Managerial Economics & Business Strategy: Basic Oligopoly Models

Managerial Economics & Business Strategy Chapter 9
Basic Oligopoly Models
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Hakan TASCI Elon University McGraw-Hill/Irwin
2006 by The McGraw-Hill Companies, rights reserved. Department ofThe Economics Spring 2007 Copyright Copyright 2006 by McGraw-Hill Companies, Inc.Inc. AllAll rights reserved.
Overview
I. Conditions for Oligopoly? II. Role of Strategic Interdependence III. Profit Maximization in Four Oligopoly Settings
I I I I
Sweezy (Kinked-Demand) Model Cournot Model Stackelberg Model Bertrand Model
IV. Contestable Markets

Michael R. Baye, Managerial Economics and Business Strategy, 5e. Hakan TASCI Elon University Copyright 2006 by The McGraw-Hill Companies, Inc. All Spring rights reserved. Department of Economics 2007
Oligopoly Environment
The most difficult firm to manage. You have to think not only the decisions you make but also the reactions of the competitors. Relatively few firms, usually less than 10.
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Duopoly - two firms Triopoly - three firms
The products firms offer can be either differentiated or homogeneous.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Hakan TASCI Elon University
Copyright 2006 by The McGraw-Hill Companies, Inc. All Spring rights reserved. Department of Economics 2007
Role of Strategic Interaction

Your actions affect the profits of your rivals. Your rivals actions affect your profits.
An Example
You and another firm sell differentiated products. How does the quantity demanded for your product change when you change your price?
D2 (Rival matches your price change)
PH P0 PL
D1 (Rival holds its price constant)

QH1 QH2 Q0 QL2
QL1
D2 (Rival matches your price change) Demand if Rivals Match Price Reductions but not Price Increases
P0
D1 D Q0
(Rival holds its price constant) Q
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 arent in complete control of your own destiny!
Sweezy (Kinked-Demand) Model

Few firms in the market serving many consumers. Firms produce differentiated products. Barriers to entry. Each firm believes rivals will match (or follow) price reductions, but wont match (or follow) price increases. Key feature of Sweezy Model
I
Price-Rigidity.
Sweezy Demand and Marginal Revenue

P
D2 (Rival matches your price change) DS: Sweezy Demand
P0
D1 MR1 MR2 MRS: Sweezy MR (Rival holds its price constant)
Q0
Sweezy Profit-Maximizing Decision

P
D2 (Rival matches your price change)
P0
MC1 MC2 MC3
D1 (Rival holds price constant) MRS DS: Sweezy Demand
Q0
Sweezy Oligopoly Summary

Firms believe rivals match price cuts, but not price increases. Firms operating in a Sweezy oligopoly maximize profit by producing where MRS = MC.
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The kinked-shaped marginal revenue curve implies that there exists a range over which changes in MC will not impact the profit-maximizing level of output. Therefore, the firm may have no incentive to change price provided that marginal cost remains in a given range.
Example: Sweezy Oligopoly

PC Connection and CDW are two online retailers that compete in an internet market for digital cameras. While the products they sell are similar, the firms attempt to differentiate themselves through their service polices. Over the last couple of months, PC Connections has matched CDWs price cuts, but has not matched its price increases. Suppose that when PC connection matches CDWs price changes, the inverse demand for CDW is given by P=1250-2Q. When it does not match price changes, CDWs inverse demand is P= 800-0.5Q. Based on this information, determine CDWs inverse demand and marginal revenue functions over the last couple of months. Over what range will changes in marginal cost have no effect on CDWs profit maximizing level of output?
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.
Inverse Demand in a Cournot Duopoly

Market demand in a homogeneous-product Cournot duopoly is
P = a b(Q1 + Q2 )
Thus, each firms marginal revenue depends on the output produced by the other firm. More formally,
MR1 = a bQ2 2bQ1
MR2 = a bQ1 2bQ2

