Chapter 19

Oligopoly

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All

Rights Reserved.

Main Topics
Oligopoly and game theory
The Bertrand model
Cournot quantity competition
Price competition with differentiated products
Collusion
Market entry and monopolistic competition
Antitrust policy

19-2

Oligopoly and Game Theory

Economists use game theory to analyze
oligopoly competition
Game theory looks for price or quantity choices
at which each firm is doing as well as it can
given the prices charged or quantities produced
by its rivals
In a Nash Equilibrium, each firm is making a
profit-maximizing choice given the actions of its
rivals
In game theory, a firms most profitable choice
given the actions of its rivals is called its best
response
19-3

Figure 19.1: Oligopoly Pricing Game

19-4

Bertrand Model
The simplest possible oligopoly market is one with two firms (a
duopoly) that produce identical (homogeneous) goods
Firms set their prices simultaneously
Buyers observe prices and decide how much to purchase from each
firm
Purchase from firm with lower price

This is the Bertrand model of oligopoly

After Joseph Bertrand, published in 1883

Each firms most profitable choice depends on what the other

does
With linear demand curve, a price that is closer to the monopoly price
results in greater profit
Firms have an incentive to undercut each others price in order to win
sales
Undercutting behavior drive prices down to marginal cost

Example: two concrete companies, marginal cost = $40 per cubic

yard, monopoly price = $70
19-5

Individual Firm Demand

To identify the Nash equilibrium in the Bertrand game,
think about each firms demand curve
A firms demand curve shows the relationship between
the firms price and the quantity it sells given the
behavior of its rivals
A firm has many demand curves, each one
corresponding to a different choice by its rival
Notice that if a firm charges a higher price than his
rival, he sells nothing
If he sets the same price as his rival, his sales equal
half the market demand at that price
If he charges a lower price than his rival, his sales
equal the market demand at his price
19-6

Figure 19.2: Market Demand and

Firm Demand Curve

19-7

Nash Equilibrium in the

Bertrand Duopoly
In the concrete company example, if both firms charge $40 it is a
Nash equilibrium
Recall that $40 is their marginal cost
$40 is the best each firm can do given that the other is charging $40

Bertrand result is the same as the perfectly competitive outcome

Monopoly price would be $70

To maximize their joint profit each firm would need to charge $70
Each firm undercuts that price to increase its own profit
Each firm ignores the negative effect of its behavior on its rivals profit

Implies that welfare losses due to market power are limited to

monopoly markets
Overly optimistic
Some of the models assumptions may be at odds with reality

19-8

Figure 19.3: Nash Equilibrium in

the Bertrand Model

Joe cant do better than

charging $40 if his rival is
charging $40

The parallel argument holds

from his rivals perspective
So both firms charging $40 is
a Nash equilibrium

100
Price ($/cubic yard)

D40 is Joes demand curve

when his rival charges $40
Joes profit is zero if he
charges $40, negative if he
charges less than $40, and
zero if he charges more than
$40

D40
MC

40

2000
4000
3000

6000

8000

10000

Concrete (Cubic Yards per Year)

19-9

Sample Problem 1 (19.1)

Suppose Joe, Louie, and Rebecca compete
in the Bertrand ready-mix concrete market
described in Section 19.2. Show that in any
Nash equilibrium, all sales must occur at a
price of $40 (equal to marginal cost). Extend
your argument to show that this statement
will be true as long as two or more firms are
competing in the market.
In that example: P = 100 0.01Q

Cournot Quantity Competition

In many settings a firm can sell only a limited quantity
at a time
Bertrand model may overstate firms ability to steal business
from one another

In some situations quantities rather than prices drive

market outcomes
In the Cournot model of oligopoly:
Firms choose quantities simultaneously
Price clears the market given the total quantity produced
Named after French mathematician Augustin Cournot,
introduced in 1838

Assume homogeneous goods

Provides insights when firms make capacity decisions
that determine sales capabilities
19-11

Figure 19.4: Price Determination

in the Cournot Model
Given the output of the
two firms:
The price clears the
market
Amount demanded equals
amount supplied

Here, total output is

4,000
Price = $60/cubic yard

19-12

Nash Equilibrium in a
Cournot Market
Important difference from equilibrium in Bertrand market:
equilibrium price is always above marginal cost
P=MC will yield profit of zero
Firm could do better by reducing output
This would raise market-clearing price above marginal cost
Profit would be positive

In a Nash equilibrium each firms output choice maximizes its profit

given its rivals output choice
Need to find each firms best response for each possible output level
for its rival

First step is to derive one firms demand curve for each possible
output level for its competitor
For the cement example, the firms demand curve is shifted
leftward from the market demand curve by an amount equal to its
rivals output at every price
19-13

