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Week 11 – 18th April 2019
BUDAPEST UNIVERSITY OF TECHNOLOGY AND ECONOMICS
ECONOMICS I
Lecturer: Krisztina Sőreg
FACULTY OF ECONOMIC AND SOCIAL SCIENCES
Department of Economics
Course code: BMEGT301004
TIMELINE OF THE SEMESTER
Week Topic Date
1. Introduction – Basic Definitions of Microeconomics 7th Febr 2019
2. Market Theory: The Basics of Supply And Demand 14th Febr 2019
3. Markets and Welfare 21st Febr 2019
4. Consumer Theory 28th Febr 2019
5. Production and Cost Theory 7th Mar 2019
6. 1st Test 14th Mar 2019
7. SPRING BREAK 21st Mar 2019
8. Sketch Design week 28th Mar 2019
9. Firm Behaviour and the Organization of Industry: Competitive Markets & Monopolistic Competition 4th Apr 2019
10. Firm Behaviour and the Organization of Industry: Monopoly 11th Apr 2019
11. Firm Behaviour and the Organization of Industry: Oligopolistic Markets 18th Apr 2019
12. The Economics of Labour Markets 25th Apr 2019
13. Externalities, The Economics of the Public Sector 2nd May 2019
14. 2nd Test 9th May 2019
15. Draughting Week 16th May 2019
16. Re-Submission: Repetitive Tests – Application in Neptun (Exams)! 20th & 23rd May
Outline of the Presentation
I. Characteristics of Oligopolies
1.1 Market Concentration
1.2 Game Theory
II. Cournot Duopoly
III. Stackelberg Duopoly
IV. Bertrand Competition
Oligopolies – Clash Among the Toughest
Oligopoly
Number of firms
Few
Freedomof entry
Controlled Access
ProductHomogeneous or
Differentiated
Firm sizeLarge
(dominated)
Pricingstrategy
Price takeror maker
(P or Qcompetition)
Oligopoly
T-Mobile, Vodafone
Commercial TV channels
Wizz Air, Ryanair
Oligopolies – Clash Among the Toughest
What is an Oligopoly?
A market structure in which only a few sellers offer similar
or identical products.
o Market power relatively few firms provide the good or
service within the industry;
o Oligopolies compete with each other: imperfect competition;
o Result: higher prices (P) and lower level of production (Q)
Strategic behavior in oligopoly:
A firm’s decisions about P or Q can affect other firms and cause
them to react. The firm will consider these reactions when
making decisions.
Characteristics of Oligopolies
Few sellers & many customers
High interdependence action and reaction!
Intense competition watching the rivals starting a
counterattack
High entrance barriers (license, patent, high capital,
regulations, social capital, etc.)
No uniformity among companies
Measuring Market Concentration
Concentration ratio: the percentage of the market’s total output
supplied by its largest firms.
The higher the concentration ratio, the less competition.
Market Concentration
Key element: relative market share of the company
Rule: if relatively few firms control most of the market sales,
then an oligopoly exists.
Tool: Herfindahl-Hirschman Index (HHI)
It ranges from 1 (least concentrated) to 10,000 (most concentrated)
HHI >1500: low concentration;
1500 < HHI < 2500: moderate concentration;
HHI > 2500: high concentration.
Market Concentration – Calculating the HHI
1. Take the percentage market share of each firm;
2. Square that number;
3. Add all the squares together.
s refers to the percentage market share
n is the number of companies
Most concentrated industries:
coal mining, metal ore mining,
postal service, tobacco, crude
oil processing, sugar
Least concentrated industries:
real property transactions,
catering industry, construction, wholesale distribution, furniture
Market Concentration – Calculating the HHI
Calculate the HHI of the industry on the base of followingcompanies’ market shares!
A: 40% ; B: 30% ; C: 15% ; D: 15%
HHI = 402 + 302 + 152 + 152
HHI = 1600 + 900 + 225 + 225
HHI = 2950
Type of industry: highly concentrated (>2500)
Only 4 companies
5045
6040
7035
8030
9025
10020
11015
12010
1305
140$0
QP
1,750
1,800
1,750
1,600
1,350
1,000
550
0
–650
–1,400
Profit
500
600
700
800
900
1,000
1,100
1,200
1,300
$1,400
Cost
2,250
2,400
2,450
2,400
2,250
2,000
1,650
1,200
650
$0
Revenue
Cell Phone Duopoly Example
Competitive
outcome:
P = MC = $10
Q = 120
Profit = $0
Monopoly
outcome:
P = $40
Q = 60
Profit = $1,800
Cell Phone Duopoly Example
o One possible duopoly outcome: collusion
o Collusion: an agreement among firms in a market about quantities to produce or prices to charge
o T-Mobile and Verizon could agree to each produce half of the monopoly output:
o For each firm: Q = 30, P = $40, profits = $900
o Cartel: a group of firms acting in unison, e.g., T-Mobile and Verizon in the outcome with collusion
Cartel is a formal orinformal agreementbetween a number ofoligopolistic firms toexploit and share themarket.
