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Chapter 15: Oligopoly and Strategic Behavior

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The more Beta supplies the less is left for Air Lion and the D and MR curves move left. ( The profit-maximizing level of output decreases for Air Lion. ... – PowerPoint PPT presentation

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Title: Chapter 15: Oligopoly and Strategic Behavior


1
Chapter 15 Oligopoly and Strategic Behavior
  • Overview
  • All market models studied thus far have
    explicitly assumed that firms exhibit no
    strategic behavior. This chapter extends the
    theory of markets to that of oligopoly, where
    firms in the industry do exhibit strategic
    behavior. When firms are aware that the price or
    output decisions made by one firm affects the
    profits of all other firms, then they are said to
    recognize their mutual interdependence. Whenever
    a firm takes the potential reactions of other
    firms into consideration when choosing its best
    course of actions, that firm is behaving
    strategically.

2
  • The Fundamental Assumptions of Oligopoly
  • Unique to oligopoly is mutual interdependence
    between firms and strategic behavior of firms.
  • Sellers are price makers The firm-specific
    demand curve is down-sloping.
  • Sellers behave strategically.
  • Entry into the market may range from completely
    blocked to perfectly free.
  • Buyers are price takers.

3
  • Appropriate Market Structure
  • The size and number of buyers. There is a large
    enough number of buyers that no one individual
    can influence price.
  • b. The size and number of sellers. There are few
    suppliers who behave strategically. There must
    be more than one seller, but few enough that
    mutually interdependence is felt between firms.
  • c. The degree of substitutability of different
    sellers products. Firms products can range from
    perfect substitutes (basic metals) to highly
    differentiated (automobiles).
  • d. The extent to which buyers are informed about
    prices and available alternatives. Oligopoly
    includes both well-informed and poorly-informed
    consumers.
  • e. The conditions of entry. Entry ranges from
    free to completely blocked.

4
  • 15.1 Quantity-Setting Oligopolists (Cournot
    Model)
  • Additional Assumptions
  • There are two firms in the industry, i.e., a
    duopoly.
  • Entry into the market is completely blocked.
  • The firms produce homogeneous products.
  • The firms have identical, constant marginal costs
    equal to c. Thus, if the output level is x, then
    total cost is cx.

5
  • Market Equilibrium
  • A self-enforcing agreement is one which firms
    find in their best interest to abide by, given
    that other firms do the same.
  • 2. A tacit agreement is a common understanding
    between firms as to how they should behave
    without discussing it.
  • 3. Equilibrium is a situation in which no
    economic decision maker wants to change his or
    her action given the market outcome, and hence
    there is a tendency for the market to stay put at
    that outcome.
  • 4. A firm chooses the best response when it
    chooses the best course of action, given what the
    other firms are doing.

6
  • A market is in equilibrium when every firm
    pursues a strategy that is a best response to the
    strategies of the other firms in the market.
    This equilibrium is called a Nash equilibrium,
    named for John Nash from the movie A Beautiful
    Mind.
  • In the example, a firms strategy consists of its
    choices of output level y for Air Lion and z
    for Beta. A Nash equilibrium in quantities
    consists of two output levels, y1 and z1, such
    that
  • a. Given that Beta Airlines sells z1 tickets,
    Air Lions profit is maximized by selling y1
    tickets. and
  • b. Given that Air Lion sells y1 tickets, Beta
    Airlines profit is maximized by selling z1
    tickets.
  • 7. A Cournot equilibrium is a Nash equilibrium in
    a market where firms strategy consists of output
    choices.

7
  • Finding a Cournot Equilibrium
  • Deriving the Best-Response Functions
  • 1. Cournot duopolists produce where MR MC.
  • Find the firm-specific demand curve in panel B
    from panel A of Figure 15.2.
  • a. Suppose that the price/seat is 115 and that
    Beta sells 200 seats/day.
  • b. Air Lion can sell 650 seats/day without
    driving the price above 115.
  • c. If Beta sells 200 seats, then Air Lion can
    sell 250 seats without driving the price above
    205.
  • Air Lion has a different residual demand curve
    for each value of Betas output level. If Beta
    sells 250 seats/day rather than 200/day, then Air
    Lions residual demand curve moves to the left as
    in Figure 15.3.
  • The more produced by Beta at a given price, the
    smaller the residual left for Air Lion.

