Microeconomic

Dr. Karim Kobeissi

Chapters 25: Oligopoly

OV E RV I E W
An oligopoly is an industry comprising a few firms. A duopoly, which
is a special case of oligopoly, is an industry consisting of two firms.
The distinguishing feature of oligopolistic or duopolistic market
structures it is the degree to which the output, pricing and other
decisions of one firm affect, and are affected by, the similar decision
made by other firms in the industry. What is important is the
interdependence of the managerial decisions among the various
firms in the industry. The analysis oligopolistic behavior may be
modeled as a non-cooperative game in which the actions of one firm
to increase market share will, unless countered, result in a reduction
of the market share of other firms in the industry. Thus, action will
be followed by reaction. This interdependence is the essence of an
analysis of duopolistic or oligopolistic market structures .

Characteristics of an Oligopoly
The characteristics of oligopoly are:
1. Relatively few sellers,
2. Either

standardized

or

differentiated

products,
3. Price interdependence
4. Relatively difficult entry into and exit from
the industry

Game Theory
Game theory is perhaps the most important
tool in the economists analytical kit for
analyzing the strategic behavior. Strategic
behavior is concerned with how individuals
make decisions when they recognize that
their actions affect, and are affected by, the
actions of other individuals or groups.

Game Theory

can also be illustrated by what is called

THE

PRISONERS DILEMMA.
The police have enough evidence to convict Bonnie and Clyde of
possession of an illegal firearm so that each would spend 1 year
in jail. But they suspect that the two have pulled off some bank
robberies but they have no evidence. They put Bonnie and Clyde
in separate rooms and offer a deal.

Right now, we can lock you up for one

year. But if you testify against your
partner, we will set you free and your
partner will get 20 years in prison. If you
both confess to the crime, we can avoid
the cost of a trial and you both get 8
years.

THE PRISONERS DILEMMA GAME AND THE REAL WORLD

The Prisoners Dilemma is an example of a twoperson,

non-cooperative,
simultaneous-move,
one-shot game in which both players have a
strictly dominant strategy.
A player has a strictly-dominant strategy if it
results in the largest payoff regardless of the
strategy adopted by other players.
A Nash equilibrium occurs in a non-cooperative
game when each player adopts a strategy that is
the best response to what is believed to be the
strategy adopted by the other players.
When a game is in Nash equilibrium, neither
player can improve their payoff by unilaterally
changing strategies.

THE PRISONERS DILEMMA GAME AND THE REAL WORLD

(con)
The key insight of the prisoners dilemma game is the tension between
the equilibrium outcome (in which both players best strategy is to
confess because they cant trust each other) and the fact that both
players could make themselves better off if only they would cooperate.
This tension helps explain complex events in the real world.
The Organization of Petroleum Exporting Countries (OPEC) provides a
classic example of this tension. OPEC is a cartel that controls a large
fraction of the worlds oil. Looking at OPEC as a whole, restricting the
supply of petroleum and keeping the price of petroleum high is in OPECs
interest. Keeping the price of petroleum high, perhaps near $40 a barrel,
which was the price about 20 years ago, would maximize the total
revenues and profits of the OPEC nations. But when the price is this high,
the individual interest of each nation lies in pumping more oil than the
amount allocated to it under the OPEC agreement. Each nation figures
that if it and it alone cheats on the output restriction imposed by the
cartel agreement, the effect on the world price of oil would be small but
the positive impact on its profit from selling more oil would be large. So
each nation is tempted to cheat on the cartel.

The SHERMAN ANTITRUST ACT (1890) elevated agreements

between oligopolists from an unenforceable contract to criminal
conspiracy.

The CLAYTON ACT (1914) stated that if a person could prove

that he was damaged by an illegal arrangement to restraint of
trade, that person could sue and receive three times the
damages.

These laws are used to prevent oligopolists from acting

together in ways that would make their markets less
competitive.

Non-cooperative Oligopoly/Duopoly

Four popular models of firm behavior in oligopolistic

industries are:
1) The Cournot Model is an economic model used
to describe an industry structure in which the two
companies compete on the quantities of output
they will produce (to maximize profits), which
they decide on independently of each other and
simultaneously.
2) The Stackelberg Model is an economic model
used to describe an industry structure in which
the two companies compete on the quantities of
output they will produce (to maximize profits),
which they decide on independently of each
other and consecutively (Leader firm and
Follower firm).

Non-cooperative Oligopoly/Duopoly (con)

3) The Sweezy Model is an economic model used

to describe an industry structure in which the two
companies compete on the price they will set to
maximize profits. Each firm will follow a price
decrease by other firms in the industry, but will
not follow a price increase.
4) The Bertrand Model is an economic model used
to describe an industry structure in which each
firm sets the price of its product to maximize
profits and ignores the price charged by its rival.

C o u r n o t M o d e l Fo r a
Duopoly

Five Assumptions:
1) The two firms produce a homogeneous product,
i.e. there is no product differentiation (e.g., water).
2) The two firms do not cooperate.
3) The two firms have market power, i.e. each firm's
output decision affects the product's price.
4) The firms are economically rational and act
strategically, usually seeking to maximize profit
given their competitors' decisions.
5) The two firms compete on quantities, and choose
quantities simultaneously (each firm take the
output quantity of the other as a given
constant).

Cournot Model of an Airlines Market

Example: American Airlines and
United
Airlines
compete
for
customers
on
flights
between
Chicago and Los Angeles.
Cournot
equilibrium
(NashCournot equilibrium) - a set of
quantities sold by firms such that,
holding the quantities of all other
firms constant, no firm can obtain a
higher profit by choosing a different

Cournot Model of an Airlines Market

(cont).
Residual Demand Curve
The market demand that is not met by
other sellers at any given price.

Cournot Model of an Airlines Market

(cont).
Market demand function is
Q = 339 p
p - dollar cost of a one-way flight
Q total quantity of the two airlines (thousands
of passengers flying one way per quarter).

Each airline has a constant marginal cost,

MC, and average cost, AC, of $147 per
passenger per flight.

Cournot Model of an Airlines Market

(cont).

Residual demand American Airlines faces is:

qA = Q(p) qU = (339 p) qU.

rewriting

p = 339 qA qU

The marginal revenue function is:

MRr = 339 2qA qU

Cournot Model of an Airlines Market

(cont).

American Airlines best response is the

output that equates its marginal
revenue, and its marginal cost:
MRr = 339 2qA qU = 147 = MC
and rearranging

qA = 961/2 qU

Cournot Model of an Airlines Market

(cont).

United Airlines best-response

function is
qU = 961/2 qA
This statement is equivalent to saying
that the Nash-Cournot equilibrium is a
point at which the best response
curves cross.

Cournot Model of an Airlines Market

(cont).

To solve the model:

qA = 961/2 (961/2 qA)
and solve for qA.

Doing so, we find that

qA = 64; qU = 64
Q = qA + qU = 128.
Nash - Cournot equilibrium price is
$211.