Lecture 6

Oligopoly Models

OLIGOPOLY MODELS

What are Oligopolies: Monopoly and Perfect Competition correspond to two polar cases. Most of the industries belong to neither group. Rather they are characterized by a small number of biggish firms which interact strategically in the market. They are Oligopolies, which in Greek means A small number of sellers.

Examples of Oligopolies: i. ii. iii. The Automobile Industry Big Supermarkets in Champaign-Urbana The Cola Industry

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Modeling Oligopolies:

Fact:

Modeling these industries is not as straightforward as modeling monopolies and perfectly competitive firms.

Reason:

The strategic behavior of firms in oligopolies depends on many factors among which: ' ' The number and relative size of firms in the industry. The number and type of strategic variables the firms have at their disposal. The sequence of firms actions. Consumer preferences.

' '

Firm behavior can differ substantially on the basis of the above considerations.

Consequence: There is no Oligopoly Model. Instead there is a whole number of Oligopoly Models, each one of which is applicable to a particular set of circumstances.

We will examine a few of them below. 278

Oligopoly Models:

We will examine the following models. Taken together, they provide some intuition about the interaction of firms in markets.

Dominant Firm with a Competitive Fringe

Stackelberg Duopoly: Follower-Leader Quantity Games.

Cournot Oligopolies: Simultaneous Quantity Games.

Bertrand Oligopolies: Simultaneous Price Games.

Quantity or Price Competition with Differentiated Products.

[This last one is covered in the next chapter in the Lecture Notes.]

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6.1. DOMINANT FIRM WITH A COMPETITIVE FRINGE.

This is a combination of the Monopoly and Perfect Competition models.

Similarity with Perfect Competition: There is a large number of firms.

Difference with Perfect Competition (and similarity with Monopoly): One of the firms is big relative to the market.

Examples: i. OPEC can be considered the dominant producer of oil, the other countries and firms the fringe producers. US Steel was considered the dominant producer of steel until 20 years ago. Ticketmaster in the ticket issuing for entertainment and sports events. It is the exclusive ticketing agent for 70% of the market. DuPont and titanium oxide.

ii.

iii.

iv.

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Key Modeling Features:

As in Perfect Competition, it makes sense to assume that the small firms will be price takers. However, it is not reasonable to assume that the big firm will ignore the impact that it has on market price.

Therefore, ~ ~ Dominant Firm sets the market price. Firms in the Competitive Fringe form their production decisions taking this market price as given.

Dominant firm is Strategic, that is, it takes into consideration the impact that its actions have on the actions of the other firms.

Firms in the competitive fringe are Non-Strategic.

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Denote: QM(P)
S

Market Demand

q i (P)

Supply of fringe firm i

Sequence of Actions:

This is a dynamic game. We are interested in computing the Subgame Perfect Equilibrium in this game, i.e., we will not allow the small firms to threaten the dominant firm with an unreasonable production level if it does not yield a high price. As described in our overview of Game Theory, this entails solving this game backwards, starting by the action of the competitive firms. This can best be illustrated by an example. 282

Example

Number of fringe producers:

N Y

Demand:

P = 100 - Q Q = 100 - P

Marginal Costs:

MCi = 10 qi MCD = 0

We then have:

Supply of a single fringe firm:

qi '

P 10

Total fringe firm supply:

Qf(P) ' N

P 10

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Sales by Dominant Firm:

QD(P) ' 100 & P & N ' 100 & 1 %

P 10 N 10 P

The profits of the Dominant Firm as a function of the price it chooses are equal to: AD(P) ' P QD(P) & TC(QD(P))

From the above, we have: AD(P) ' P 100 & 1 % N 10 P

The First Order Conditions of profit maximization yield: d A(P) ' 0 dP N 10 Y

100 & 1 %

P & 1 %

N 10

P ' 0

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50 ' 1 %

N 10

P '

50 1 % N 10

Observations 3 The Dominant Firm charges a price that allows the fringe firms to produce.
For this example one would expect this since the fringe firms will be driven off the market only when P=0, that is, at a price where the profits of the Dominant Firm will be zero too. However, this result is more general: A Dominant Firm will often choose not to push the fringe firms out of the market even if it could do so and maintain positive profits.

