Master in Engineering Policy and Management of Technology

MicroEconomics Oligopoly
Presented by Students: Joo Pita Francisco Vilhena da Cunha Bruno Pereira Jorge Oliveira

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Oligopoly
The regimen of oligopoly is characterized by a restricted number of agents on the offer side and a large number on the demand side. The agents of the offer are in such number that their market share allows each one of them to affect the formation of prices and from there affect other competitors.

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Oligopoly
This is, realistically, the regimen most current in the not controlled economies.
Easiness of communications Information Transports Technological competition

Selection of the most capable firms

Automobile Market, Energy, Microprocessors, Photograph, etc

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Types of Oligopoly
- Cooperative Oligopoly
Implicit and explicit agreements about prices, amounts and types of product. Eventual barriers to the entrance of other companies in the market

- With indifferentiated products

With identical prices and equally available techniques of production for all the companies of the oligopoly - pure oligopoly

- Concorrencial oligopoly

When the companies compete between themself, having or not in consideration the reaction of the other companies in the market.

- With differentiated products

- When the companies differentiate its products, in order to create a search that specifically is directed them

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Cournot Model
Static Game: Players act simultaneously Strategies: Any Price between 0 and infinity denoted p1 and p2

Developed by Antoine Augustin Cournot in 1838

In a two firm oligopoly (called a duopoly), if both firms set their output levels assuming that the other firms strategic choice variable (quantities in Cournot competition) is fixed, the equilibrium outcome is a Cournot-Nash Non-cooperative Equilibrium.

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Cournot Model
Description: Firm 1 excepts that firm 2 production will be y2e units of output, Then decides to produce y1, The total production will be Y= y1+y2e and market price p(Y) = p( y1 + y2e )

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Properties of the Cournot-Nash Equilibrium for Duopoly

When the duopolists compete in quantities, we can compare the outcome to both the monopoly and competitive outcomes. Each duopolist produces less than a monopolist in the same market but together they produce more than the monopolist and less than the amount two competitive firms would have produced with the same cost structure and demand curves. The sum of the economic profits of each duopolist is less than the economic profits of a monopoly in the same market.

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Cournot Model: Waters Reaction Curve Firm 1

q1 (litres)
120

Waters reaction curve

60

20

30

50

60

120

Firm 2
q2 (litres)

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Cournot Model
Firm 1
q1 (litres)
120 reaction curve

60

40

reaction curve

40

60

120

Firm 2 q2 (litres)

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Cournot Model
Firm 1
q1 (litres)
120 reaction curve

60 Cournot Equilibrium 40 reaction curve 40 60 120

Firm 2
q2 (litres)

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Properties of the Cournot-Nash Equilibrium for Duopoly

The profit-maximization problem The optimal choice of firm 1 is y1 = f1(y2e ) This reaction function gives one firms optimal choice as a function of its beliefs about the other firms choice. For arbitrary values of y1e and y2e this won't happen - in general firm 1s optimal level of output, y1, will be different from what firm 2 expects the output to be, y1e.

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Bertrand-Nash equilibrium
Static Game: Players act simultaneously
Strategies: Any Price between 0 and infinity denoted p1 and p2 The Bertand equilibrium is a price level for each firm such that the firms profits are maximized given the price level of the other firm. Assuming that firms are selling identical products Bertrand equilibrium is the competitive equilibrium, where price equals marginal costs. Consider that both firms are selling output at some price > marginal cost.

Cutting its price by an arbitrarily small amount firm 1 can steal all of the customers from firm 2.
Firm 2 can think the same way! Any price higher than marginal cost cannot be an equilibrium
The only equilibrium is the competitive equilibrium

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Bertrand-Nash equilibrium
Graphical demonstration of Why P1=P2> MC is not a Nash Equilibrium

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Sequential Models
Companies act sequentially, as opposed to simultaneously (Cournot and Bertrand models)
Competitors decisions are taken into account Dominant player or Leader (first mover) and Follower anticipation strategy from the Leader Perfect information: Follower has complete information on Leaders actions Competitive Intelligence

Examples: IBM, Microsoft

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Sequential Models - Stackelberg

Stackelberg Model
Heinrich Freiherr von Stackelberg
1905 (Germany) 1946 (Spain) Theory of competition

