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Oligopoly
Oligopoly
There are many models describes an oligopolists output and pricing decision:
The Cournot Model The Stackelbery Model Dominant Firm Model The Collusion Model
DA
D MR Q1 Q
MCA
MRA
Q2
MR
DA
D Q
D MR Q1+Q2 Q
Shows the relationship between a firms profitmaximizing output level and the output level of another firm. Reaction curve of firm A: QB
If QB = 0, QA = Qm (firm A Q PC becomes a monopoly) If QB = QPC, QA = 0 (as an additional unit can only be Qm sold lower than the MC).
Reaction Curve
Qm
QPC QA
Reaction Curve
Steps in finding the equilibrium outputs: If QB = Q1, QA = Q2 If QA = Q2, QB = Q3 If QB = Q3, QA = Q4
QA = Q*, QB = Q* QB
QPC Qm Q* Q3 Q1 Q* 4 2 Qm QPC QQ
QA
PC vs Mono vs Oligopoly
Assumption: a firm takes over all the competitive firms without changing their costs and then split into two firms.
P PM P* PPC MR MRA Q*QM 2Q* QPC DA D Q S =MCM =MCA+B
PC vs Mono vs Oligopoly
Price:
Stackelberg Model
In the Cournot model, firms are assumed to make output decisions simultaneously. However, in some market, a firm (leader) makes output decision first and other firms (followers) do this afterwards. The Stackelberg model uses this assumption. Firm A is the leader; Firm B is the follower.
Stackelberg Model
Parkin Shops promotion: $88 / 2 on 2nd July. Wellcomes promotion: $88 / 2 on 3rd July. Parkin Shop is the leader and Wellcome is the follower.
Stackelberg Model
As firm A is the leader, it does not need to response to firm Bs action. There is no reaction curve for firm A.
QB
QPC Qm
Qm
QPC QA
Stackelberg Model
To determine the firm As (leader) profitmaximizing output and price level, we check its cost curves and its residual demand curve. Firm As residual demand curve is derived by adjusting firm Bs output level according to firm Bs reaction function instead of having it fixed at a certain level.
Stackelberg Model
1. 2. 3. 4. 5. If QA = Q3, QB = Q4. Q m If QA = Q5, QB = Q6. Q4 QB Residual demand = DAQ6 P It derives MR = MRA QPC Firm A produces QA and firm B produces P* QB . 6. As there are QA + QB units in the market, P = P*.
QB
Stackelberg Model
Question: Are the two firms get their profit maximized? Firm A (leader) produces at QA, where MRA = MCA. Firm B (follower) produces at QB. It is the best response to QA but this does not necessary maximize its profit. The leader sets its output and the market price to maximize its profit at the expense of the follower. The first-mover advantage.
S MCA Q2
MRA
2. 3. 4. 5. 6.
If P = P2, QA = 0 P2 If P = P1, QS = Q2, P1 QA = Q1 Demand to firm A = DAP3 As firm A is the leader, it will produce Q1 where MRA = MCA 7. Total supply = Q1+ Q2
DA
Q2Q1 Q1+Q2
MCA A ACA DA
QA QB
MCB
B ACB DB
Failure of cartel
1. Incentive to cheat: PCartel > POligopoly once the agreement on higher price has been achieved, each cartel member has an incentive to cheat by increasing their own production and lowering its own price below the agreed price.
Failure of cartel
Market Firm A Firm B
MCCartel
PCartel
MCA A ACA
P* B B
MCB ACB DB
DMarket MRCartel
QCartel =QA + QB QA
MRB
QB Q*
(given QA)
> B
Failure of cartel
Actually, both firm A and firm B will make more profit if they cheat. Will the cartel break-down?
Firm B cooperate cheat cooperate Mono/2; Mono/2 Mono/2-; Mono/2+ Firm A cheat Mono/2+; Mono/2- olig; olig
Cartel
Nash Equilibrium:olig; olig Finally, the cartel will break-down and the firms will compete among themselves.
Failure of cartel
2. Disagreement over cartel policy In the previous example, we assume that the two firms have the identical cost curves and the cartel shares the combined profit eqully. But, in reality, it is very likely that the costs of the two firms are different. That implies that the ability in making profit should be different. The more capable one may be unhappy cheat with the sharing policy.
Failure of cartel
3. Potential new entrants As the combined profit is huge, it creates incentive for potential entrants to enter the market. It will driven down the cartel price and hence the Economic Profit. With new entrants, the incentive to cheat of the existing firms increases.
Failure of cartel
Because of the above reason, cartel is not common in reality. Why is there still cartel existing in the real world? It is a continuous game!
Repeated Game
cooperate Firm A cheat Firm B cooperate cheat 50; 50 20; 80 80; 20 40; 40
If it is a one-shot game (only one round is run), both firms will cheat. However, if they cheat in the first round, they cannot cooperate anymore in the future. If the game last for 5 rounds, how will the firms behave?
Repeated Game
One firm decides to cheat
Firm As Payoff 80 (cheat)
40 (cheat) 40 (cheat) 40 (cheat) 40 (cheat) Payoffs in 5 rounds: 240
As the total profit for them to cooperate is larger, they will cooperate in a continuous game.
Repeated Game
If the two firms have to make their decisions repeatedly, they will maximize their total profit from each round. If this is a finite game (with ending), they have an incentive to cheat in the last round. If this is an infinity game (no ending), they will cooperate forever.
Conclusion
In an oligopoly market, firms are strategic interdependent. Each firm has to make pricing and output decisions by taking the behaviour of its competitors into account. To deal with this characteristic, we use game theory. Accounting to the assumptions we hold, different models are used to describe the behaviour of the firms.
Conclusion
The Cournot model assumes both firms make their decisions simultaneously. The Stackelberg model assumes that there is a leader in the market. The dominant firm model assumes that the leader is a dominant firm in the market. As the combined profit of oligopolists is smaller than that of a monopolists, firms have incentive to cooperate the collusion model.