Transcript Oligopoly

ECON6021 (Nov 2004)
Oligopoly
Market Structure
 Monopoly – a single firm
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A patented drug to cure SARS
A single power supplier on HK Island
 Oligopoly – a few major players
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The top 4 cereal manufacturers sell 90% of all
cereals in the US
HK property developing market
Collusion: price fixing
 Monopolistic competition – a large number of
firms, selling differentiated goods, with some
market power, easy entry and exit
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Local bakery
 Perfect competition – numerous firms,
homogeneous product, no market power,
easy entry and exit
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International agricultural product market
Profit Maximization
 Regardless of market structure, the following
are assumed:
 Firm’s objective: to maximize economic profit
 Choice variable: quantity, unless otherwise
stated
 Hence, setting Q so that MR = MC (provided
that MR cuts MC from above, and the
resulting profit is not lower than not producing
at all)
Oligopoly
Three models of oligopoly
 Cournot competition
 Bertrand competition
 Stackelberg competition
 Most complex market – strategic
interaction, collusion, first mover
advantage, commitment, etc.
Cournot Competition
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An industry is characterized as Cournot
oligopoly if
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There 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.
Reaction Functions and Equilibrium
 further simplifications: duopoly --
2 firms only
 reaction function defines the profitmaximizing level of output for a firm
for given output levels of the other
firm.
Q₁=r₁(Q₂). and
 Q₂=r₂(Q₁).
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Reaction Functions
Finding reaction functions
 If the (inverse) demand is P=a-b(Q₁+Q₂).
 The marginal revenues of firms 1 and 2 are
 MR₁(Q₁,Q₂) = a-bQ₂-2bQ₁
 MR₂(Q₁,Q₂) = a-bQ₁-2bQ₂ ∙
 Assume constant marginal costs c₁ and c₂.
 Setting MR=MC, we have a-bQ₂-2bQ₁=c₁for firm 1.
 Firm 1’s reaction function:
 Q₁=r₁(Q₂)=((a-c₁)/(2b))-(1/2)Q₂
 Similarly, firm 2’s reaction function:
 Q₂=r₂(Q₁)=((a-c₂)/(2b))-(1/2)Q₁
Isoprofit curves for firm 1
Firm 1’s Isoprofit curve
Cournot Equilibrium
In case c1 = c2=c,
we have
Q1c=Q2c=2(a-c)/3
Extensions: Changes in Marginal Cost
Collusion
Firm 2 colludes but firm 1 cheats
Stackelberg Oligopoly
 An industry is characterized as a Stackelberg
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oligopoly if:
There are few firms in the market serving many
consumers.
The firms produce either differentiated or
homogeneous products.
A single firm (the leader) selects 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 leader's output.
Barriers to entry exist.
Model ∙
 Two firms--Firm 1 is the leader with a "first-
mover" advantage, and Firm 2 is the follower,
who maximizes profit given the output
produced by the leader. ∙
 same cost functions, and demand function as
in Cournot model
 Follower's reaction function:
Q₂=r₂(Q₁)=((a-c₂)/(2b))-(1/2)Q₁,
 which is simply the follower's Cournot
reaction function.
Firm 1’s profit exceeds that under
Cournot competition
Bertrand Oligopoly
 An industry is characterized as a Bertrand oligopoly
if:
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There are few firms in the market serving many
consumers.
The firms produce identical products as 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.
Model
 Consider a Bertrand duopoly, and both firms
have the same marginal cost.
 Price war -- Both firms charge a price equal to
marginal cost: P₁=P₂=MC!
 If fixed costs >0, both earn negative profits!
Hence a so called Bertrand paradox!!
Some solutions to the Bertrand
paradox ∙
 Product Differentiation -- undercutting will not steal all
the sale from the other firm
 Capacity constraint (Edgeworth)
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price cutting now is less profitable if you cannot satisfy
the extra quantity demanded (because of your limited
capacity)
Kreps & Scheinkman (1983, Bell J. of Economics) -"Quantity Precommitment & Bertrand Competition yield
Cournot Outcomes"
in stage 1, two firms choose capacity
In stage 2, after capacities fixed and observed, the two
firms choose prices
Result: Cournot outcome is replicated
Application 1: Capital investment
 capital investment (equipment, building, etc.)
as a deterrence device
 many such investment is sunk cost and
difficult to resell, making it a credible threat to
potential entrants
Application 2: Horizontal Merger
 Before merger
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three firms (each with one plant), same
marginal costs, Cournot competition
 After merger
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firm 1 and firm 2 merge together to become a
mega firm, with a single owner-manager
making decisions for both plants, marginal
cost in each plant remains unchanged,
Cournot competition
Further insights: Merger and
divisionalization
 Horizontal merger -- which allows output decision
coordination among the merged firms -- is beneficial
only when a sufficiently large fraction of firms are
involved
 More generally, flexibility and ability of coordination
might weaken one's position to profit [∴inflexibility
may improve your profitability]
 Oligopolists have incentives to divisionalize,
franchise, and even divest [≡ set off assets]
 M - form firms -- e.g., General Motor, consisting of a
number of almost autonomous divisions selling often
same class of automobiles
Alfred P. Sloan and General Motors
 Alfred Sloan (1963): “According to General Motors
plan of organization … the activities of any specific
Operation are under the absolute control of the
General Manager of that Division, subject only to very
broad contact with the general officers of the
Corporation.”
 Description of GM’s operating divisions in Moody’s
Instustrial Manual (1993): “ …each of which is selfcontained administrative unit with a general manager
responsible for all functional activities of his division.”
 Other major automobile manufacturers have similar
structures.
Divisionalization
 Divisionalization is traditionally explained by the
difficulty arising from managing a large firm
 Baye, Crocker, and Ju (1996, AER) argue that in the
absence of such consideration, divisionalization still
arises from strategic interaction in oligopolistic
competition
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a fixed number of firms
in stage 1, each firm decides the number of autonomous
divisions to have (divisionalization is costly)
in stage 2, all divisions of all firms compete by choosing
output levels
In equilibrium, each firm chooses more than one division
despite costs to set up a division
Commitment not to intervene
 Assumption in the paper: the headquarters
can commit not to interfere with each
autonomous division's decision.
 In reality. Is this assumption reasonable? Or
how firms can make it to happen?
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compensation of each division's manager is
made to depend on his sale, making the
manager defiant to headquarters' incentive to
coordinate, if any.
franchising
divestiture
Recap
 Three models of oligopoly have been
introduced.
 Interdependence of choices are emphasized.
 A lot of interesting issues can be addressed.