Oligopoly Overheads Market Structure Market structure refers to

Oligopoly Overheads

Market Structure Market structure refers to all characteristics of a market that influence the behavior of buyers and sellers, when they come together to trade Market structure refers to all features of a market that affect the behavior and performance of firms in that market

Definition of a competitive agent A buyer or seller (agent) is said to be competitive if the agent assumes or believes that the market price is given and that the agent's actions do not influence the market price We sometimes say that a competitive agent is a price taker

Common Market Structures Perfect (pure) competition Agents take prices as given Entry and exit barriers are minimal or nonexistent

Common Market Structures Monopoly (seller) or Monopsony (buyer) Firm sets price (faces market demand or supply curve) Entry and exit barriers result in the existence of one seller or one buyer

Common Market Structures Oligopoly Firm sets prices (faces residual demand) Entry and exit barriers result in the existence of few sellers or buyers

Common Market Structures Monopolistic competition Firm sets prices (faces residual demand) Entry and exit barriers are minimal

Strategic interdependence When individuals make decisions in environments characterized by strategic interdependence, the welfare of each decision maker depends not only on her own actions, but also on the actions of the other decision makers (firms). Moreover, the actions that are best for her to take may depend on what she expects the other firms to do

Formal definition of oligopoly Noncooperative oligopoly is a market structure where a small number of firms act independently, but are aware of each other's actions A noncooperative oligopoly is a market structure in which a small number of firms are strategically interdependent

Cooperative oligopoly is a market structure in which a small number of firms coordinate their actions to maximize joint profits

Oligopoly is an intermediate market structure in the sense that the firms are price makers as compared to the price takers of perfect competition, but because there are others firms in the market, the firm cannot act in the independent fashion of the monopolist

Duopoly A duopoly is a market with only two firms, each selling the same or similar product

A Duopoly Model Two firms with no additional entry Each firm produces a homogeneous product such that q 1 + q 2 = Q, where Q is industry output and qi is the output of the ith firm There is a single period of production & sales (zucchini) The market demand inverse demand are linear

Demand

Marginal and average cost are constant and equal to $4. 00

Monopoly solution Firm 1 is the only firm in the market Revenue is given by

Using the same intercept, twice the slope rule, marginal revenue is given by

If we set marginal revenue equal to marginal cost we can obtain the optimal level of q 1

If we substitute this into the demand equation we can find the market price

Profit for Firm 1 is given by revenue minus cost or

Zucchini Market Monopoly 30 $ 25 Demand/P MR 20 15 10 5 0 MC 0 2 4 6 8 10 12 14 Quantity 16

Q 0. 00 Price 28. 00 TR 0. 00 MR Cost 28. 00 0. 00 MC 4. 00 Profit 0. 00 1. 00 26. 00 24. 00 22. 00 2. 50 24. 00 23. 00 48. 00 57. 50 20. 00 18. 00 10. 00 40. 00 47. 50 3. 00 3. 50 4. 00 4. 50 5. 00 5. 50 6. 00 22. 00 21. 00 20. 00 19. 00 18. 00 17. 00 16. 00 66. 00 73. 50 80. 00 85. 50 90. 00 93. 50 96. 00 14. 00 12. 00 10. 00 8. 00 6. 00 4. 00 12. 00 14. 00 16. 00 18. 00 20. 00 22. 00 24. 00 4. 00 54. 00 59. 50 64. 00 67. 50 70. 00 71. 50 72. 00 7. 00 8. 00 9. 00 10. 00 14. 00 12. 00 10. 00 8. 00 96. 00 90. 00 80. 00 28. 00 32. 00 36. 00 40. 00 4. 00 70. 00 64. 00 54. 00 40. 00 44. 00 22. 00 11. 00 66. 00

Competitive Solution We set price (p) equal to marginal cost (MC) Notice that MC doesn’t depend on qi or Q

If we substitute p = 4 in the demand equation we obtain Profits will be zero

Zucchini Market Competition 30 $ 25 Demand/P 20 15 10 5 0 MC 0 2 4 6 8 10 12 14 Quantity 16

Cooperative (collusive) oligopoly solution If the two firms in this market were to coordinate their actions and maximize joint profit, they would choose the monopoly output and price Such cooperative agreements are called cartels The two firms together would produce 6 units and charge a price of $16. 00 The division of the output between the firms would have to negotiated between them

Noncooperative Oligopoly Joint profits maximized with Q = 6 and p = $16 Will this outcome occur?

