BUS 525: Managerial

Economics
Lecture 9
Basic Oligopoly Models

Overview
I. Conditions for Oligopoly?
II. Role of Strategic Interdependence
III. Profit Maximization in Four
Oligopoly Settings
Sweezy (Kinked-Demand) Model
Cournot Model
Stackelberg Model
Bertrand Model

IV. Contestable Markets

9-2

9-3

Oligopoly Environment
A market structure there are only a few
Firms, each of which is large relative the total
industry
Relatively few firms, usually less than 10.
Duopoly - two firms
Triopoly - three firms

The products firms offer can be either

differentiated or homogeneous.
Firms decisions impact one another.
Many different strategic variables are modeled:
No single oligopoly model.

9-4

Role of Strategic Interaction

Your actions affect the profits of
your rivals.
Your rivals actions affect your
profits.
How will rivals respond to your
actions?

An Example
You and another firm sell
differentiated products.
How does the quantity demanded for
your product change when you
change your price?

9-5

9-6

D1 (Rival matches your price change)

PH
P0

PL

QH1 QH2 Q0 QL2

QL1

D2 (Rival holds its

price constant)
Q

9-7

D2 (Rival matches your price change)

Demand if Rivals Match Price

Reductions but not Price Increases
P0

D1
D2

Q0

(Rival holds its

price constant)
Q

Note that demand is more inelastic when rivals match a price change than
when they do not
Reason: For a given price reduction, a firm will sell more if rivals do not cut
their prices D2 than it will if they lower their prices D1

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 arent in
complete control of your own destiny!

9-8

Sweezy (Kinked-Demand)
Model Environment
Few firms in the market serving many
consumers.
Firms produce differentiated products.
Barriers to entry.
Each firm believes rivals will match (or
follow) price reductions, but wont match
(or follow) price increases.
Key feature of Sweezy Model
Price-Rigidity.

9-9

Sweezy Demand and

Marginal Revenue
P

D2 (Rival matches your price change)

DS: Sweezy Demand

P0
D1

(Rival holds its

price constant)

MR1
MR2
MRS: Sweezy MR

Q0

9-10

Sweezy Profit-Maximizing
Decision
P
D2 (Rival matches your price change)
A

MC1
MC2
MC3

P0
C

D1 (Rival holds price

constant)

E
MRS

Q0

DS: Sweezy Demand

9-11

Sweezy Oligopoly Summary

9-12

Firms believe rivals match price cuts, but not

price increases.
Firms operating in a Sweezy oligopoly
maximize profit by producing where
MRS = MC.
The kinked-shaped marginal revenue curve implies
that there exists a range over which changes in
MC will not impact the profit-maximizing level of
output.
Therefore, the firm may have no incentive to
change price provided that marginal cost remains
in a given range.

Cournot Model
Environment
A few firms produce goods that are
either perfect substitutes (homogeneous)
or imperfect substitutes (differentiated).
Firms control variable is output in
contrast 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).
Barriers to entry exist.

9-13

Inverse Demand in a Cournot

Duopoly
Market demand in a homogeneousproduct Cournot duopoly is
P a b Q1 Q2
Thus, each firms marginal revenue
depends on the output produced by the
other firm. More formally,
MR1 a bQ2 2bQ1

MR2 a bQ1 2bQ2

9-14

9-15

Best-Response Function
Since a firms marginal revenue in a
homogeneous Cournot oligopoly depends on both
its output and its rivals, each firm needs a way to
respond to rivals output decisions.
Firm 1s best-response (or reaction) function is a
schedule summarizing the amount of Q1 firm 1
should produce in order to maximize its profits for
each quantity of Q2 produced by firm 2.
Since the products are substitutes, an increase in
firm 2s output leads to a decrease in the profitmaximizing amount of firm 1s product.

Best-Response Function for a

Cournot Duopoly
To find a firms best-response function, equate
its marginal revenue to marginal cost and solve
for its output as a function of its rivals output.
Firm 1s best-response function is (c1 is firm 1s
MC)
a c1 1
Q1 r1 Q2
Q2
2b
2
Firm 2s best-response function is (c2 is firm 2s
MC)
a c2 1
Q2 r2 Q1
Q1
2b
2

9-16

Graph of Firm 1s BestResponse Function

9-17

Q2
(a-c1)/b

Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2

Q2
r1 (Firm 1s Reaction Function)
Q1

Q1M

Q1

9-18

Cournot Equilibrium
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 to improve
its profit.
A point where the two firms bestresponse functions intersect.

9-19

Graph of Cournot Equilibrium

Q2
(a-c1)/b
r1
Q2

Cournot Equilibrium

Q2 *

E
C

B
r2
Q1*

Q1M

(a-c2)/b

Q1

Summary of Cournot
Equilibrium
The output Q1* maximizes firm 1s
profits, given that firm 2 produces Q2*.
The output Q2* maximizes firm 2s
profits, given that firm 1 produces Q1*.
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!

