AN INTRODUCTION

TO OLIGOPOLY
To p ic : O lig o p o ly
tu to r2 u ; Mo Tanweer;
mohammed.tanweer@cantab.net
Content

W h a t is a n o lig o p o ly?
K in ke d d e m a n d m o d e l

Price - w a rs a n d ca rte ls

Priso n e rs ’ d ile m m a

E xte n sio n s : B e rtra n d / C o u rn o t/ S ta cke lb e rg

co m p e titio n
Oligopoly
A few large firms dominating an
industry , with strategic
A interdependence
One firm ’ s output and price decisions are influenced by
very high concentration ratio

Intel/AMD duopoly

ist is likely to be aware of the actions of the others . The decisions

Boeing/Airbus duopoly UK Supermarkets (CR4 = 74%)

Possible examples

Fastfood restaurants (KFC, McD’s, Wimpy)

e Big Four accountancy firms
Pizza chains: Pizza Hut, Dominos
eds to take into account the likely responses of the other market par

P&G and Unilever (dominate detergent market)

 Characteristics

Price makers Long run supernormal profits

“Few” number of dominant sellers Strategic interdependence

§The main key to behaviour in an oligopoly, is that companies must take into
account what other companies will do. In perfect competition, firms are
price-takers and can ignore other firms. In a (pure) monopoly, there is only
one firm, and it does not take into account what competitors will do.
Oligopolists are torn between:
§cooperating to increase profits by obtaining the monopoly outcome,
or;
§competing to try to gain an advantage over competitors.
The Kinked-Demand curve
model
An oligopolist faces a downward sloping demand curve but the elasticity may
depend on the reaction of rivals to changes in price and output.
(a) rivals will not follow a price
increase by one firm, so the acting
firm will lose market share - therefore
demand will be relatively elastic and a
rise in price would lead to a fall in
(b)the
rivals
totalare more likely
revenue of the to match a
firm
price fall by one firm to avoid a
loss of market share. If this
happens demand will be more Rev &
inelastic and a fall in price will Costs
Rev &also lead to a .fall
Rel in total
Elastic
Costs revenue.
P*

Rel . inelastic AR2=D2

Discontinuity AR=D
MR2
AR=D Q* q
MR MR
Price competition
In oligopolistic markets, we tend not to see much price competition for
the following reasons:
This is because competitors will generally ignore price increases, with
the hope of gaining a larger market share as a result of now having
comparatively lower prices
even a large price decrease will gain only a few customers because such
an action will begin a price war with other firms.

Rev &
Costs

P*

Furthermore, price stickiness occurs

because there is a discontinuity which
means a change in MC has no effect on
profit-max P* or Q*

AR=D
MR
Non-price competition
Due to undesirability of price competition, due to risk of price wars; firms in
oligpolistic tend to undergo non-price competition:
Mass media advertising and marketing ( informative vs


persuasive
Visual / Sound) branding ; “ Every little helps ” ; “ Just Do It ”;
“ The Worldcards
Store loyalty
’ s Local Bank ” , Nectar points )
( airmiles
Home delivery

Extension of opening hours

Innovative use of tech . ( self - scanning machines )

Internet shopping ( some price discrimination here? )

Offering complementary g / s e . g . Tesco ’ s banking services
Offering compli mentary g / s e . g . Amazon free delivery
BOGOF ( price / non - price? )

BOGOFL

In - store chemists / post offices / creches

Promoting domestic ( nationalism ) g / s

Celebrity Endorsements

After - sales service / warranties / guarantees

Corporate social responsibility / charitable work / / ethical
values
Store e . g . Starbucks Fairtrade
layout
Cartels
When there are only a few dominant firms in a market, they can cooperate
to restrict output or fix
e.g. higher
OPEC prices
Why might cartels break down?

