1. OLIGOPOLY-II

2. 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

3. Duopoly Example from Text RevisitedQ1 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

4. 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.

5. 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)

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

7. Bertrand Model – Heterogeneous Good CaseP1
Firm 2’s Reaction Curve $4
Nash Equilibrium $6
Collusive Equilibrium
Firm 1’s Reaction Curve P2 77

8. Competition Versus Collusion: The Prisoners’ Dilemma
Assume: 85

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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

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

22. 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