9-20

The Isoprofit Curve

9-22

Firm 1s Isoprofit Curve

The combinations of outputs of the two firms
that yield firm 1 the same level of profit

Q2
r1

B
A

C
D

Increasing
Profits for
Firm 1
0 = $100

1 = $200
2 = $300
Q1M

Q1

Another Look at Cournot

Decisions
Q2
r1

Q2*

Firm 1s best response to Q2*

0 = $100
1 = $200
2 = $300

QA QB

Q 1*

QD

Q 1M

Q1

9-23

Another Look at Cournot

Equilibrium
Q2
r1 Firm 2s Profits
Cournot Equilibrium

Q2M
Q2*

Firm 1s Profits
r2
Q 1*

Q1M

Q1

9-24

Collusion Incentives in
Cournot Oligopoly
Q2
r1

2Cournot

Q2M

1Cournot

r2

Q1M

Q1

9-25

Impact of Rising Costs on the

Cournot Equilibrium
Q

9-26

r1*

Cournot equilibrium after

firm 1s marginal cost increase

r1**
Q2**

Cournot equilibrium prior t

firm 1s marginal cost incr

Q2*
r2
Q1**

Q1*

Q1

Price Leadership Model

In a price leadership model, one dominant firm takes
reactions of all other firms into account in its output and
pricing decisions
Competitive fringe: A group of firm that act as a price taker
in a market dominated by a price leader
A dominant firms demand curve is the residual demand
curve that shows what it can sell after accounting for sales
by other firms
Other firms accept whatever price is set by the dominant
firm and produce an output where P=MC
Note that P>MC for dominant firm, total industry output is
less than competitive output

Dominant Firm
Model

Fig : Equilibrium in the Dominant Firm

Model

Stackelberg Model
Environment
Few firms serving many consumers.
Firms produce differentiated or
homogeneous products.
Barriers to entry.
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 leaders output.

9-29

The Algebra of the Stackelberg

Model

9-30

Since the follower reacts to the leaders output,

the followers output is determined by its
reaction function

a c2
Q2 r2 Q1
0.5Q1
2b

The Stackelberg leader uses this reaction

function to determine its profit maximizing
output level, which simplifies to

a c2 2c1
Q1
2b

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.

9-31

Bertrand Model
Environment
Few firms that sell to many consumers.
Firms produce identical products at
constant marginal cost.
Each firm independently sets its price in
order to maximize profits (price is each
firms control variable).
Barriers to entry exist.
Consumers enjoy
Perfect information.
Zero transaction costs.

9-32

9-33

Bertrand Equilibrium
Firms set P1 = P2 = MC! Why?
Suppose MC < P1 < P2.
Firm 1 earns (P1 - MC) on each unit sold,
while firm 2 earns nothing.
Firm 2 has an incentive to slightly undercut
firm 1s price to capture the entire market.
Firm 1 then has an incentive to undercut firm
2s price. This undercutting continues...
Equilibrium: Each firm charges P1 = P2 = MC.

9-34

Contestable Markets
Key Assumptions
Producers have access to same technology.
Consumers respond quickly to price changes.
Existing firms cannot respond quickly to deter 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).

9-35

Conclusion
Different 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 (P or Q) and the nature
of the product market (differentiated or
homogeneous products).
Your ability to credibly commit prior to your
rivals.

.
Basic model
Monopoly case

Q 120 P

P 120 Q

Assuming zero costs,

we have

P.Q 120Q - Q

Maximum profits may be found by setting d /dQ 0

d
120 - 2Q 0
dQ
or
Q 60
and, therefore
P 60

PQ 3600

Duopoly case

P 120 - (Q1 Q2)

Q Q1 Q2

1 P.Q 1 120Q1 Q 12Q1Q2

2 P.Q 2 120Q2 - Q1Q2 - Q 22

d1
dQ2
120 - 2Q1 - Q1
- Q2 0
dQ1
dQ1
d2
dQ1
120 - Q1
- Q1 - 2Q2 0
dQ2
dQ2

Cournot Solution
dQ2 dQ1

0
dQ1 dQ2
d1
120 - 2Q1 - Q2 0
dQ1
d 2
120 - Q1 - 2Q2 0
dQ2

Q1

120 - Q2
2

Q2

120 - Q1
2

Q1 120 - Q2
2

120 - (120 - Q1)/2

2

[by substituting value of Q2]

4Q1 120 Q1
Q1 40
Q2 120 - Q1 40
2
P 120 - (Q1 Q2) 120 - 80 40

1 PQ1 1600
2 PQ2 1600 [Cournot profit 3200 3600(monopoly profit)]

Stackelberg solution
One firm has discovered its rivals reaction function, suppose
dQ2
1
dQ1
2
d 1
1
120 - 2Q1 Q1 Q2 0
dQ1
2
Q1 80 - 2 3 Q 2
Q1 60
Q2 30
P 120 - (Q1 Q2) 120 - 90 30
1 PQ1 1800

2 PQ2 900 Firm 1 has been able to increase its profit by using its knowledge of firm 2' s reaction.
Firm 2' s profit has been seriously eroded in the process

Zero cost monopoly

P

120

Q = 120 - P

60

0
P

Cournot solution

Q
60

120

MR

Stackelberg solution

Price

120

120
Q = 120 - P

R1 : Q1 120 - Q2
2

Monopoly

60

60
Equilibrium

Cournot

40

R2 : Q2 120 - Q1
2

40

0
40

60

120

Stackelberg

60

80

120

Q per
period