MicroEconomics Oligopoly Presented by Students:João Pita Francisco Vilhena da Cunha Bruno Pereira...

MicroEconomics

Oligopoly

Presented by Students: João PitaFrancisco Vilhena da Cunha

Bruno PereiraJorge Oliveira

Master in Engineering Policy and Management of Technology

Oligopoly

The regimen of oligopoly is characterized by a restricted number of agents on the offer side and a large number on the demand side.

The agents of the offer are in such number that their market share allows each one of them to affect the formation of prices and from there affect other competitors.


Oligopoly

This is, realistically, the regimen most current in the not controlled economies.

Easiness of communicationsInformationTransports

Technological competition

Selection of the most capable firms

Automobile Market, Energy, Microprocessors, Photograph, etc


Types of Oligopoly

- Cooperative OligopolyImplicit and explicit agreements about prices, amounts and types of product.Eventual barriers to the entrance of other companies in the market

- Concorrencial oligopolyWhen the companies compete between themself, having or not in consideration the reaction of the other companies in the market.

- With indifferentiated productsWith identical prices and equally available techniques of production for all the companies of the oligopoly - pure oligopoly

- With differentiated products

- When the companies differentiate its products, in order to create a search that specifically is directed them


Cournot Model

Developed by Antoine Augustin Cournot in 1838

In a two firm oligopoly (called a duopoly), if both firms set their output levels assuming that the other firm’s strategic choice variable (quantities in Cournot competition) is fixed, the equilibrium outcome is a Cournot-Nash Non-cooperative Equilibrium.

• Static Game: Players act simultaneously

• Strategies: Any Price between 0 and infinity denoted p1 and p2


Cournot Model

Description:

Firm 1 excepts that firm 2 production will be y2e units of output,

Then decides to produce y1,

The total production will be

Y= y1+y2e

and market price p(Y) = p( y1 + y2

e )


Properties of the Cournot-Nash Equilibrium for Duopoly

When the duopolists compete in quantities, we can compare the outcome to both the monopoly and competitive outcomes.

Each duopolist produces less than a monopolist in the same market but together they produce more than the monopolist and less than the amount two competitive firms would have produced with the same cost structure and demand curves.

The sum of the economic profits of each duopolist is less than the economic profits of a monopoly in the same market.


Cournot Model: Water’s Reaction Curve

Firm 2q2

(litres)

Firm 1q1

(litres)

20

120

60

120

6030 50

Water´s reaction curve


Cournot Model

Firm 2q2

(litres)

Firm 1q1

(litres)

120

60

120

40

6040

reaction curve

reaction curve


Cournot Model

Firm 2q2

(litres)

Firm 1q1

(litres)

120

60

120

40

6040

reaction curve

reaction curve

CournotEquilibrium


Properties of the Cournot-Nash Equilibrium for Duopoly

The profit-maximization problem

The optimal choice of firm 1 is y1 = f1(y2e )

This reaction function gives one firm’s optimal choice as a function of its beliefs about the other firm’s choice.

For arbitrary values of y1e and y2

e this won't happen - in general firm 1´s optimal level of output, y1, will be different from what firm 2 expects the output to be, y1

e.


Bertrand-Nash equilibrium Static Game: Players act simultaneously

Strategies: Any Price between 0 and infinity denoted p1 and p2

The Bertand equilibrium is a price level for each firm such that the firm´s profits are maximized given the price level of the other firm.

Assuming that firms are selling identical products Bertrand equilibrium is the competitive equilibrium, where price equals marginal costs.

• Consider that both firms are selling output at some price > marginal cost.

• Cutting its price by an arbitrarily small amount firm 1 can steal all of the customers from firm 2.

Firm 2 can think the same way!