A Comparison of Market Outcomes
When firms in an oligopoly individually choose production to maximize profit,
oligopoly Q is greater than monopoly Q but smaller than competitive Q.
oligopoly P is greater than competitive P but less than monopoly P.
Types of Oligopolies
OLIGOPOLIES
Pure/Homogeneous
Differentiated
Non-Collusive/Non-
Cooperative
Cournot Duopoly
Stackelberg Duopoly
Bertrand DuopolyCollusive/Cooperative
Types of Oligopolies – What’s the Difference?
1. Pure/Homogeneous Oligopoly: price differences between the products are insignificant great homogeneity great interdependence between sellers. If we change the price the rivals will also modify it!
e.g. Coca Cola and Pepsi, Airbus and Boeing
2. Differentiated Oligopoly: slightly different products. Price changes have less effect on rivals interdependence is less significant!
e.g. Tesco and Auchan
Types of Oligopolies – What’s the Difference?
3. Non-Collusive Oligopoly: firms behave independently
behavior depends on how he thinks his rivals will react to his
decision-making (making guesses). It may often lead to
cutthroat competition among sellers - ultimately leading
towards monopoly business.
4. Collusive Oligopoly: to prevent competitive price cutting
making collusive agreements
Open agreement: cartel
Tacit: price leadership, rule of thumb or average cost pricing
Cournot Duopoly - “Competition Amongst the Few”
Strategic game - Simultaneous quantity decision
players: firms
each firm’s set of actions: set of all possible outputs
each firm’s preferences are represented by its profit
each actor has to take into account what others do
1. Two firms profit maximisers;
2. Each chooses the quantity of output;
3. Neither firm knows the other’s decision;
4. Each firm makes an assumption about the other’s decision;
5. Each firm’s profit depends on the other firm’s output.
Cournot Duopoly - “Competition Amongst the Few”
o Similar companies, homogeneousproduct
o Same cost functions
MC1 = MC2 = MC
o p1 = p2 = P(q1 + q2)
o Firms compete in quantities, and choose quantities simultaneously
Cournot Duopoly - “Competition Amongst the Few”
o p = a – bQ inverse demand curve
o a: reservation price of the highest
WTP-consumer
o b: steepness of the function
price sensitivity
o Q: output
o q1 = 𝒂 −𝑴𝑪𝟏𝟐𝒃
-𝟏
𝟐q2
o q2 = 𝒂 −𝑴𝑪𝟐𝟐𝒃
-𝟏
𝟐q1
Cournot Duopoly – Exercise 1
There are two restaurants by the university campus operating
under similar conditions. The base of their competition is
quantity. The marginal cost of producing the daily menu of the
two restaurants is the same, MC1 = MC2 = 600. The demand
for the menus can be identified by the following inverse
demand function: P = 2400 – 3Q.
a) Indicate the two reaction functions of the firms!
b) How many menus will be sold and at what price?
c) How much consumer surplus and producer surplus would
be compared to a perfect competition situation?
a) Calculate the profit of the first company! What is the
difference between the firms’ producer surplus and profit?
Cournot Duopoly – Exercise 1
MC1 = MC2 = 600, P = 2400 – 3Q
a) Indicate the two reaction functions of the firms!
q1 = 𝑎 −𝑀𝐶12𝑏
-1
2q2 q1 =
2400 −600
2 𝑥 3-1
2q2
q2 = 𝑎 −𝑀𝐶22𝑏
-1
2q1 q2 =
2400 − 600
2 𝑥 3-1
2q1
q1 = 1800
6-1
2q2 ; q2 =
1800
6-1
2q1
q1 = 300 -𝟏
𝟐q2 ; q2 = 300 -
𝟏
𝟐q1
Cournot Duopoly – Exercise 1
MC1 = MC2 = 600, P = 2400 – 3Q
b) How many menus will be sold and at what price?
If MC1 = MC2 q1 = q2
q1,2 = 300 -1
2q
3
2q = 300
q1,2 = 200
q1 + q2 = Q = 200 + 200 = 400
P = 2400 – 3 x 400 = 1200
Cournot Duopoly – Exercise 1
MC1 = MC2 = 600, P = 2400 – 3Q
c) How much would consumer surplus and producer surplus
would be compared to a perfect competition situation?
