Lecture 9: Oligopoly and Strategic Decision Making

Oligopoly

Chapter 9

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Oligopoly
ƒ An oligopoly implies there are only a few
firms in the market
ƒ The firms may sell identical or differentiated
products
ƒ Barriers to entry prevent new firms from
entering (the difference between Oligopoly
and Monopolistic Competition)
ƒ When making decisions, the Oligopolist must
consider the reaction of its rivals. Firms will
act strategically.
ECON 2106: Managerial Economics © Prof. Colin Mang, 2010
Lecture 9: Oligopoly and Strategic Decision Making

Basic Oligopoly Models

1. Sweezy Oligopoly
2. Cournot Oligopoly
3. Stackelberg Oligopoly
4. Bertrand Oligopoly

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Sweezy Oligopoly
1. There are few firms and many
customers
2. The firms produce differentiated
products
3. Each firm believes that rivals will
match price cuts, but not price
increases
4. Barriers to entry exist

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Sweezy Oligopoly
ƒ Demand is “Kinked”

ƒ For prices above P0, you lose

customers rapidly as they move to other
firms with lower prices
ƒ For prices below P0, you can’t steal
customers from your rivals because
they match price cuts

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Sweezy Oligopoly
ƒ Marginal Revenue
– The Marginal Revenue Curve is not
straight. We need to compare the MR
curves associated with the two portions of
the demand curve

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Sweezy Oligopoly
ƒ Profit Maximization
– Sweezy firms set MR = MC

– Notice though that there is a range of MC

in which Q would not change

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
1. There are few firms and many
customers
2. The firms could produce either
homogenous or differentiated products
3. Firms believe that they can vary their
output without drawing a response
from their rivals
4. Barriers to entry exist

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ Basically each firm believes that its own
demand curve (called the residual curve
dr) is exactly the same shape as the
market demand curve
ƒ The difference between the two curves
is the Residual Quantity (Qr) produced
by the firm’s rivals

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ Each firm sets MR = MC ; however, MR
will depend on the size of Qr.

ƒ The more your rivals produce, the less

you will

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ Taking all the possible values of Qr, we
can find all the values of output the firm
would choose. This is called the
Reaction Function
Q1 = r1(Q2)
ƒ We can do the same for Firm 2
ƒ This will yield an equilibrium where the
two functions intersect

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ Finding the Reaction Function
– Suppose Inverse Demand is given by
P = a – b(Q1 + Q2)
How much residual demand does firm 1
face?

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ If P = (a – bQ2) – bQ1 then

MR = (a – bQ2) – 2bQ1
ƒ Using MR = MC we can find the
reaction function

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ Ex. Suppose Inverse Market Demand is
given by P = 324 – (Q1 +Q2) and each
firm has a cost function
1 2
C = 10,000 + Qi where MC = Qi
2
What is the equilibrium quantity that
each firm supplies and what is the
market price?

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Cournot Competition
ƒ Ex. Suppose Inverse Market Demand is
given by P = 120 – (1/5)(Q1 +Q2) and
each firm has a cost function
3 2 3
C = 1000 + Qi where MC = Qi
10 5
What is the equilibrium quantity that
each firm supplies and what is the
market price?

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Graphing Cournot Profits

ƒ We can collect all the combinations of
Q1 and Q2 that yield the same level of
profits to Firm 1. This is called an
Iso-Profit Curve

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Graphing Cournot Profits

ƒ Features of Iso-Profit Curves
1. Every point on the curve yields the same level of
profit
2. Lower Iso-profit curves correspond to HIGHER
profits for Firm 1 (opposite for Firm 2) because
we are moving closer towards the Monopoly
output level
3. Iso-Profit curves reach their peak when they
intersect the reaction function (since the reaction
function gives the firm’s most profitable output
choices)
4. Iso-profit curves do not intersect each other

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Graphing Cournot Profits

ƒ Choosing Output
– For any given quantity of Q2, we can see
that the reaction function gives the most
profitable action for Firm 1

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Graphical Equilibrium
ƒ Each Firm is as best off as it can be
when producing at the equilibrium point

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Changing Equilibrium
ƒ Suppose Firm 2 develops a new
technology that lowers its Marginal
Cost. A reduction in MC2 will shift Firm
2’s Reaction Function outwards
(because it is now willing to supply more
output at any price)
ƒ Firm 2 will produce more and also have
a greater market share
ECON 2106: Managerial Economics © Prof. Colin Mang, 2010
Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Changing Equilibrium
ƒ Notice that Firm 2 also moves to a
higher Iso-Profit Curve. This incentive to
get increased profits is a main driver of
research and development spending

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Stackelberg (Unequal) Oligopoly

1. There are few firms and many customers
2. The firms could produce either homogenous
or differentiated goods
3. One firm (Leader) is large relative to its
competitors. It is either historically large or
has a “first-mover advantage”
– It sets its output level before other firms
4. All other firms (Followers) take the Leader’s
output as given
5. Barriers to entry exist

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Stackelberg Oligopoly
ƒ Graphically
– Given that Firm 2 will always choose along r2 its
Reaction Function, Firm 1 should choose the point
on r2 that yields itself the most profit (where its Iso-
profit curve is tangent to r2)

– Firm 1 produces a lot more under Stackelberg

than under Cournot competition while Firm 2
produces a lot less

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Stackelberg Oligopoly
ƒ Mathematically
Step 1 : Find the Follower’s Reaction
Function
Step 2 : Find the Profit Maximizing
point for the Leader
Step 3 : Find the Follower’s Quantity

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Bertrand Competition
1. There are few firms and many
customers
2. The firms sell similar products
3. Firms compete on price and always
react to price changes by competitors
4. Consumers can easily observe the
prices of different firms
5. Barriers to entry exist

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Bertrand Competition
ƒ Each time a firm sets a price, its rivals
will try to beat it
ƒ HOW LOW WILL THEY GO?

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010

Lecture 9: Oligopoly and Strategic Decision Making

Bertrand Competition
ƒ Firms value production in two ways:
P = AC Firm can’t lose money

P = MC Firm values each unit at the

Marginal Cost

ƒ The Firm will set P = MC as long as P > AC

ƒ So Price Competition leads to the same
outcome as Perfect Competition
ECON 2106: Managerial Economics © Prof. Colin Mang, 2010
Lecture 9: Oligopoly and Strategic Decision Making

Bertrand Competition
ƒ Bertrand Competition is good for
consumers but not always good for
firms as reduced prices lead to lower
profits

ECON 2106: Managerial Economics © Prof. Colin Mang, 2010