Best-Response Function
Since a firms marginal revenue in a homogeneous Cournot oligopoly depends on both its output and its rivals, each firm needs a way to respond to rivals output decisions. Firm 1s best-response (or reaction) function is a schedule summarizing the amount of Q1 firm 1 should produce in order to maximize its profits for each quantity of Q2 produced by firm 2. Since the products are substitutes, an increase in firm 2s output leads to a decrease in the profitmaximizing amount of firm 1s product.
Best-Response Function for a Cournot Duopoly

To find a firms best-response function, equate its marginal revenue to marginal cost and solve for its output as a function of its rivals output. Firm 1s best-response function is (c1 is firm 1s MC) a c1 1 Q1 = r1 (Q2 ) = Q2
2b 2
Firm 2s best-response function is (c2 is firm 2s MC) a c2 1 Q2 = r2 (Q1 ) = Q1

2b 2
Graph of Firm 1s Best-Response Function

Q2
(a-c1)/b Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2
Q2 r1 (Firm 1s Reaction Function) Q1 Q1M Q1
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 to improve its profit.
I
A point where the two firms best-response functions intersect.
Graph of Cournot Equilibrium

Q2 (a-c1)/b r1 Cournot Equilibrium Q2M Q2*
r2 Q1* Q1M (a-c2)/b Q1
Summary of Cournot Equilibrium

The output Q1* maximizes firm 1s profits, given that firm 2 produces Q2*. The output Q2* maximizes firm 2s profits, given that firm 1 produces Q1*. Neither firm has an incentive to change its output, given the output of the rival. Beliefs are consistent:
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In equilibrium, each firm thinks rivals will stick to their current output and they do!
Firm 1s Isoprofit Curve

Q2 r1
The combinations of outputs of the two firms that yield firm 1 the same level of profit
B A
C D 1 = $100
Increasing Profits for Firm 1
1 = $200 Q1M Q1
Another Look at Cournot Decisions

Q2 r1 Firm 1s best response to Q2*
Q2*
1 = $100 1 = $200
Q1*
Q1M
Q1
Another Look at Cournot Equilibrium

Q2 r1 Q2M Q2* Firm 1s Profits Firm 2s Profits Cournot Equilibrium
r2 Q1*
Q1M
Q1
Impact of Rising Costs on the Cournot Equilibrium

Q2 r1* r1** Q2**
Cournot equilibrium prior to firm 1s marginal cost increase Cournot equilibrium after firm 1s marginal cost increase
Q2* r2 Q1**
Q1*
Q1
Collusion Incentives in Cournot Oligopoly

Q2 r1 Q2M
Cournot 2
1Cournot
r2 Q1M
Q1
Formula Sheet: Cournot Duopoly

P = a - b(Q1+Q2) and costs are C1(Q1)=c1Q1 and C2(Q2)=c2Q2 then the reaction functions are
Example: Cournot Duopoly

The inverse market demand in a homogenous product Cournot Duopoly is P=100-2(Q1+Q2) and costs are C1(Q1)=12Q1 and C2(Q2)=20Q2 1. Determine the reaction function for each firm 2. Calculate each firms equilibrium output. 3. Calculate the equilibrium market price 4. Calculate the profit each firm earns in equilibrium.
Stackelberg Model
There are few firms serving many customers. Firms produce differentiated or homogeneous products. Barriers to entry. Firm one is the leader.
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The leader commits to an output before all other firms. They choose their outputs so as to maximize profits, given the leaders output.
Remaining firms are followers.

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Stackelberg Equilibrium
Q2 2C Followers Profits Decline r1 FS Stackelberg Equilibrium
Q2C Q2S 1C LS Q1C Q1S Q1M
r2 Q1
Stackelberg Summary
Stackelberg model illustrates how commitment can enhance profits in strategic environments. Leader produces more than the Cournot equilibrium output.
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Larger market share, higher profits. First-mover advantage.
Follower produces less than the Cournot equilibrium output.

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Smaller market share, lower profits.