If Perfect Competition: P = MC
2400 – 3Q = 600 QPC = 600; PPC = 600
CS = (1800 x 600) / 2 = 540,000 Ft per day.
If Duopoly: QC = 400; PC = 1200
CS = ((2400 – 1200) x 400) / 2 = 240,000 Ft per day
PS = (1200 – 600) x 400 = 240,000 Ft per day
DWL = (200 x 600) / 2 = 60,000 Ft per day.
Together: 540,000 Ft
Cournot Duopoly – Exercise 1
MC1 = MC2 = 600, P = 2400 – 3Q
c) How much would consumer surplus and producer surplus
would be compared to a perfect competition situation?
Cournot Duopoly – Exercise 1
MC1 = MC2 = 600, P = 2400 – 3Q
d) Calculate the profit of the first company! What is the
difference between the firms’ producer surplus and profit?
= PS + CS
If no FC = PS
= 240,000 Ft per day total profit of the 2 firms,
= 120,000 Ft per day profit of one firm.
Stackelberg Duopoly – Leader vs. Follower
The leader firm moves first and then the follower firms reacts
sequentially a model of imperfect competition based on a
non-cooperative game 2-period sequential game
Two firms, homogeneous products, the same demand and
cost functions.
One firm (leader), is better known or has greater brand equity
and is better placed to decide first which quantity q1 to sell.
The other firm, the follower, observes this and decides on its
production quantity q2.
The perfect equilibrium of the game is the Stackelberg
equilibrium.
Stackelberg Duopoly – Leader vs. Follower
o Production will be larger for the firm with lower marginal costs
o Total production will be greater and prices lower, but player one will be better off!
o Products: homogeneous
o Mean: to get accurate market information
o Condition: interdependence of each player’s strategies
o Nash equilibrium is not Pareto efficient
o There will be a loss in economic efficiency < Cournot!
o The quantity sold by the leader is greater than the quantity sold by the follower
Stackelberg Duopoly – 4 Scenarios
1.) Duopolist A wants to be leader and B wants to be
follower.
2.) Duopolist B wants to be leader and A wants to
be follower.
3.) Both firms want to be followers.
4.) Both firms desire to be leaders.
Stackelberg Duopoly – Leader vs. follower
p = a – bQ
Intercepts:
qL = 𝑎 −𝑀𝐶
2𝑏
qF = 𝑎 −𝑀𝐶
4𝑏
Reaction functions:
qF = 𝒂 −𝑴𝑪
𝟒𝒃-𝟏
𝟐qL
qL = 𝒂 −𝑴𝑪
𝟐𝒃-𝟏
𝟐qF
Bertrand Duopoly – Stick to Your Price!
Each firm expects that the rival will keep its price constant,
irrespective of its own decision about pricing
a simultaneous game where the strategic choice is on prices.
1. There is a market for a single, homogeneous good.
2. Firms announce prices.
3. Each firm does not know the other’s announcement when making its own.
It does not lead to the maximization of the industry ( joint)
profit firms behave naively by always assuming that their
rival will keep its price fixed!
Bertrand Duopoly – Stick to Your Price!
Few firms in market serving many customers.
Firms produce a homogeneous product at a
constant marginal cost.
Firms engage in price competition and react
optimally to prices charged by competitors.
Consumers have perfect information and there are
no transaction costs.
Bertrand Duopoly – Stick to Your Price!
Consumers will buy from the firm that offers the lowest price
The Nash equilibrium is going to be the two firms setting the same price
Bertrand’s equilibrium occurs when P1=P2=MC, being MC the marginal cost, yielding the same result as perfect competition.
If the price set by both firms is the same but the MC is lower,
there will be an incentive for both firms to lower their prices
and seize the market.
Equilibrium at P = MC
Bertrand Duopoly – Stick to Your Price!
Bertrand’s paradox: in case of imperfect competition (duopoly), where there is a strong incentive to collude the same outcome as in perfect competition.
p1 = p2 = MC
Perfect Competion arises in caseof 2 companies! theoretically, at least…
Limited capacities might solve
the paradox.
SummaryStackelberg Duopoly
• Homogeneous product
• Quantity based decision
• Price Leader & Price Follower
• Sequential acting
• Leader reduces P
• Follower reduces P
• Differentiation: quality, service,
functionality, customer experience
Bertrand Duopoly
• Homogeneous product
• Perfect Competition
• Price competition
• No leader & follower
• Simultaneous acting
• Independent price decision
• Can adjust capacity easy
Cournot Duopoly
• Homogeneous product
• Output competition
• Decisions based on previos data
• Simultaneous acting
• Independent price decision
• Hard to adjust capacities
Thank you for your attention!
Mankiw: Chapter 17
pp. 365-378
