Oligopoly in Economics

Introductory Course in Economics: Oligopoly

11 Oligopoly Overview

  • Objectives of this chapter:

    • Understand the basic application of game theory to markets with large firms

    • Understand how the Cournot equilibrium is constructed

    • Describe the properties of the Cournot equilibrium

    • Describe the properties of the Bertrand equilibrium

    • Understand simple game theoretic models of product differentiation

11.1 Motivation

  • Current state of American industry:

    • American industry is increasingly concentrated compared to 50 years ago.

    • Observation of seemingly abundant choices in stores (grocery, clothing, etc.) may not reflect real competition.

    • Notable market concentrations exist despite the illusion of variety; Figure 11.1 illustrates this.

  • Questions to consider:

    • How do individual firms behave in concentrated markets?

    • What equilibria exist in such markets?

    • What are the economic repercussions of firm behavior and market equilibria?

11.2 Cournot Equilibrium

  • Definition:

    • The Cournot equilibrium pertains to an oligopoly, specifically a duopoly, where two firms produce identical products.

  • Key concepts:

    • Starting point from monopoly pricing; recall market pricing assumptions:
      Q = q_1 for monopoly (single firm).

    • Demand assumption: Linear demand function, e.g., P = 20 - Q

    • For marginal cost, assume MC = 9 .

  • Firm interaction:

    • In a duopoly, a firm’s output decision influences and is influenced by the other firm’s output.

    • Residual demand serves as the basis for profit maximization:

    • If Firm 1 produces 3 units, Firm 2 faces residual demand and adjusts its output accordingly.

  • Profit maximizing calculations illustrated in Table 11.1:

    • Firm 2’s calculations depending on Firm 1’s output reveal complexity in strategic responses.

  • Nash condition:

    • Need to establish mutual best responses for both firms.

    • With firm behavior analyzed in Tables 11.1 and 11.2, determine equilibrium at:

    • Each firm optimizing output, confirming equality in production volumes: q1 = q2 .

    • Nash equilibrium identified as both firms producing 4 units each; total output of 8 units, Price = 12, Total profit = 24.

  • General implications:

    • As more firms enter the market, individual firm output decreases, total industry output increases, price decreases, and profits diminish, ultimately converging toward competitive equilibrium:

    • ext{Quantity converges}
      ightarrow ext{efficient quantity}

    • ext{Price converges}
      ightarrow ext{competitive equilibrium price}

    • ext{Profit converges}
      ightarrow 0 in the long-run competitive equilibrium.

11.3 Bertrand Equilibrium

  • Key concept:

    • Contrasts with Cournot equilibrium where quantity is strategic; in Bertrand, quantity is fixed, and price is strategic.

  • Incentives:

    • If one firm sets a lower price, they capture the entire market.

    • Price competition leads to undercutting until profit converges to zero at marginal costs.

  • Changes in market dynamics with product differentiation:

    • Products perceived differently allow firms to maintain higher prices without losing all customers.

    • Demand structure illustrated with differentiated products, resulting in different price elasticity.

    • Lesson: Unique product offerings can capture market segments beyond price competition.

11.4 Mergers: Intro and Theoretical Considerations

  • Definition of mergers:

    • Combination of independent firms into a single entity, reducing the number of firms in the market.

  • Trends:

    • Significant volume of mergers observed (approx. 20,000 annually in 2021/2022).

  • Types of mergers:

    • Conglomerate mergers: Firms from unrelated markets (e.g., bike factory and nail salon).

    • Horizontal mergers: Firms within the same industry (e.g., two bakeries).

    • Vertical mergers: Firms in supply chains (e.g., bakery and flour supplier).

  • Economic implications of mergers:

    • Potential for efficiency gains and increased mark-ups due to reduced competition.

    • Post-merger effects on price, output, and profit depend on existing market structure and firm strategy.

  • Study by Blonigen and Pierce (2016):

    • Analysis of mergers in US manufacturing (1997-2007) showed significant increases in mark-ups but not in productivity.

  • Specific merger case:

    • Health sector mega-merger analyzed, with implications on patient costs, revenue, and outcomes presented (Figure 11.6).

11.5 Product Differentiation

  • Focus on strategic differentiation while ignoring price factors to examine product differentiation models.

  • Example scenario:

    • Two vendors (identical products) competing on location along a mile stretch.

    • Market division based on proximity; strategic location becomes crucial for market capture.

  • Nash equilibrium in location strategies:

    • Firm positioning at equilibrium (both at midpoint) illustrates competition and conflicts in location strategy.

11.5.1 Political Interpretation

  • Parallel drawn between political candidates and firms:

    • Candidates strive for median voter appeal in first-pass-the-post elections, mirroring firm strategies in market location.

    • Candidates moving towards the center to capture votes can alienate their party base; strategic positioning impacts electoral outcomes.

11.6 More Firms!

  • Complexity of equilibrium increases with more firms, leading to the possibility of mixed strategies:

    • Example of three firms illustrates requirements of logical positioning.

  • Sequential entry assumptions alter competitive dynamics:

    • Expectation formation leads to rational location choices among incoming firms to ensure coverage of market needs while mitigating risks.

11.7 Glossary of Terms

  • Bertrand equilibrium: When price is strategic in an oligopoly.

  • Cournot equilibrium: When quantity is strategic in an oligopoly.

  • Heterogeneous goods: Differentiated by characteristics.

  • Homogeneous goods: Identical in relevant attributes.

  • Horizontal differentiation: Variants based on non-qualitative differences.

  • Location game: Strategic location competition.

  • Market concentration: Measure of firm numbers in an industry.

  • Rational expectations: Expectations that align with model outcomes.

  • Vertical differentiation: Differentiated based on perceived quality.

11.8 Practice Questions

11.8.1 Discussion

  • Evaluate efficiency in firm location setups due to transportation cost considerations in two-player and four-firm scenarios.

11.8.2 Multiple Choice

  • Analyze outcomes and strategic responses of firms in a one-shot Cournot Nash Game scenario.