Oligopoly Managerial Economics Kyle Anderson Kelley School of Business – Indiana University

What makes oligopoly different? Profit max is still MR=MC. Competitors (optimally) respond to a firm’s actions. This response will affect demand and MR. Anticipate rivals’ actions in making decisions. $ Lower price? MC D D* Kelley School of Business Q MR* MR

Cournot oligopoly Few firms serving many customers. Firms produce either differentiated or identical products. Firms compete on the basis of output, the market determines price. Barriers to entry exist. Kelley School of Business

Cournot oligopoly Firms choose output first. The supply curve is the sum of all firms’ output. Then, based on supply and the level of demand, price is determined. Firms want to choose the profit maximizing output. Cournot oligopoly SLow SHigh $ P* P D Kelley School of Business Q Q* Q

Cournot oligopoly Market demand in a Cournot duopoly is: Thus, each firm’s marginal revenue depends on the output produced by the other firm. More formally, Kelley School of Business

Cournot marginal revenue P = a – bQ  Market Demand, Q=q1+q2 P = a – b(q1+q2) TR1 = q1*P = q1*(a - bq1 - bq2) TR1 = aq1 – bq12 – bq1q2 MR1 = a – 2bq1 – bq2 Kelley School of Business

Solving for Cournot (Example) Suppose there are two furniture mfrs. in a country (and no imports). Market (inverse) demand for couches is P = 2000 – .5Q. Both firms produce at a cost C(Q) = 300,000 + 500Q. What are industry output, firm output, price, and profits? Firm 2 produces 0? Firm 2 produces 3000? Kelley School of Business

Cournot reaction function Q1 1500 Firm 1’s Reaction Function Q2 Kelley School of Business 3000

Solving for Cournot Now we examine firm 2: Kelley School of Business

Cournot reaction function Q1 Firm 2’s Reaction Function 3000 1500 Firm 1’s Reaction Function Q2 Kelley School of Business 1500 3000

Cournot equilibrium Q1 = 1000, Q2 = 1000, Q=2000 P=2000 - .5Q, P = $1000 Firm π = 1000(1000) – (300000 + 500(1000)) = $200,000 Kelley School of Business

Cournot vs. Monopoly Cournot Monopoly Total output 2,000 Price $1000 Profits $200,000 Total output 1,500 Price $1250 Profits $825,000 Collusion Collusion Total output 1,500 – firm 750 Price $1250 Profits $262,500 Collusion is illegal in U.S. Q1 = 1500 – ½ Q2 Cheating is hard to detect. Kelley School of Business

Cournot Model Variations More than two firms: One firm moves first: Stackelberg model Assumes one firm can commit first. The first firm chooses a larger output and earns higher profits. Second firm smaller output. Overall output is higher than Cournot. First mover advantage Each firm’s output is smaller. Overall output is higher. Price is lower. From the consumer point of view – the more firms the better. Kelley School of Business

Bertrand Oligopoly Few firms serving many customers Firms compete on the basis of price Barriers to entry exist Identical products, constant MC Perfect information, no transaction costs Kelley School of Business

Undercutting continues until: Bertrand Competition Two firms, 10 customers, each wanting 1000 brake pads. Both firms can produce a large supply at a constant MC = $20. What price should a firm charge? $30 $28 $26 $25 Undercutting continues until: P = Marginal Cost $24 $21 Bertrand Trap $20.10 $20.09 $20 Kelley School of Business

Managing out of the Bertrand Trap? Mr. Crandall: I think it’s dumb as hell for Christ’s sake, all right, to sit here and pound the -------- out of each other and neither one of us making a --------- dime. Mr. Putnam: Do you have a suggestion for me? Mr. Crandall: Yes, I have a suggestion for you. Raise your goddamn fares 20 percent. I’ll raise mine the next morning. Mr. Putnam: Robert, we... Mr. Crandall: You’ll make more money and I will, too. Mr. Putnam: We can’t talk about pricing! Mr. Crandall: Oh --------, Howard. We can talk about any goddamn thing we want to talk about. Robert Crandall – Pres. American Airlines Howard Putnam – CEO Braniff February 21, 1982 Kelley School of Business

Managing out of the Bertrand Trap Few firms serving many customers Firms compete on the basis of price Barriers to entry exist Identical products, constant MC Perfect information, no transaction costs Product differentiation Collusion – explicit vs. tacit Uninformed consumers Transaction costs Kelley School of Business

Product Differentiation Bruce Hall: Beer Vendor Pittsburgh Steelers and Pirates Age: 41 Pay: $175 to $300 per Steelers game; $50 to $150 at Pirates games. He works on commission. “The Miller Lite guys might sell a little more than me, but I can usually hang with them. Bud Light does pretty well for football. Twenty-some years ago, nobody cared about the brand. It was always just ‘Beer here. Beer here.’ Now people want their Miller Lite, their Bud Light, their Yuengling.” Kelley School of Business

Loyal Customers MC=$20, Max price=$30 What price do you charge? Loyal to You Shoppers Loyal to me MC=$20, Max price=$30 What price do you charge? Note that you can always earn $10, by charging $30. Always price between $21.11 and $30. ($10/9=$1.11) Price above marginal cost! Kelley School of Business

The higher the proportion of loyal customers, the higher the prices! Loyal to You Shoppers Loyal to me MC=$20, Max price=$30 What price do you charge? Now you can always earn $40, by charging $30. Always price between $26.67 and $30. ($40/6 = $6.67) The higher the proportion of loyal customers, the higher the prices! Kelley School of Business

Uninformed consumers Consumers lack perfect information on prices. Information is costly, so not getting information can be rational. As a result, firms that charge higher prices still make sales. Kelley School of Business Source: Indianagasprices.com

Price Matching Guarantees Price matching is not always a good thing for consumers. Little incentive for firms to lower price. May lead to tacit collusion. Kelley School of Business

Transactions costs: Example: distance between competitors. Switching costs are a form of transaction cost that allows firms to charge prices above MC. Kelley School of Business

Bertrand Lessons Pure Bertrand rarely, if ever exists. Evaluating markets: Identical products Constant marginal cost Perfect information No transaction costs Pricing close to MC Kelley School of Business

Oligopoly Different models make different predictions. Firms make decisions based on the anticipation of what their rivals’ will do. Game theory – strategic interaction between players. Kelley School of Business