Week 9 - Oligopoly

Question 1

What is oligopoly?

Answer 1

it refers to a market with many buyers and sellers

Question 2

What are some examples of oligopoly?

Answer 2

Coke and Pepsi
Visa and MasterCard
Google and Bing
Apple and Microsoft

Question 3

What is oligopoly characterised by?

Answer 3

strategic interaction
->Unlike the extreme cases of perfect competition (where no firm has any influence on the
market) and monopoly (where there is only one firm)

Question 4

What theory can help us analyse how decisions are made in oligopolistic markets?

Answer 4

game theory

Example: Firms compete by producing new products, but must incur significant costs to do so, while the
projected return depends on the reactions of their rivals.

Question 5

What is collusion?

Answer 5

the collaboration between companies that seek to gain an extensive competitive advantage in the marketplace

Question 6

What is a cartel?

Answer 6

a group of independent market participants who collude with each other in order to improve their profits and dominate the market

(business cartels are usually illegal)

Question 7

What is the worlds best known carte?

Answer 7

OPEC, formed in 1960 to control oil production, it is legal

Question 8

Cartel instability graph

Answer 8

Downward demand curve with P and Q
£2 down to 2,000 Qd
£2 down to 1,000 Qd on Marginal cost.
A monopolist with zero marginal cost would produce 1,000 bottles per day (quantity at which marginal revenue equals 0) and sell them at a price of £1 per bottle
MR=MC

In cartel instability by cutting his price slightly a cartel member can sell all of 1,100 units rather than only half on 1,000 units
from £1 to £0.90 per bottle, the firms that cuts the price can sell the entire market demand at that price, 1,100 bottles per day rather half of the monopoly quantity of 1,000 bottles per day

people will go to the firm with the lower price, but firm now doesnt need to share profit with the other firm

Question 9

Eg payoff Matrix for a Cartel Agreement

Answer 9

,
Firm 2
Charge £1 Charge £0.9
Ch £1 500,500 0,990
Firm 1
Ch £0.9 990, 0 450,450

Question 10

What is the tit for tat strategy

Answer 10

a game theory strategy in which each participant mimics the action of their opponent after cooperating in the first round

(solution to the prisoners dilemma problem when a game is repeated frequently)

Question 11

What would the tit for tat strategy cause in oligopoly?

Answer 11

Since rival firms in the same industry interact with one another repeatedly, it might seem that the tit for-tat strategy would ensure widespread collusion to raise prices

Question 12

What are 2 difficulties of the tit-for-tat strategy?

Answer 12

One difficulty is that tit-for-tat’s effectiveness is greatly weakened if there are more than two players in
the game

The other difficulty is that even if there are only two firms in an industry, these firms realise that other firms may enter their industry.

Question 13

What do firms decide on in an oligopoly?

Answer 13

a level of output, allowing markets to determine price or
decide on a price and allow markets to determine the volume of sales

Question 14

What are the two models in an oligopoly?

Answer 14

1. The Cournot model
2. The Bertrand Model

Question 15

What is the Cournot model?

Answer 15

a market where firms choose output levels

Question 16

What is the Bertrand model?

Answer 16

a market where firms decide on price

Question 17

What do we focus on in the Cournot model?

Answer 17

duopoly, two producers
but the model can be generalised to more than two producers

Question 18

What do we assume in the Cournot model?

Answer 18

1. highly substitutable products
2. firms have the same technology and face the same input costs
3. constant unit costs and straight line market demand curve

Question 19

What is the reaction function in the Cournot model?

Answer 19

the best response of a player
if firms maximise profits, the best response is the response that yieds the highest profit

Question 20

What is the reaction curve graph?

Answer 20

x axis Firm1 output
y axis Firm2 output
Curve is Firm1’s reaction curve, it shows the preferred output for Firm1 for any output by Firm2

Qpc is the quantity that would be produced in perfect competition, on the y axis
Qm is the quantity a monopolist would choose, on the x axis

Question 21

What is the analysis of the reaction function graph?

