Chapter 13
Oligopoly
1
Objectives


Explain how managers of firms that operate
in an oligopoly market can use strategic
decision-making to maintain relatively high
profits
f
Understand how the reactions of market
rivals
l influence
fl
the
h effectiveness
ff
off d
decisions
in an oligopoly market
2
4. Oligopoly




A market with a small number of firms (usually big)
Oligopolists “know” each other
Characterized by interdependence and the need for
managers to explicitly consider the reactions of rivals
Protected by barriers to entry that result from
government fiat, economies of scale, or control of
strategically important resources
3
Strategic interaction



Actions of one firm will trigger re-actions of others
Oligopolist must take these possible re-actions into
account before deciding on an action
Therefore, no single, unified model of oligopoly exists




Cartel
Price leadership
Bertrand competition
C
Cournot
t competition
titi
4
Stages
g of evolution
5
Market introduction and growth

New technology
technology, high uncertainty
uncertainty, innovators
profit





Product is new,, no close substitutes
Learning curve is steep
Temporal
p
monopoly
p y in the market possible
p
But high set-up costs
What market is most receptive of the
product?
d

Strategic decisions about market introduction
6
Maturity and decline





No more growth of the market
Product gets more homogeneous
Price (and service) get more important
Price competition
p
(oligopoly)
( g p y)
Overcapacity
O
it ==> major
j ingredient
i
di t for
f
price wars
7
Cartels

The small number of firms in an oligopoly
market tends to encourage cooperative
behavior (collusion).



Increase profits
Decrease uncertainty
Raise barriers to entry
8
Cartels

Adam Smith (1776):


people of the same trade seldom meet together, even for
merriment and diversion, but the conversation ends in a
conspiracy
p
y against
g
the public,
p
, or in some contrivance to raise
prices
Incentive to collude:


recall the newspaper industry in Detroit
Change in profits: each lost about 10 Mill. a year, afterwards
profits were high as 150 Mill.
9
Cooperative behavior

Cartel: A collusive arrangement made openly and
formally



Cartels, and collusion in general, are illegal in the US and EU.
Cartels maximize profit by restricting the output of member firms
to a level that the marginal cost of production of every firm in
the cartel is equal to the market's marginal revenue and then
charging the market-clearing
market clearing price
price.
The need to allocate output among member firms results in an
incentive for the firms to cheat by overproducing and thereby
increase profit
10
Cartel: A collusive agreement
made openly and formally
11
Cartel



Cartels act like multiplant monopolies.
Profit of cartel is maximized if marginal costs among members
of cartel are equalized
W ld mean that
Would
th t high-cost
hi h
t firms
fi
produce
d
less
l



firms may still agree on equal quotas
use of side payments
Examples



Lysine (The informant!), DRAM industry, US school milk markets,
elevators, Lombard club
OPEC, Coffee cartel
Worker unions, Firm associations
12
Cartel as a multi-plant monopoly
PRICE
MC1
MC2
D
MC
Supply
D
MR
Q1
FIRM 1
Q2
TOTAL OUTPUT
FIRM 2
13
Cartel

Instability of cartel: incentive for members to cheat


If a firm deviates it gets the total market at least for one
period


Break down of the cartel
Deviator


I
Incentive
i biggest
bi
for
f small
ll members
b
compares profits from one-time deviating + profits from
competition further after with profits from collusion
Decision whether to deviate
14
Instability of Cartel:
demand curve gets much flatter (D‘)
(D )
We started at Price P0
15
Problem 1
The Bergen Company and the Gutenberg Company are the only two firms that
produce and sell a particular kind of machinery. The demand curve for their
product
d t iis
P = 580 – 3Q
where P is the price of the products, and Q is the total amount demanded.
The total cost function of the Bergen Company is
TCB = 410 QB.
The total cost function of the Gutenberg Company is
TCG = 460 QG.
a) If these two firms collude, and if they want to maximize their combined profits,
how much will the Bergen Company produce?
b) How much will the Gutenberg Company produce?
16
Solution Problem 1
a) Bergen’s marginal cost is always less than Gutenberg’s marginal cost.
Therefore Bergen
g would produce
p
all the combination’s output.
p
Setting
g
Bergen’s marginal cost equal to the marginal revenue derived from the
demand function, we get:
410 = 580 – 6Q => QB = 28.33 and QG = 0.
b) If Gutenberg were to produce one unit and Bergen one unit less, it
would reduce their combined profits by the difference in their marginal
costs.
t
If direct payments of output restrictions between the firms were legal,
G tenbe g would
Gutenberg
o ld a
accept
ept a zero
eoo
output
tp t q
quota.
ota B
Butt if competition
ompetition were
e e to
break out, Gutenberg would make zero profits and Bergen would earn
$2,000. Thus the most Bergen would pay for Gutenberg’s cooperation is
$408.33 and the least Gutenberg would accept to not produce is $0.01.
17
Price Leadership by a dominant firm



