Oligopoly

SET3055: Economics and Regulation of Sustainable Energy Systems

Gideon Ndubuisi (PhD)

TPM, Delft University of Technology

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Oligopoly (#1): Introduction
o So far, we have considered two extreme market structures: monopoly (one seller) and perfect
competition (many sellers)

o Most firms operate under intermediate market structures rather than the two extremes
Þ …, they are not monopolies because their industries contain several firms, which often compete against each other
Þ …, these firms do not operate in perfectly competitive markets because the number of competing firms is often small,
and, even when the number is large, the first are not price takers

o One of such example is Oligopoly

o Basic Characteristics
o Industries with a relatively small number of firms (duopoly as a special case)
o Each firm has some market power
o Firms sell identical or differentiated products
o Strong interdependence: Each firm consider each other’s actions (strategic interaction)
o Firms can choose to collude rather compete to set prices or quantities that maximize the sum of their profit

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Oligopoly (#2): Introduction

o There is no one model of oligopoly as interactions could be sequential or simultaneous,

while other’s actions of interest could be price, quantity, …
Þ Cournot, Bertrand, Stackelberg, Chamberlin , Edgeworth, Price leadership, Market
sharing cartel, …etc.

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Oligopoly (#3): Introduction
o Lecture Focus: Cournot
Þ The model is named after Antoine Augustin Cournot (1801-1877)
Þ Firms have market power
Þ There are two firms selling a homogenous products
Þ This can be easily extended to the case of differentiated products as well as 𝑁 number of firms (see Problem set on
Oligopoly)
Þ Strategic interdependence is on quantity
Þ It is a non-collusive oligopoly model, but we will consider the model’s outcome when
Þ Case 1: Firms act simultaneously (Classic case)
Þ Case 2: Firms act sequentially (Stackelberg)
Þ Case 3: Firms collude (Cartel)

o Example
Þ Assume a duopoly market for a homogenous product 𝑥
Þ The demand function for the product is given as 𝑝 = 18 − 𝑄
Þ Each firm in the market faces a constant MC given as 6

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Oligopoly (#4): Case 1¾ Simultaneous Interaction
o Firm 1’s profit function is given as:
𝜋! 𝑞! , 𝑞" = 18 − 𝑞! − 𝑞" 𝑞! − 6𝑞! = 12𝑞" − 𝑞"# − 𝑞" 𝑞#

o Firm 2’s profit function is given as:

𝜋" 𝑞! , 𝑞" = 18 − 𝑞! − 𝑞" 𝑞" − 6𝑞" = 12𝑞" − 𝑞! 𝑞" − 𝑞""

o Firm 1’s First-order condition is given as:

¶𝜋!
= 0Û12 − 2𝑞! − 𝑞" = 0
¶𝑞!
1 Firm 1’s action depends on its “best
𝑞! = 6 − 𝑞"
2 guess” of what firm 2 does
o Firm 2’s First-order condition is given as:
¶𝜋"
= 0Û12 − 2𝑞" − 𝑞! = 0
¶𝑞"
1 Firm 2’s action depends on its “best
𝑞" = 6 − 𝑞!
2 guess” of what firm 1 does

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Oligopoly (#5): Case 1¾Simultaneous Interaction

o Note
Þ 𝑞! implies Firm 1 sets quantity as a function of Firm 2’s choice. The
reverse argument holds for firm 2 𝑞!
Þ This is known as the reaction function or the best response function
(BRF) as it describes how a firm reacts to others choice
𝑅" (𝑞! )
Þ Mathematically, this is denoted as 𝑅" ($)
!
Þ 𝑞!= 𝑅!(𝑞#)=6 − 𝑞#
# 6
!
Þ 𝑞#= 𝑅#(𝑞!)= 6 − 𝑞! Equilibrium
#

Þ The pair of strategies here, 𝑅!(𝑞#) and 𝑅# 𝑞! is known as the Nash 𝑅! (𝑞" )
equilibrium

Þ The Cournot equilibrium occurs at the point where both firm’s BRF 𝑞"
6
intersects

