Week 9 - Oligopoly Flashcards
What is oligopoly?
it refers to a market with many buyers and sellers
What are some examples of oligopoly?
Coke and Pepsi
Visa and MasterCard
Google and Bing
Apple and Microsoft
What is oligopoly characterised by?
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)
What theory can help us analyse how decisions are made in oligopolistic markets?
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.
What is collusion?
the collaboration between companies that seek to gain an extensive competitive advantage in the marketplace
What is a cartel?
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)
What is the worlds best known carte?
OPEC, formed in 1960 to control oil production, it is legal
Cartel instability graph
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
Eg payoff Matrix for a Cartel Agreement
,
Firm 2
Charge £1 Charge £0.9
Ch £1 500,500 0,990
Firm 1
Ch £0.9 990, 0 450,450
What is the tit for tat strategy
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)
What would the tit for tat strategy cause in oligopoly?
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
What are 2 difficulties of the tit-for-tat strategy?
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.
What do firms decide on in an oligopoly?
a level of output, allowing markets to determine price or
decide on a price and allow markets to determine the volume of sales
What are the two models in an oligopoly?
- The Cournot model
- The Bertrand Model
What is the Cournot model?
a market where firms choose output levels
What is the Bertrand model?
a market where firms decide on price
What do we focus on in the Cournot model?
duopoly, two producers
but the model can be generalised to more than two producers
What do we assume in the Cournot model?
- highly substitutable products
- firms have the same technology and face the same input costs
- constant unit costs and straight line market demand curve
What is the reaction function in the Cournot model?
the best response of a player
if firms maximise profits, the best response is the response that yieds the highest profit
What is the reaction curve graph?
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
What is the analysis of the reaction function graph?
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
What is Cournot behaviour?
consider two firms, each of which seeks to maximise its own profit under the assumption that the other firm’s output is given
What does the Cournot graph look like?
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
What is the analysis of the Cournot graph?
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.
