L19 Quantity-Setting Oligopolists

Microeconomics is the study of individuals and businesses in an economy, focusing on how they make decisions and interact in specific markets. One important structure in microeconomics is oligopoly, where a few firms dominate the market. Here, we discuss quantity-setting oligopolists and how they operate.

Theories of Oligopoly

• Cournot Theory (1838): This theory suggests that firms decide how much to produce (output quantity). They choose their production levels simultaneously without knowing what their competitors will produce.

• Bertrand Theory (1883): This theory critiques the Cournot model by focusing on price as the key factor. Instead of just looking at how much to make, it considers how firms might compete by setting lower prices to attract customers.

Key Distinction: Oligopoly models can generally be divided into two categories:

• Quantity-setting (Cournot): Firms choose the quantity of output they want to sell.

• Price-setting (Bertrand): Firms choose the price of their products to attract buyers.

Aims of the Lecture:

• Understand the concept of quantity-setting oligopolies.

• Build on previous lessons about how firms interact strategically.

• Apply the Cournot model to real-world situations, revealing similarities to Nash equilibrium (a concept in game theory where players make decisions that are optimal for themselves, considering the decisions of others).

• Compare production quantities and pricing strategies in oligopolies versus monopoly and perfect competition.

Lecture Outline:

1. Assumptions of oligopolies

2. Characteristics of the appropriate market structure

3. Cournot’s model of oligopoly

4. Comparison between oligopoly and monopoly

5. Comparison between oligopoly and perfect competition

1. Assumptions of Oligopolies

• A(1) and A(2): In perfect competition, there are many buyers who cannot influence prices, and everyone has complete knowledge about products and prices. In oligopoly,

  • A(3): Sellers are price makers. They have some control over the prices due to their market power, which means they can influence the prices based on how much they decide to produce. The demand curve (which shows how many products consumers are willing to buy at different prices) slopes downwards, indicating that if they raise their prices, they will sell fewer products.

  • A(4): New companies cannot enter the market easily; barriers to entry are high, similar to a monopoly where one firm dominates.

2. Appropriate Market Structure

• Market Dynamics: In oligopoly, there are many informed buyers, but only a few sellers.

  • (a) Size & Number of Sellers: The market can have a few large firms or many smaller ones, but each firm must be big enough to affect prices.

  • (b) Barriers to Entry: There are significant barriers preventing new firms from entering the market, ensuring the current firms can maintain their market power.

  • (c) Product Substitutability: The products sold can be the same (homogeneous) or different (differentiated), with many analyses assuming that they are similar.

3. Cournot’s Model of Oligopoly

• Specific Assumptions:

  • A(1): Suppose there are two companies (let's call them A and B) that compete by choosing how much to produce at the same time.

  • A(2): We do not allow any new firms to join the market.

  • A(3): Both firms create similar products.

  • A(4): We examine how the market operates using the inverse demand function (which shows the relationship between price and quantity demanded).

4. Finding the Cournot-Nash Equilibrium

• Behavioral Analysis: A balance is reached (Nash equilibrium) when neither company wants to change its production based on what the other firm is doing.

• Equilibrium Criteria: For equilibrium to occur, both firms must respectively maximize their profits considering the production decisions of the other firm. The residual demand curves (showing demand left over after considering the rival's output) depend on each firm's production.

Graphical Analysis of Firms’ Outputs

Nash Equilibrium diagrams represent the points where the best responses of both firms intersect, showing stable levels of production. Each firm's extra revenue (marginal revenue) comes from the market demand curves.

5. Comparisons to Monopoly and Perfect Competition

• Market Outcomes: In an oligopoly, the prices set by two firms are generally higher than their marginal costs (the cost of producing one more unit), but lower than prices in a monopoly (where one firm controls the entire market).

  • More products are produced in an oligopoly than in a monopoly, but less than what is produced under perfect competition (where many firms work without barriers).

Summary of Key Points

• In oligopoly, sellers strategically set prices within a limited market.

• It consists of a few large companies with high barriers to entry.

• Quantity-setting firms keep prices above marginal costs, allowing them to earn larger profits than in perfect competition but less than in monopoly.

• The outcomes in oligopoly differ: more is produced than in monopoly but less than in perfect competition.

Learning Objectives

• Describe the market structures suitable for oligopoly.

• Explain how best response functions slope downwards in Cournot's model.

• Derive the Cournot-Nash equilibrium.

• Compare the equilibrium outcomes of Cournot model with monopoly and perfect competition