic competition market?

Answer 21

Competitiors producing other brands enter the market if it is profitable, leading to a market equilibrium.

Question 22

In the long run, what does the entry and exit of competitors in an oligopolistic market cuase?

Answer 22

It gives rise to an equilibrium price equal to the average costs, meaning firms make no profits in the long run.

Question 23

How do firms maximize their profits in oligopolistic competition?

Answer 23

By ensuring marginal costs are equal to marginal revenue, both of which are smaller than the price.

Question 24

What is the “markup” in the context of oligopolistic competition?

Answer 24

The difference between the equilibrium price and the marginal cost.

Question 25

Why is the quantity produced in oligopolistic competition considered inefficiently low?

Answer 25

Because just like in a monopoly, firms make no profits, and the quantity traded is insufficient to maximize efficiency.