Copyright © 2009 Pearson Education, Inc. All rights reserved. 1 Oligopoly

Copyright © 2009 Pearson Education, Inc. All rights reserved. 2 After reading this chapter, you will have learned: How to derive the Cournot-Nash equilibrium using reaction functions, and how the Cournot-Nash equilibrium compares to the competitive and monopoly equilibria. How to derive the Stackelberg equilibrium, and how the Stackelberg equilibrium differs from the Cournot-Nash equilibrium. How to derive the Bertrand equilibrium using reaction functions for a homogeneous product and for a heterogeneous product. The dominant firm model for the case of an oligopoly market dominated by one large firm that competes with a group of small fringe firms. Why the Prisoner’s Dilemma typically makes collusion difficult and how firms try to solve the Prisoner’s Dilemma by developing methods of coordinated behavior.

Copyright © 2009 Pearson Education, Inc. All rights reserved. 3 Residual Demand Curve — A demand curve that’s the leftover portion of an industry demand, after a group of firms in the industry have chosen their outputs. The Cournot-Nash Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 4 The Cournot-Nash Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 5 The Cournot-Nash Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 6 Reaction Function — A function identifying one firm’s optimal output (price) response to every possible output (price) produced (charged) by competitors. The Cournot-Nash Model Reaction Functions and the Cournot-Nash Equilibrium

Copyright © 2009 Pearson Education, Inc. All rights reserved. 7 Cournot-Nash Equilibrium — The equilibrium outcome in a simultaneous-move game in which all the firms assume the outputs of all the other firms in the industry will remain constant. The Cournot-Nash Model Reaction Functions and the Cournot-Nash Equilibrium The Cournot Equilibrium as a Nash Equilibrium

Copyright © 2009 Pearson Education, Inc. All rights reserved. 8 Application: Experimental Games and the Cournot-Nash Model Because it’s difficult to empirically test the validity of the Cournot-Nash model, economists have developed experimental games to check the model’s predictions. Games played by pairs of college students often confirm that players reach the Cournot-Nash equilibrium. As the number of players increases, the Cournot-Nash equilibrium becomes less likely, in these experimental games. The Cournot-Nash Model Reaction Functions and the Cournot-Nash Equilibrium The Cournot Equilibrium as a Nash Equilibrium

Copyright © 2009 Pearson Education, Inc. All rights reserved. 9 Stackelberg Follower — The firm that moves second in the Stackelberg game. Stackelberg Leader — The firm that moves first in the Stackelberg game. The Stackelberg Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 10 The Stackelberg Model Firms with Identical Costs and Demand

Copyright © 2009 Pearson Education, Inc. All rights reserved. 11 Common Error: Failing to Correctly Substitute the Follower’s Reaction Function into the Leader’s Demand Curve When calculating the Stackelberg equilibrium, students often incorrectly substitute the follower’s reaction function into the leader’s reaction function. If you do this, you’ll calculate the Cournot-Nash equilibrium, not the Stackelberg equilibrium. The Stackelberg Model Firms with Identical Costs and Demand

Copyright © 2009 Pearson Education, Inc. All rights reserved. 12 From 1993 through 1996, Kodak expanded its photofinishing capacity substantially. After observing Kodak’s capacity expansion, Fuji responded by dramatically increasing its capacity and gaining control over all of Wal- Mart’s photofinishing services. Fuji’s conduct is consistent with a Stackelberg follower’s predicted behavior. The Stackelberg Model Firms with Different Costs Application: Fuji's Purchase of Wal-Mart's Photo-Processing Plants

Copyright © 2009 Pearson Education, Inc. All rights reserved. 13 Bertrand Model — A model developed by Joseph Bertrand that criticized Cournot’s model by arguing that if firms assume all other firms hold their prices constant, Cournot’s logic results in an entirely different outcome, with price equal to marginal cost. The Bertrand Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 14 The Bertrand Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 15 The Bertrand Model Application: Bertrand Pricing in the Airline Industry

Copyright © 2009 Pearson Education, Inc. All rights reserved. 16 The Dominant Firm Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 17 Common Error: Incorrectly Identifying the Price in the Dominant Firm Model The Dominant Firm Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 18 There’s considerable empirical evidence that dominant firms often lose most of their market power to competitive fringe firms as a result of high-price policies and passivity. Examples include U.S. Steel in steel, Xerox in copiers, Reynolds International Pen Company in ballpoint pens, International Harvester in farm equipment, Goodyear in tires, RCA in color televisions, General Electric in appliances, and IBM in computers. The Dominant Firm Model Application: The Decline of Dominant Firms

Copyright © 2009 Pearson Education, Inc. All rights reserved. 19 Collusion: The Great Prisoner’s Dilemma Collusion with Identical Demand and Cost Conditions

Copyright © 2009 Pearson Education, Inc. All rights reserved. 20 Infinite Game — A static game that’s repeated forever. Tit-for-Tat — A strategy in a Prisoner’s Dilemma game in which a player starts off cooperating in the first round and, in every subsequent round, adopts its opponent’s strategy in the previous round. Collusion: The Great Prisoner’s Dilemma Collusion with Identical Demand and Cost Conditions

Copyright © 2009 Pearson Education, Inc. All rights reserved. 21 Application: Price Fixing in the Computer Memory Market The DRAM card price-fixing conspiracy illustrates how direct collusion can be used to solve the Prisoner's Dilemma. The companies in the cartel solved the Prisoner’s Dilemma, consistent with Robert Axelrod’s conclusion, by being extremely nice to each other. They colluded, via phone calls, meetings, and s, to set high prices. Without the Department of Justice's intervention, it might have been possible for DRAM card collusion to continue for many more years. Collusion: The Great Prisoner’s Dilemma Collusion with Identical Demand and Cost Conditions

Copyright © 2009 Pearson Education, Inc. All rights reserved. 22 Kinked Demand Curve Model — An oligopoly model in which a firm’s demand curve is based on the assumptions that, if it independently raises price, its competitors maintain their prices, whereas a price decrease will be matched. As a consequence, the firm’s demand curve is highly elastic for price increases, but highly inelastic for price decreases. Collusion: The Great Prisoner’s Dilemma Collusion with Differing Costs or Demand Conditions The Kinked Demand Curve Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 23 Collusion: The Great Prisoner’s Dilemma Collusion with Differing Costs or Demand Conditions The Kinked Demand Curve Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 24 Price Leadership — A model of oligopoly behavior in which the firms depend on one firm to signal price changes to the other firms, who then decide whether to follow the changes. Price Leader — The firm in an oligopoly that’s first to change price in response to a change in an industry’s underlying demand or cost conditions. Collusion: The Great Prisoner’s Dilemma Collusion with Differing Costs or Demand Conditions The Price Leadership Model

Copyright © 2009 Pearson Education, Inc. All rights reserved. 25 In a 1992 antitrust case, the U.S. Department of Justice charged eight major American airlines and the Airline Tariff Publishing Company (ATPCO) with fixing the price of airline tickets over the Internet. According to the charges, the airlines were able to signal each other when one of them wanted another airline to raise fares. In May 1994, the eight airlines and ATPCO settled the case by agreeing to eliminate some of the signaling practices. Collusion: The Great Prisoner’s Dilemma Collusion with Differing Costs or Demand Conditions The Price Leadership Model Application: Price Leadership in Cyberspace: The Airlines Case