L19 Quantity-Setting Oligopolists

Microeconomics Overview

• Topic: Quantity-Setting Oligopolists

• Course: ECA002

• Instructor: Luke Garrod

Theories of Oligopoly

• Cournot Theory (1838)

  • Assumes firms choose output quantity to produce.

• Bertrand Theory (1883)

  • Critiques Cournot's model, emphasizing price as the strategic variable in some markets.

• Key Distinction

  • Contemporary models are either quantity-setting (Cournot) or price-setting (Bertrand).

Aims of the Lecture

• Learn about quantity-setting oligopolists.

• Build on strategic interaction tools covered in the previous lecture.

• Apply the Cournot model as a real-world example of Nash equilibrium.

  • Similar features to Nash equilibrium discovered over 100 years prior to Nash's theory.

• Analyze production quantity and pricing in quantity-setting oligopoly.

• Compare outcomes with monopoly and perfect competition.

Lecture Outline

1. Assumptions of oligopoly

2. Appropriate market structure

3. Cournot’s model of oligopoly

4. Comparison with monopoly

5. Comparison with perfect competition

• Reading Assignments:

  • Core: Lipsey & Chrystal, ch. 8

  • Extra: Perloff, ch. 13.3

1. Assumptions of Oligopolies

• A(1) and A(2) from perfect competition lectures:

  • Buyers are price takers.

  • Complete information for buyers and sellers.

• A(3): Sellers are price makers.

  • They can influence the price; demand curve slopes downwards.

  • Seller's output choice affects rival responses.

• A(4): Entry is blocked.

  • No potential sellers can enter the market even in the long run (similar to monopoly).

2. Appropriate Market Structure

• Market Dynamics

  • Many informed buyers vs. few sellers.

• (a) Size & Number of Sellers:

  • Can be many small, few large, or one large entity.

  • Each seller must be substantial enough to influence prices.

• (b) Barriers to Entry:

  • Must be high to prevent market entry.

• (c) Product Substitutability:

  • Products can be undifferentiated or differentiated, with homogeneous products often assumed.

3. Cournot’s Model of Oligopoly

• Specific Assumptions:

  • A(1): Two sellers (A & B) compete in quantities, choosing output simultaneously.

  • A(2): No further market entry allowed.

  • A(3): Firms produce homogeneous products.

  • A(4): The market's (inverse) demand function is used to analyze efficiencies.

4. Finding the Cournot-Nash Equilibrium

• Behavioral Analysis:

  • Nash equilibrium achieved when no firm alters its output given the other's output.

• Equilibrium Criteria:

  1. Firm A maximizes profit based on B's output.

  2. Firm B maximizes profit based on A's output.

• Residual demand curves depend on rivals' outputs.

Graphical Analysis of Firms’ Outputs

• Nash Equilibrium diagrams showcase points where firms' best response functions intersect, indicating stable output levels.

• Each duopolist's marginal revenue is derived from demand curves.

5. Comparisons to Monopoly and Perfect Competition

• Market Outcomes:

  • Duopolist prices exceed marginal costs but are less than monopolist prices.

  • More units produced in oligopoly than monopoly, less than perfect competition.

Summary of Key Points

• Sellers are strategic price makers in a limited market.

• Oligopoly consists of few large sellers with high entry barriers.

• Quantity-setting duopolists maintain a market price above marginal cost, allowing for supernormal profits.

• Outcomes differ: more produced than under monopoly, less than under perfect competition.

Learning Objectives

• Describe appropriate market structures for oligopoly.

• Explain downward sloping best response functions in the Cournot model.

• Derive the Cournot-Nash equilibrium.

• Compare equilibrium outcomes of Cournot with monopoly and perfect competition.