Any price higher than marginal cost cannot be an equilibrium

The only equilibrium is the competitive equilibrium


Bertrand-Nash equilibriumGraphical demonstration of Why P1=P2> MC is not a Nash Equilibrium


Sequential Models

Companies act sequentially, as opposed to simultaneously (Cournot and Bertrand models)

Competitors decisions are taken into account

Dominant player or Leader (first mover) and Follower – anticipation strategy from the Leader

Perfect information: Follower has complete information on Leader’s actions – Competitive Intelligence

Examples: IBM, Microsoft


Stackelberg Model Heinrich Freiherr von Stackelberg

1905 (Germany) – 1946 (Spain) Theory of competition

Model Duopoly where both firms have market power with

undifferentiated products First model to assume asymmetries between companies Cournot-like competition on quantity/output followed by

Bertrand-like competition on price 1st mover’s decision remains constant and follower

decides based on that (otherwise it’s a Cournot model)


Sequential Models - Stackelberg

Firm 1 (leader) decides on quantity to produce (y1), assuming that Firm 2 (follower) will react to maximise its profits, producing y2:

Total output: Y = y1 + y2 = f(y1) Equilibrium price P is a function of total output, Y

What will be the quantity produced by Firm 1 (Leader)?Look forward and reason back

Firm 1 knows that: It has influence over Firms2’s output and Firm 2 will react in order to maximise its profit

Leading to…



Follower's profit-maximization problem Firm 2 will choose y2 in order to maximise its

profit, 2

2 = P(y1+y2)(y2) - w2(y2), where w2 is Firm 2’s unit costs

To Firm 2 and considering profit maximization:• y1=constant and it will have to define y2 from:

• MR(y1,y2*)=MC(y2) y2

* = f2(y1)

y2* = f2(y1): Firm 2 reaction function

• y2* is a function of Firm 1’s decision



Follower's profit-maximization problem

y’1

Reaction Curve f2(y1)

Isoprofit lines – Firm 2

y2 = f2(y’1)

y2

2 max

(Monopolist)


y1

+

-


Leader’s Problem

Assuming Firm 2’s reaction to its output, Firm 1 now aims at maximizing it profit:

1 = P[y1+f(y1)](y1) - w1(y1), since y2 = f(y1)

Leader knows that his actions influence the output choice of the follower,



Isoprofit lines – Firm 1

Stackelberg model - EquilibriumMathematical deduction: http://josemata.org/ee/17/stackelberg2/

y*1

Reaction Curve Firm 2 f2(y1)

y*2

y2


y1

+

-


Reaction Curve Firm 1

Cournot Equilibrium

Stackelberg Equilibrium

Stackelberg model compared



PriceBertrand < Stackelberg < Cournot

Competitive < Stackelberg < Monopoly

Total OutputMonopoly < Stackelberg < Competitive

Cournot < Stackelberg < Bertrand

Consumer Surplus Cournot < Stackelberg < Bertrand

Identifying the leader Stackelberg model based on Cournot with an

anticipation strategy from one of the companies on setting its output

The model doesn’t explain what is the asymmetry neither in what it is based on

There can be several reasons, e.g.: Company already in the market and new entrant

• 1st can decide on the installed capacity• If installed capacity irreversible, 2nd can assume capacity of the

1st as an input for decision Depending on fixed costs, 2nd may not be able to enter

the market (monopoly) If seond enters the market Stackelberg model



Collusion Model

When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion.

• Explicit collusion occurs when firms ostensibly agree to maintain their joint-profit-maximizing output. Cartels -- such as DeBeers and OPEC -- are obvious examples.

•Tacit collusion occurs when firms act without explicit agreement to achieve the cooperative outcome. Can take the form of a verbal ‘gentleman’s agreement’ to fix prices and output.

Types of Cooperative Behaviour


Factors that affect the ability to collude:

Number and size distribution of sellers Similar easier to collude

Product heterogeneity Homogeneous easier to collude

Cost structures Similar easier to collude

Size and frequency of orders Frequent smaller easier to collude

Secrecy and retaliation Less secrecy, easier retaliation easier to collude

Social structure of the industry Social interaction easier to collude


Tacit CollusionPrice Leader (Barometric Firm)

Largest, dominant, or lowest cost firm in the industry

Demand curve is defined as the market demand curve less supply by the followers

Followers Take market price as given and behave as

perfect competitors


Price Leadership


Oligopoly isn’t a problem unless it becomes a Cartel

Cartel – a formal or informal agreement among firms in an oligopolistic industry

Cartel members may agree on such issues as prices, total industry output, market shares, and division of profits

Cartels or collusive agreements are illegal in most cases.


Cartels

OPECColombian Drug CartelMafia or Crime SyndicateIvy League SchoolsGovernment enforced cartels: market

intervention to raise prices!


Cartel as a Monopolist D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel).

Cartel profits are maximized when the industry produces quantity Q and charges price p.