Formula Sheet: Stackelberg Duopoly

P = a - b(Q1+Q2) and costs are C1(Q1)=c1Q1 and C2(Q2)=c2Q2 then the reaction functions are
Example: Stackelberg Duopoly

The inverse market demand in a homogenous product Stackelberg Duopoly is P=20,000-5Q and costs are C1(Q1)=3,000Q1 and C2(Q2)=4,000Q2 1. Determine the reaction function for each firm 2. Calculate each firms equilibrium output. 3. Calculate the equilibrium market price 4. Calculate the profit each firm earns in equilibrium.
Bertrand Model
Few firms that sell to many consumers. Firms produce identical products at constant marginal cost. Each firm independently sets its price in order to maximize profits. Barriers to entry. Consumers enjoy
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Perfect information. Zero transaction costs.
Bertrand Equilibrium
Firms set P1 = P2 = MC! Why? Suppose MC < P1 < P2. Firm 1 earns (P1 - MC) on each unit sold, while firm 2 earns nothing. Firm 2 has an incentive to slightly undercut firm 1s price to capture the entire market. Firm 1 then has an incentive to undercut firm 2s price. This undercutting continues... Equilibrium: Each firm charges P1 = P2 = MC.
Comparing Oligopoly Models

P=1,000-(Q1+Q2) and costs are C1(Q1)=4Q1 and C2(Q2)=4Q2 Find Cournot Equilibrium. Find Stackelberg Equilibrium. Find Bertrand Equilibrium. Find the Collusive Equilibrium.
Contestable Markets
Key Assumptions
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Producers have access to same technology. Consumers respond quickly to price changes. Existing firms cannot respond quickly to entry by lowering price. Absence of sunk costs. Threat of entry disciplines firms already in the market. Incumbents have no market power, even if there is only a single incumbent (a monopolist).
Key Implications
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Conclusion
Different oligopoly scenarios give rise to different optimal strategies and different outcomes. Your optimal price and output depends on
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Beliefs about the reactions of rivals. Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products). Your ability to credibly commit prior to your rivals.
Additional Review
Bayes Text, pages 345-348 Question #1, 2, 3, 4, 5, 7, 8, 9, 11, 12, Chapter 3 Demonstration Problems 1, 2, 3, 4, 5, 6 Math Review Ratio and Fractions Algebra, Functions

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Managerial Economics & Business Strategy Chapter 9

Basic Oligopoly Models

Sweezy (Kinked-Demand) Model Cournot Model Stackelberg Model Bertrand Model

IV. Contestable Markets

Duopoly - two firms Triopoly - three firms

The products firms offer can be either differentiated or homogeneous.

Role of Strategic Interaction

D2 (Rival matches your price change)

D1 (Rival holds its price constant)

(Rival holds its price constant) Q

Sweezy (Kinked-Demand) Model

Sweezy Demand and Marginal Revenue

Sweezy Profit-Maximizing Decision

MC1 MC2 MC3

D1 (Rival holds price constant) MRS DS: Sweezy Demand

Sweezy Oligopoly Summary

Example: Sweezy Oligopoly

Inverse Demand in a Cournot Duopoly

MR2 = a bQ1 2bQ2

Best-Response Function for a Cournot Duopoly

Firm 2s best-response function is (c2 is firm 2s MC) a c2 1 Q2 = r2 (Q1 ) = Q1

Graph of Firm 1s Best-Response Function

Q2 r1 (Firm 1s Reaction Function) Q1 Q1M Q1

A point where the two firms best-response functions intersect.

Graph of Cournot Equilibrium

r2 Q1* Q1M (a-c2)/b Q1

Summary of Cournot Equilibrium

Firm 1s Isoprofit Curve

Increasing Profits for Firm 1

Another Look at Cournot Decisions

Another Look at Cournot Equilibrium

Impact of Rising Costs on the Cournot Equilibrium

Collusion Incentives in Cournot Oligopoly

Formula Sheet: Cournot Duopoly

Example: Cournot Duopoly

Remaining firms are followers.

Q2C Q2S 1C LS Q1C Q1S Q1M

Larger market share, higher profits. First-mover advantage.

Follower produces less than the Cournot equilibrium output.

Smaller market share, lower profits.

Formula Sheet: Stackelberg Duopoly

Example: Stackelberg Duopoly

Perfect information. Zero transaction costs.

Comparing Oligopoly Models

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