Oligopoly and Monopolistic

Competition

Key issues

1. market structure

2. game theory

3. Cournot model of oligopoly

4. Stackelberg model of oligopoly

5. cartels

6. monopolistic competition

7. Bertrand model of oligopoly

Market structures

markets differ according to

• number of firms in market

• ease of entry and exit

• ability of firms to differentiate their

products

Oligopoly

• small group of firms in a market with substantial barriers to entry

• because relatively few firms compete in such a market,

• each firm faces a downward-sloping demand curve

• each firm can set its price: p > MC

• market failure: inefficient (too little) consumption

• each affects rival firms

• typical oligopolists differentiate their products

Strategies and games

• oligopolistic or monopolistically competitive firm

use a

• strategy:

• battle plan of actions (such as setting a price or

quantity) it will take to compete with other firms

• oligopolies engage in a

• game:

• any competition between players (such as firms) in

which strategic behavior plays a major role

Game theory

• set of tools used by economists, political scientists, military analysts, and others to analyze decision making by players (such as firms) who use strategies

• these analytic tools can be used to analyze

• oligopolistic games

• poker

• coin-matching games

• tic-tac-toe

• elections

• nuclear war

Firm's objective

• obtain largest possible profit (or payoff) at

game’s end

• typically, one firm's gain comes at expense

of other firms

• each firm's profit depends on actions taken

by all firms

Nash equilibrium

• set of strategies is a Nash equilibrium if,

• holding strategies of all other players (firms) constant,

• no player (firm) can obtain a higher payoff (profit) by

choosing a different strategy

• in a Nash equilibrium, no firm wants to change its

strategy because each firm is using its

• best response:

• strategy that maximizes its profit given its beliefs about

its rivals' strategies

Duopoly

• consider single-period, duopoly, quantity-

setting game

• duopoly: an oligopoly with two ("duo")

firms

Firms act simultaneously

• each firm selects a strategy that

• maximizes its profit

• given what it believes other firm will do

• firms are playing

• a noncooperative game of imperfect

information:

• each firm must choose an action before

observing rivals’ simultaneous actions

Dominant strategy

• a strategy that strictly dominates all other

strategies regardless of which actions

rivals’ chose

• firm chooses its dominant strategy

• where a firm has a dominant strategy, its

belief about its rival's behavior is irrelevant

Noncooperative game

• firms do not cooperate in a single-period

game

• In Nash equilibrium, each firm earns less

than it would make if firms restricted their

outputs

• sum of firms' profits is not maximized in

this simultaneous choice, one-period game

Why don't firms cooperate?

• don't cooperate due to a lack of trust:

• each firm can profitably use low-output

strategy only if it trusts other firm!

• each firm has a substantial profit incentive

to cheat on a collusive agreement

Prisoners' dilemma game

all players have dominant strategies that

lead to a profit (or other payoff) that is

inferior to what they could achieve if they

cooperated and played alternative strategies

Collusion in repeated games

• in a single-period prisoners' dilemma game, firms produce more than they would if they colluded

• why, then, are cartels frequently observed?

• collusion is more likely in a multiperiod game: single-period game played repeatedly

• punishment: not possible in a single-period game but possible in a multiperiod game

Noncooperative oligopoly

• many models of noncooperative oligopoly

behavior

• firms choose quantities

• Cournot model

• Stackelberg model

• firms set prices: Bertrand model

Basic Cournot model

• duopoly: 2 firms (no other firms can enter)

• firms sell identical products

• market that lasts only 1 period (product or service cannot be stored and sold later)

• as in prisoners' dilemma game, firms are playing noncooperative game of imperfect information

• each firm chooses its output level before knowing what other firm will choose

• firms may choose any output level they want

Cournot equilibrium

• Nash equilibrium where firms choose quantities

• set of quantities sold by firms such that, holding quantities of all other firms constant, no firm can obtain a higher profit by choosing a different quantity

• When firms move simultaneously, why doesn’t one firm announce it will produce Stackelberg-leader output, to force its rival to produce the Stackelberg-follower’s output level?

• Answer: The follower doesn’t view the threat as credible. • not in the leaders best interest to produce large quantity

unless it is sure the follower believes the threat.

• When one firm moves first, its threat to produce a large quantity is credible because it has already committed to producing large quantity

Credibility and Commitment

Supergame

• if a single-period game is played repeatedly, firms

engage in a

• supergame:

• players’ strategies in this period may depend on rivals'

actions in previous periods

• in a repeated game, firm can influence its rival's

behavior by

• signaling

• threatening to punish

Supergame Outcomes

• If firms know the number of periods

• “Unravels” from the end, so firms don’t

collude

• If the timing of the last period is uncertain

or the game is played indefinitely

• Firms can sustain collusion by threatening to

punish each other for cheating

Cartels

Adam Smith:

"People of the same trade seldom meet

together, even for merriment and diversion,

but the conversation ends in a conspiracy

against the public, or some contrivance to

raise prices"

Factors that Facilitate the Formation of Cartels

• The ability to raise the market price

• Low expectation of severe punishment

• Low organization costs

Enforcing a Cartel Agreement

• Detecting cheating

• Cartels with little incentive to cheat

• Methods of preventing cheating

* most-favored nation clause

* meeting but not beating competition clause

Cartels and Price Wars

Structure of Industry:Incentives for Collective Action

• Firm Concentration

• Demand Elasticity

• Barriers to entry

• Industry Excess Capacity

• Product homogeneity

• Facilitating mechanisms

Why can cartels raise profits?

