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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

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Oligopoly and Monopolistic Competition

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key issues
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
Market structures

markets differ according to

  • number of firms in market
  • ease of entry and exit
  • ability of firms to differentiate their products
  • 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
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
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
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
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
  • consider single-period, duopoly, quantity-setting game
  • duopoly: an oligopoly with two ("duo") firms
firms act simultaneously
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
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
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
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
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
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
Noncooperative oligopoly
  • many models of noncooperative oligopoly behavior
  • firms choose quantities
    • Cournot model
    • Stackelberg model
  • firms set prices: Bertrand model
basic cournot 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
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
stackelberg model
Stackelberg model
  • Cournot model: both firms make their output decisions simultaneously
  • Heinrich von Stackelberg's model: firms act sequentially
    • leader firm sets its output first
    • then its rival (follower) sets its output
credibility and commitment
Credibility and Commitment
  • 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
  • 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
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

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
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
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
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

cartels fail
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
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
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
Maintaining cartels

to maintain a cartel, firms must

  • detect cheating
  • punish violators
  • keep its illegal behavior hidden from governments
detection and enforcement
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
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
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
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
  • 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
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
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
  • 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
  • firms set price instead of quantity
  • changes equilibrium
  • (unlike monopoly, choice of quantity vs. price matters)
1 market structure
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
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
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
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
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
6. Monopolistic competition
  • monopolistically competitive firms are price setters: MR= MC, so p > MC
  • there's free entry: p = AC