MANAGERIAL ECONOMICS

LECTURE 11 - PRODUCER THEORY (OLIGOPOLY)

Prof. THIAGU RANGANATHAN

AGENDA

• OLIGOPOLY

• TYPES OF OLIGOPOLY
• COURNOT
• STACKELBERG
• BERTRAND

• COMPARISON
OLIGOPOLY

 Oligopoly market structures are characterized by only a few firms

 Typical number of firms is between 2 and 10

 Products can be identical or differentiated

 An oligopoly market composed of two firms is called a duopoly

COURNOT OLIGOPOLY

 Few firms Quantity2

Firm 1’s Reaction Function

𝑄1 = 𝑟1 𝑄2
 Homogeneous or Differentiated Products

Cournot equilibrium
𝑄2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 C
 Barriers to entry Firm 2’s Reaction F
D A 𝑄2 = 𝑟2 𝑄1
B

 Each decides the output by assuming the

amount of output that will be produced by 𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦 Quantity1
the rival companies
COURNOT OLIGOPOLY

P  a  b(Q1  Q2 ) P  200  3(Q1  Q2 )

C1 (Q1 )  c1Q1 C1 (Q1 )  26Q1
C2 (Q2 )  c2Q2 C2 (Q2 )  32Q2
MR1 (Q1 , Q2 )  MC1
a  bQ2  2bQ1  c1
a  c1 1
Q1  r1 (Q2 )   Q2
2b 2
a  c2 1
Q2  r2 (Q1 )   Q1
2b 2
 COURNOT OLIGOPOLY

Quantity2
Quantity2
Monopoly
𝑟1 (Firm 1’s reaction function) point for
firm 2

𝑄2 𝑀
Firm 2’s profit increases as isoprofit
curves move toward 𝑄2 𝑀
A B C
𝑄2 1
1
𝐶 𝐶 𝑟2 (Firm 2’s reaction function)
1 2
Firm 1’s profit increases as isoprofit 2

curves move toward 𝑄1 𝑀 2

Quantity1
𝐶 𝑀
𝑄1 𝑄1 𝑄1 𝑄1 Quantity1
 Cournot Equilibrium
Quantity2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
2

𝑄2 𝑀 Cournot Equilibrium

𝑄2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡

𝐶𝑜𝑢𝑟𝑛𝑜𝑡
1

𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀 Quantity1
Effect of Decline in Firm 2’s Marginal Cost on
Cournot Equilibrium
Quantity2
𝑟1

F
𝑄2
Due to decline in
firm 2’s marginal cost

E
𝑄2 𝑟2 𝑟2

𝑄1 𝑄1 𝑄1 𝑀 Quantity1
Incentive to Collude in a Cournot
Oligopoly
Quantity2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
2
𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
2

Collusion outcome
𝑄2 𝑀

𝑄2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
We can’t legally discuss price. However,
𝐶𝑜𝑢𝑟𝑛𝑜𝑡 look at how many sugar cubes I can stack!
1
𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
1

𝑄1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛 𝑄1 𝑀 Quantity1
Incentive to Renege on Collusive
Agreements in Cournot Oligopoly
Quantity2
𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
2 1𝐶ℎ𝑒𝑎𝑡
2

𝑄2 𝑀

𝑄2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛

𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
1
𝐶ℎ𝑒𝑎𝑡
1

𝑄1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛 𝑄1 𝐶ℎ𝑒𝑎𝑡 𝑄1 𝑀 Quantity1

STACKELBERG OLIGOPOLY

 Few Firms
Quantity 2 (Follower)
𝐶𝑜𝑢𝑟𝑛𝑜𝑡
2

 Differentiated or Homogeneous Products 𝑟1

𝑆
2

 Barriers to Entry 𝑟2
𝑄2 𝑀

 A single firm (the leader) chooses an output

before all other firms choose their outputs
𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑆 1
𝑄2
 All other firms (the followers) take as given the
𝑆
output of the leader and choose outputs that 1
maximize profits given the leader’s output
𝑄1 𝑀 𝑄1 𝑆 Quantity 1 (leader)
BERTRAND OLIGOPOLY

 Few Firms  The conditions for a Bertrand oligopoly

imply that firms in this market will undercut
one another to capture the entire market
leaving the rivals with no profit. All
 Identical products at a constant marginal consumers will purchase at the low-price
cost firm

 Barriers to entry exist  This “price war” would come to an end

when the price each firm charged equaled
marginal cost

 Firms engage in price competition and

react optimally to prices charged by
competitors  In equilibrium, 𝑃1 = 𝑃2 = 𝑀𝐶.
 Socially efficient level of output

 Consumers have perfect information and

there are no transaction costs
SWEEZY OLIGOPOLY

 Few Firms
Price

 Differentiated Products Sweezy Demand MC 0

A
B
P0
MC 1

 Barriers to entry C
D2

E MR 1
D1
MR
 Each firm believes its rivals will cut
0 Q0 F
their prices in response to a price MR 2
Output

reduction but will not raise their prices

in response to a price increase
SWEEZY OLIGOPOLY

 Problem 1 Baye & Prince 120

 $60 and 10 units 100

 Which demand curve is relevant when

80
rivals will match any price change?

Price
 Which demand curve is relevant when 60
D1
rivals will not match any price change?
D2
40
 Price when Q=20?
20
 Q when price = $70?
0
 For what range in marginal cost will the 0 5 10 15 20 25 30
firm continue to charge a price of $60? Quantity
COMPARISON

𝑷 = 𝟏, 𝟎𝟎𝟎 − 𝑸𝟏 + 𝑸𝟐  BERTRAND OLIGOPOLY

𝑪𝒊 𝑸𝒊 = 𝟒𝑸𝒊
𝑃 = 𝑀𝐶, 𝑃 = 𝑅𝑠. 4
 COURNOT OLIGOPOLY R𝑠. 4 = 1,000 − 𝑄
1 𝑄 = 996
𝑄1 = 498 − 𝑄2 1 = 2 = 𝑅𝑠. 0
2
1
𝑄2 = 498 − 𝑄1
2
𝑄1 = 𝑄2 = 332
𝑃 = 𝑅𝑠. 336  COLLUSION
= 2 = 𝑅𝑠. 110,224 𝑀𝑅 = 1,000 − 2𝑄
1
1,000 − 2𝑄 = 4
 STACKELBERG OLIGOPOLY
𝑄 = 498 units
𝑃 = 1,000 − 498 = 𝑅𝑠. 502
1,000 + 4 − 2 × 4 1 = 2 = 𝑅𝑠. 124,002
𝑄𝑙𝑒𝑎𝑑𝑒𝑟 = = 498
2×1
1
𝑄𝑓𝑜𝑙𝑙𝑜𝑤𝑒𝑟 = 498 − × 498 = 249
2
The market price is: 𝑃 = 1,000 − 498 − 249 = $253
𝑙𝑒𝑎𝑑𝑒𝑟 = 𝑅𝑠. 124,002
𝑓𝑜𝑙𝑙𝑜𝑤𝑒𝑟 = 𝑅𝑠. 62,001
CONTESTABLE MARKETS

 Contestable markets involve strategic interaction among existing firms and potential
entrants into a market

 A market is contestable if:

 All producers have access to the same technology.
 Consumers respond quickly to price changes.
 Existing firms cannot respond quickly to entry by lowering price.
 There are no sunk costs.

 If these conditions hold, incumbent firms have no market power over consumers