Theme 10 - Oligopoly Flashcards
What characterizes a oligopoly?
- Market with only a few producers
- Firms have market power
- Entry into the market is impeded
- There are strategic interactions between firms as they consider how other firm’s actions affect their own
How do you compute market share?
Sales from firm / total sales in the market
What is the Herfindahl index and how do you compute it?
The Herfindahl index measures the degree of competitiveness in the market: if H is close to zero, it means that the market is very competitive.
H= sum of the squares of the shares
Describe the Cournot model.
- N firms are competing in a market
- Firms are selling the same homogeneous product
- Firms choose output simultaneously
- Unique market price determined by demand
- Demand = output of all firms
- Strategic interaction
- We look for Nash Equilibrium
What is game theory?
Allow to predict the outcome of a strategic interaction
How to solve the Cournot Model?
- Find the residual demand for firm 1
- Find the best response function for firm 1 using the profit maximising condition MR = MC
- To find the best response function for firm 2, redo steps 1 and 2, for firm 2.
- Find the Nash equilibrium using the best response functions for firms 1 and 2
- Find the market price and each firm’s profit using the equilibrium quantities
What are the similarities and differences between the Cournot model and the Stackelberg model
Same strategic configuration as in the Cournot model but there are two differences:
- Firms choose their production sequentially
- Firm 1 chooses its output first
- Firm 2 observes q1, then chooses q2 - To find the equilibrium of the sequential game, we use backward induction: firm 2 plays its best response to observed q1
- Firm 1 anticipates that firm 2 plays its best response and chooses q1 to maximize profits
What are the steps to solve the Stackelberg model?
If firm 1 plays first:
- Find the best response function for firm 2 (the best response for firm 2 will be the same as in the Cournot model)
- Solve for firm 1 using the profit-maximising condition, MR=MC
a) Compute R1 (since firm 1 anticipates firm 2’s reaction, it means that firm 1 anticipates revenue that take into account the best response function for firm 2)
b) Compute MR1
c) Using MR1 = MC1, solve q1
d) Find q2 by replacing q1 in the best response function for firm 2 - Find the market price and each firm’s profit using the quantities produced by both firms
Between the Stackelberg model and the Cournot model, which market is the more competitive?
Quantity produced? Qs>Qc -> S is more competitive
Market price Ps<Pc -> S is more competitive
Welfare Ws>Wx -> S is more competitive
How are the profits in oligopolies?
Cournot equilibrium: lower profits than a monopoly
Room for cooperation (as in prisoner’s dilemma)
What is a collusive strategy? What is a difficulty that comes with this strategy? What can help with this strategy?
Dividing the market between oligopolist.
Total output = monopoly output
Total profits = monopoly profits
Difficulty: maintain incentives to cooperate: there is an incentive to cheat (Nash)
Repeated interaction can help (reputation and trust)
Reward: cooperation as long as firms stick to collusion
Punishment: Back to Nash equilibrium if somebody cheats
-> Trade-off between a potential increase in profit today against the potential loss of profits tomorrow.
What is a cartel? Is it legal? If not, what is preserving competition?
A cartel is a group of firms that meet to discuss how to organize collusion. Prices and output are discussed and/or market shares are decided. If all firms keep the cartel agreement, they can increase their profits compared to Cournot competition.
However, discussing price or production plans with competition is illegal and therefore cartels are illegals.
Antitrust laws and competition policy make sure that competition is preserved.
Antitrust refers to laws to enforce free competition in markets: eliminate barrier to entry.
