PAPER ASSIGNMENT

MANAGERIAL ECONOMICS

Lecturer:
Mr. Yoopi Abimanyu, Ph.D.

Composed by:
ANDY
000009361
MAGISTER MANAGEMENT
UNIVERSITAS PELITA HARAPAN
The Plaza Semanggi
Granadha Business District, 3rd, 16th, and 17th Floor
Jl. Jend. Sudirman Kav.50
Jakarta 12930

TABLE OF CONTENTS
Cover Page....1
Table of Contents.....2
Basic Oligopoly Models3
Sweezy Oligopoly..3
Cournot Oligopoly4
Stackelberg Oligopoly..5
Bertrand Oligopoly..6
Oligopoly Models Comparison7
Contestable Markets....7
Bibliography.....8

BASIC OLIGOPOLY MODELS

Oligopoly refers to a market structure in which there are only a few firms (usually
ranging from 2 to 10), each of which is large relative to the total industry. Such
oligopolistic firm (oligopolist) is most difficult to manage since the manager shall
consider the impact of his/ her decision on other firms. Demand for an oligipolists
product highly depends on how the rivals respond to its pricing decision: whether they
will match the price changes (in which demand will become more inelastic) or not.
There are four models of oligopoly, each of which has different implications for the
managers optimal decision as a result of rivals different responses to a firms action.
Sweezy Oligopoly
Sweezy model is an industry in which there are few firms serving many customers;
the firms produce differentiated products; each firm believes rivals will respond to a
price reduction, but will not follow a price increase; and barriers to entry do exist.
Demand curve in Sweezy oligopoly is ABD1,
while its marginal revenue curve is ACEF. The
profit-maximizing output (Q0) is reached when
marginal revenue equals marginal cost (B) and
maximum price for that output will be the profitmaximizing price (P0). As price exceeds marginal
cost (P0 > MC0), industry output is below socially
efficient level and thus, there is a deadweight loss.
In Sweezy oligopoly, there is a range (CE) over which changes in marginal cost will
not affect the profit-maximizing output and thus, there is no incentive for the firms to
change their pricing behavior due to the assumptions that rivals will match a price cut,
but not a price increase. This is the reason why Sweezy gasoline retailers in some
areas may not decrease their price despite the fall in their marginal cost as a result of
oil price decline.
Sweezy model shows that strategic interaction amongst firms and managers belief on
rivals reactions can have profound impact on pricing decision. However, this model
is criticized for no explanation on how the industry settles on the initial price (P0) that
generates kink in every firms demand curve.

Cournot Oligopoly
Cournot model is an industry in which there are few firms serving many consumers;
the firms produce differentiated or homogeneous products; each firm believes rivals
will hold their output constant if its output is changed; and barriers to entry do exist.
The relationship amongst Cournot oligopolists is called best-response function or
reaction function, which defines a firms profit-maximizing output for given output
level of other firm. The reaction functions for Cournot duopolists are as follows:
And
Cournot equilibrium occurs at the intersection of
the reaction curves (C), in which neither firm has
incentive to change its output given the other
firms output.
Market demand in homogeneous-product Cournot
duopoly is defined as P = a b (Q1 + Q2) and thus
marginal revenues for such Cournot duopolists are denoted as follows:
MR1(Q1,Q2) = a bQ2 2bQ1

and

MR2(Q1,Q2) = a bQ1 2bQ2

The greater the output of a firm; the lower the demand, marginal revenue, and profitmaximizing output of the rival.
In Cournot oligopoly, industry output is below socially efficient level since P > MC
and thus, there is deadweight loss. The amount by which P > MC depends on number
of firms in the industry and the degree of product differentiation. In homogeneousproduct Cournot oligopoly with large number of firms, equilibrium price is close to
MC and industry output approximates perfect competitions with no deadweight loss.
Basic tool to summarize Cournot oligopolists profit is isoprofit curve, which defines
the output combination of all firms that yield a given firm the same profit level. Every
point on isoprofit curve yields the same profit level. The closer the isoprofit curve to a
firms monopoly output, the higher the profit. Isoprofit curve reaches its peak when it
intersects the firms reaction function. However, isoprofit curves do not intersect each
other.