• if a competitive firm is maximizing its profit, why should joining a cartel increase its profit?

• competitive firm is already choosing output to maximize its profit

• however, it ignores effect that changing its output level has on other firms' profits

• cartel takes into account how changes in one firm's output affect cartel profits

Why some cartels persist

1. Tacit collusion

2. International cartels (OPEC) and cartels

within certain countries operate legally

3. Difficult to detect

4. Ease of enforcement

5. Government support

Diamond Cartel

Cartels fail

luckily for consumers, cartels often fail

because

• each firm in a cartel has an incentive to

cheat on the cartel agreement by producing

extra output

• governments forbid them

Why cartels fail

• cartels fail if noncartel members can supply consumers with large quantities of goods (example: copper)

• each member of a cartel has an incentive to cheat on cartel agreement

Solved problem

• initially, all identical firms in a market

collude

• if some of these firms leave the cartel and

act like price takers, how are consumers

affected?

Maintaining cartels

to maintain a cartel, firms must

• detect cheating

• punish violators

• keep its illegal behavior hidden from

governments

Detection and enforcement

• inspect each other's books (e.g., most-favored nation clauses)

• governments report bids on

government contracts

• divide market by region or by customers

mercury cartel (1928-1972) allocated

U.S. to Spain and Europe to Italy

• use industry organizations to

detect cheating

• offer "low price" guarantees

Entry and cartel success

• barriers to entry help cartel: limit competition

• cartels with large number of firms rare (except

professional associations)

• Dept. of Justice price-fixing cases 1963-1972

• 48% involved 6 or fewer firms

• average number of firms: 7.25

• only 6.5% involved 50 or more conspirators

• cartels often fall apart after entry (mercury)

Lysine cartel

• 1996: Archer Daniels Midland (ADM) pleaded guilty to price fixing

• ADM admitted to price fixing in lysine (used in livestock feed) and citric acid (used in soft drinks and detergents)

• Taped oral conversations

Lysine buyers

• individual U.S. buyers received

compensation ≈ their losses

• that is, they did not get treble damages

• total U.S. corporate settlements: about $85

million

Mergers

• if antitrust or competition laws prevent

firms from colluding, they may try to merge

• U.S. laws restrict ability of firms to merge if

effect would be anticompetitive

• Must determine relevant markets and

pricing effects

Some mergers raise efficiency

• efficiency due to greater scale

• sharing trade secrets

• closing duplicative retail outlets

Chase and Chemical banks merged in 1995:

closed or combined 7 branches in Manhattan

located within 2 blocks of another branch

Monopolistic competition

• market structure in which firms

• have market power

• are price setters

• firms enter if there is a profit opportunity ( = 0)

• monopolistically competitive equilibrium:

MR = MC

p = AC (demand curve tangent to AC curve)

Number of firms

• number of firms in equilibrium is smaller,

• greater economies of scale

• less market demand at each price

• fewer monopolistically competitive firms,

• less elastic is each firm’s residual demand

curve at equilibrium

• higher fixed cost

Bertrand

• firms set price instead of quantity

• changes equilibrium

• (unlike monopoly, choice of quantity vs.

price matters)

1. Market structure

• prices, profits, and quantities in a market

equilibrium depend on the market's structure

• all firms maximize profit by setting MR = MC

• oligopolies and monopolistically competitive

firms are price setters: face downward-sloping

demand curves

• oligopoly: entry blocked

• monopolistic competition: free entry

2. Game theory

• set of tools used to analyze conflict and

cooperation between firms

• each firm forms a strategy or battle plan of the

actions to compete with other firms

• firms' set of strategies is a Nash equilibrium if,

• holding the strategies of all other firms constant,

• no firm can obtain a higher profit by choosing a

different strategy

3. Cournot model of

noncooperative oligopoly• if oligopoly firms act independently, market

output and firms' profits lie between competitive and monopoly levels

• Cournot model: each oligopoly firm sets its output simultaneously

• Cournot (Nash) equilibrium: each firm produces its best-response output given rivals’ outputs

• as number of Cournot firms increases, Cournot equilibrium price, quantity, and profits approach price-taking levels

4. Stackelberg model of

noncooperative oligopoly

• Stackelberg leader chooses its output first

• then its rivals - Stackelberg followers –

choose outputs

• leader produces more and earns a higher

profit than followers

5. Cooperative oligopoly models

• with collusion, firms collectively produce

monopoly output and earn monopoly profit

• each individual firm has an incentive to

cheat on a cartel arrangement so as to raise

its own profit even higher

6. Monopolistic competition

• monopolistically competitive firms are price

setters: MR= MC, so p > MC

• there's free entry: p = AC