In oligopolistic industries,
industries managers at one firm may
have significant market power and can set their price.
Industry is composed of a large
large, dominant firm and
many small firms, big firm has cost-advantage
Big firm can behave as a monopolist, small firms make
no super-normal profits
18
Assumptions





One firm sets price and others follow
There is a single firm, the price leader, that sets price in the market.
There are also follower firms who behave as price takers, producing
a quantity at which marginal cost is equal to price. Their supply
curve is the horizontal summation of their marginal cost curves
curves.
The price leader faces a residual demand curve that is the
horizontal difference between the market demand curve and the
followers' supply curve.
The price leader produces a quantity at which the residual marginal
revenue is equal to marginal cost.
cost Price is then set to clear the
market.
19
20
Examples

Example 1: Price cuts for breakfast



In April 1996,
1996 the Kraft Food Division of Philip Morris cut prices on
its Post and Nabisco brands of breakfast cereal by 20 percent as
demand stagnated
Market shares: PM 16  20,
20 Kellog: 36  32
Example 2: Cranberries



Market is dominated by a giant growers
growers’ cooperative
Ocean Spray has 66 percent market share and sets prices each
year in fall based on anticipated and actual supply and demand
conditions
Based on this price other firms decide on how much they wish to
harvest for sale, for inventory, but for use in other products or
leave in the bogs
21
How can a few firms compete
p
against each other?

Many different models

Some simplifying assumptions:





Identical product
2 firms (can easily be extended to more)
Same (constant) cost functions
K
Know
the
th (linear)
(li
) demand
d
d function
f
ti
Firms act simultaneously
22
Price (= Bertrand) Competition








Total costs:
Market demand:
M C
i
T C i  5 0 0  4 q i  0 .5 q i2
P  100  q  100  qA  qB
 4  qi
WTP for first unit = 99, MC = 5
If firm A would set price at 98, firm B would set price to 97 …
If firms compete over prices, they would go down to marginal costs
P=
Q=
23
Example: Collusion (cartel)

Calculate price, quantity and profit for a
collusion in this example

Add up marginal costs horizontally
Q  q A  qB  4  MC A  4  MCB  8  2 MC

MC  4 
Q
2
24
Cournot-Nash Duopoly



Quantity (capacity) competition
Taking the other‘s output as given, what
output is optimal for firm X?
Series of “What if?” questions necessary


for each potential output of the rival you must
have a p
potential answer
Actual decision taken by assuming what rival
will actually do
25
26
27
28
Finding the reaction curves



Reaction curve: given the output of X,
what output of Y is optimal?
Of course, whatever Y does, will produce
further reactions, i.e. X is not constant in
general.
Equilibrium only when both firms „sit“ on
their reaction curves: no surprises and no
incentive to alter the behavior
29
Cournot-Nash Duopoly


Firms are competing in quantities
A
Assume
that
th t fi
firms are symmetric:
ti


MC(A) = 4 + q(A)
MC(B) = 4 + q(B)

Industry demand: Q = 100 – P

Calculate reaction curves and optimal outputs and prices
30
Cournot-Nash Duopoly
P = 100 – Q = 100 – (q(A) + q(B))




TR(A) = P x q(A) = (100 – q(A) – q(B)) x q(A)
MR(A) = 100 – 2q(A) – q(B) = 4 + q(A) = MC(A)
96 – q(B) = 3 q(A)
q(A) = 32 – 1/3 q(B) reaction curve of firm A
 q(B) = 32 – 1/3 q(A) reaction curve of firm B
31
Cournot-Nash Duopoly






IIntersection:
t
ti
optimal
ti l output
t t ffor b
both
th fi
firms
q(A) = 32 – 1/3 (32 – 1/3 q(A))
q(A) = 32 – 1/3 32 + 1/9 q(A)
q(A) = 24
q(B) = 24
Q = 48 and P = 100 – 48 = 52
32
Example: comparison
2 firms
fi
that
th t maximize
i i their
th i profits
fit π(i),
(i) i=A,B
i AB





