Oligopoly

Oligopoly

Market Structure characterized by few sellers and interdependent price/output decisions Significant barriers to entry Product could be homogenous (similar) or differentiated Potential for economic profits in the long run Incentive for illegal price setting Competition can be vigorous among the few firms

Oligopoly may be Collusive or Non collusive

Non collusive oligopoly cournot model Sweezy model

Collusive Oligopoly Cartel Price leadership

The Cournot Model

Assumptions:

Each firm assumes that its rival will continue to produce their current output level The two firms have constant marginal cost (and hence constant average cost: thus, both firms experience constant returns to scale). For simplicity, we assume MC = 0 The market demand curve is given by: P = a b(Q1 + Q2)

If there is a duopoly, and MC = ZERO

A will produce OQ ( -1/8 1/321/128.) = OQ/3 B will produce OQ( +1/16+1/64+ ..) = OQ/3
DEMAND

Suppose demand function is P = 950 Q MC = 50 COMPARE PERFECT COMPETITION, MONOPOLY AND DOUPOLY

SWEEZY MODEL STICKY PRICES

The model- There is a certain price above which if the firm raises its price, no one copies him. Below that price, if the firm reduces his price everyone copies him. Hence there are two different elasticity on either side of this price. This causes a discontinuity in the demand curve and hence a gap in the MR Curve.

Stable price under conditions of a kinked demand curve

MC2

P1

MC1

a b
O Q1

D = AR
Q

MR

As shown in the diagram, the firm continues with the same price and output despite an increase in costs. Hence one can understand why prices remain sticky. The limitation of the model is that there is no identified price at which the kink will occur.

Price - leadership

Dominant firm Low cost firm Barometric firm- a firm which has established itself as a good forecaster of economic changes.

PRICE LEADERSHIP BY DOMINANT FIRM

Cartels

A cartel is an agreement between firms to restrict output and raise price The cartel tries to maximise joint profit the full cartel outcome Cartels aim at market sharing loose cartel Joint profit is maximised by setting MR= MC1=MC2

Figure 11.4

Firm A Price and cost ($) MC A

Firm B Price and cost ($) Price and cost ($)

Industry

S MC ATC A MC B ATC B P* D MR

XA Output

XB Output

X Output
Copyright 2000 by Harcourt, Inc.

If a cartel has absolute control over all firms in an industry they can operate as a monopoly Summing each firms MC curve gives the industry MC Combining this with the industry MR shows the profit maximizing output and price Like a monopoly Profits divided among firms by production, market share, etc.

cartel

Cartels MC curve is the horizontal summation of the firms MC function . Once the optimal qty for the cartel is decided the members are given quotas. All the members sell their allocated quotas at the price determined by a cartel

REASONS FOR FAILURE OF CARTELS:

Mistakes in the estimation of market demand Errors in estimating MC Slow process of cartel negotiation cheating on quotas Stickiness of negotiated price. Fear of govt interference Fear of entry Lack of freedom in innovation

Three cartel members with mc1 = 100+.01q, mc2 = 120+ .008q2 and mc3 =150+.016q3 found that at the profit maximising price, the cartels qty sold = 20,000 and the price =84. Find the quota for each if at that qty the cartels mr = 50

Strategic Behavior &Game theory

Strategic behavior refers to the plan of action of an oligopolist after taking into consideration all the possible reactions of the competitors as they compete for profits. Study of such behaviour is called game theory Every model has players, strategies and payoffs.

Players are the decision makers. Strategies : to change prices, develop new products, advertising, R&D Payoff is the outcome or consequence of each strategy. Table showing payoffs from all strategies open to the firm and its rivals is called payoff matrix.

Prisoners dilemma

individual B confess

not confess

confess (5,5)
Indiv A not conf (10,0)

(0,10)
(1,1)

Prisoners Dilemma by Coke and Pepsi

Pepsi (right) Discount Price Discount Price Coke (left) Regular Price $1,500, $6,500 $12,500, $9,000 $4,000, $2,000 Regular Price $10,000, $1,000

Weekly Profits from Grocery Store

DOMINANT STRATEGY:

Optimal choice for a player no matter what the opponent does.

Advertising as a Prisoners Dilemma: (Dominant strategy for both firms is advertise)

Firm 1

Dont Firm 2 advertise Advertise

Dont advertise 1 = 500 2 = 500 1 = 0 2 = 750

Advertise
1 2 1 2 = = = = 750 0 250 250

Game in which firm 2 has no dominant strategy

Firm 1

Dont Firm 2 advertise Advertise

Dont advertise 1 = 500 2 = 400 1 = 200 2 = 0

Advertise
1 2 1 2 = = = = 750 100 300 200

Nash Equilibrium:

This is a situation in which each player chooses his optimal strategy given the strategy chosen by the other player. This implies no player can obtain a higher payoff by choosing a different strategy.

Game Theory

No dominant strategy for both:

Low price firm1 High price

firm2
Low price high price

2,0 0,7

1,2 6,6

Two companies A and B have to decide on whether they should cut price or maintain them. If firm A cuts prices it will 10 crores in profits if firm B also cuts prices, and 20 crores if firm B does not change prices. If firm A makes no price change it will earn nothing if firm B reduces price and Rs 5 crores if firm B makes no price change. The outcomes for B are same as for A.

Two major networks are competing for viewer ratings in the 8 to 9 p.m. and 9 to 10 p.m. slots on a given weeknight. Each has two shows to fill this period and is juggling its lineup. Each can choose to put its bigger show first or to place it second in the 9-10 p.m. slot. The combination of decisions leads to the following rating points results: Network 2 first Second Network 1 first Second 15, 15 30, 10

20,30

18,18

PAYOFF FOR A TWO PERSON CONSTANT SUM GAME

A s strategies a a b c Column maxima 10 11 6 11
Bs strategies b c

d 13 15 17 17

9 8 7 9

14 4 15 15

Row minima 9 4 6 9=9

Non determined game:

As BS STRATEGIES strategies 1 2 3 1 19 23 11

Row minima
11

2
3 Column. max

15
27 27

19
18 23

20
19 20

15
18 18/20

Concentration of economic power:

Herfindahls index: Sum of squared values of market shares of all the firms. Higher the index greater the concentration. H= S12+ S2 2+S32+.. where si is %share of ith firm Maximum value =10,000 (monopoly) If 2 equal firms, H = (50)2+(50)2= 5000. Larger firms have a larger weightage.

CONCENTRATION RATIOS: It is the percentage of total industry sales made by the four , or eight largest firms in the industry Lerners index = P MC P

EFFECT OF UNIT TAXES UNDER PC

EFFECT PRICE SHORT RUN INCREASES BUT BY LESS THAN TAX DECREASES DECREASES SAME LONG RUN INCREASES BY FULL AMOUNT OF TAX UNCHANGED DECREASES DECREASES

FIRMS OUTPUT INDUSTRY OUTPUT NUMBER OF FIRMS

EFFECT OF LUMPSUM TAX UNDER PC

EFFECT SHORT RUN LONGRUN

PRICE

NO CHANGE

INCREASED
INCREASED

QUANTITY BY NO CHANGE FIRM INDUSTRY NO CHANGE OUTPUT NO. OF FIRMS NO CHANGE

DECREASED
DECREASED