Answer 21

The best output for Firm1 given any
output produced by Firm2 is given by
Firm 1’s Reaction Curve.
If firm 2 produces the perfectly
competitive output Qpc with P = AC and
π = 0, Firm1’s best choice is to produce
nothing
If Firm2 chooses to produce nothing,
leaving the entire market to Firm1, the
best output for Firm1 is the monopoly
output
The closer its output is to the monopoly
output on its own axis, the higher are its
profits

Question 22

What is Cournot behaviour?

Answer 22

consider two firms, each of which seeks to maximise its own profit under the assumption that the other firm’s output is given

Question 23

What does the Cournot graph look like?

Answer 23

x axis Firm B output
y axis Firm A output

B’s reaction function curve starts higher on the y axis and closer on the x axis
A’s reaction function curve starts lower on the y axis and further on the x axis crossing B’s reaction function curve

Question 24

What is the analysis of the Cournot graph?

Answer 24

Each firm horizontally subtracts the other firm’s output from the market demand curve to yield a residual demand curve - from which it evaluates its MR and profit maximising output.

The profit maximising output for each firm will be greater the smaller is the other firm’s output. Hence each firm derives its reaction function, showing how much it will produce at each possible level of output for its rival.

Question 25

What is the Cournot equilibrium on the graph?

Answer 25

q1* and q2*

Question 26

What is the Cournot equilibrium?

Answer 26

changing quantities continues until the firms reach a Cournot equilibrium

where the reaction functions intersect, each firm takes the other firm’s output as given, and each firm’s response is optimal given the other firm’s action

the firms dont change their output level anymore, a stable point, a best response against a best response

Question 27

What is the Cournot equilibrium analysis?

Answer 27

each firm is setting MC equal to (residual) MR and so is producing to the left of the point at which AC reaches a minimum. Industry output is
below what a perfectly competitive industry would provide, but above what a monopolist would provide. There is allocative inefficiency.

Firms earn supernormal profit, but not as much as they could earn if they were to collude (thus effectively becoming a monopoly).

Question 28

How to numerically find the Nash equilibrium eg

Answer 28

the profit function of firm 1 is
π_1 = pq_1 – 0.25q_1
p = 30 – 0.2(q_1+q_2)

input p into π_1, then expand and differentiate
make the equation equal zero then arrange to make q_1
q_1 is equivalent to q_2 but the q_2 and q_1 is switched
then input one into the other and find either q_1 or q_2 which both have the same answer

Question 29

What is the Bertrand Competition the name given to?

Answer 29

given to oligopolistic strategies based around price setting.

Firms compete on price, allowing the market to determine the volume sold at that price. Each firm assumes the others will charge current prices: undercutting

Question 30

What is undercutting?

Answer 30

firms typically see opportunities with Bertrand pricing to just price below
their rivals and steal the whole market

Question 31

Can any firm use undercutting?

Answer 31

Any firm can do this up so long as the price they set does not fall beneath their Marginal Cost (they would then be making a loss)

eg Newspapers
Insurance firms
Supermarkets

Question 32

What is the Bertrand Paradox?

Answer 32

For two similar firms producing a highly substitutable output, the Nash
equilibrium in prices is P = MC

That is, as long as there are at least two players, the perfectly competitive price emerges

Question 33

Why in the Bertrand Paradox is the Nash equilibrium priced at P=MC?

Answer 33

supposed MC<P1<P2
Firm 1 earns (P1 - MC) on each unit sold, while Firm 2 earns nothing.
Firm 2 has an incentive to slightly undercut Firm 1’s price to capture the entire market!
Firm 1 then has an incentive to undercut Firm 2’s price. This undercutting continues until P1 = P2 = MC …

Question 34

What are five sources of market power in oligopoly and monopoly?

Answer 34

1. Exclusive control over important inputs
2. Patents and copyrights
3. Government licences or franchises
4. Economies of scale (Natural monopolies)
5. Network economies

Question 35

What is an example of patents and copyrights?

Answer 35

Pharmaceutical companies (Pfizer)

Question 36

What is an example of government licences or franchises?

Answer 36

Water companies in each country

Question 37

What are examples of network economies?

Answer 37

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