Industrial Organization PGDMM501

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Industrial Organization PGDMM501

• Lecture 4 Oligopoly

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Today

• Tutorial 1
• Two types of oligopoly introduced.
• Cartels versus the non-cooperative oligopoly
• The challenges in cartel formation
• Game theory and Nash Equilibrium
• Strategic bahaviour and best response function
• Bertrand, Cournot and Stakelburg models of
  oligopoly

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The competitive spectrum
Oligopoly
Monopoly
Atomism
?
No one can affect price. Behavior perfectly
predictable.
Only one can affect price. Behavior not
constrained, but only one rational result.
Price and quantity depend on interaction among
firms. Expectations matter.
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Oligopoly

• There are few firms producing identical goods.
• The firms decision about q affects P.
• Contrast this with monopolistic and perfectly
  competitive markets.
• Two variations
• Cooperative oligopoly
• Non-cooperative oligopoly

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Cooperative oligopoly

• Also known as cartels
• Aim is to cut output and increase ?
• Possible only if P increase more than
  proportionately
• However if done individuallyIndividual gain lt
  individual cost

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Cartel Behavior (with many firms)
P
p
D
MC
MCcartel
AC
q/t
Q/t
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Why would cartel members cheat
MC
p
AC
q/t
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Cartels thrive when

• Price can be increased
• Inelastic demand
• Entry barriers to non members
• No close substitutes
• Low expectation of punishment under anti-trust
  laws
• Low organization costs of cartels

• Enforcement possible
• Detection easy if
• Few firms
• No independent price ?
• Prices widely known
• Homogeneous goods
• Less incentive to cheat (p.139)
• Preventive method
• MFN clause
• Meeting-competition clause

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A cartel member quitting
S1non-cartel
P
p
MC1cartel
Dr
MR1cartel
q/t
q/t
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A cartel member quitting
S1non-cartel
P
p
MC1cartel
Dr
MR1cartel
q/t
q/t
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A cartel member quitting
P
p
Dr
MR1cartel
q/t
q/t
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A cartel member quitting
S1non-cartel
P
p
MC1cartel
Dr
MR1cartel
q/t
q/t
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When cartels fail

• Non-cartel supply increase
• Cartel supply falls
• Residual demand curve flattens
• Prices come down and output increases
• CS ?gt PS? ? Overall welfare ?
• The benefits is due to DWL of cartels
• See p.147

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Non-cooperative oligopoly

• Firms act independently of each other (like in
  Perfect competition and unlike in cartels)
• However unlike in Perfect competition what one
  does affects the others profits
• Thus strategic behavior is important
• Game theory is useful to model this phenomenon

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Prisoner's Dilemma
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Coordination Game
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Lets play a game now
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In games

• There are two or more players
• Each player wants to maximize his/her payoff
• Each is aware that the others actions affect
  there payoffs
• Thus suited to model non-cooperative oligopoly
  conditions

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Single period models

• Bertrand Model
• The two players engage in price competition
• Residual demand curve based on beliefs about the
  others price

• Cournot model
• The players engage in quantity
• The residual demand curve is based on the others
  strategy regarding the quantity

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Single period models

• Bertrand Model

• Cournot model

p2
p2
p1
MC
MC
q2
q2
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Firm 1s Best Response function

• Bertrand Model

• Cournot model

p2
q2
MC1
p1
q1
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Two BRFs can locate the equm

• Bertrand Model

• Cournot model

p2
q2
Firm 1s BRFp1R1(p2)
Firm 1s BRFq1R1(q2)
Firm 2s BRFp2R2(p1)
Firm 2s BRFq2R2(q1)
p1
q1
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Two BRFs can locate the equm

• Bertrand Model

• Cournot model

p2
q2
Firm 1s BRFp1R1(p2)
Firm 1s BRFq1R1(q2)
Firm 2s BRFp2R2(p1)
Firm 2s BRFq2R2(q1)
p1
q1
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Leader follower model
p

• Due to Stakelberg
• The leader knows followers Cournot BRF.
• The residual demand curve for leader is based on
  follower BRF

MC1
q1
q2
q1
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p
Firm 1s Dr
MC1
q1
q1
q2
Firm 2s BRF
q2
q1
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Oligopoly pricing
How secure is the relationship between
concentration and market power?
p2
Profit possibilities frontier
On the frontier means joint-monopoly pricing.
Cournot
Assumptions are everything.
Stackelberg
Bertrand
At the origin means efficient pricing.
p1
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Tutorial 2

• Chapter 4
• Q2
• Q6
• Q8
• To be submitted next week 28th July 2005