3 The market price is a declining function of the number of fringe firms.

The higher the number of fringe firms the more aggressive the Dominant Firm has to be in order to maintain some market share.

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Graphical Analysis - Relationship with Monopoly Model.

This model is essentially a modified version of the monopoly model. The Dominant Firm is a monopolist in the residual demand curve, i.e, the demand curve the results after one subtracts the output of the competitive fringe.

The above example can be analyzed graphically in the figures below: 1. In a figure with the market demand we can add the Fringe Supply as a function of price.

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2. Subtracting the Fringe Supply from the Market Demand we can construct the Residual Demand of the Dominant Firm. We also add the Marginal Revenue of this Residual Demand.

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3. The Dominant Firm will behave like a monopolist in this residual demand curve. Its optimal output will be given from the condition MR=MC, which is zero in our example. The associated price is read off the residual demand curve. The difference between the residual demand curve and the market demand curve at that price is equal to the output of the Competitive Fringe.

where Qd = output of Dominant Firm. Qm = total output in the market.

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This graphical analysis can be confirmed algebraically as well. Solving the residual demand for price we have: P ' 100 1 & Q N N 1 % 1 % 10 10

The Dominant Firm acts as a monopolist facing this residual demand curve.

The associated Marginal Revenue is MR ' 100 2 & Q N N 1 % 1 % 10 10

Optimal choice of output is given by 100 2 ( & QD ' 0 N N 1 % 1 % 10 10 QD ' 50

(

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Substituting this into the residual demand curve we get P( ' 100 1 & 50 N N 1 % 1 % 10 10 50 1 % N 10

'

This is the same answer as the one we obtained before.

Remark: In this example the quantity produced by the Dominant Firm is not a function of the number of fringe firms. This is not true in general.

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STACKELBERG DUOPOLY: FOLLOWER-LEADER QUANTITY GAMES.

Motivation:
What if N is very small, say N=1 ? Then it is not reasonable to assume that the follower firm will be a price taker. It is more reasonable to assume that it will realize that it has some market power and will exercise it accordingly.

A model along this lines is the Stackelberg Duopoly. i. ii. Two firms share a single market. One of the two firms, the Leader, commits to certain quantity or capacity qL. The other firm, the Follower, observes this choice of quantity and chooses his own quantity qF to maximize profits. The Follower takes the Leaders choice of quantity as given, i.e., he knows he can not affect it.

iii.

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Both Players are Sophisticated in that: The Followe r takes into consideration the impact his choice of quantity has on the market price. The Leader takes into consideration the response of the Follower to his own choice of quantity. The Leader will ignore any incredible threats by the Follower, i.e., we have Subgame Perfection.

Sequence of actions:

Note: To simplify notation we assumed here that demand is linear.

Solution Approach: As is the case in any dynamic game, this one is solved backwards starting from the response of the Follower to the action of the Leader, and then working back to the optimal action of the Leader.

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Example.

Demand:

P ' 10 & Q

Costs:

MC F ' C F MC L ' cL

Followers Profit conditional on Leaders output: AF(q F, qL) ' P qF & TC(q F) ' (P & cF) q F ' (10 & q F & qL & cF) q F

Optimal choice of Followers output: d AF(qF, qL) d qF Y

' 0

10 & q F & qL & cF & qF ' 0

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q F (q L) '

10 & q L & cF 2

This is knows as the Followers Reaction Function: It yields the optimal reaction of the Follower to the Leaders choice of output.

The Reaction Function is shown graphically below:

Note: The y-axis intercept is the monopoly output of the Follower.

Insight: The Leader can choose any point on the reaction function of the Follower. By the choice of his output he also chooses the Followers output.

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The Leaders profit is: AF(q F (q L), qL) ' P qL & TC(q L) ' (P & cL) q L ' (10 & q F (q L) & qL & cL) q L where we have made explicit the dependence of the Followers output on that of the Leader. Substituting in for q F (q L) we get: 10 & qL & cF 2 qL 2 & cL % cF 2
( ( (

AF(q F (q L), qL) '

10 &

& q L & cL

qL

'

5 &

qL

The First Order Condition of profit maximization yields: d AL(qL) d qL Y

' 0

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5 &

qL 2

& cL %

cF 2 cF 2

&

qL 2

' 0

qL ' 5 & cL %
Observations:

The higher the Leaders cost the lower his optimal output. The higher the Followers cost the higher the Leaders output. However, the Leaders output is more sensitive to his own cost.

