Oligopoly Notes

Oligopoly

  • Oligopoly: A market with a small number of large firms and significant barriers to entry.
  • Key characteristic: Firms have market power but are interdependent.
  • Duopoly: A special case of oligopoly with only two firms.

Market Structures

  • Markets differ based on:
    • Number of firms.
    • Ease of entry and exit.
    • Product differentiation.
  • Oligopoly:
    • Few firms.
    • Limited entry.
    • Long-run profit \geq 0.
    • Price setter, P > MC.
    • Strategy dependent on rival firms.
    • Products may be differentiated.

Cartels

  • Cartel: Firms collude to coordinate activities and produce at monopoly output levels.
  • Objective: Increase profits by restricting output and raising prices.
  • Why cartels fail:
    • Lack of market control.
    • Cheating among members.
  • Laws: Sherman Antitrust Act and Federal Trade Commission Act prohibit actions that reduce competition.

Oligopoly Dilemma

  • Firms must decide to compete or cooperate.
  • Cooperation (cartel): Higher profits for all if output is restricted.
  • Temptation to cheat: Individual firms can gain extra profit by increasing output, but if all cheat, prices fall.

Game Theory and Oligopoly

  • Game theory explains why cartels fail.
  • Firms make strategic decisions that affect each other.
  • Cooperation: Restrict output, set high prices.
  • Temptation: Cheat to gain profit.
  • Outcome if both cheat: Supply increases, prices fall, profits decrease.

Cournot Duopoly

  • Duopoly: Oligopoly with two firms.
  • Models:
    • Cournot: Firms choose quantities simultaneously.
    • Stackelberg: Leader firm chooses quantity first.
    • Bertrand: Firms choose prices simultaneously.
  • Assumptions for Cournot model:
    • Identical firms with same cost functions.
    • Market lasts for one period.

Nash-Cournot Equilibrium

  • Firms independently set output levels.
  • Equilibrium: No firm can gain by changing output, given the output of competitors.

Airlines Market Example

  • Market demand: Q = 339 - p
  • Marginal cost: MC = $147
  • American Airlines' inverse residual demand: p = (339 - qU) - qA
  • American Airlines' marginal revenue: MR = (339 - qU) - 2qA
  • Best response function (BRF) for American Airlines: qA = 96 - (1/2)qU
  • Cournot equilibrium: qA = qU = 64, P = $211

Key Takeaways

  • Monopoly (Cartel): Higher price (243), lower output (96).
  • Duopoly (Nash-Cournot): Lower price (211), higher output (128).
  • Duopoly leads to lower prices and profits compared to a monopoly due to diluted market power.