Industrial Economics

Oligopoly
Peter Wagner, Ph.D.
Department of Economics
University of York

1
1. Introduction

2
Oligopolies
Oligopolies are markets or industries in which a small number of large firms supply the
entire market
Market power is shared collectively among these firms
Firms behave strategically;
They make a prediction what competitor's do
Choose their own action (price, quantity, etc) based on their estimation of the
competitors' behaviour
We use game-theoretic modelling to characterise such markets and form prediction
for market outcomes/
3
Oligopoly theories
Static competition:
Two standard theories:
Cournot (1838): quantity competition
Bertrand (1883): price competition
Dynamic Competition:
Stackelberg (model of "entry")
Repeated Cournot / Bertrand competition

4
Case. DVD-by-mail industry
Facts
< 2004: Netflix almost only active firm
2004: entry by Wal-Mart and Blockbuster (later Amazon), not foreseen by Netflix
Sequential decisions
Leader: Netflix
Followers: Wal-Mart, Blockbuster, Amazon
Price competition
Wal-Mart and Blockbuster undercut Netflix
Netflix reacts by reducing its prices too.
Quantity competition? Need to store more copies of latest movies
5
Static models of competition
Effect of ``imperfect'' competition depends whether competing in price or quantity and on
the timing of decisions (in contrast to monopoly)
We consider markets with homogenous products: consumers cannot differentiate among
brands, or distinguish among the producers.
Examples:
agricultural products: corn, wheat, dairy, fruits & vegetables
raw materials: oil, natural gas, coal, iron, aluminum
...
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2. Price Competition

7
Bertrand competition with symmetric cost
2 firms
Homogenous products
Constant marginal costs c > 0
Set price simultaneously to maximise profits
Consumers
Demand D(p)
Consumers always purchase from the cheapest seller.
If prices are the same, firm i receives share αi where α1 + α2 = 1
​ ​ ​

8
Firm i's individual demand is then given by
⎧0 if pi > p−i
qi (pi , p−i ) = ⎨αi D(pi )
​ ​

if pi = p−i
⎩
​ ​ ​ ​ ​ ​
​ ​ ​ ​

D(pi ) ​ if pi < p−i

​ ​

Idea: firms can ``undercut'' each other and capture the entire market
The profit for firm i is then
πi (pi , p−i ) = (pi − c)qi (p1 , p2 ).
​ ​ ​ ​ ​ ​ ​

9
Equilibrium of the Betrand competition
We are interested in Nash equilibria
each firm takes as given the price set by the competitor
chooses its own price in response to max profits
Assume you can only set prices in 0.01 increments
Best response for each firm:
If p−i > c, set pi = p−i − 0.01
If p−i = c, set price pi = c
​ ​ ​

If p−i < c, set price pi = c.

​ ​

​ ​

The only equilibrium is p1 = p2 = c.

​ ​

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There is a unique Nash equilibrium!

Intuition: Each firm can undercut the other when the competitor's price is above cost
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Linear Betrand with asymmetric costs
Assume that marginal costs are different across firms, w.l.o.g., c1 < c2 .
​ ​

New tie-breaking rule: at identical prices, buy from Firm 1

Unique Bertrand Equilibrium: p1 = p2 = c2 .
​ ​ ​

Why?
Firm 1 has the entire market, loses it when it increases price, and lowering price
lowers profits since demand is constant
Firm 2 has no market share, and gains market share only by pricing below cost

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Betrand Paradox
Only two firms, but competitive outcome with zero profits
This phenomenon is called the Betrand Paradox
If p1 = p2 = c, then both firms make zero profits.
If either firm lowers its price it makes losses.
​ ​

If it increases its price its demand drops to zero, and it continues to make zero profit.
Lesson
In a homogeneous product Bertrand duopoly with identical and constant marginal costs,
the equilibrium is such that firms set price equal to marginal costs
and firms do not enjoy any market power.