Best Responses
A firms best response is the quantity that equates his
marginal revenue with his marginal cost
The marginal revenue curve is derived from the firms
demand curve
By graphing the firms best response at each of its
competitors possible output levels we obtain its best
response curve:
Shows its best choice in response to each possible action by
its rival

Nash equilibrium occurs where the two firms best

response curves cross
19-14

Figure 19.6: Best Responses in

the Cournot Model

19-15

Figure 19.7: Best Response

Curves in the Cournot Model

19-16

 The Nash equilibrium is

the point where the best
response curves cross
Each firm produces 2,000
cubic yards

Can also find these

equilibrium output
choices using algebra

Joes Output (Cubic yards per year)

Figure 19.8: Nash Equilibrium in

the Cournot Model
6000
5000
4000
3000

BRRebecca
Nash equilibrium

2000

BRJoe

1000

1000 2000 3000

4000 5000 6000

Rebeccas Output (Cubic yds per year)

19-17

Figure 19.9: Deadweight Loss

from Duopoly vs. Monopoly
Deadweight loss with
oligopoly:
Equals area of the light
red triangle
$20,000 per year

Deadweight loss of
monopoly
Equals total of dark and
light red areas
$45,000 per year
Larger than oligopoly
because monopoly price
is further above marginal
cost
19-18

Sample Problem 2 (19.3)

Repeat worked out problem 19.1 (page
712), but assume instead that Joe and
Rebecca both have a marginal cost of
$55 per cubic yard. What is the
deadweight loss in this market?
In this problem: Qd = 10,000 100P

Oligopoly and Perfect Competition

When the number of competitors in a market grows
very large, expect firms to begin acting like price takers
In a Cournot market, as the number of firms grows
larger, the market outcome approaches competitive
equilibrium
Expand the cement example to include additional firms
Joes doesnt care who is producing the rest of the output in the
market, the effect on the price he receives is the same
Only their total output matters in determining his best response
His best response function will take the same form as before
but consider the total output of his rivals rather than just
Rebeccas output

As the number of firms increases the price falls and the

quantity produced increases
19-20

Markups in a Cournot Model

In Cournot oligopoly, size of the markup is related to the elasticity
of market demand:

P MC
1

d
P
NE

Here, N denotes the number of identical Cournot competitors

For a given number of firms, the less elastic the demand the
greater the markup
The less elastic the demand, the greater the increase in price that
results from a given reduction in a firms output
The more attractive the idea of restricting output

For a given demand elasticity, the larger the number of firms, the
lower the markup
Confirms that as N grows larger, the markup falls to zero, so the
market price approaches the marginal cost
19-21

Price Competition with

Differentiated Products
Often, the products that firms in an oligopoly
market sell are not homogeneous
Coke and Pepsi, for example

When consumer do not view similar products as

perfect substitutes, those products are
differentiated
The Bertrand model result of competition driving
prices down to marginal cost does not hold with
differentiated products
Firms can make a positive profit by raising their
price above marginal cost
19-22

Differentiated Products: Coke and

Pepsi Example
Assume there are no other relevant products
Marginal cost to produce a can of either brand is 30
cents
If Pepsis price is 30 cents and Coke charges slightly
more, it will lose some customers but not all of them
Coke can make a positive profit by raising its price above
marginal cost

Cokes demand curve decreases gradually as its price

rises
Cokes marginal revenue curve is derived from its demand
curve

A lower Pepsi price shifts Cokes demand curve to the

left since they are substitutes
19-23

Figure 19.12: Cokes Demand Curves

19-24

Best Responses and

Nash Equilibrium
Obtain Cokes best response curve by graphing the
firms best response at each possible price that Pepsi
might charge
Cokes profit-maximizing sales quantity occurs at the
intersection of the marginal revenue and marginal cost curves
The corresponding price is found on the firms demand curve

Cokes best response curve is upward sloping

The more Pepsi charges, the more Coke should charge
Follow the same steps to find Pepsis best response curve

Graph the two curves with Cokes price on one axis and
Pepsis on the other
Nash equilibrium is where the two curves cross
Each firm chooses the price that maximizes its profit given its
rivals price
19-25

Figure 19.14: Nash Equilibrium

with Differentiated Products

19-26

Incentives to Differentiate
Competition becomes more intense as
products become less differentiated
Consumers are more willing to switch in response to
price differences

A firm has an incentive to differentiate its

products from those of rivals
Product differentiation is an important strategy
firms use to ensure a profit

19-27

Sample Problem 3 (19.8)

Suppose a single monopolist controls the market
for Coke and Pepsi in worked out problem 19.2
(page 722). If the monopolist sets the same price
for Coke and Pepsi, what price would maximize
its profit? How does that price compare to the
equilibrium prices in worked-out problem 19.2?
In that problem: QC = 45 50PC + 200(PP-PC),
QP = 45 50PP + 200(PC-PP) and MC=0.30

