L20 Price-Setting Oligopolists

Microeconomics ECA002 focuses on how companies that dominate a market, called oligopolists, set their prices. The lecture aims to explain the interactions between these companies and how they influence each other's pricing strategies.

In the previous lecture, we discussed how oligopolists engage in competition based on the number of items they produce, a model known as the Cournot model. Today, we will dive into Bertrand's criticism of this model, which suggests that companies compete primarily on price rather than quantity.

Bertrand, who proposed his model about 70 years prior to the modern game theory we know today, laid the groundwork for understanding how firms decide on prices in a competitive environment. This lecture's goal is to explore how production levels and pricing mechanisms in an oligopoly differ from what we see in other types of market scenarios.

Lecture Outline

Bertrand’s Model of Oligopoly (Assumptions)
- A(1): Duopoly Structure
  - In this model, there are only two firms in the market, let’s call them Firm A and Firm B. Both companies simultaneously decide the prices of their products, competing directly with each other.
- A(2): Market Entry
  - This model assumes that no new firms can enter the market, which allows us to focus on the competition between the existing two firms.
- A(3): Cost Structure
  - Both firms have the same cost structure: they incur constant costs for each additional unit they produce, with no fixed costs at the beginning. For example:
  - Total Costs for Firm A: C
  - Marginal Costs: MC
  - Average Costs: AC
- A(4): Product Characteristics
  - The products offered by both firms are identical, meaning consumers see them as perfect substitutes. Hence, buyers always choose the cheaper option. For example, if Firm A sets a lower price than Firm B, all the customers will buy from Firm A, leaving Firm B with no sales. If both firms charge the same price, they will share the market equally.
- A(5): Market Demand
  - The demand in the market significantly relies on the prices set by these firms. If Firm A lowers its price, all demand shifts toward Firm A and similarly for Firm B.

Finding the Bertrand-Nash Equilibrium

In this part of the lecture, we explore how firms behave given the assumptions of the Bertrand model. The Nash equilibrium refers to a situation in which no firm would benefit from changing their price while considering the pricing decision of the competitor.
The prices at which these firms settle, known as pA for Firm A and pB for Firm B, fulfill the criteria for maximum profit, given their competitors' prices.

Comparing with Monopoly and Perfect Competition

Under monopoly conditions, a single firm sets higher prices compared to the average price charged by duopolists, enabling a higher profit margin. In contrast, duopolists often set prices closer to those seen in a perfectly competitive market. The outcome of this is no inefficiencies (known as deadweight loss) in the market, maximizing total welfare and consumer satisfaction.

The Bertrand Paradox

This paradox highlights why having just one extra competitor in a market can turn it from a monopolistic situation (where one firm dominates) to a competitive one, equalizing prices among firms as a result.

Breaking the Bertrand Paradox

There are several factors that can mitigate this paradox, including:
1. Product Differentiation - making products less identical to reduce price competition.
2. Capacity Constraints - limits on how much a firm can produce affecting the price strategies.
3. Incomplete Information & Search Costs - when consumers lack information on prices, steady demand might not be established.
4. Repeated Interaction between firms - ongoing competition leads to different strategies rather than fixed pricing.

Summary of Lecture

Overall, price-setting behaviors illustrate that firms must carefully respond to each other's pricing actions. In markets dominated by just a few large players, competitive conditions can arise, leading to efficient production patterns, resembling outcomes seen in perfect competition rather than in a monopolistic market.