The more companies in the industry, the harder it is to form a cartel and
enforce it (trust)
The weaker the barriers to entry are, the harder it is to ensure a
successful cartel
Strong incentive to cheat: Firm’s output/prices cannot easily be checked
Whisteblowing legislation (OFT; Virgin-BA)
When can collusion be good for con
If demand is not inelastic enough (PED/YED) – too variable
Different types of restrictive practices:
Price fixing
Information sharing StrategicHigher SNPe.g.
alliances leads to Savings
more
Blu-Ray non-price
dvds competition (benefits
on advertising/R&D (wasteful consumer) Stability
duplication?) (passed ontoin consumer?)
prices
Tacit vs formal collusion

Unwritten / unspoken agreements

for example, in some industries, there may be an acknowledged market lead
which informally sets prices to which other producers respond, known as
Examples of collusion
Examples of anti-trust in
action
Examples of anti-trust in
action
Examples of anti-trust in
action
Examples of anti-trust in
action
 Game theory is the study of how people behave in strategic situations
(i.e. when they must consider the effect of other people’s responses to
their own actions). In an oligopoly, each company knows that its profits
depend on actions of other firms. This gives rise to the "prisoners’
dilemma".
The prisoners' dilemma is a particular game that illustrated
why it is difficult to cooperate, even when it is in the best interest of
both parties. Both players select their own dominant strategies for
shortsighted personal gain. Eventually, they reach an equilibrium in which
they are both worse off than they would have been, if they could both
agree to select an alternative (non-dominant) strategy.

Oligopoly theory makes heavy use of game theory to model the

behaviour of oligopolies:
Bertrand’s oligopoly: In this model the firms simultaneously
choose prices
Cournot’s duopoly: In this model the firms simultaneously
choose quantities
Stackelberg’s duopoly: In this model the firms move
sequentially
Game Theory
Game theory is the study of how people behave in strategic situations
(i.e. when they must consider the effect of other people’s responses to
their own actions). In an oligopoly, each company knows that its profits
depend on actions of other firms. This gives rise to the "prisoners’
dilemma".
The prisoners' dilemma is a particular game that illustrated
why it is difficult to cooperate, even when it is in the best interest of
both parties. Both players select their own dominant strategies for
shortsighted personal gain. Eventually, they reach an equilibrium in which
they are both worse off than they would have been, if they could both
agree to select an alternative (non-dominant) strategy.

Oligopoly theory makes heavy use of game theory to model the

behaviour of oligopolies:
Bertrand’s oligopoly: In this model the firms simultaneously
choose prices
Cournot’s duopoly: In this model the firms simultaneously
choose quantities
Stackelberg’s duopoly: In this model the firms move
sequentially
 Pay - off matrix
Prisoners’ DilemmaNormal form
sequential, is there first-mover or second-mover advantage?
The Nash equilibrium is (Betray, Betray); although it is Pareto-dominated by (S

B
Silent Betray

A Silent 6mths,6mths 10 years,0 years

Betray 0 years,10 years 5 years, 5 years

charge
R: low price”
The first number; “advertise/don’t advertise”;
always goes to the player on“invest in R&D/don’t
the LEFT, do R&D”
and the second number always goes to the player
 Cournot competition
Cournot ’ s duopoly : In this model the firms simultaneo
rnot ( 1801 - 1877 ) was a French economist , philosopher and mathematician .

Assume two firms that compete in quantities (q1, q2)

 q
1 = f ( q 2 ); q 2 = f ( q 1 )

Linear ( inverse ) demand curve : P = a – bQ ( where Q = q 1 +

q2) (1.1)
For simplicity assume constant marginal costs TC i = cq i for
i = 1,2
We are trying to find the optimal q1 and q2 that will be
chosen , given the other firm ’ s output decisions , and thus
the price that will be charged in the market in
equilibrium

Firm 1 chooses the best q1 given q2 and Firm 2 chooses the best q2
given q1
Cournot competition
Firm 1
Profit for any firm is total revenue minus total costs ; ∏ =
( TR – TC )
∏1 = p . q 1 - c . q 1
 (1.2)