In order to obtain the corresponding output of the Follower we plug q L into the Followers Reaction Function.
( (

( qF

'

10 & qL & cF 2 10 & 5 & cF 2 2 % c L & cF

'

5 & '

3 c % cL 2 F 2

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First Mover Advantage.

When the firms have different marginal costs it is less clear which one would have the higher profits and what advantage, if any, moving first has over moving second. When costs are the same we can isolate the effect of moving sequence.

Special Case:

c F ' cL ' c 1 c 2 2 1 c 2

5 & qF '
(

qL ' 5 &

The Follower produces half the output of the Leader. Since price and marginal cost is the same for both firms the Follower will make half the profit of the Leader.

297

In this game, moving first confers an advantage.

Intuition: Committing to a level of output before the competition is able to do so, allows a firm to be more aggressive and stake out a bigger slice of the market for itself.

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Discussion.
The general insight of this game carries over to situation when there is a large number of firms, each one moving sequentially after the other. The relatively early movers receive higher profits than the relatively late movers. A crucial element of this model is the idea that the Leader can commit to a production level. This is plausible when a production or sales plan can not change easily, while the price at which the firm is selling the output can adjust much more easily. Examples: 1 Farmers taking a particular amount of produce to a Farmers market. 1 The building of a particular size plant to produce an item of low marginal cost. Here quantity is interpreted as capacity. Just having the option to wait can be disadvantageous: The firm that must commit to a quantity today will make greater profits than the firm that could commit today but could also wait until later. Moving first can actually be disadvantageous, as we will soon see. 299

COURNO T OLIGOPO LIES: SIMULTA NEOUS QUANTITY GAMES.

Motivation:
What if no firm has a particular first mover advantage ? Then, it is possible that both firms commit to their production plans at the same time.
Note: At the same time should be interpreted in the information sense. It will, of course, not be simultaneously in calendar time.

Sophisticated players would commit to a quantity level such that none of them will be willing to unilaterally deviate by changing their quantity level, that is, their strategies will form a Nash Equilibrium.

These considerations lead to the Cournot Model. Sequence of actions:

Note: For simplicity we have assumed here that the market demand is linear.

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Example.
P ' " & q1 & q2 MC1 ' MC2 ' c

Demand:

Marginal Costs:

Profits of Firm 1: A1(q1, q2) ' P q1 & TC(q1) ' (" & q1 & q2) q1 & c q1 ' (" & q1 & q2 & c) q1

The First Order Condition, taking the output of firm 2 as given yield: M A1(q1, q2) M q1 Y

' 0

" & q1 & q2 & c & q1 ' 0 " & 2 q1 & q2 & c ' 0

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Similarly for Firm 2 we have: " & 2 q2 & q1 & c ' 0

The Nash Equilibrium choice of quantities is the solution to this system of equations. We can solve this system by the substitution method. However, in this example we can use firm symmetry to look for symmetric equilibrium where both firms produce the same amount. This greatly simplify the solution.
Aside: In these games the symmetric equilibrium always exists. However, it is not true in general that if players are symmetric there will be a symmetric equilibrium. For instance, consider the Battle of the Sexes.

At the symmetric equilibrium q1 ' q2 ' q . The system of equations then becomes: " & 3 q & c ' 0 " & 3 q & c ' 0

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One of these two equations is now redundant.

Caution: If it were not, then this would have been a mis-application of symmetry.

We can use either one of them to solve for the equilibrium output of either firm. q( ' " & c 3

Total Industry output is Q ' q1 % q2 ' 2 (" & c) 3

Industry price is P ' " & Q ' " & ' 2 (" & c) 3

" 2 % c 3 3

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Observations: Had either of these firms been a monopolist in this market, its optimal output would satisfy " & 2 Qmonopoly ' c " & c 2 Y

Qmonopoly '

The associated monopoly price would have been: Pmonopoly ' " & Qmonopoly ' " & ' " & c 2

" % c 2

Had this been a competitive industry, i.e., had both firms been price takers, the market price and quantity would have been Pcompetitive ' c Qcompetitive ' " & c

Had the price been higher than c, firms would increase output since P>MC. The reverse would have been true had price been less than c.

