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Chapter 9Basic Oligopoly ModelsCopyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Chapter OutlineConditions for OligopolyRole of beliefs and strategic interactionProfit maximization in four oligopoly settingsSweezy oligopolyCournot oligopolyStackelberg oligopolyBertrand oligopolyComparing oligopoly modelsContestable markets

9-2Chapter Overview2IntroductionChapter 8 examined profit-maximizing behavior in perfectly competitive, monopoly, and monopolistically competitive markets. One distinguishing feature is the absence of strategic interaction among the firms In perfectly competitive and monopolistically competitive markets so many firms are competing that no individual firm has any effect. In monopoly markets, strategic interaction is irrelevant since only one firm exists.This chapter focuses on how managers select the optimal price and quantity in the following oligopoly market (a market with only few large firms) environments:SweezyCournotStackelbergBertrand9-3Chapter Overview3Key ConditionsOligopoly market structures are characterized by only a few firms, each of which is large relative to the total industry.Typical number of firms is between 2 and 10. Products can be identical or differentiated.An oligopoly market composed of two firms is called a duopoly.Oligopoly settings tend to be the most difficult to manage since managers must consider the likely impact of his or her decisions on the decisions of other firms in the market.

9-4Conditions for Oligopoly4Conditions for Sweezy OligopolyThere are few firms in the market serving many consumers.The firms produce differentiated products.Each firm believes its rivals will cut their prices in response to a price reduction but will not raise their prices in response to a price increase.Barriers to entry exist.9-5Profit Maximization in Four Oligopoly Settings5Sweezy Oligopoly9-6OutputPrice0MR2Demand2(rival matches price change)ABMC1MR1MC0Demand1(rival holds price constant)FECMRSweezy DemandProfit Maximization in Four Oligopoly Settings6Conditions for Cournot OligopolyThere are few firms in the market serving many consumers.The firms produce either differentiated or homogeneous products.Each firm believes rivals will hold their output constant if it changes its output.Barriers to entry exist.9-7Profit Maximization in Four Oligopoly Settings7Cournot Oligopoly: Reaction FunctionsConsider a Cournot duopoly. Each firm makes an output decision under the belief that its rival will hold its output constant when the other changes its output level.Implication: Each firms marginal revenue is impacted by the other firms output decision.A function that defines the profit-maximizing level of output for a firm given the output levels of another firm is called a best-response or reaction function.9-8Profit Maximization in Four Oligopoly Settings8Cournot Oligopoly: Reaction Functions Formula9-9Profit Maximization in Four Oligopoly Settings9Cournot Reaction Functions9-10Quantity2Quantity1Cournot equilibriumABCDProfit Maximization in Four Oligopoly Settings10Cournot Oligopoly: EquilibriumA situation in which neither firm has an incentive to change its output given the other firms output.9-11Profit Maximization in Four Oligopoly Settings11Cournot Oligopoly: Isoprofit CurvesA function that defines the combinations of outputs produced by all firms that yield a given firm the same level of profits.9-12Profit Maximization in Four Oligopoly Settings12Cournot Oligopoly In Action: Problem9-13Profit Maximization in Four Oligopoly Settings13Cournot Oligopoly In Action: Answer9-14Profit Maximization in Four Oligopoly Settings14Firm 1s Best Response to Firm 2s Output9-15Quantity2Quantity1ABCProfit Maximization in Four Oligopoly Settings15Quantity2Quantity1Firm 2s Reaction Function and Isoprofit CurvesMonopoly point for firm 29-16Profit Maximization in Four Oligopoly SettingsQuantity2Quantity1Cournot EquilibriumCournot Equilibrium9-17Profit Maximization in Four Oligopoly SettingsQuantity2Quantity1Effect of Decline in Firm 2s Marginal Cost on Cournot EquilibriumDue to decline in firm 2s marginal costFE9-18Profit Maximization in Four Oligopoly SettingsCournot Oligopoly: CollusionMarkets with only a few dominant firms can coordinate to restrict output to their benefit at the expense of consumers. Restricted output leads to higher market prices.Such acts by firms is known as collusion.Collusion, however, is prone to cheating behavior.Since both parties are aware of these incentives, reaching collusive agreements is often very difficult.9-19Profit Maximization in Four Oligopoly Settings19Incentive to Collude in a Cournot Oligopoly9-20Quantity2Quantity1Collusion outcomeProfit Maximization in Four Oligopoly Settings*Assuming both firms have the same cost structure20Incentive to Renege on Collusive Agreements in Cournot Oligopoly9-21Quantity2Quantity1Profit Maximization in Four Oligopoly Settings21Conditions for Stackelberg OligopolyThere are few firms serving many consumers.Firms produce either differentiated or homogeneous products.A single firm (the leader) chooses an output before all other firms choose their outputs.All other firms (the followers) take as given the output of the leader and choose outputs that maximize profits given the leaders output.Barriers to entry exist.9-22Profit Maximization in Four Oligopoly Settings22Stackelberg Equilibrium9-23Quantity 2 (Follower)Quantity 1 (leader)Profit Maximization in Four Oligopoly Settings23Stackelberg Oligopoly: Equilibrium Output Formulae9-24Profit Maximization in Four Oligopoly Settings24Stackelberg Oligopoly In Action: Problem9-25Profit Maximization in Four Oligopoly Settings25Stackelberg Oligopoly In Action: Answer9-26Profit Maximization in Four Oligopoly Settings26Conditions for Bertrand OligopolyThere are few firms in the market serving many consumers.Firms produce identical products 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.Barriers to entry exist.9-27Profit Maximization in Four Oligopoly Settings27Bertrand Oligopoly: Equilibrium9-28Profit Maximization in Four Oligopoly Settings28Comparing Oligopoly Outcomes9-29Comparing Oligopoly Models29Comparing Oligopoly: Cournot Outcome9-30Comparing Oligopoly Models30Comparing Oligopoly: Stackelberg Outcome9-31Comparing Oligopoly Models31Comparing Oligopoly: Bertrand Outcome9-32Comparing Oligopoly Models32Comparing Oligopoly: Collusion Outcome9-33Comparing Oligopoly Models33Contestable Markets: Key ConditionsContestable markets involve strategic interaction among existing firms and potential entrants into a market.A market is contestable if:All producers have access to the same technology.Consumers respond quickly to price changes.Existing firms cannot respond quickly to entry by lowering price.There are no sunk costs.If these conditions hold, incumbent firms have no market power over consumers.9-34Contestable Markets34ConclusionDifferent oligopoly scenarios give rise to different optimal strategies and different outcomes.Your optimal price and output depends on Beliefs about the reactions of rivals.Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products).Your ability to credibly commit prior to your rivals.9-3535