 Recall from the previous slide , equation 1 . 1 , that P = a –
bQ and Q = q 1 + q 2
 So we get :
P = a – b ( q 1 + q 2)
P = a – bq 1 - bq 2 (1.3)

 If we then substitute 1 . 3 into 1 . 2

Then ∏
1 = (a-bq1-bq2)q1 - c.q1

∏1 = aq1-bq12-bq2q1 - c.q1 (1.4)

 Cournot competition
Now that we have the profit function for Firm 1, as a function of its own output and the
other firm’s output, we can now differentiate this function w.r.t. its own quantity, to find
out at what quantity, q1, it should produce at to profit-maximise:

Differentiate Equation (1.4) w.r.t q1



∂Π1
= a − 2bq1 − bq2 − c = 0 a − 2bq1 − bq2 − c = 0
∂q1

2bq1 + bq 2 = a − c − 2bq1 − bq2 = c − a

a − c − bq2
on ( q 2 ), the 2bq
profit 1 = a−c−
- maximising bq2
“ best q1” =for firm is q 1
response
2b
This is known as Firm 1 ’ s REACTION FUNCTION
 Cournot competition
Since Firm 1 and Firm 2 are identical, both of the firm’s reaction functions can be
found by differentiating their relevant profit functions, which gives:

a − c − bq2 a − c − bq1
q1 = q2 =
2b 2b

his is known as Firm 1 ’ s REACTION FUNCTION

This is known as Firm 2 ’ s REACTION FUNCTI
 Cournot competition
We can now plot these two functions on the same graph:

q2
a − c − bq2
If Firm 1 q1 =
went for a different quantity ( say q1a ), Firm 2 ’ s best
2b

If Firm 2 went for that q2a , Firm 1 ’ s best response

a − c − bq1
q 2a q2 =
2b
q 1b q 1a q1
But if Firm 1 went for q1b , then Firm 2 ’ s best response is
heatdefinition of athere
q * 1 , q * 2 that Nash is
equilibrium
no tendency for change , given the other firm ’ s output decision
 Cournot competition
eactions ; The pattern continues until a point is reached where neither firm de

We can now plot these two functions on the same graph:

q2
a − c − bq2This
q1 =
nition of a Nash equilibrium point is the COURNOT EQUILIBRIU
2b

Recall that these two functions are “ reac

ither firm has a profit icnentive to diverge from them

q*2 a − c − bq1
q2 =
2b
q*1 q1

They
s the best response , given Firmshow
1 hasthe
gone“ best
for q * 1response ” given what the other
where they cross , implies that for Firm 1 , q * 1 , is the best response , given Firm 2 has gon
 Cournot competition
Solving algebraically, we have two equations with two unknowns, q1 and q2:

a − c − bq2 a − c − bq1
q1 = q2 =
2b 2b
rating the component parts and cancel the “ b ”

a c bq
q1 = − − 2
2b 2b 2b
Factor out the 1 / 2

1a c  1  a c  a − c − bq1  
q1 =  − − q2  q1 =  − −   
on function , q2 2 top
( yellow box b right
b ), into
 here
2b b  2b 
 Cournot competition
Continuing…:

1  a c  a − c − bq1  
q1 =  − −   
2b b  2b 
oss by 2 to get rid of the fraction

 a c  a − c − bq1  
2q1 = 1 − − 1  
b b  2b  Simplify
Simplify
Multiply across by 2 to get rid of the fraction

a c a c q1 2a 2c 2a 2c 2q1
2q1 = − − + + 4q1 = − − + +
b b 2b 2b 2 b b 2b 2b 2
 Cournot competition
Continuing…:

2a 2c a c
4q1 = − − + + q1
b b b b
range so q1 is on one side

2a a 2c c
4q1 − q1 = − − +
b b b b
Simplify

a c a−c
3q1 = − q1 =
b b 3b
 Cournot competition
Since Firm 1 and Firm 2 are identical (whilst you could work it out again for Firm 2,
you would get the same result) so:

a−c a−c
q1 = q2 =
3b 3b

resent the q * 1 and q * 2 that we showed on our diagram – i . e . the Cournot Nash equ