Bertrand: p = 4, Q = 96 and π(i) = 0
Cournot: calculate reaction functions



MR(A) = 100 – 2q(A) – q(B) = 4 = MC(A)
q(A) = q(B) = 32, Q = 64, P = 36 and π(i) = (36 - 4)32 = 1024
M
Monopoly:
l MR = MC


marginal cost are constant: MC(i) = 4 and
Demand is linear: P = 100 – Q
Q = 48, P = 52 and π(i) = (52 - 4)48 = 2304
Cartel: firms divide profits  π(i) = 1152
33
Problem 2
The International Air Transport Association (IATA) has
been composed of 108 U
U.S.
S and European airlines that
fly transatlantic routes. For many years, IATA acted as
a cartel: it fixed and enforced uniform prices.
a) If IATA wanted to maximize the total profit of all
member
b airlines,
i li
what
h t uniform
if
price
i would
ld it charge?
h
?
b) How would the total amount of traffic be allocated
among the member airlines?
c) Would IATA set price equal to marginal cost? Why or
whyy not?
34
Solution Problem 2
a) The IATA would charge the price that clears the
market at the level of output where marginal revenue
equals the horizontally summed marginal cost curves
of each operator in the market.
b) The traffic should be allocated so that the marginal
costs of all the members operating in the market
would
ld be
b equall and
d that
th t no member
b nott currently
tl in
i
the market would have a lower marginal cost.
c) No, the IATA would set a price equal to marginal cost
multiplied by 1/(1+1/e) where e is the elasticity of
question.
demand in the market in q
35
Problem 3
In Britain price competition among bookshops has been suppressed
for over 90 years by the Net Book Agreement (of 1900), which was
aimed at the prevention of price wars
wars. However
However, in October 1991
1991,
Waterstone and Company began cutting book prices at its 85 British
shops. According to Richard Barker, Waterstone’s operations director,
the decision to reduce the price of about 40 titles by about 25% was
d to price cuts by
due
b Dillons,
ll
Waterstone’s
’ principall rival.
l
a) According to the president of Britain’s Publishers Association, the
price-cutting
i
i was “an
“ enormous pity”
i ” that
h will
ill “damage
“d
many
booksellers who operate on very slim margins. Does this mean that
price-cutting of this sort is contrary to the public interest?
b) Why would Dillons want to cut price? Under what circumstances
would this be a good strategy? Under what circumstances would it be
a mistake?
36
Solution Problem 3
a) No. A price war, although always “an enormous pity”
for producers,
producers usually is very good news for
consumers.
b) If demand is elastic at high prices, and if Dillons has
a comparative advantage with respect to its rivals at
high volumes,
volumes it may prefer a low competitive price
to a high collusive one. If demand is inelastic, of if
Dillons does not have a comparative advantage over
it rivals
its
i l att high
hi h volumes,
l
it may be
b a mistake
i t k to
t cutt
prices.
37
Product Differentiation in
Monopolistic Competition and
Oligopoly
Product Differentiation

Vertical differentiation: quality


Horizontal differentiation: design,
g ,
location,…



consumers have uniform preferences
consumers have different preferences
by differentiation product gets unique
small monopoly can be constructed
39
Hotelling Model



consumers (and shops) located along a
line (Linz - Landstrasse)
consumers would like to shop at the
nearest shops (transport is costly)
linear model:


here location
differentiation can often be analyzed using line
segments
40
Linear Model,, prices
p
are the
same
L
R
These customers buy from L
Firm L
These customers buy from R
Firm R
41
Setting Prices I





cost of moving from L to R is c
suppose a customer sits at a point that is
the fraction x of the way from L to R
pL, pR
customer pays: pL  xc if shopping at L
pR  ((1  x )c if shopping
pp g at R
and shops wherever cheaper
42
Setting Prices II

Marginal customer x* who is indifferent
pL  x * c  p R  (1  x*)c =>
1
pR  pL
x* 

2
2c



if pR = pL ... marginal customer in the middle
if pR > pL ... L has more customers
if c is small => small price change results in big
sales gains, product hardly differentiated
43
Setting Prices III


disregard production costs
1 p  pL
L maximizes pLx* (revenue): pL (  R
)  Max
pL
2
2c
1
*
p L  ( c  pR )
2



if transport cost (differentiation) increases => pL 
if pR increases => pL 
similarly for firm R:


R
1
 ( c  pL )
2
Only partial response to price increase of competition
=> p L  p R  c
profits increase the higher differentiation is
*

p
*
*
44
Choice of location I

simplify: hold prices constant
L
R

by moving right
right, market share increases

both firms will locate in center

analogy to political parties
45
Choice of location II

if prices are flexible, it pays to be distant

by moving away prices can rise for L



as a reaction competitor R will raise prices as well
is beneficial for firm L
t d ff more diff
trade-off:
differentiation
ti ti means

being close to customers is also close to
competitors
46