1. Oligopoly
chapter 19
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2. Learning Objectives
Discuss how economists use game theory to understand oligopolies and describe the concept of Nash equilibrium.
Describe the Bertrand model and the Cournot model, and identify the Nash equilibrium in each model.
Explain why product differentiation makes price competition less intense and identify the Nash equilibrium in a market with product differentiation.
Analyze whether collusion is sustainable in a setting with repeated price competition.
Determine the number of firms that will enter a market and discuss the factors that affect this number.
Describe the main U.S. antitrust statutes and discuss their rationales.
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3. Overview
Analyze what a firm’s best actions are in oligopolies using game theory
Contrast models of oligopoly: Bertrand and Cournot model
Examine the factors that determine the number of firms that enter an oligopolistic market
Observe strategic decisions shaping long-term competition with rivals, along with collusion when firms compete repeatedly
Study major antitrust statutes and their applications
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4. Oligopoly and Game Theory
Economists determine the outcome of oligopolistic competition by applying game theory
In a Nash equilibrium of an oligopoly market, each firm is making a profit-maximizing choice given the choices of its rivals
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5. Oligopoly Pricing Game
Pepsi’s dominant strategy
Nash’s payoffs
Coke’s dominant strategy
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6. Bertrand Model Duopoly: two sellers in the market
Homogeneous goods: firms sell identical products
Bertrand model of oligopoly: firms produce homogeneous products and set their prices simultaneously
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7. Market Demand and Firm Demand Curves
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8. Nash Equilibrium in the Bertrand Model
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9. Cournot Model
Cournot model of oligopoly: firms choose how much to produce simultaneously, and the price clears the market given the total quantity produced
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10. Residual Demand Curves
Residual demand curve: shows the relationship between a firm’s output and the market price given the outputs of the firm’s rivals
Joe’s residual demand when Rebecca produces 4,000
Joe’s residual demand when Rebecca produces 2,000
Market demand
Market demand
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11. Best Responses in the Cournot Model
Q = 2,000
MR = MC
Joe behaves like a monopolist given his residual demand
P = 50, Q = 1,000
MR = MC
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12. Best-Response Curves in the Cournot Model
Best-response curve: shows a firms best choice in response to each possible action by its rival
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13. Nash Equilibrium in the Cournot Model
Each chooses its profit-maximizing output level given its rival’s output
Neither firm has an incentive to deviate from (2,000, 2,000)
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14. Deadweight Loss from Duopoly versus Monopoly
The deadweight loss of monopoly is larger because the monopoly price is further above marginal cost than is the oligopoly price
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15. Markups In a Cournot Market
The elasticity of market demand and the number of firms affects the size of the markup
The less elastic demand, the greater the markup
The larger the number of firms, the lower the markup
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16. Price Competition with Differentiated Products
Differentiated products: when consumers do not view similar products as perfect substitutes
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17. Bertrand Competition with Differentiated Products
Coke’s Best Responses
Coke’s residual demand
Coke’s residual demand
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18. Bertrand Competition with Differentiated Products
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19. Repeated Competition
Infinitely repeated Bertrand model: firms play the Bertrand pricing game over and over, with no definite end
In a setting of repeated competition, the noncooperative outcome is the repetition in each period of the Nash equilibrium outcome that would arise were the firms to compete just once
Other equilibrium outcomes may exist, including the possibility of both firms charging the monopoly price
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20. Collusion
Firms may adopt a strategy in which they charge the monopoly price if no one has yet undercut that price; otherwise they charge a price near or at their marginal cost
With this strategy, firms can cooperate by charging the monopoly price
Otherwise, firms engage in a price war
Collusion will work if firms value the future highly enough (that is, if the interest rate is low enough)
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21. Factors that Inhibit Collusion: Price Undercutting
A firm will refrain from undercutting if
With two firms, R must be below 1
With five firms, R must be below 0.25
With 11 firms, R must be below 0.10
The greater the number of firms, the harder it is to collude
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22. Factors That Inhibit Collusion: Imperfect Price Observation
In many real-world settings a firm observes its rivals’ prices imperfectly, if at all
This makes collusion harder to sustain because a firm will doubt whether its rivals have abided by the collusive agreement
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23. Factors That Inhibit Collusion: Different Marginal Costs of Production
When firms’ marginal costs of production differ, they may disagree about the best collusive price, since each will have a different monopoly price