Model
Duopoly where both firms have market power with undifferentiated products First model to assume asymmetries between companies Cournot-like competition on quantity/output followed by Bertrand-like competition on price 1st movers decision remains constant and follower decides based on that (otherwise its a Cournot model)

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Sequential Models - Stackelberg

Firm 1 (leader) decides on quantity to produce (y1), assuming that Firm 2 (follower) will react to maximise its profits, producing y2:
Total output: Y = y1 + y2 = f(y1) Equilibrium price P is a function of total output, Y What will be the quantity produced by Firm 1 (Leader)? Look forward and reason back Firm 1 knows that:
It has influence over Firms2s output and Firm 2 will react in order to maximise its profit

Leading to

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Sequential Models - Stackelberg

Follower's profit-maximization problem
Firm 2 will choose y2 in order to maximise its profit, P2
P2 = P(y1+y2)(y2) - w2(y2), where w2 is Firm 2s unit costs To Firm 2 and considering profit maximization:
y1=constant and it will have to define y2 from: MR(y1,y2*)=MC(y2) y2* = f2(y1) y2* = f2(y1): Firm 2 reaction function y2* is a function of Firm 1s decision

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Sequential Models - Stackelberg

Follower's profit-maximization problem
y2

P2 max (Monopolist) y2 = f2(y1)

Isoprofit lines Firm 2

Reaction Curve f2(y1)

y1

y1

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Sequential Models - Stackelberg

Leaders Problem
Assuming Firm 2s reaction to its output, Firm 1 now aims at maximizing it profit:
P1 = P[y1+f(y1)](y1) - w1(y1), since y2 = f(y1)

Leader knows that his actions influence the output choice of the follower,

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Sequential Models - Stackelberg

Stackelberg model - Equilibrium
Mathematical deduction: http://josemata.org/ee/17/stackelberg2/

y2

Reaction Curve Firm 1

Isoprofit lines Firm 1 Cournot Equilibrium
y*2

Stackelberg Equilibrium Reaction Curve Firm 2 f2(y1)

y*1

y1

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Sequential Models - Stackelberg

Stackelberg model compared
Price

Bertrand < Stackelberg < Cournot Competitive < Stackelberg < Monopoly
Monopoly < Stackelberg < Competitive Cournot < Stackelberg < Bertrand Cournot < Stackelberg < Bertrand

Total Output

Consumer Surplus

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Sequential Models - Stackelberg

Identifying the leader
Stackelberg model based on Cournot with an anticipation strategy from one of the companies on setting its output The model doesnt explain what is the asymmetry neither in what it is based on There can be several reasons, e.g.:
Company already in the market and new entrant
1st can decide on the installed capacity If installed capacity irreversible, 2nd can assume capacity of the 1st as an input for decision

Depending on fixed costs, 2nd may not be able to enter the market (monopoly) If seond enters the market Stackelberg model

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Collusion Model
Types of Cooperative Behaviour

When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion.
Tacit collusion occurs when firms act without explicit agreement to achieve the cooperative outcome. Can take the
form of a verbal gentlemans agreement to fix prices and output.

Explicit collusion occurs when firms ostensibly agree to maintain their joint-profit-maximizing output. Cartels -- such as DeBeers and OPEC -- are obvious examples.

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Factors that affect the ability to collude:

Number and size distribution of sellers Similar easier to collude Product heterogeneity Homogeneous easier to collude Cost structures Similar easier to collude Size and frequency of orders Frequent smaller easier to collude Secrecy and retaliation Less secrecy, easier retaliation easier to collude Social structure of the industry Social interaction easier to collude

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Tacit Collusion
Price Leader (Barometric Firm)
Largest, dominant, or lowest cost firm in the industry Demand curve is defined as the market demand curve less supply by the followers

Followers
Take market price as given and behave as perfect competitors

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Price Leadership

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Oligopoly isnt a problem unless it becomes a Cartel

Cartel a formal or informal agreement among firms in an oligopolistic industry Cartel members may agree on such issues as prices, total industry output, market shares, and division of profits Cartels or collusive agreements are illegal in most cases.

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Cartels
OPEC Colombian Drug Cartel Mafia or Crime Syndicate Ivy League Schools Government enforced cartels: market intervention to raise prices!

