Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter 9 Basic Oligopoly Models

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Overview I. Conditions for Oligopoly? II. Role of Strategic Interdependence III. Profit Maximization in Four Oligopoly Settings n Sweezy (Kinked-Demand) Model n Cournot Model n Stackelberg Model n Bertrand Model IV. Contestable Markets

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Oligopoly Relatively few firms, usually less than 10. n Duopoly - two firms n Triopoly - three firms The products firms offer can be either differentiated or homogeneous.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Role of Strategic Interaction What you do affects the profits of your rivals What your rival does affects your profits

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 An Example You and another firm sell differentiated products How does the quantity demanded for your product change when you change your price?

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 P Q D1D1 P0P0 Q0Q0 PLPL D 2 (Rival matches your price change) PHPH (Rival holds its price constant)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 P Q D1D1 P0P0 Q0Q0 D 2 (Rival matches your price change) (Rival holds its price constant) D Demand if Rivals Match Price Reductions but not Price Increases

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Key Insight The effect of a price reduction on the quantity demanded of your product depends upon whether your rivals respond by cutting their prices too! The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too! Strategic interdependence: You aren’t in complete control of your own destiny!

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Sweezy (Kinked-Demand) Model Few firms in the market n Each producing differentiated products. Barriers to entry Each firm believes rivals will match (or follow) price reductions, but won’t match (or follow) price increases. Key feature of Sweezy Model n Price-Rigidity

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Sweezy Marginal Revenue P Q D1D1 P0P0 Q0Q0 D 2 (Rival matches your price change) (Rival holds its price constant) MR 1 MR 2 D MR

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Sweezy Profit-Maximization P Q P0P0 Q0Q0 D MR MC MC H MC L

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Cournot Model A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect substitutes (differentiated) Firms set output, as opposed to price Each firm believes their rivals will hold output constant if it changes its own output (The output of rivals is viewed as given or “fixed”) Barriers to entry exist

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Reaction Functions Suppose two firms produce homogeneous products. Firm 1’s reaction (or best-response) function is a schedule summarizing the amount of Q 1 firm 1 should produce in order to maximize its profits for each quantity of Q 2 produced by firm 2. Since the products are substitutes, an increase in firm 2’s output leads to a decrease in the profit- maximizing amount of firm 1’s product.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Graphically Q2Q2 Q1Q1 (Firm 1’s Reaction Function) Q1MQ1M Q2*Q2* Q1*Q1* r1r1

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Cournot Equilibrium Situation where each firm produces the output that maximizes its profits, given the the output of rival firms No firm can gain by unilaterally changing its own output

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Cournot Equilibrium Q2*Q2* Q1*Q1* Q2Q2 Q1Q1 Q1MQ1M r1r1 r2r2 Q2MQ2M

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Summary of Cournot Equilibrium The output Q 1 * maximizes firm 1’s profits, given that firm 2 produces Q 2 * The output Q 2 * maximizes firm 2’s profits, given that firm 1 produces Q 1 * Neither firm has an incentive to change its output, given the output of the rival Beliefs are consistent: n In equilibrium, each firm “thinks” rivals will stick to their current output -- and they do!

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Firm 1’s Isoprofit Curve The combinations of outputs of the two firms that yield firm 1 the same level of profit Q1Q1 Q1MQ1M r1r1 A BC  1 = $100  1 = $200 Increasing Profits for Firm 1 D Q2Q2

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Another Look at Cournot Decisions: Q2Q2 Q1Q1 Q1MQ1M r1r1 Q2*Q2* Q1*Q1* Firm 1’s best response to Q 2 *  1 = $100  1 = $200

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Another Look at Cournot Equilibrium Q2Q2 Q1Q1 Q1MQ1M r1r1 Q2*Q2* Q1*Q1* Firm 1’s Profits Firm 2’s Profits r2r2 Q2MQ2M Cournot Equilibrium

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Stackelberg Model Few firms n Producing differentiated or homogeneous products Barriers to entry Firm one is the leader n The leader commits to an output before all other firms Remaining firms are followers. n They choose their outputs so as to maximize profits, given the leader’s output.

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Stackelberg Equilibrium Q1Q1 Q1MQ1M r1r1 Q2*Q2* Q1*Q1* r2r2 Q2Q2 Q1SQ1S Q2SQ2S Follower’s Profits Decline Leader’s Profits Rise Stackelberg Equilibrium

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Stackelberg Summary Stackelberg model illustrates how commitment can enhance profits in strategic environments Leader produces more than the Cournot equilibrium output n Larger market share, higher profits n First-mover advantage Follower produces less than the Cournot equilibrium output n Smaller market share, lower profits

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Bertrand Model Few firms n Firms produce identical products at constant marginal cost. n Each firm independently sets its price in order to maximize profits Barriers to entry Consumers enjoy n Perfect information n Zero transaction costs

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Bertrand Equilibrium Firms set P 1 = P 2 = MC! Why? Suppose MC < P 1 < P 2 Firm 1 earns (P 1 - MC) on each unit sold, while firm 2 earns nothing Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues... Equilibrium: Each firm charges P 1 = P 2 =MC

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Contestable Markets Key Assumptions n Producers have access to same technology n Consumers respond quickly to price changes n Existing firms cannot respond quickly to entry by lowering price n Absence of sunk costs Key Implications n Threat of entry disciplines firms already in the market n Incumbents have no market power, even if there is only a single incumbent (a monopolist)

Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Summary Different oligopoly scenarios give rise to different optimal strategies and different outcomes Your optimal price and output depends on … n Beliefs about the reactions of rivals n Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products) n Your ability to commit