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