In Cournot oligopoly, marginal cost reduction shifts

a firms reaction function upward (r**), leading to a
new equilibrium (F) at the firms higher output
(Q2**) and market share, but at the rivals expense of
lower output (Q1**).
Collusion may happen in Cournot oligopoly, in
which firms agree to restrict output or to charge
higher prices in order to benefit at the consumers
expense. In this case, the corresponding market price
and output are identical to monopolys and P > MC.
Thus, industry output is below the socially optimal
level and hence, there is a deadweight loss.
Colluding firms will enjoy higher profit than Cournot oligopolists (collude > Cournot).
The output levels that yield such colluding firms higher profits are shown by shaded
lens-shaped area in Figure 4, while output combinations that maximize total industry
profit is denoted by line AB.
However, reaching such collusive agreement is
uneasy as each firm has an incentive to cheat by
expanding its own output (Q1cheat at Point G) to earn
higher profits (1cheat > 1collude) at its collusion
partners expense (2 at Point G < 2 at Cournot
equilibrium at Point C).
Stackelberg Oligopoly
Stackelberg model is an industry in which there are few firms serving many
customers; the firms produce differentiated or homogeneous products; a single firm
(the leader) chooses its output before rivals select theirs; all other firms (the
followers) take the leaders output as given and select their profit-maximizing outputs
given such leaders (behave like Cournot oligopolists); and barriers to entry do exist.

Leader has first-mover advantage by choosing a point of profit-maximizing output

(Q1) on the followers Cournot reaction curve. Hence, the leaders profits (1) are
higher than that in Cournot equilibrium (C), but the followers profits are lower.
and
Meanwhile, followers reaction function [r2(Q1)] is the same as Cournot oligopolists.
Stackelberg equilibrium (S) is reached when
the leaders isoprofit curve is tangential to the
followers reaction function (r2).
As P > MC, industry output in Stackelberg
oligopoly is below the socially efficient level
and hence, there is a deadweight loss, which
is lower than that in pure monopoly.
Bertrand Oligopoly
Bertrand model is an industry in which there are few firms serving many customers;
the firms produce identical products at a constant marginal cost; firms compete in
price and react optimally to rivals prices; consumers have perfect information and
there are no transaction costs; and barriers to entry do exist.
Bertrand oligopoly is undesired by manager as it leads to zero economic profit.
However, it is desired by consumers since it leads to the same outcome as perfectly
competitive market. Due to perfect information, zero transaction costs, and identical
products, all consumers will buy from a firm that charges the lowest price and thus,
there will be price war that will just end when each firms price equals marginal cost
(P = MC), in which neither firm will then lower or raise its price as the economic
profit is already zero. In homogeneous-product Bertrand oligopoly, as P = MC,
industry output equals the socially efficient level such that in perfectly competitive
market and there is no deadweight loss.
The strategies to mitigate such Bertrand trap (cut-throat competition in homogeneousproduct market) include either raising switching costs or eliminating the perception
that firms products are identical. Product differentiation allows firms to price above
marginal cost without losing customers to rivals since reaction functions in such

differentiated-product market are upward sloping and thus, the equilibrium occurs at a
point where P > MC.
Oligopoly Models Comparison
A firms optimal decision and profit in oligopolistic market vary depending on
interaction type existing in the market. Using the same market demand and cost
conditions, the outcomes in different oligopolies reveals the followings:
The highest market outputs are produced in Bertrand oligopoly, followed by
Stackelberg, Cournot, and then, collusion.
The highest profit is generated by Stackelberg leader and colluding firms, followed
by Cournot, Stackelberg follower, and then Bertrand.
Contestable Markets
Contestable market is an industry in which all firms have access to the same
technology; consumers respond quickly to price changes; incumbent firms cannot
respond quickly to an entry by lowering their prices; and there are no sunk costs. In
such a market, potential incumbent firms have no market power over customers and
strategic interaction between incumbents and potential entrants is similar to Bertrand
oligopoly. Hence, the equilibrium price corresponds to marginal cost (P = MC) and
firms earn zero economic profits.
In perfectly contestable market, incumbents are disciplined by new firms threat of
entry. A new firm can enter the market with the same technology and charge slightly
lower price. As the incumbents cannot quickly lower their prices, all their customers
will shift to be the entrants and thus, the incumbents have no alternative but to lower
their prices equal to the production cost in order to keep out the entrant.
The absence of sunk costs is important for contestable market since if sunk costs exist
and potential entrant believes that incumbents will lower their prices to respond to its
entry, the entrant may be left with no customers and such new entry will be
unprofitable. In this case, incumbents may not be disciplined by potential entry and
higher prices may prevail.

BIBLIOGRAPHY
Michael R. Baye. 2010 Managerial Economic and Business Strategy, 7th ed.
McGraw-Hill.
Yoopi Abimanyu, Ph.D. 2012. Ekonomi Manajerial (Second Edition), Cet.1.
Bogor: Penerbit Ghalia Indonesia