Some illegal Cartels get caught:

Electrical equipment manufacturers in the 1950s

Pharmaceutical companies more recently

Some don’t…


Cheating

Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement

By offering a price slightly below the established price, a firm can usually increase its sales and economic profit

Because oligopolists usually operate with excess capacity, some cheat on the established price


How can either of the firms be sure that the other firm isn’t cheating on their agreement, and selling the product for lower price?

“BEAT ANY PRICE”

One way is to offer to beat any price a costumer can find. That way, the costumer report any attempt to cheat on the collusive arrangement


OPEC Illustrates Cartel Difficulties

Incentive to CheatCheating increases individual profitsCheating decreases cartel profits

Different Members Have Different GoalsHigh prices encourage substitutes

Supply expansion by non-membersDevelopment of alternative products

More important to some members than to others


OPEC and CIPEC OPEC is the Organization of Petroleum Exporting Countries CIPEC is the French acronym for Int’l Council of Copper Exporting Countries Why has OPEC been successful in raising its price, but CIPEC has not? OPEC as a dominant firm

PriceMCnon-opec

P1

P2

Popec

Qc+c

Pcomp

Output

DmktMRopec

MCopec

QopecQfringeQtotal

Oil Market


OPEC and CIPEC CIPEC (Chile, Peru, Zambia, Zaire) MCCIPEC is not much less than MCnon-cipec

Why has OPEC been successful in raising its price, but CIPEC has not?

CIPEC as a dominant firm

Output

Price

Dmkt

MCnon-cipec

P1

P2

MRopec

MCcipec

Qcipec

Pcipec

Qfringe

Qtotal

Qc+c

Pcomp

Why can’t CIPEC increase

copper prices much? D for copper is more elastic

(aluminum is a good substitute) Comp’ve supply more elastic than for

oil (if P rises, simply go to scrap heap) Successful cartel needs relatively inelastic

D.

Copper Market


Obstacles to Collusion

Demand and cost differences between firms.Higher numbers of firms, particularly if a

number of firms outside collusive agreement.Incentives to cheat.Recession.Legislative obstacles: Trade Practices Law.


COMPARISON OF THE SOLUTIONS

OLIGOPOLY MODELS

Stackelberg(Quantity-

leader)

One firm leads by setting its output, and the other firm follows. When the leader chooses an output, it will take into account how the follower will respond

Cournot(Price-leader)

One firm sets its price and the firm chooses how much it wants to supply at that price. Again the leader has to take into account the behavior of the follower when it takes its decision

Bertrand(Simultaneous price setting)

Each firm chooses its prices given its beliefs about the price that the other firm will choose. The only equilibrium price is the competitive equilibrium

Collusion(Cartel)

A number of firms colluding to restrict output and to maximize industry profit. A cartel will typically be unstable in the sense that each firm will be tempted to sell more than its agreed upon output if it believes that the other firms will not respond


Sweezy Model- It tries to explain the rigidity

of the price, many times observed in oligopolistc markets;

- If a companie increases its price, the other companies will not, making the first one to lose its customers;

- On the other hand, if a company lower the prices, the other companies also will lower the price, for that it will not have advantage to do that.

P

Q

D

mC

mC’

mR


Conclusions - Balance in the Long Run

Profits, equilibrium or damage

In the long run, the oligopolist will leave the industry if has no profits.

It prepares its company to present the very best level of production in the long run.

If it will have some profits, other companies will try to enter in the sector, if the entrance will not be restricted.

Competition based on strategy, quality, product project, advertisement, services, innovation


Bibliography

Lipsey & Chrystal

Mata, José, “Economia da empresa”, Fund. Calouste Gulbenkian, Lisboa, 2nd edition, 2002

Mata, José in http://josemata.org/ee, 2006

Pindyck, Robert S., Rubinfield, Daniel L., “Microeconomics”, 5th edition, ch. 12, pgs. 429 to 451

Samuelson

Salvatore, Dominick, “Microeconomy”, Schaum, MacGraw-Hill, 1984

Sousa, Alfredo de, “Análise Económica”, Universidade Nova de Lisboa, Faculdade de Economia, 1988

“The Home of Economics on the Internet” in www.tutor2u.net, 2006

Varian, Hal R., “Intermediate Microeconomics”, 6th edition, ch. 26, pgs. 459 to 479


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