8
  • Examine MR, MC, D curves for Air Lion using
    Figures 15.5 15.6.
  • Given the number of seats supplied by Beta, there
    is a unique D and MR for Air Lion. (Figure 15.5)
  • The more Beta supplies the less is left for Air
    Lion and the D and MR curves move left. (The
    profit-maximizing level of output decreases for
    Air Lion.)
  • The less Beta supplies the more is left for Air
    Lion and the D and MR curves move right. (The
    profit-maximizing level of output increases for
    Air Lion.)
  • Best-response curves (reaction curves) can be
    derived that show a decision makers best course
    of action for each set of choices made by other
    decision makers.
  • a. Figure 15.7 shows that if Beta is selling 240
    seats/day that Air Lions best response is to
    sell 290 seats, etc.
  • b. Figure 15.8 shows that if Air Lion is selling
    yq seats/day that Beta should sell zq seats/day,
    etc.

9
  • Use Reaction Curves to Find the Cournot
    Equilibrium using Figures 15.9 15.10.
  • In equilibrium each firm must choose a best
    response to the other, so that once to the
    equilibrium point neither firms wants to move
    away from it. This means that each firm must be
    on their reaction curve.
  • See in Figure 15.9 that points i, g, h have only
    one firm on its reaction curve. Point f has
    neither firm on their reaction curve. None of
    the points i, g, h, f cannot be an equilibrium.
  • See in Figure 15.10 that point e1 represents a
    pair of output levels that can be supported by a
    self-enforcing agreement and is a Cournot-Nash
    equilibrium, where the two reaction curves
    intersect.

10
  • 15.2 Price-Setting Oligopolies
  • A Bertrand equilibrium is a Nash equilibrium in a
    market in which each firms strategy consists of
    choosing a price at which to sell its output.
  • Suppose there are two firms, Air Lion and Beta
    Airlines.
  • The strategy consists of Air Lion choosing pA and
    Beta Airlines choosing pB.
  • A Nash equilibrium in prices consists of two
    prices, p1A and p1B, such that
  • Given that Beta Airlines charges p1B per ticket,
    Air Lions profit is maximized by charging p1A
    per ticket.
  • Given that Air Lion charges p1A per ticket, Beta
    Airlines profit is maximized by charging p1B per
    ticket.

11
  • Three Cases to Consider
  • Air Lion charges a higher price than Beta. (Air
    Lion sells no seats.)
  • Air Lion charges a lower price than Beta. (Beta
    sells no seats.)
  • Air Lion and Beta charge the same price.
    (Equilibrium will exist if the price is above
    marginal cost.)
  • Figure 15.15 shows Betas firm-specific demand
    curve when Air Lion charges 130.
  • a. Beta can sell no tickets above the price of
    130.
  • b. Beta can sell half of the market quantity
    demanded at 130, 300 tickets.
  • c. Beta can sell on the demand curve below 130.

12
  • Figure 15.16 shows how Beta and Air Lion can
    share the market at the price pg and with output
    Xg/2 per firm.
  • Figure 15.17 shows the potential for Beta to
    undercut Air Lion on price to increase profits.
  • Bertrand Equilibrium
  • If price is set equal to marginal cost, then it
    would not be cut by either firm, for that would
    drive profits negative.
  • Each firm setting price equal to marginal cost is
    a self-enforcing agreement.
  • Conclusion When all firms have costs that are
    constant at c, the Bertrand equilibrium requires
    that firms set their price to c.

13
  • Cournot or Bertrand Which model is best?
  • The Cournot model is appropriate when firms make
    fixed production plans, i.e., changing price is
    easier than changing production. (Examples
    supermarkets, gas stations, discount stores)
  • The Bertrand model is appropriate when firms have
    committed to prices rather than to quantities,
    e.g., mail-order catalog stores.

14
  • 15.3 Cooperation and Punishment
  • The costs and benefits of cheating are explained
    in Figure 15.19, where benefits are A, costs B
    and T is the time to detect the cheating.
  • General Predictions With few of firms comes the
    potential for collusion.
  • The longer it takes to catch a cheater, the
    greater the incentive to cheat.
  • The less likely it is that a cheater will be
    caught, the greater the incentive to cheat.
  • The harsher the punishment that a cheater faces,
    the lower the incentive to cheat on an agreement.
  • The more complex the collusive agreement has to
    be, the less likely it is to succeed.

15
  • Market Structure and Collusion
  • The more that the firms costs differ, the less
    likely is cooperation, ceteris paribus.
  • The more that demand varies from period to
    period, the less likely is cooperation, ceteris
    paribus.
  • The easier it is for firms to monitor their
    rivals output levels, the more likely is
    cooperation, ceteris paribus.
  • Product differentiation may increase or decrease
    the likelihood of cooperation, ceteris paribus.
  • When prices are negotiated with each customer
    separately, collusion is less likely to be
    successful, ceteris paribus.
  • When individual orders are large relative to the
    overall market, collusion is less likely to be
    successful, ceteris paribus.
  • The more firms in a market, the less likely is
    cooperation, ceteris paribus.

16
Chapter 15 Discussion Questions
  • Work the following problems on pages 518-519
    15.2, 15.4, 15.8.
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