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3. Supply Competition

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"Cournot model" of competition:
Several firms that jointly supply the market
Market demand determines the price at given total market supply
Difference to Bertrand:
Firms cannot "undercut" each other
Effect of competition: a firm's ability to raise market price by lowering its output is
curtailed by competitors' supply
We will consider two variants of the "linear" Cournot model:
Asymmetric Cournot Duopoly (two asymmetric firms)
Symmetric Cournot Oligopoly (many symmetric firms)
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Baseline: Linear Cournot Model
A set N = {1, … , n} of firms produce homogenous goods
Firm i chooses quantity qi
Total output: Q = q1 + q2 + … + qn
​

Market demand: P (Q) = a − bQ

​ ​ ​

Cost function: Ci (qi ) = ci qi for each i ∈ N

Notation: q−i = Q − qi
​ ​ ​ ​

Firm i's profit:

​ ​

πi (qi , q−i ) = (a − bq−i − bqi )qi − ci qi

​ ​ ​ ​ ​ ​ ​ ​

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Solve for Cournot equilibrium
Again, we are interested in Nash equilibria
Firm i’s payoff, given quantities q−i of all other firms is:
​

πi (qi , q−i ) = (a − bq−i − bqi )qi − ci qi

​ ​ ​ ​ ​ ​ ​ ​

First-order condition (for firm i)

a − bq−i − 2bqi − ci = 0 ​ ​ ​

Solving for best-response qi : ​

a − ci 1
qi (q−i ) = − q−i
​

2b 2
​ ​ ​ ​ ​

Two tractable cases: asymmetric duopoly and symmetric oligopoly (n firms)

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Asymmetric Cournot Duopoly
Assume c1 < c2 and c2 ≤ (a + c1 )/2.
​ ​ ​ ​

An equilibrium (q1∗ , q2∗ ) solves q1∗ = q1 (q2∗ ) and

q2∗ = q2 (q1∗ ) or equivalently:
​ ​ ​ ​ ​

​ ​ ​

a − c1 1 ∗ a − c2 1 ∗
q1∗ = ∗
− q2 , q2 = − q1
​ ​

2b 2 2b 2
​ ​ ​ ​ ​ ​ ​ ​

Solving for q1∗ and q2 yields:

​ ​

1
q1∗= (a − 2c1 + c2 )
3b
​ ​ ​ ​

∗ 1 ​

q2 = (a − 2c2 + c1 )
3b
​ ​ ​ ​

Note that q1∗ ≥ q2∗ ⇒ π1∗ ≥ π2∗

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​ ​ ​ ​
Symmetric Cournot Oligopoly
Assume ci = c for all i ∈ N .
Symmetric equilibrium (q∗ , … , q∗ ) solves
​

∗ a−c 1 ∗ ∗ a−c
q = − (n − 1)q ⟹ q =
2b 2 (n + 1)b
​ ​ ​

The total quantity, price and profit in this equilibrium are

2
n a − c a + nc (a − c)
Q∗ = , p∗ = , π∗ =
n+1 b n+1 b(n + 1)2
​ ​ ​ ​

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Symmetric Cournot model in the limit
Take the limit as n → ∞
q∗ = 0
∗ a−c
Q =
b
​

​ ​

p∗ = c

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Compare with perfect competition:
In a perfectly competitive market, the supply curve is given by p∗ = c.
Since MC is constant, the supply curve is horizontal from the perspective of each
firm.
In competitive equilibrium, we thus have p∗ = c, and Q∗ is given by P (Q∗ ) = a −
bQ∗ = c, i.e., Q∗ = (a − c)/b.
Lesson
The (symmetric linear) Cournot model converges to perfect competition
as the number of firms increases.

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Surplus and Welfare in the Cournot model
Consumer surplus is:
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(a −
CS ∗ = ( )
n c)
n+1 2b
​ ​

Welfare:
2 2
+ 2n (a −
W ∗ = CS ∗ + nπ ∗ = ( 2 )⋅
n c)
n + 2n + 1 2b
​ ​

It is straightforward to show that consumer surplus and welfare are increasing in n.

→ increasing competition increases consumer surplus and welfare

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Cournot Pricing Formula
General Cournot competition model:
Inverse demand function P (⋅) is differentiable and decreasing
Each firm i has a differentiable and convex cost function ci (⋅).
​

Individual supply of firm i is qi , and total market supply is Q = q1 + … + qn

​ ​ ​

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Each firm i solves the profit maximization problem
max P (Q)qi − ci (qi )
​ ​ ​ ​

qi ​

The first-order condition is

P ′ (Q)qi + P (Q) − c′i (qi ) = 0
​ ​ ​

Recalling that ∣P ′ (q)q/P (q)∣ = 1/ϵ(P (q)), we obtain

P (Q) − c′i (qi ) 1 qi
=
​ ​ ​

P (Q) ϵ(P (Q)) q

​ ​ ​

This is the Cournot pricing formula.