Back (a while ago now!) we said that P = a – bQ (the inverse linear demand curve)
We can now substitute the above two equations into the original demand curve to find
the price that will be charged by the firms

a−c a−c
P = a − b + 
 3b 3b 
Cournot competition
Simplifying these:

a−c a−c
P = a − b + 
 3b 3b 

 a−c a−c
P = a − + 
 3 3 

a c a c
P = a − − + − 
 3 3 3 3
Cournot competition
Simplifying these:

a c a c
P = a − − + − 
 3 3 3 3

1 This1 is the
1 price
1
P =a− a− a+ c+ c that will be charged for the outputs th
3 3 3 3

2 2 1 2 a + 2c
P =a− a+ c P = a+ c P=
3 3 3 3 3
Cournot competition
In terms of the industry output that will be produced, it is simply q1 + q2:

a−c a−c
q1 = q2 =
3b 3b

a−c a−c
Q= +
3b 3b

2a−c
Q=  
3 b 
Cournot competition
Using MC=MR
Firm1’s demand function is P = (60 - Q2) - Q1 where Q2 is the quantity
produced by the other firm and Q1 is the amount produced by firm 1.
Assume that marginal cost is 12.
Firm 1 wants to know its maximizing quantity and price. Firm 1 begins
the process by following the profit maximization rule of equating
MC=MR.
Firm 1’s total revenue function is PQ = Q1(60 - Q2 - Q1) = 60Q1- Q1Q2 -
Q12. The marginal revenue function is MR = 60 - Q2 - 2Q.
Set MC = MR
12 = 60 - Q2 - 2Q
2Q = Q2 – 60
Q1 = 30 - 0.5Q2 [1.1]
Q2 = 30 - 0.5Q1 [1.2]
Equation 1.1 is the reaction function for firm 1.
Equation 1.2 is the reaction function for firm 2.
To determine the Cournot equilibrium you can solve the equations
simultaneously.
The equilibrium quantities can also be determined graphically. The
equilibrium solution would be at the intersection of the two reaction
functions.
 Bertrand competition
Bertand ’ s duopoly : In this model the firms simultan

thematician Joseph Louis François Bertrand ( 1822 – 1900 )

The Bertrand model is essentially the Cournot model except the strategic
variable is price rather than quantity.
‘Bertrand competition’ refers to a model of oligopoly in which two or more
firms compete by simultaneously setting prices and in which each firm is
committed to provide consumers with the quantity of the firm’s product they
demand given these ‘posted prices’.

In a Bertrand (Nash) equilibrium, firms compete in prices, i.e.Firm 1 chooses
the best p1 given p2 and Firm 2 chooses the best p2 given p1

The model assumptions are there are two firms in the market, producing a
homogeneous product, at a constant marginal cost.

Firms choose prices PA and PB simultaneously

The only Nash equilibrium is PA = PB = MC.

Neither firm has any reason to change strategy. if the firm raises prices it
will lose all its customers. If the firm lowers price P < MC then it will
be losing money on every unit sold.

The Bertrand equilibrium is the same as the perfectly competitive outcome.

Each firm will produce where P = marginal costs and there will be zero
supernormal profits.
Bertrand Paradox
In the ‘classic’ model of Bertrand competition, each of the firms produces an identical
product at a constant unit cost
Since their products are perfect substitutes, firms effectively compete for the total
demand
The firm setting the lowest price gets all of this demand; in the event of a tie, the
firms charging the lowest price share total demand equally
Consequently, all firms earn zero supernormal profits in equilibrium, a result that has
come to be known as the Bertrand paradox
The paradox stems from the fact that, while a monopolist would earn strictly positive
profits by charging a price in excess of marginal cost, it takes only two firms to
completely dissipate the monopoly profits and achieve the competitive outcome
In a Bertrand equilibrium, all transactions take place at marginal cost, and all firms
earn normal zero profits
Another way of thinking about it, a simpler way, is to imagine if both firms set equal
prices above marginal cost, firms would get half the market at a higher than MC price.
However, by lowering prices just slightly, a firm could gain the whole market, so both
firms are tempted to lower prices as much as they can. It would be irrational to price
below marginal cost, because the firm would make a loss. Therefore, both firms will lower
prices until they reach the MC limit