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Therefore: The Cournot market quantity is higher than the monopoly market quantity and lower than the competitive market quantity.

The Cournot market price is lower than the monopoly market price and higher than the competitive market quantity.

The Cournot Duopoly yields a market performance that is between that of the Monopoly and Perfect Competition models.

Key Question:
What determines whether an industry will be a Monopoly, Cournot Duopoly, Perfectly Competitive, or, for that matter, anything in between ?

So far we treated the number of firms in Oligopolies as given. We next consider what would determine this number, and hence, the structure or an industry.

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ENTRY AND EXIT: THE EQUILIBRIUM NUMBER OF FIRMS IN THE INDUSTRY

Consider an industry with N identical firms. Cost Structure: MC i ' c FC i ' FC Demand: P ' " & Q Q ' ji'1 q i
N

where

The profit of firm i is given by: Ai ' P qi & c qi & FC ' " & jj'1 q j & c q i
N

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The First Order Condition of profit maximization is: dA ' 0 d qi

N

" & jj'1 q j & c & qi ' 0

The Cournot equilibrium is given by the solution of the N x N system of equations, one for each firm. Here, like in the previous example, we can utilize firm symmetry and look for equilibria where qi = q for every i.

The system then collapses to the equation: " & jj'1 q & c & q ' 0
N

Y Y

" & N q & c & q ' 0 " & c N % 1

q '

Observation:

Optimal firm output is an increasing function of the strength of the demand and a decreasing function of the number of firms and their marginal cost.

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Industry Output is: Q ' N (" & c) N %1

Total output is an increasing function of N.

Industry Price is: P ' " & ' N (" & c) N %1

" % N c N % 1

Market price is a decreasing function of N.

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The profits of each individual firm are: Ai ' (P & c) qi & FC ' " & N c & c N % 1 " & c & FC N % 1

'

" % N c & (N % 1) c " & c & FC N % 1 N % 1 " & c N % 1

2

'

& FC

Firm profits are a declining function of the number of firms in the industry. This is not surprising since both price and the output of an individual firm are declining as N increases.

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Observations: 3 For N=1 we have: P ' " % c 2 and Q ' " & c 2

which are the monopoly price and quantity. 3 As N goes to infinity: P ' c and Q ' " & c

which are the Competitive Industry price and quantity. 3 For 1 < N < 4 the Cournot Equilibrium yields prices and quantities between the Monopoly and Perfectly Competitive Industry extremes.

The Cournot model has Monopoly and Perfect Competition as its special cases. This is a property that every good oligopoly should possess.

We are now left with the determination of the equilibrium number of firms. 310

The determination of the industry equilibrium can be easily seen through the following figure which plots the gross profits of every firm in the industry as a function of the N.

Firms will have an incentive to enter as long as these profits exceed the fixed cost.

The equilibrium number of firms will be the number Neq that results in net profits being equal to zero.

Observe that in this example at equilibrium all firms make zero profits.

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Variations:
1. In this model we described above, firms make zero profits. However, this is due to the assumption that all firms are identical in terms of their fixed cost. If firms differed in their fixed costs, then the marginal firm would make zero profits, but the other firms would make positive profits. This can be seen at the figure below.

The gross profits of all firms are given by the value of the gross profit function at Neq. The net profits of a particular firm, say firm 7, are equal to the difference between that number and the corresponding Fixed Cost for that firm.

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2. Firms in the industry may not have fixed costs. However, there may an entry cost. Firms will continue to enter until the Present Discounted Value of current profits is equal to the entry cost. Entry costs may differ across firms. In that case, all firms except the marginal firm will have made positive Present Discounted net profits. However, all firms will be making current profits after entry.

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Discussion.
O The equilibrium number of firms is determined by a combination of i. the size of market, ii. the cost structure of the firms.

O Concentrated markets may result in high price-cost margins, but these margins are necessary in order for the marginal firm to cover its fixed and/or entry costs.

