Chapter 13 Oligopoly 1

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1 Chapter 13 Oligopoly 1

2 4. Oligopoly A market structure with a small number of firms (usually big) Oligopolists know each other: Strategic interaction: actions of one firm will trigger re-actions of others Oligopolist must take these possible re-actions into account before deciding on an action Therefore No single, unified model of oligopoly exists 2

3 Stages of evolution 3

4 Market introduction and growth New technology, high uncertainty, innovators profit Product is new, no close substitutes Learning curve is steep Temporal monopoly in the market possible But high set-up costs What market is most receptive of the product? Strategic decisions about market introduction 4

5 Maturity and decline No more growth of the market Product gets more homogeneous Price (and service) get more important Price competition (oligopoly) Overcapacity ==> major ingredient for price wars 5

6 Cartel: A collusive agreement made openly and formally 6

7 Cartel Cartels act like multiplant monopolies. Profit of cartel is maximized if marginal costs among members of cartel are equalized Would mean that high-cost firms produce less Instability of cartel: incentive for members to cheat Incentive biggest for small members 7

8 Cartel as a multi-plant monopoly PRICE MC 1 MC 2 D MC Supply D MR Q 1 Q 2 TOTAL OUTPUT FIRM 1 FIRM 2 8

9 Instability of Cartel: demand curve gets much flatter (D ) We started at Price P 0 9

10 Problem 1 The Bergen Company and the Gutenberg Company are the only two firms that produce and sell a particular kind of machinery. The demand curve for their product is P = 580 3Q where P is the price of the products, and Q is the total amount demanded. The total cost function of the Bergen Company is TC B = 410 Q B. The total cost function of the Gutenberg Company is TC G = 460 Q G. a) If these two firms collude, and if they want to maximize their combined profits, how much will the Bergen Company produce? b) How much will the Gutenberg Company produce? 10

11 Solution Problem 1 a) Bergen s marginal cost is always less than Gutenberg s marginal cost. Therefore Bergen would produce all the combination s output. Setting Bergen s marginal cost equal to the marginal revenue derived from the demand function, we get: 410 = 580 6Q => QB = and QG = 0. b) If Gutenberg were to produce one unit and Bergen one unit less, it would reduce their combined profits by the difference in their marginal costs. If direct payments of output restrictions between the firms were legal, Gutenberg would accept a zero output quota. But if competition were to break out, Gutenberg would make zero profits and Bergen would earn $2,000. Thus the most Bergen would pay for Gutenberg s cooperation is $ and the least Gutenberg would accept to not produce is $

12 Price Leadership by a dominant firm One firm sets price and others follow Industry is composed of a large, dominant firm and many small firms, big firm has cost-advantage The demand curve for the dominant firm is derived by subtracting the amount supplied by the small firms at each price from the total demanded at that price Big firm can behave as a monopolist, small firms make no super-normal profits 12

13 13

14 How can a few firms compete against each other? Many different models Some simplifying assumptions: Identical product 2 firms (can easily be extended to more) Same (constant) cost functions Know the (linear) demand function Firms act simultaneously 14

15 Price Competition (= Bertrand competition) Total costs: Market demand: TC = q + 0.5q 2 i i i P= 100 q= 100 qa + qb M C i = 4 + q i WTP for first unit = 99, MC = 5 If firm A would set price at 98, firm B would set price to 97 If firms compete over prices, they would go down to marginal costs P= Q= 15

16 Example: Collusion (cartel) Calculate price, quantity and profit for a collusion in this example Add up marginal costs horizontally Q = q + q = 4+ MC 4+ MC = 8+ 2MC A B A B Q MC =

17 Cournot-Nash Duopoly Quantity (capacity) competition Taking the other s output as given, what output is optimal for firm X? Series of What if? questions necessary for each potential output of the rival you must have a potential answer Actual decision taken by assuming what rival will actually do 17

18 18

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21 Finding the reaction curves Reaction curve: given the output of X, what output of Y is optimal? Of course, whatever Y does, will produce further reactions, i.e. X is not constant in general. Equilibrium only when both firms sit on their reaction curves: no surprises and no incentive to alter the behavior 21

22 Problem 2 The International Air Transport Association (IATA) has been composed of 108 U.S. and European airlines that fly transatlantic routes. For many years, IATA acted as a cartel: it fixed and enforced uniform prices. a) If IATA wanted to maximize the total profit of all member airlines, what uniform price would it charge? b) How would the total amount of traffic be allocated among the member airlines? c) Would IATA set price equal to marginal cost? Why or why not? 22

23 Solution Problem 2 a) The IATA would charge the price that clears the market at the level of output where marginal revenue equals the horizontally summed marginal cost curves of each operator in the market. b) The traffic should be allocated so that the marginal costs of all the members operating in the market would be equal and that no member not currently in the market would have a lower marginal cost. c) No, the IATA would set a price equal to marginal cost multiplied by 1/(1+1/e) where e is the elasticity of demand in the market in question. 23

24 Problem 3 In Britain price competition among bookshops has been suppressed for over 90 years by the Net Book Agreement (of 1900), which was aimed at the prevention of price wars. However, in October 1991, Waterstone and Company began cutting book prices at its 85 British shops. According to Richard Barker, Waterstone s operations director, the decision to reduce the price of about 40 titles by about 25% was due to price cuts by Dillons, Waterstone s principal rival. a) According to the president of Britain s Publishers Association, the price-cutting was an enormous pity that will damage many booksellers who operate on very slim margins. Does this mean that price-cutting of this sort is contrary to the public interest? b) Why would Dillons want to cut price? Under what circumstances would this be a good strategy? Under what circumstances would it be a mistake? 24

25 Solution Problem 3 a) No. A price war, although always an enormous pity for producers, usually is very good news for consumers. b) If demand is elastic at high prices, and if Dillons has a comparative advantage with respect to its rivals at high volumes, it may prefer a low competitive price to a high collusive one. If demand is inelastic, of if Dillons does not have a comparative advantage over its rivals at high volumes, it may be a mistake to cut prices. 25

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