Þ Notice that both reaction functions are downward-sloping, meaning Fig 1

that the more firm 𝑖 sells, the less residual demand for Firm 𝑗, where 𝑖 ≠ 𝑗

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Oligopoly (#6): Case 1¾Simultaneous Interaction
o Cournot equilibrium quantity for each firm is given as:
1 1
𝑞!$ = 6 − 6 − 𝑞! = 4
2 2
𝑞!
1 1
𝑞#$ = 6 − 6 − 𝑞# = 4
2 2
Þ Why is the solution same for both firms? 𝑅" (𝑞! )
Þ Note: We obtain the equilibrium quantity of each firm in a simultaneous
interaction by substituting 𝑅! (𝑞" ) to 𝑅" (𝑞! ) or vice versa the. This is not
trivial as we will see in the case of sequential interaction 6
Equilibrium
o Equilibrium quantity supplied on the market is given as:
4 𝑅! (𝑞" )
𝑄$ = 𝑞!$ + 𝑞#$ = 4 + 4 = 8
o The equilibrium price on the market is given as:
𝑞"
𝑝$ = 18 − 4 − 4 = 10 4 6

o The equilibrium profit of each firm is given as follows: Fig 2

𝜋"$ = 𝑝$ − 𝑐" 𝑞"$ = 10 − 6 4 = 16

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Oligopoly (#7): Case 2¾Sequential Interaction
o Case 1 assumes that firms actions are simultaneous. What if their actions are sequential such that a
firm known as a quantity leader chooses quantity and the others follow?
Þ This is the case of Stackelberg competition named after the German economist Heinrich Freiherr von Stackelberg in
1934
Þ The Stackelberg leader can be a market leader. It can also be an incumbent firm, while the follower as a potential
entrant
Þ Unlike the classic Cournot model that is a static game, the Stackelberg is a dynamic game
Þ Here, we use backward induction to find the subgame-perfect Nash equilibrium

o What are the equilibrium quantity and price levels?

o Continue with the previous exercise, but consider firm 1 as a quantity leader
o Small details to consider
Þ In Cournot, firms have “best guess” of others action
Þ Here, the follower knows the “actual” choice of the leader and it takes action informed by this knowledge
Þ The leader knows it is the market leader, and controls for the follower’s action
Þ The follower have no means of committing to a future non-Stackelberg leader's action

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Oligopoly (#8): Case 2¾Sequential Interaction
o Step 1: Derive follower’s BRF; 𝑅"(𝑞!)
1 Firm 2’s action depends on what firm
𝑞# = 𝑅#(𝑞!) = 6 − 𝑞!
2 1 “actually” does
Þ See slide 5 on how we derived the BRF of firm 2
Þ However, note, that for sequential interaction understudy this is the second stage of the game
Þ Implication: while in the case of simultaneous interaction 𝑞# is a guess, here firm 2 “actually” knows 𝑞! as it is given in
stage 1

o Step 2: Derive the leader’s profit function:

𝜋! 𝑞!, 𝑞# = 18 − 𝑞! − 𝑅# (𝑞! ) 𝑞! − 6𝑞#
! !
= 18 − 𝑞! − 6 − # 𝑞! 𝑞! − 6𝑞! = 6𝑞! − # 𝑞!#

Þ Unlike in the case of simultaneous interaction, the follower’s BRF is substituted into the leader’s profit function. Why?
Þ The leader knows that it is a leader and its action influences those of others. Hence, it accounts for others’ possible reaction
when it choose its output level

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Oligopoly (#9): Case 2¾Sequential Interaction
o Step 3: Determine the leaders equilibrium quantity:
¶𝜋!
= 0Û6−𝑞!= 0
¶𝑞!
Û 𝑞!% = 6
Þ The pair of strategies 𝑞# = 𝑅#(𝑞!), 𝑞!% = 6 is called subgame-perfect Nash equilibrium
o Step 4: Determine firm 2’s equilibrium quantity level:
1
𝑞!& = 𝑅#(𝑞!) = 6 − 6 =3
2
o Equilibrium quantity supplied on the market is given as:
𝑄 ' = 𝑞#& +𝑞!% = 3 + 6 = 9
o Step 5: The equilibrium price on the market is given as:
𝑝 ' = 18 − 6 − 3 = 9
o What are the pay-off functions in equilibrium?
𝜋#& = 𝑝 ' − 𝑐# 𝑞#& = 9 − 6 3 = 9; 𝜋!% = 𝑝 ' − 𝑐! 𝑞!% = 9 − 6 6 = 18

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Oligopoly (#10): Case 3¾Collusion

o Case 1 shows outcome in a situation where firms simultaneously take action about quantity, while
Case 2 shows outcome in a situation where firms sequentially take action about quantity
Þ In either of the above case, they are competing against each other

o What happens if firms decide to collude rather than compete?

