Oligopoly
Oligopoly
• Oligopoly
• Only a few sellers
• Offer similar or identical products
• Interdependent
• Game theory
• How people behave in strategic situations
• Choose among alternative courses of action
• Must consider how others might respond to the action
he takes
Two Main Models
• Cournot model:
• An oligopoly model in which firms simultaneously choose
output.
• Bertrand model:
• An oligopoly model in which firms simultaneously choose
prices.
And A Common Approach
• Game theory:
• Best response
• A strategy that produces the highest payoff among all possible
strategies for a player, given what the other player is doing.
• Nash equilibrium
• A set of strategies, one for each player, that are each best responses
against one another.
Overview: Pricing of Homogeneous
Goods
• Competitive outcome (C)
• Bertrand model
• Perfect cartel outcome (M)
• Monopoly
• And in between (A)
• Cournot
Cournot Model
• Two firms, A and B, operate springs. The water is
homogeneous. The firms decide how much water, qA
and qB, to supply. MC = 0.
• Market demand: Q = 120 – P
• P = 120 – Q, where Q = qA + qB
• We want to find the Nash equilibrium:
• A set of outputs, qA* and qB*, such that neither firm has an
incentive to change their output, given the output of the other
firm.
Cournot Model
• Each firm maximizes profit by producing output where
MR = MC.
• TRA = (120 – qA – qB) x qA
• MRA = 120 – 2qA – qB (same intercept, twice the slope)
• 120 – 2qA – qB = 0 = MC
• qA = (120 – qB) / 2 Firm A’s best-response function
• qB = (120 – qA) / 2 Firm B’s best-response function
Cournot Best Response Diagram
• In equilibrium, qA* = qB* so:
• qA* = (120 – qA*)/2
• qA* = 40
• Q = 80, P = $40
• Profit per firm = (P – MC) x q
• ($40 – 0) x 40 = $1,600
Comparing Cournot to Other
Markets
• Perfect Competition:P = $0 , Q = 120, πi = 0
• Cournot: P = $40, Q = 80, πi = $1,600, πTotal
= $3,200
• Monopoly: P = $60, Q = 60, π = $3,600
• Why don’t the firms attain the monopoly outcome?
• Cournot firms do not take into account that an increase in
their output lowers price and, therefore, the profits of the
other firm.
Bertrand Model Assumptions
• Two firms in the market, A and B, that produce a
homogeneous product.
• Marginal cost and average cost is constant and equal to
c.
• Firms choose prices, PA and PB, simultaneously.
• If PA = PB, sales are split evenly.
• If PA ≠ PB, all sales go to the firm with the lowest price.
• What’s the Nash equilibrium?
Bertrand Paradox
• Why is the Nash equilibrium in the Bertrand Model
paradoxical?
• How can we resolve the paradox?
• Firms choose output (Cournot)
• Products are differentiated
• The firms have different marginal costs
• Repeated interaction
• Capacity constraints
Cournot and Bertrand Compared
• With Bertrand: P = MC and profits equal to zero. With
Cournot: P > MC and profits are greater than zero.
• Actual behavior in oligopoly markets may exhibit a wide
variety of outcomes.
• In both cases, firms would be better off by
“cooperating”:
• Not stable since both firms have an incentive to cheat.