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Implications:
In the Cournot model, the mark-up of firm i is larger the larger the market share of firm
i and the less elastic is market demand.
Hence, the Cournot model gives the empirically testable prediction that in a given
market, a larger firm should have a larger mark-up

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Cournot and market concentration
The average Lerner index is equal to the HHI index:
N N N
1 qi 1 1
L = ∑ si Li = ∑ si [ ]= ∑ si = HHI
2 ​

∣ϵ∣ q ∣ϵ∣ i=1 ∣ϵ∣

​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

i=1 i=1
si

→ markup increasing in (1) market concentration (high HHI) and decreasing in market
elasticity (high ϵ).

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The Cournot model makes the following prediction for market structure:
The average Lerner index (weighted by market shares) is proportional to the
Herfindahl index.
This means that in the linear Cournot model, there is a one-to-one relationship
between market power and concentration.
Calculating the Herfindahl index and estimating the price elasticity of demand allows
for calculation of the average markup (or average Lerner index) in the market.

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4. Competition with sequential moves

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So far: simultaneous decisions, competitors unobservable
Now: sequential decisions
Firms make decisions one after the other
The "leader" chooses its output first
The "follower" chooses its output after observing the leader's output
Difference to simultaneous moves?
The follower can respond to choice of the leader
The leader anticipates the response of the follower
First-mover or second-mover advantage? Is it better to be leader or follower?
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The Stackelberg model of oligopoly
In the following, we assume that the firms choose their outputs sequentially as follows:
First, firm 1 (the Stackelberg-leader) sets its quantity q1 .
Second, firm 2 (the Stackelberg-follower) observes q1 and then sets its output q2 .
​

​ ​

Similar to Cournot duopoly, but one firm chooses its quantity before the other.

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We are interested in subgame perfect equilibria (no empty threats)
Solve for SPE via backwards induction:
First, assume follower observes output of leader, and chooses its subsequent
ouput optimally at that stage
Second, assume leader anticipates followers response, and chooses its output
based on the follower's response

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More formally...
To solve for the Stackelberg equilibrium: backwards induction
Start with period 2!
Assume that firm 1 has set quantity q1 .
Find the "best-response" function q2∗ (q1 ) that maximises firm 2's profits for any q1 !
​

Go back to period 1 and find choice q1 of firm 1 that maximises profit for firm 1 given
​ ​ ​

firm's two best-response q2∗ (q1 ).

​

​ ​

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Step 1: Consider period 2. Suppose firm 1 chose q1 . Firm 2 sets q2 to maxmimise profits:
​ ​

π2 (q1 , q2 ) = (a − b(q1 + q2 ) − c)q2

​ ​ ​ ​ ​ ​

To maximise, solve first-order condition:

d
π2 (q1 , q2 ) = a − bq1 + 2bq2 − c = 0.
dq2
​ ​ ​ ​ ​ ​

Solve for q2 to get the best-response function:

​

a−c 1
q2∗ (q1 ) = − q1
2b 2
​ ​ ​

Note that q2∗ is a function that gives the optimal output for each choice of firm 1.
​

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Step 2: Consider period 1. Firm 1 knows that firm 2 sets q2 = q2∗ (q1 ). ​ ​ ​

The profit function for firm 1 is

a−c
− c)q1 = ( ) q1 − q1
b 2
π1 (q1 , q2∗ (q1 )) = (a − b(q1 + q2∗ (q1 ))
2 2
​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​

To maximise, solve first-order condition:

a−c ∗ a−c
− bq1 = 0 ⟹ q1 =
2 2b
​ ​ ​ ​

For the follower, this implies:

a−c a−c a−c
q2∗ = q2∗ (q1∗ ) = − =
2b 4b 4b
​ ​ ​ ​ ​ ​

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Result: Stackelberg equilibrium
Thus, the Stackelberg equilibrium is the pair
a−c a−c
(q1∗ , q2∗ ) =( , )
2b 4b
​ ​ ​ ​

The demand is then given by

∗ a + 3c
p = P (q1∗ + q2∗ ) = a − b(q1 + q2 ) = >c
4
​ ​ ​ ​ ​

Observations:
Production is profitable, since p∗ exceeds the marginal cost c.
The leader produces more (twice as much) as the follower
First-mover advantage: the "leader" makes more profit than "follower".
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36
Stackelberg with endogenous number of followers
Consider now a scenario with one leader and followers which choose to "enter"
Example: market for a drug whose patent expired
Leader: patent holder / Followers: generic producers
Observation: leader cuts its price, possibly to keep the number of entrants low
Theoretical prediction
Leader always acts more aggressively (i.e., sets larger quantity or lower price)
than followers.
Intuition: leader is also concerned about the effect of its own choices on the
number of firms that enter; nature of strategic variables is less important.
Confirms the observations.
See Problem Set! 37