Note that colluding to charge the monopoly price and supplying one half of the market
each is the best that the firms could do in this set up. However not colluding and
charging marginal cost , which is the non-cooperative outcome is the only Nash
equilibrium of this model.
If one firm has lower average cost (a superior production technology), it will charge the
highest price that is lower than the average cost of the other one (i.e. a price just
below the lowest price the other firm can manage) and take all the business. This is
known as "limit pricing“.
Critique of Bertrand
Since the Bertrand model assumes that firms compete on price and not output
quantity, it predicts that a duopoly is enough to push prices down to marginal cost
level, meaning that a duopoly will result in perfect competition;
Whereas in Cournot the competition based on quantities leads to effectively
acting as a cartel and restricting output

Themost critical flaw of the model is the assumption that firms compete
in one period, the price being chosen and set forever. However, as it
is unreasonable to expect the other firm to indefinitely keep higher
prices and sell nothing, each firm must expect that lowering the price
will almost immediately be met with the same move by the other firm,
thus no firm can expect to get bigger market share by cutting price,
and the preferred strategy is keeping prices at monopoly price level.
The situation is analogous to the prisoner's dilemma, single-period
version of which has completely opposite implications than the
iterated version.
It assumes firms compete purely on price, ignoring non-price
competition. Firms can differentiate their products and charge a
higher price. For example, would someone travel twice as far to save
1% on the price of their vegetables?
There are rarely just two firms in a market.
If a firm does undercut a rival and get full market share, it now has
to supply the whole market; many firms would not have the capacity to
do this. In general, the greater the overall capacity constraints, the
higher the price is than marginal cost.
Perfect competition
(Bertrand) vs Monopoly vs
Cournot
Given the same cost structures:

P = a − bQ and TCi = cqi

In Perfect Competition:

a −c
P = MC ⇒ P = C ⇒ Q pc =
b
In Monopoly:

Π = TR − TC Π = aQ − bQ 2 − CQ 2bQ = a −c
Π = PQ − CQ ∂Π a −c
= a − 2bQ − C = 0 Qm =
∂Q 2b
Π = ( a − bQ ) Q − CQ
Π = aQ − bQ 2 − CQ P = a −bQ
 a −c 
P = a −b 
 2b 
a +c
PM =
2
 Perfect competition
(Bertrand) vs Monopoly vs
Cournot
Recall that in Cournot the respective prices and quantities were:

2 a−c a + 2c
Q CO
=   P CO =
3 b  3
In Perfect Competition:
a −c
Q pc
= P =c Therefore : Q M < Q CO < Q PC
b
In Monopoly: Therefore : P M > P CO > P PC

a −c a +c
Qm = PM =
2b 2

intuitive sense , since more competition should lead to more output and lower p
 Stackelberg competition
Stackelberg ’ s duopoly : In this model the fir

ch Freiherr von Stackelberg who published Market Structure and Equilibrium ( 1934 )

The firms adopt a leader-follower relationship and they compete on quantity.

Firmsmay engage in Stackelberg competition if one has some sort of

advantage enabling it to move first.
The leader must know ex ante that the follower observes his action.
The leader must have commitment power.
Moving observably first is the most obvious means of commitment:
once the leader has made its move, it cannot undo it - it is
committed to that action.
Moving first may be possible if the leader was the incumbent
monopoly of the industry and the follower is a new entrant.
Holding excess capacity is another means of commitment.

