Overview. Economics Chapter 9. Oligopoly. Role of Strategic Interaction. An Example. Basic Oligopoly Models
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1 Economics 3030 Chapter 9 Basic Oligopoly odels Overview I. Conditions for Oligopoly? II. Role of Strategic Interdependence III. rofit aximization in Four Oligopoly Settings Sweezy (Kinked-emand) odel Cournot odel Stackelberg odel Bertrand odel IV. Contestable arkets Oligopoly Relatively few firms, usually less than 0. uopoly - two firms Triopoly - three firms The products firms offer can be either differentiated or homogeneous. Role of Strategic Interaction What you do affects the profits of your rivals What your rival does affects your profits 3 4 An Example (Rival matches your price change) You and another firm sell differentiated products How does the quantity demanded for your product change when you change your price? H L 0 5 6
2 (Rival matches your price change) 0 emand if Rivals atch rice Reductions but not rice Increases 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! 7 8 Four Basic odels () Sweezy (Kinked-emand) () Cournot (3) Stackelberg (4) Bertrand () Sweezy (Kinked-emand) odel Few firms in the market Each producing differentiated products. Each firm believes rivals will match (or follow) price reductions, but won t match (or follow) price increases. Key feature of Sweezy odel rice-rigidity 9 0 Sweezy arginal Revenue Sweezy rofit-aximization (Rival matches your price change) C H C C L R R 0 R 0 R
3 () Cournot odel Reaction Functions 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 ) exist 3 Suppose two firms produce homogeneous products. Firm s reaction (or best-response) function is a schedule summarizing the amount of firm should produce in order to maximize its profits for each quantity of produced by firm. Since the products are substitutes, an increase in firm s output leads to a decrease in the profitmaximizing amount of firm s product. 4 Graphically (Firm s Reaction Function) 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 (since the other firm will also change its output) 5 6 Summary of Cournot Equilibrium The output maximizes firm s profits, given that firm produces The output maximizes firm s profits, given that firm produces Neither firm has an incentive to change its output, given the output of the rival Beliefs are consistent: In equilibrium, each firm thinks rivals will stick to their current output -- and they do! 7 8 3
4 Firm s Isoprofit Curve The combinations of outputs of the two firms that yield firm the same level of profit Another Look at Cournot ecisions: Firm s best response to A B C π = $00 π = $00 Increasing rofits for Firm π = $00 π = $ Another Look at Collusion can increase profits for both firms... onopoly output anywhere along this line Firm s rofits Firm s rofits Collusion (both firms on higher isoprofit curves) But, it can lead to cheating... (3) Stackelberg odel Collusion collusion cheat Firm Cheats Firm s rofits Few firms roducing differentiated or homogeneous products Firm one is the leader The leader commits to an output before all other firms Remaining firms are followers. They choose their outputs so as to maximize profits, given the leader s output
5 Stackelberg Equilibrium S Leader s rofits Rise Follower s rofits ecline Stackelberg Equilibrium S 5 Stackelberg Summary Stackelberg model illustrates how commitment can enhance profits in strategic environments Leader produces more than the Cournot equilibrium output Larger market share, higher profits First-mover advantage Follower produces less than the Cournot equilibrium output Smaller market share, lower profits 6 Few firms (4) Bertrand odel Firms produce identical products at constant marginal cost. Each firm independently sets its price in order to maximize profits Consumers enjoy erfect information Zero transaction costs 7 Bertrand Equilibrium Firms set = = C! Why? Suppose C < < Firm earns ( - C) on each unit sold, while firm earns nothing Firm has an incentive to slightly undercut firm s price to capture the entire market Firm then has an incentive to undercut firm s price. This undercutting continues... Equilibrium: Each firm charges = =C 8 Contestable arkets Key assumptions roducers 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 Key Implications Threat of entry disciplines firms already in the market Incumbents have no market power, even if there is only a single incumbent (a monopolist) 9 Summary ifferent oligopoly scenarios give rise to different optimal strategies and different outcomes Your optimal price and output depends on Beliefs about the reactions of rivals Your choice variable ( or ) and the nature of the product market (differentiated or homogeneous products) Your ability to commit 30 5
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