oligopoly(sept2010) [compatibility mode]

8/4/2019 Oligopoly(Sept2010) [Compatibility Mode]

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Oligopoly

Mihir Mahapatra

9/10/2010 1

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Issues for Discussion Oligopoly

Duopoly

Conditions lead to emergence ofOligopoly Market?

Equilibrium in Oligopoly Market

9/10/2010 2

Cournot Solution Application of Game Theory in

Oligopoly Market



Oligopoly is a market structure in which there areonly few sellers (firms) of ahomogeneous or differentiated product.

Pure Oligopoly: Product is HOMOGENEOUS

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Differentiated Oligopoly: Product isDIFFERENTIATED

Duopoly: An oligopoly with two sellers(competitors)

Duopoly is the limiting case of Oligopoly



Oligopoly

Oligopoly: Most prevalent form of Market organizationExp: Detergent, Cigarettes, Electrical Equipment, Computer-Differentiated Product

Homogeneous Product: Close Resemble Petrochemicals, Telecom

serviceReliance, Tata Indicom, BSNL, MTNL, AIRTEL,IDEA, HUTCH-BPL etc ! (excluding service)

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As FEW firms operate in the industry so ACTION of each firm affectsthe other firms in the industry and vice-versa.

If one firm Reduces price then other firms can not RemainINDIFFERENT

To avoid PRICE WAR Oligopolist prefer to compete on the basis

of product differentiation, advertising and service



CAN ADVERTISEMENT SOLVE the PROBLEM?

Advertisement: Coca-cola vis-à-vis Pepsi

(Aamir Khan vis-à-vis Shahrukh Khan)

KING FISHER vis-à-vis Jet and other domestic players

If one firm opts for major advertising campaign then others will follow suit.

Overall Inference: INTERDEPENDENCE OR RIVALRY AMONG THE FIRMS

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.

As There are FEW firms in the industry

INFERENCE: EACH OLIGOPOLIST NEEDS TO TAKE INTO ACCOUNT

EXPECTED COMPETITORS REACTION WITH RESPECT TO

PRICING POLICY, DEGREE OF PRODUCT DIFFERENTIATION, LEVEL

OF ADVERTISING TO BE UNDERTAKEN AND AMOUNT OF SERVICES

TO BE PROVIDED .



Why does Oligopoly Emerge?

Barriers to market entry: Conditions that make itdifficult for new firms to enter the industry where existing firms have

long-run interests.

Entry-limit pricingSet a price lower than the Profit Maximizing price to discouragepotential rivals to enter the market

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Excess Capacity and Economies of scale(Serve as a signal to potential entrants that exiting firm can reduceprice and expand output if a new firm attempts to gain a share of

market)Incumbent firms may adopt strategic actions to deter entry (Pindyck et al.)

Threaten to flood market and drive prices down if entry occurs.

To make threat credible, can construct excess production capacity



Sources of Oligopoly continues…….

Economies of Scale: Operates over sufficiently large rangeof output so as to leave only few firms supplying the output.

Average Cost of Production low

Requirement of Huge Capital Investment and Specialized inputsto enter Oligopolistic Market

New Firms to raise tremendous amount of investment funds to install the

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.

[Exp: Automoblie, Aluminium, Steel (SAIL, ISPAT, TATA STEEL etc)]

Product differentiation or brand recognition(Existing firms Develop preference for their product by the

consumers. New firms cannot attract the customers easily)

Need to spend more money for Market Recognition and MarketReputation



Sources of Oligopoly…… © Brand Reflects the quality of product

(Quality of Product and Services are two important factors thatdetermine profit)

Patent Rights: Few firms own patent right or exclusive right

to produce

Control of supply of Required Raw Material by few Firms restricts newentrants entering the industry

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Access to Technology exclude potential competitors

Sales and Distribution Networks



Equilibrium in Oligopoly Market

Management Challenges

Strategic actions to Deter Entry

Threaten to decrease price against new Competitorsby keeping Excess Capacity

Rival behavior

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Because only a few firms, each must consider how itsactions will affect its rivals and in turn how their rivals

will react



Equilibrium: Oligopoly

If one firm decides to cut price, then it mustconsider what other firms in the industry will do

Could cut price.How much? The same amount, or more

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Could lead to PRICE WAR and drastic FALL inPROFITS for all

Actions and reactions are dynamic, evolving overtime



Oligopoly: Equilibrium

Defining Equilibrium

Market is in equilibrium if firms are doing thebest they can and have no incentive to changetheir prices or output.

9/10/2010 11

rms assume compe ors are a ng r vadecisions into account

Nash Equilibrium

Each firm is doing the best it can given what its competitors are doing



Equilibrium in Duopoly Market: The Cournot Model

Duopoly: Market in which Two Firms Compete with eachother

Introduced by French Mathematical Economist: Augustin Cournot (1838)

Two Profit Maximizing Duopolists selling Spring Waterunder Zero long run Marginal Cost of Production

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EACH FIRM TREATS OUTPUT of its COMPETITORS asFIXED.