O It is wrong to think that concentration in industries is the cause of high price-cost margins. It is the structural elements of an industry, i.e., its demand and cost structures, that leads to high concentration, with high mark-ups being a side-effect.

O Government policy can not affect the price-cost margin independently of the number of firms in the industry.

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BERTRAND OLIGOPOLIES: SIMULTANEOUS PRICE GAMES.

Motivation: M What if the assumption that firms commit on their output levels is not a realistic one ? M In many industries the more important commitment is to a price, with the quantity being somewhat flexible.
Examples: Restaurant menus. Mail-order catalogues.

This nature of the competitive interaction between firms, i.e., whether it is prices or quantities is an attribute of the industry and not up to the discretion of the firms themselves.

M Models with price commitment have been developed and yield strikingly different results.

The oldest of these models is the Bertrand Duopoly.

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Key Features: 1. Two firms share an industry. 2. The firms post prices. 3. If one firm has a lower price than the other, all consumers buy from that firm. 4. If both firms charge the same price, half the consumers buy from the one and half from the other.

The figure below shows the cost and demand structure of such an industry.

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Equilibrium.

Problem: Unlike the previous models, we can not use calculus to solve for the equilibrium in this one. Cause: The profit functions are non-differentiable: As the price of firm drops below that of the competition, the profit jumps from zero to something greater than zero.

We have to reason our way to an equilibrium. No firm will charge a price below its marginal cost. If it sells anything it will be losing money. It is not an equilibrium for both firms to charge a price above c2. The high price firm can increase its profits from zero to something positive by dropping its price below that of the competition. It is not an equilibrium from both firms to charge the same price if that price is above c2. Either firm will have an incentive to cut its price slightly below the competition and almost double its profits.

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 This leaves one possibility: i. The high cost firm charges a price equal to its cost. ii. The low cost firm will charge the profit maximizing price amongst those in the interval [c1 , c2). This will be the monopoly price if it is lower than c2 or a price just slightly below c2 if the monopoly price is higher than c2.

Intuition: You can think of the low cost firms problem as that of a monopolist whose demand is horizontal at c2.

This firm will price slightly below c2.

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However, this firm will set a price equal to Pm.

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Bertrand Oligopoly with Identical Firms.

When an industry consists of N firms each one of which with identical marginal costs, all firms will set a price equal to marginal cost and share the market. Contrary to quantity competition it only takes two firms for the price to drop to marginal cost.

Unlike the case of monopoly, it really matters what are the strategic variables along which the firms interact.

Implication:

The price-cost margin and the number of firms in the industry depend not only on the demand and cost structure of the industry but also on the nature of competitive interaction among firms.

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Problem: The model of price competition must leave most of you somewhat unsatisfied: Surely the result that two firms are sufficient to bring about a perfectly competitive outcome seems unreasonable.

Cause:

The driving force behind this result is the hypothesis that all consumers will shop from the least expensive firm. This is clearly false for many reasons. Perhaps the most important of these is the fact that most consumers do not perceive the products of different firms as perfect substitutes: They are willing to pay a price premium to purchase they product they like the most.
Examples: A Benetton sweatshirt is not a perfect substitute for a L.L.Bean sweatshirt. A Ford Contour is not a perfect substitute for a Toyota Corolla.

Note: In some markets, of course, products are nearly perfect substitutes (for instance, steel, oil, agricultural products). In these cases the above models are applicable.

In the next lecture we turn to the discussion of models that allow for products that are not perfect substitutes.

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Measures of Concentration.
A major part of Industrial Organization [Anti-trust] is concerned with the anti-competitive effects of industrial concentration.

Substantial discussion of this topic would require a separate course.

We are, however, going to define some of the key indices of concentration typically used by Anti-trust economists.

1. Four and Eight-Firm Concentration Ratios, C4 and C8. This is the percentage of output in an industry produced by the four or eight largest firms, respectively.

2. The Herfindahl-Hirschman Index. This is defined as: HHI ' ji s i

2

where si is the share of firm i. Clearly, this measure goes from 0 to 1.

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Discussion.

These measures are typically used to assess the anti-competitive effect of mergers.

Our discussion above indicates that measures like these do not rank industries from more to less competitive. The nature of competition matters, too.

This particularly true for industries with differentiated products, where simply defining the market may be a challenge.

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