The principal difference between cournot and stackelberg
competition lies on the order of actions. While in Cournot
competition firms choose simultaneously the quantity they
produce, in Stackelberg competition, firms are deciding
sequentially. Thus the leader firm has a strategic advantage
since she knows how will react the follower. It follows that in
Stackelberg competition the leader gets higher profit than in
Cournot while it is the reverse for the follower.
 Stackelberg competition
Stackelberg ’ s duopoly : In this model the fir

ch Freiherr von Stackelberg who published Market Structure and Equilibrium ( 1934 )

The Stackelberg model can be solved to find the subgame perfect Nash equilibrium
or equilibria (SPNE), i.e. the strategy profile that serves best each player, given
the strategies of the other player and that entails every player playing in a Nash
equilibrium in every subgame.

The model is solved by backward induction. The leader considers what

the best response of the follower is, i.e. how it will respond once it
has observed the quantity of the leader. The leader then picks a
quantity that maximises its payoff, anticipating the predicted
response of the follower. The follower actually observes this and in
equilibrium picks the expected quantity as a response.
To calculate the SPNE, the best response functions of the follower must
first be calculated
TO UNDERSTAND HOW TO SOLVE STACKELBERG GAMES IT WOULD HELP IF YOU WENT
OVER THIS GAME THEORY LECTURE focusing on the backward induction
extensive form idea

Algebraic example

Two competing firms, selling a homogenous good

The marginal cost of producing each unit of the good: c1 and c2

Firm 1 moves first and decides on the quantity to sell: q1

Firm 2 moves next and after seeing q1, decides on the quantity to sell:
q2
Q = q1+q2 total market demand
The market price, P is determined by (inverse) market demand:
P = a-bQ
Both firms are profit-maximisers
Algebraic example

Suppose firm 1 produces q1

Firm 2’s profits, if it produces q2 are:

π2 = Total revenue – total costs:


∏2 = P.q2 − c2 .q2
∏2 = [( a − b(q1 + q2 )] − c2 q2
∏2 = ( P − c2 )q2


Maximising this profit function involves finding the FOC and setting it
to 0.

 ∂ ∏2
= a − 2bq 2 − bq1 − c2


∂q2
Which is effectively setting MR – MC = 0 (or MR = MC)

(a − c2 ) q1
q2 = − This is firm 2 ’ s BEST RESPONSE ( REACTION ) FUNCT
2b 2
Algebraic example

Firm 1’s profits, if it produces q1 are:



∏1 = ( P − c)q1 = [a − b(q1 + q2 )]q1 − c1q1
We know that from the best response of Firm 2:


(a − c2 ) q1


q2 = −

2b 2
Substitute q2 into π1:


 (a − c2 ) q1 (a + c2 ) bq1
∏1 = [a − b(From
q1 +FOC: − )]q1 − c1q1 ∏1 = [ − − c1 ]q1

2b 2 2 2

∂ ∏1 (a + c2 ) (a − 2c1 + c2 )
= − bq1 − c1 = 0 q1 =
∂q1 2 2b
Algebraic example

So we have Firm 1’s profits, if it produces q1:

(a − 2c1 + c2 )


q1 =

2b
And firm 2’s best response:

 (a − c2 ) q1
 q2 = −
Therefore: 2b 2


 (a + 2c1 − 3c2 )
If c1 = c2q2= =
c
4b

(a − c) (a − c) 3(a − c)
q1 = q2 = Q=
2b 4b 4b
Bertrand vs Cournot vs
Stackelberg
Recall that in Cournot the respective prices and quantities were:

2 a−c a + 2c
Q CO
=   P CO =
3 b  3
In Bertrand they were:
a −c
Q pc
= P =c
b
In Stackelberg:
( a +3c )
3( a −c ) ( a −c ) ( a −c ) PM =
Q m
= =( + ) 4
4b 2b 4b

Firm output / prices :

Bertrand ≤ Stackelberg ≤ Cournot ≤ Monopoly
AN INTRODUCTION
TO OLIGOPOLY
Topic : Oligopoly
tutor2u ; Mo Tanweer;
mohammed.tanweer@cantab.net