Individual firm conjectures and market equilibrium Conjecture A supposition or guess Each firm makes a conjecture about the action of the other firm and then chooses its own action

Story Firm 1 conjectures that Firm 2 will produce 3 units Why?

Inverse demand given the conjecture

Revenue for Firm 1 given the conjecture

Marginal revenue is given by because

If we set marginal revenue equal to marginal cost we can obtain the optimal level of q 1

If Firm 2 produced 3 units, price would be

Profit for Firm 1 is given by revenue minus cost or

Profit for Firm 2 is given by Total profit for the two firms is $67. 50 Monopoly profit was $72

Is Firm 2 happy? Is Firm 2 content? Is Firm 2 going to keep producing 3 units? Let’s See

Suppose Firm 2 conjectures that Firm 1 will produce 4. 5 units

Inverse demand given the conjecture

Marginal revenue is given by because

If we set marginal revenue equal to marginal cost we can obtain the optimal level of q 2

If Firm 1 produces 4. 5 units and Firm 2 produces 3. 75 units, price will be

Profit for Firm 1 is given by

Profit for Firm 2 is given by Total profit for the two firms is $61. 875 Monopoly profit was $72

Because Firm 2 is producing 3. 75 and not 3 units Firm 1 will want to adjust its output level And then Firm 2 will want to change its output This silly game could go on forever

We can compute the best response for each firm given the action of the other firm to see this Other q 3. 00 3. 25 3. 50 3. 75 4. 00 4. 25 4. 50 4. 75 5. 00 q 1* 4. 500 4. 375 4. 250 4. 125 4. 000 3. 875 3. 750 3. 625 3. 500 q 2 4. 500 4. 375 4. 250 4. 125 4. 000 3. 875 3. 750 3. 625 3. 500

What if Firm 1 conjectures that Firm 2 will bring 4 units to market? Other q 3. 75 4. 00 4. 25 4. 50 q 1* 4. 125 4. 000 3. 875 3. 750 q 2 4. 125 4. 000 3. 875 3. 750 Firm 1 will bring 4 units to market!

What if Firm 2 conjectures that Firm 1 will bring 4 units to market? Other q 3. 75 4. 00 4. 25 4. 50 q 1* 4. 125 4. 000 3. 875 3. 750 q 2 4. 125 4. 000 3. 875 3. 750 Firm 2 will bring 4 units to market!

Both firms are happy and content We have an equilibrium!!

Graphically Zucchini Market Response Functions 14 q 1 12 q 1* 10 8 q 2* 6 4 2 0 0 2 4 6 8 10 12 q 2 14 16

A situation in which all economic actors (firms) interacting with one another choose their best strategy, given the strategies that all other actors have chosen, is called a Nash Equilibrium A market outcome is a Nash Equilibrium if no firm would find it beneficial to deviate from its output level provided that all other firms do not deviate from their output levels at this market outcome

The market outcome of this noncooperative oligopoly market is an output of 8 units with a price of $12. 00. The output is lower than the competitive output but higher than the monopoly output The price is lower than the monopoly price but higher than the competitive one This is a result that holds generally

Results Total Firm 1 Firm 2 Q q q Monopoly 6 6 -Perfect Competition 12 ? ? Cooperative Oligopoly 6 ? ? Noncooperative Oligopoly 8 4 4 P 16 4 16 12 Total B $72 $0 $72 $64 Firm 1 Firm 2 B B $72 -$0 $0 ? ? $32

Oligopoly and the number of firms Small number of firms large price impact of individual Larger number of firms less price impact As the number of firms in an oligopoly rises, the impact of any one firm on price falls As numbers keep getting larger, firms start to act more and more like price takers

The End