Collusion
In the real world firms compete against each other over
and over
Repetition can make a big difference in the outcome of
oligopolistic competition
In the infinitely repeated Bertrand model, firms play
the Bertrand pricing game over and over with no
definite end
The noncooperative outcome is the repetition of the
Nash equilibrium that would arise if the firms were to
compete just one time
There may be other equilibrium outcomes
Sometimes possible for firms to sustain the monopoly price
E.g., by adopting a grim strategy
19-29

Collusion, continued
Collusion relies on the credible threat of a future price
war to keep firms from undercutting each others prices
If future profits are important enough firms will not want
to risk a price war
This will be the case if the interest rate is not to high
So future losses are significant from todays perspective

Factors that inhibit collusion:

With more firms, there is more to gain today and less to lose in
the future from undercutting
Differing marginal costs
Observing rivals costs imperfectly

19-30

Tacit vs. Explicit Collusion

What determines which equilibrium prevails
when firms compete repeatedly?
Explicit collusion is one possibility
Firms engage in explicit collusion when they
communicate to reach an agreement about prices
Illegal in many countries, including the U.S.

Tacit collusion is another

Collusion without communication, sustaining a price
above the noncooperative price
Generally not illegal, but less likely to be successful
19-31

Market Entry and

Monopolistic Competition
Firms enter an oligopolistic market in response
to profit opportunities
Several factors affect the number of firms that
enter:
Fixed cost associated with becoming active in the
market
As the fixed cost shrinks and the number of firms grows,
the possible profits of an active firm approach zero

Size of the market

Intensity of competition
Because profits are lower in a market with more intense
competition, fewer firms will enter
19-32

Figure 19.17: Factors Affecting

the Number of Firms

19-33

Market Entry and Social Welfare

Firms individual entry decisions in oligopoly
markets may not maximize aggregate surplus
Entry may not occur even if it would increase
aggregate surplus
If entry by the first firm would be unprofitable
Government may want to subsidize entry by first firm
to increase aggregate surplus

Once one firm has entered the market, excessive

entry may result and lower aggregate surplus
Business stealing arises when some of a new
entrants sales come at the expense of existing
firms
19-34

Figure 19.19: Entry and Welfare

19-35

Product Differentiation and

Monopolistic Competition
In markets with product differentiation firms must
decide what kind of good to produce
Monopolistic competition is a market with:
A large number of firms
Each produces a unique product
Prices above marginal cost
Close to zero profit, net of fixed costs

Firms demand curve is downward sloping due to

differentiation
At the firms profit-maximizing price and quantity, P=AC
so the firm breaks even
Entry in monopolistically competitive markets may be
excessive or insufficient relative to the level that
maximizes aggregate surplus
19-36

Figure 19.20: Monopolistic

Competition

19-37

Antitrust Policy
Antitrust legislation focuses on maintaining rules of
competition that enable markets to produce good
outcomes
Limit welfare losses from market power
Investigation and intervention occur only when the rules may
have been violated

Thee U.S. laws provide the foundation of antitrust policy:

Sherman Act (1980), Clayton Act (1914), and Federal Trade
Commission Act (1914)
Enforced by the DOJ, FTC, and through private suits

Two categories of antitrust laws:

Collaboration among competitors
Exclusion from the market

Firms engage in price fixing when they agree on the

prices they will charge or the quantities they will produce
19-38

Horizontal Mergers
In a horizontal merger, two or more competing firms
combine their operations
A main form of collaboration
In the US, large firms who wish to merge must notify the DOJ and
FTC in advance

Concern with horizontal mergers is that they may raise

market prices by reducing competition
Can also have beneficial effects:
Cost reductions from reorganized production processes
Increase aggregate surplus
Reduce market prices

Antitrust agencies must weigh these factors when

deciding whether to approve a merger
Typical test applied for merger approval in the U.S.
requires that prices not rise
19-39

Figure 19.23: Welfare Effects of

Horizontal Mergers

19-40

Exclusionary Behavior
Focuses on the ways a dominant firm can reduce
competition by excluding rivals from the market
Either fully or by impairing their competitiveness
Recent Microsoft case involved exclusionary behavior

Exclusionary behaviors may include:

Predatory pricing
Exclusive contracts
Bundling

Difficult to restrain dominant firms without limiting their

surplus-enhancing actions
Balancing these two concerns is a challenge

19-41

Sample Problem 4 (19.18)

An economist has found that patients
who suffer from diseases that are more
prevalent than other diseases are more
likely to take the medicine their doctors
prescribe. Why might this be so?