When firms produce differentiated products, they may need to agree on many different prices rather than just one
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24. Forms of Collusion
Explicit collusion: when firms communicate to reach an agreement affecting the prices they will change
Tacit collusion: when firms collude without communicating, sustaining a price above the one that would arise in a single competitive interaction
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25. Market Entry Lower fixed costs reduce barriers to entry
Increases in demand also encourage entry
The number of firms that enter a market is also affected by the intensity of competition
For example, a Bertrand market has more intense competition than a Cournot market
Because profits are lower in a market with more intense competition, fewer firms will enter
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26. Factors Affecting the Number of Firms
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27. Entry in the Bertrand vs. Cournot Markets
Cournot profit
Bertrand profit
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28. Market Entry and Monopolistic Competition
Monopolistic competition: occurs in a market with free entry when there is a large number of firms, each of which produces a unique product, prices above marginal cost, and earns (close to) zero profit net of its fixed cost
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29. Back to Oligopoly - Raising Rival’s Costs
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30. How to Raise a Rival Firm’s Marginal Cost
Lobbying
Imposing stringent environmental regulations
Imposing a tariff
Increasing the cost of a rival’s inputs
Buying a lot of the supply of a critical input and not supplying it to rivals
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31. Strategic Precommitment
Strategic precommitment: when a firm commits to certain actions before rivals take theirs, with the aim of affecting rivals’ later choices
Examples
Output choice by a first-mover
Entry deterrence
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32. Output Choice by a First-Mover
Stackelberg model of quantity competition: two firms choose their outputs sequentially
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33. Entry Deterrence
By expanding one’s output sufficiently, a firm may reduce the profit its rival foresees enough to deter them from entering the market
The threat to increase output and cause loses to a potential entrant will only have an effect if the threat is credible
Playing tough versus playing soft
Commitment versus flexibility
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34. Antitrust Policy
Antitrust law focuses on maintaining basic rules of competition that enable markets to produce good outcomes
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35. U.S. Antitrust Law Sherman Act (1890)
Contracts that limit commerce among states or countries are declared illegal
Attempts to monopolize are declared illegal (felonies)
The definitions of restraint of trade and monopolizing were left to the courts
Clayton Act (1914)
Identified more clearly certain practices that would be considered illegal
Federal Trade Commission Act (1914)
Created the Federal Trade Commission, a specialist agency, to enforce antitrust law alongside the U.S. Department of Justice
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36. Collaboration Among Competitors
Price fixing: when firms agree on the prices they will charge or quantities they will produce
Price fixing is illegal under Section I of the Sherman Act
Horizontal merger: two or more competing firms combine their operations
The Department of Justice and the Federal Trade Commission review horizontal mergers, and can stop a merger if it would have negative welfare effects
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37. Welfare Effects of a Horizontal Merger
Surplus increase due to merger
Surplus decrease due to merger
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38. Antitrust Violations - Exclusionary Behavior
The law does not make being a monopolist illegal, but it does require that dominant firms not attempt to monopolize markets through tactics designed to exclude rivals
Predatory pricing: pricing below cost to drive a less financially strong rival out of the market by making it incur losses
Exclusive contracts: signing of contracts with buyers or suppliers that commit them not to deal with a rival
Bundling: selling a monopolized good only in conjunction with a competitively-supplied product to prevent customers from buying the competitive product from rivals
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39. Review
In oligopolies, a firm’s best actions and profit depend on how its rivals behave. To analyze such situations, economists use game theory.
At the equilibrium in a Bertrand oligopoly, all sales occur at a price equal to marginal cost.
In a Cournot oligopoly, the equilibrium price is less than the monopoly price but greater than marginal cost.
When a firm’s products are differentiated, the firm will not lose all its customers if it raises the price a little above marginal cost. As a result, the equilibrium price exceeds marginal cost in a market for differentiated goods.
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40. Review
When firms compete repeatedly with no definite end, other outcomes are possible, including in some cases the monopoly outcome.
The goal of antitrust law is to maintain certain basic rules of competition that enable markets to achieve good outcomes.
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41. Looking Forward
Next we will study externalities, public goods, and common property resources.
In all these cases, individual incentives may result in socially inefficient equilibria.
We will discuss private and public approaches to reaching more efficient outcomes.
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