Þ This is a case of Cartel (Cartels behave like monoplists)
Þ Continue with the previous exercise, but assume that the quota each firm contributes to the cartel is the same

o What are the equilibrium quantity and price levels?

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Oligopoly (#11): Case 3¾Collusion

o Cartel’s profit function is given as:

𝜋 = 18 − 𝑞 𝑞 − 6𝑞 = 18𝑞 − 𝑞4 − 6𝑞
o Cartel’s first-order condition is given as:
¶𝜋
= 0Û12 − 2𝑞 = 0
¶𝑞
o The equilibrium quantity on the market and the quantity supplied by each firm
!" *
𝑞( = = 6 ; 𝑞) = =3
" #
o The equilibrium price on the market is given as:
𝑝( = 18 − 6 = 12

o What are the pay-off functions in equilibrium?

𝜋"( = 𝑝( − 𝑐" 𝑞"( = 12 − 6 3 = 18

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Oligopoly (12): Some last insights

o Compared to Cournot, firm 1 (quantity leader) produces more quantity and makes more profit in
Stackelberg
Þ Firm 1 (quantity leader) “commits” to high production in hopes of getting the follower to choose a low level of
production in response
Þ Firm 2 (quantity follower) produces less than it would under Cournot
Þ Firm 1 (quantity leader) output quantity and profit are greater than those of firm 2 (quantity follower) in
Stackelberg

o When firms collude, they are able to charge higher price than when they compete. Market quantity
under collusion is lower than the market quantity when firms compete
Þ By colluding, firms make higher profit than when they compete

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 Market Concentration
o So far, we have examined different market structures. How can market structure be measured?
Þ Competition authorities need to specify concentration thresholds above which they are likely to intervene.
o Recall: We discussed earlier that market structure can be distinguished by the number of firms in the market
Þ However, consider this two cases:
Þ Industry 1: Firm 1, 95% market share; firm 2, 5%. Industry 2: Firm 1, 50% market share; firm 2, 50%
Þ Industry 1 looks like a market with a dominant firm (close to monopoly); Industry 2 looks closer to a proper
duopoly.
Þ Arguably, industry 1 is more concentrated than industry 2. This should be reflected in our measure of market
structure
Þ Market concentration measures provide alternative
o Market concentration is one of the ways to determine the extent of market/industry competition. It measures
the extent market shares are concentrated among firms in an industry
o Generally, there are two types of “statistics” that are used to measure market concentration: Concentration
ratio and Hirschmann-Herfindahl Index (HHI)

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 Market Concentration

o Concentration ratio
o This measures the total combined market share of some number of the largest firms in an industry
Þ Most widely used is the 4-Firm Concentration Ratio, CR(4), which is the combined market share of the four largest firms
in the industry. It computed as
*
𝐶𝑅4 = 8 𝑆"
")!

Þ where 𝑆" is the market share of firm 𝑖

Þ Similar to the CR(4), a two-firm concentration ratio, CR(2), is the combined market share of the two largest firms in the
industry, while an eight-firm concentration ratio, CR(8), is the combined market share of the two largest firms in the
industry

o Concentration ratios are useful, but somewhat limited: it only considers the shares of the largest few
firms and discard information about the relative size of the smaller firms
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 Market Concentration

o The Herfindahl-Hirschman Index

o This measures the sum of the squared market shares for all firms in an industry. This is computed as
follows
,
𝐻𝐻𝐼 = ' 𝑆)# = 𝑆"# + 𝑆## + 𝑆-# + … + 𝑆,#
)+"

Þ where 𝑆" is the market share of firm 𝑖, 0 ≤ 𝐻𝐻𝐼 ≤ 1. The closer the HHI is to zero, the lower is the degree of market
concentration

Þ In a perfectly competitive industry (thousands of tiny firms), the HHI is approximately zero, and for a monopoly it is 1

o Unlike the concentration ratio, HHI combines information about the shares of all firms in the market
and not just those of the largest firms

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 Thank you

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