BASED on it EACH FIRM DECIDES how much to PRODUCE

to Maximize Profit

Each Firm will adjust its output based on what it thinks the

other firm will produce



Assumptions of Cournot Model

Homogenous Product Produced by Twofirms

Each Duopolist assume OUTPUT of other

9/10/2010 13

uopo y as xe

Each Duopolist fully know the Linear Market

Demand Curve



Firm 1’s Output Decision

P1D1(0)

Firm 1 and market demand curve,D1(0), if Firm 2 produces nothing.

If Firm 1 thinks Firm 2 will produce50 units, its demand curve is

shifted to the left by this amount.

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MC1

50

MR1(75)

D1(75)

12.5

rm n s rm w pro uce

75 units, its demand curve isshifted to the left by this amount.

Q1

MR1(0)

D1(50)MR1(50)

25



Oligopoly

• The Reaction Curve

– The relationship between a firm’s

PROFIT MAXIMIZING OUTPUT and theamount it thinks its COMPETITOR will

9/10/2010 15

(Ex. If Firm 1 thinks firm 2 will produce nothing then it

(firm 1) produces 50 units. If Firm 2 Produces 50, firm1 produce 25 (=1/2 of the market not supplied by firm2). Firm 2 produce 75, firm 1 produce 12.5 (1/2 of 25),

firm 2 produce 100, firm 1 produce nothing)



’75

100

Firm 1’s reaction curve shows how much it

will produce as a function of how muchit thinks Firm 2 will produce. The x’scorrespond to the previous model.

The Reaction Curve & Cournot Equilibrium

Q1

9/10/2010 16

Curve Q*2(Q1)

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Q2

25

50

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x100755025



The Reaction Curve & Cournot Equilibrium

’75

100 In Cournot equilibrium, eachfirm correctly assumes howmuch its competitors will

produce and therebymaximizes its own profits.

Q1

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Curve Q*2(Q1)

Q225 50 75 100

25

50

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

CournotEquilibrium



Cournot Equilibrium

Equilibrium in the Cournot model, in which each firm correctly assumes how muchits competitor will produce and sets its own production level accordingly

• Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium)

The action reaction continues as the firms don’t learn from past pattern of reaction of their rival.

9/10/2010 18

Eventually equilibrium reached when each firm produces ONE-THIRD of totalmarket (or two firms produce 2/3 rd of total market).

Equilibrium Point: INTERACTION of TWO REACTION CURVES



Equilibrium……

Each firm maximizes profit in each period but industryprofits are not maximised.

Recognition of Interdependence (open Collusion)leads to HIGHER PROFIT- A case of Monopoly

power

9/10/2010 19

Collusion: Feasible to Produce ONE-HALF of total

output. If shared equally, one-fourth is produced byeach firm (instead of one third as noticed earlier).



The Linear Demand Curve

• Compare Cournot Equilibrium with Competitive

Equilibrium and the Equilibrium resulting from Collusion

– Two firms face linear market demand curve

– We can Market demand is P = 30 - Q

9/10/2010 20

– Q is total production of both firms:Q = Q1 + Q2

– Both firms have MC1 = MC2 = 0



An Example

• Firm 1’s Reaction Curve MR = MC

111 )30( QQ PQ R −==:RevenueTotal

2

1211 )(30 QQQQ

−−=

+−=

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An Example of Cournot Equilibrium

21

11

21111

2115

0

230

QQ

MC MR

QQQ R MR

−=

==

−−=∆∆=

CurveReactions2'Firm

CurveReactions1'Firm

9/10/2010 22

12

2115 QQ −=

1030

2010)2115(2115

:other)eachwithintersectcurvesreaction(Two

mEquilibriuCournot

21

1

21

=−=

=+=

=−−

=

QP

QQQQ

QQ



Cournot Equilibrium

Q1

Firm 2’sReaction Curve

30The demand curve is P = 30 - Q and

both firms have 0 marginal cost.

9/10/2010 23

Q215


15

30

10

10

Cournot Equilibrium



Profit Maximization with Collusion

15QwhenMaximizedisProfitTotal

15Qimplies 0

0.:

230

30)30(

.........&..................

2

=

==

==

−=∆∆=

−=−==

MR

ButMC MC MRm Equilibriu

QQ R MR

QQQQPQ R

equally profit split todecided colludetodecided firmstwo Let

Curve Q1 + Q2 = 15-Collusion Curve

Shows all pairs of output Q1 and Q2 that maximize total profits

9/10/2010 24

If they share profit equally, then both can produce half of the total

Q1 = Q2 = 7.5

Inference: In collusion, less output (7.5 each) and higher profits as

compared to Cournot equilibrium (more output: 10 each)

Cournot outcome (firm) is better than Perfect Competition,but not as good as the Collusion

In Collusion each firm sells lower output



Duopoly Example


Q1

30 For the firm, collusion is the best

outcome followed by the CournotEquilibrium and then thecompetitive equilibrium

9/10/2010 25


Q230

10

10

Cournot Equilibrium

CollusionCurve

7.5

7.5

Collusive Equilibrium

15

15

Competitive Equilibrium (P = MC; Profit = 0)



Thanks a lot

9/10/2010 26

oligopoly(sept2010) [compatibility mode]

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