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Cartel as a Monopolist
D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel). Cartel profits are maximized when the industry produces quantity Q and charges price p.

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Some illegal Cartels get caught:

Electrical equipment manufacturers in the 1950s Pharmaceutical companies more recently

Some dont

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Cheating
Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement
By offering a price slightly below the established price, a firm can usually increase its sales and economic profit Because oligopolists usually operate with excess capacity, some cheat on the established price

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How can either of the firms be sure that the other firm isnt cheating on their agreement, and selling the product for lower price?

BEAT ANY PRICE

One way is to offer to beat any price a costumer can find. That way, the costumer report any attempt to cheat on the collusive arrangement

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OPEC Illustrates Cartel Difficulties

Incentive to Cheat Cheating increases individual profits Cheating decreases cartel profits Different Members Have Different Goals High prices encourage substitutes Supply expansion by non-members Development of alternative products More important to some members than to others

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OPEC and CIPEC OPEC is the Organization of Petroleum Exporting Countries

CIPEC is the French acronym for Intl Council of Copper Exporting Countries Why has OPEC been successful in raising its price, but CIPEC has not? OPEC as a dominant firm Price MCnon-opec P1

Oil Market
Popec

Pcomp
P2 MRopec Q Qfringeopec Qtotal

MCopec

Dmkt

Output

Qc+c

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OPEC and CIPEC

CIPEC (Chile, Peru, Zambia, Zaire) MCCIPEC is not much less than MCnoncipec

Price

Copper Market
MCnon-cipec

Why has OPEC been successful in raising its price, but CIPEC has not? CIPEC as a dominant firm Why cant CIPEC increase P1 copper prices much? Pcipec D for copper is more elastic Pcomp (aluminum is a good substitute) Compve supply more elastic P2 than for oil (if P rises, simply go to scrap heap) Successful cartel needs relatively inelastic D.

MCcipec

Dmkt MRopec Q Qfringecipec Qtotal Qc+c Output

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Obstacles to Collusion
Demand and cost differences between firms. Higher numbers of firms, particularly if a number of firms outside collusive agreement. Incentives to cheat. Recession. Legislative obstacles: Trade Practices Law.

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OLIGOPOLY MODELS
COMPARISON OF THE SOLUTIONS
One firm leads by setting its output, and the other firm follows. When the leader chooses an output, it will take Stackelberg (Quantity-leader) into account how the follower will respond Cournot (Price-leader) Bertrand (Simultaneous price setting) Collusion (Cartel) One firm sets its price and the firm chooses how much it wants to supply at that price. Again the leader has to take into account the behavior of the follower when it takes its decision Each firm chooses its prices given its beliefs about the price that the other firm will choose. The only equilibrium price is the competitive equilibrium A number of firms colluding to restrict output and to maximize industry profit. A cartel will typically be unstable in the sense that each firm will be tempted to sell more than its agreed upon output if it believes that the other firms will not respond

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Sweezy Model
- It tries to explain the rigidity of the price, many times observed in oligopolistc markets; - If a companie increases its price, the other companies will not, making the first one to lose its customers; - On the other hand, if a company lower the prices, the other companies also will lower the price, for that it will not have advantage to do that.

mC mC

mR

D Q

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Conclusions - Balance in the Long Run

Profits, equilibrium or damage
In the long run, the oligopolist will leave the industry if has no profits. It prepares its company to present the very best level of production in the long run. If it will have some profits, other companies will try to enter in the sector, if the entrance will not be restricted. Competition based on strategy, quality, product project, advertisement, services, innovation

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Bibliography

Lipsey & Chrystal

Mata, Jos, Economia da empresa, Fund. Calouste Gulbenkian, Lisboa, 2nd edition, 2002 Mata, Jos in http://josemata.org/ee, 2006 Pindyck, Robert S., Rubinfield, Daniel L., Microeconomics, 5th edition, ch. 12, pgs. 429 to 451 Samuelson Salvatore, Dominick, Microeconomy, Schaum, MacGraw-Hill, 1984 Sousa, Alfredo de, Anlise Econmica, Universidade Nova de Lisboa, Faculdade de Economia, 1988 The Home of Economics on the Internet in www.tutor2u.net, 2006 Varian, Hal R., Intermediate Microeconomics, 6th edition, ch. 26, pgs. 459 to 479