OLIGOPOLY-II

Overview Comparison of Duopoly with Collusion & Competition in a reaction curve framework Price competition – Bertrand Model Competition vs. collusion in a game theoretic framework Kinked demand curve model Price signaling & price leadership Dominant firm model Cartels

Duopoly Example from Text Revisited Q1 30 Collusion Curve 7.5 Collusive Equilibrium For the firm, collusion is the best Outcome, followed by the Cournot Equilibrium and then the competitive equilibrium Firm 2’s Reaction Curve 15 Competitive Equilibrium (P = MC; Profit = 0) 10 Cournot Equilibrium Firm 1’s Reaction Curve Q2 30 54

Price Competition (homogenous good) – The Bertrand Model If two duopolists producing a homogenous good compete by simultaneously choosing price, the good being homogenous, consumers will buy from the lowest price seller The lower priced firm will supply the entire market and the higher priced firm will sell nothing Competitive price cutting by the firms will lead to the perfectly competitive outcome If both firms charge the same price, consumers will be indifferent between firms and each firm will supply half the market.

Criticism of Bertrand Model – Homogenous Good Case When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices (bringing us back to the Cournot model)

Price Competition – Differentiated Products Determining Prices and Output Firm 1: If P2 is fixed: 73

Bertrand Model – Heterogeneous Good Case P1 Firm 2’s Reaction Curve $4 Nash Equilibrium $6 Collusive Equilibrium Firm 1’s Reaction Curve P2 77

Competition Versus Collusion: The Prisoners’ Dilemma Assume: 85

Competition Versus Collusion: The Prisoners’ Dilemma Possible Pricing Outcomes: 86

Payoff Matrix for Pricing Game Firm 2 Charge $4 Charge $6 Charge $4 $12, $12 $20, $4 $16, $16 $4, $20 Firm 1 Charge $6 88

Competition Versus Collusion: The Prisoners’ Dilemma These two firms are playing a non- cooperative game. Each firm independently does the best it can taking its competitor into account. An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face. 89

The Prisoners’ Dilemma Scenario Two prisoners have been accused of collaborating in a crime. They are in separate jail cells and cannot communicate. Each has been asked to confess to the crime. 91

Payoff Matrix for Prisoners’ Dilemma Prisoner B Confess Don’t confess Confess -5, -5 -1, -10 -2, -2 -10, -1 Prisoner A Don’t confess 92

Implications of the Prisoners’ Dilemma for Oligipolistic Pricing In some oligopoly markets, pricing behavior in time can create a predictable pricing environment and implied collusion may occur. In other oligopoly markets, the firms are very aggressive and collusion is not possible. Firms are reluctant to change price because of the likely response of their competitors. In this case prices tend to be relatively rigid, leading to a kinked-demand curve model 99

The Kinked Demand Curve Model $/Q MC MC’ So long as marginal cost is in the vertical region of the marginal revenue curve, price and output will remain constant. Price rise matched Price rise unmatched D P* Q* Price cut unmatched Price cut matched Quantity MR 109

Price Signaling and Price Leadership Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit Price Leadership Pattern of pricing in which one firm regularly announces price changes that other firms then match 110

The Dominant Firm Model In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market. The large firm might then act as the dominant firm, setting a price that maximized its own profits. 110

Price Setting by a Dominant Firm MCD MRD SF The dominant firm’s demand curve is the difference between market demand (D) and the supply of the fringe firms (SF). Price D DD At this price, fringe firms sell QF, so that total sales are QT. P1 QF QT P2 QD P* Quantity 115

Cartels Characteristics Explicit agreements to set output and price May not include all firms Most often international Conditions for success Competitive alternative sufficiently deters cheating Potential of monopoly power--inelastic demand Either the cartel must control nearly all of the world’s supply or the supply of non-cartel producers must not be price elastic 116

The OPEC Oil Cartel Price P* QOPEC TD SC MCOPEC MROPEC DOPEC Quantity TD is the total world demand curve for oil, and SC is the competitive supply. OPEC’s demand is the difference between the two. Price MROPEC DOPEC QOPEC P* OPEC’s profits maximizing quantity is found at the intersection of its MR and MC curves. At this quantity OPEC charges price P*. Quantity 124

Cartels About OPEC Very low MC TD is inelastic Non-OPEC supply is inelastic DOPEC is relatively inelastic 125

The CIPEC Copper Cartel QCIPEC P* PC QC QT TD and SC are relatively elastic DCIPEC is elastic CIPEC has little monopoly power P* is closer to PC Price MRCIPEC TD DCIPEC SC MCCIPEC Quantity 130