MicroEconomics Oligopoly

Master in Engineering Policy and Management of Technology MicroEconomicsOligopoly Presented by Students: João Pita Francisco Vilhena da Cunha Bruno Pereira Jorge Oliveira

Oligopoly Master in Engineering Policy and Management of Technology The regimen of oligopoly is characterized by a restricted number of agents on the offer side and a large number on the demand side. The agents of the offer are in such number that their market share allows each one of them to affect the formation of prices and from there affect other competitors.

Oligopoly Master in Engineering Policy and Management of Technology This is, realistically, the regimen most current in the not controlled economies. Easiness of communications Information Transports Technological competition Selection of the most capable firms AutomobileMarket, Energy, Microprocessors, Photograph, etc

Cooperative Oligopoly Implicit and explicit agreements about prices, amounts and types of product. Eventual barriers to the entrance of other companies in the market Concorrencial oligopoly When the companies compete between themself, having or not in consideration the reaction of the other companies in the market. With indifferentiated products With identical prices and equally available techniques of production for all the companies of the oligopoly - pure oligopoly With differentiated products When the companies differentiate its products, in order to create a search that specifically is directed them Types of Oligopoly Master in Engineering Policy and Management of Technology

Master in Engineering Policy and Management of Technology Cournot Model • Static Game: Players act simultaneously • Strategies: Any Price between 0 and infinity denoted p1 and p2 Developed by AntoineAugustinCournot in 1838 In a two firm oligopoly (called a duopoly), if both firms set their output levels assuming that the other firm’s strategic choice variable (quantities in Cournot competition) is fixed, the equilibrium outcome is a Cournot-Nash Non-cooperative Equilibrium.

Cournot Model Master in Engineering Policy and Management of Technology Description: Firm 1 excepts that firm 2 production will be y2eunits of output, Then decides to produce y1, The total production will be Y= y1+y2e and market price p(Y) = p( y1 + y2e )

Properties of the Cournot-Nash Equilibrium for Duopoly Master in Engineering Policy and Management of Technology • When the duopolists compete in quantities, we can compare the outcome to both the monopoly and competitive outcomes. • Each duopolist produces less than a monopolist in the same market but together they produce more than the monopolist and less than the amount two competitive firms would have produced with the same cost structure and demand curves. • The sum of the economic profits of each duopolist is less than the economic profits of a monopoly in the same market.

Cournot Model: Water’s Reaction Curve Master in Engineering Policy and Management of Technology Firm 1 q1 (litres) 120 Water´s reaction curve 60 20 30 50 60 120 Firm 2 q2 (litres)

Cournot Model Master in Engineering Policy and Management of Technology Firm 1 q1 (litres) 120 reaction curve 60 40 reaction curve 40 60 120 Firm 2 q2 (litres)

Cournot Model Master in Engineering Policy and Management of Technology Firm 1 q1 (litres) 120 reaction curve 60 Cournot Equilibrium 40 reaction curve 40 60 120 Firm 2 q2 (litres)

Properties of the Cournot-Nash Equilibrium for Duopoly Master in Engineering Policy and Management of Technology The profit-maximization problem The optimal choice of firm 1 is y1 = f1(y2e ) This reaction function gives one firm’s optimal choice as a function of its beliefs about the other firm’s choice. For arbitrary values of y1e and y2e this won't happen - in general firm 1´s optimal level of output, y1, will be different from what firm 2 expects the output to be, y1e.

Bertrand-Nash equilibrium Master in Engineering Policy and Management of Technology • Static Game: Players act simultaneously • Strategies: Any Price between 0 and infinity denoted p1 and p2 • The Bertand equilibrium is a price level for each firm such that the firm´s profits are maximized given the price level of the other firm. Assuming that firms are selling identical products  Bertrand equilibrium is the competitive equilibrium, where price equals marginal costs. • Consider that both firms are selling output at some price > marginal cost. • Cutting its price by an arbitrarily small amount firm 1 can steal all of the customers from firm 2. Firm 2 can think the same way! Any price higher than marginal cost cannot be an equilibrium The only equilibrium is the competitive equilibrium

Master in Engineering Policy and Management of Technology Bertrand-Nash equilibrium Graphical demonstration of Why P1=P2> MC is not a Nash Equilibrium

Sequential Models Master in Engineering Policy and Management of Technology • Companies act sequentially, as opposed to simultaneously (Cournot and Bertrand models) • Competitors decisions are taken into account • Dominant player or Leader (first mover) and Follower – anticipation strategy from the Leader • Perfect information: Follower has complete information on Leader’s actions – Competitive Intelligence • Examples: IBM, Microsoft

Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Stackelberg Model • Heinrich Freiherr von Stackelberg • 1905 (Germany) – 1946 (Spain) • Theory of competition • Model • Duopoly where both firms have market power with undifferentiated products • First model to assume asymmetries between companies • Cournot-like competition on quantity/output followed by Bertrand-like competition on price • 1st mover’s decision remains constant and follower decides based on that (otherwise it’s a Cournot model)

Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Firm 1 (leader) decides on quantity to produce (y1), assuming that Firm 2 (follower) will react to maximise its profits, producing y2: • Total output: Y = y1 + y2 = f(y1) • Equilibrium price Pis a function of total output, Y What will be the quantity produced by Firm 1 (Leader)? Look forward and reason back • Firm 1 knows that: • It has influence over Firms2’s output and • Firm 2 will react in order to maximise its profit Leading to…

Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Follower's profit-maximization problem • Firm 2 will choose y2 in order to maximise its profit, P2 • P2 = P(y1+y2)(y2) - w2(y2), where w2 is Firm 2’s unit costs • To Firm 2 and considering profit maximization: • y1=constant and it will have to define y2 from: • MR(y1,y2*)=MC(y2)  y2* = f2(y1)  y2* = f2(y1): Firm 2 reaction function • y2* is a function of Firm 1’s decision

+ - Isoprofit lines – Firm 2 Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Follower's profit-maximization problem y2 P2 max (Monopolist) y2 = f2(y’1) Reaction Curve f2(y1) y’1 y1

Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Leader’s Problem • Assuming Firm 2’s reaction to its output, Firm 1 now aims at maximizing it profit: P1 = P[y1+f(y1)](y1) - w1(y1), since y2 = f(y1) • Leader knows that his actions influence the output choice of the follower,

+ - Isoprofit lines – Firm 1 Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Stackelberg model - Equilibrium Mathematical deduction: http://josemata.org/ee/17/stackelberg2/ y2 Reaction Curve Firm 1 Cournot Equilibrium Stackelberg Equilibrium y*2 Reaction Curve Firm 2 f2(y1) y*1 y1

Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Stackelberg model compared

Master in Engineering Policy and Management of Technology Sequential Models - Stackelberg Identifying the leader • Stackelberg model based on Cournot with an anticipation strategy from one of the companies on setting its output • The model doesn’t explain what is the asymmetry neither in what it is based on • There can be several reasons, e.g.: • Company already in the market and new entrant • 1st can decide on the installed capacity • If installed capacity irreversible, 2nd can assume capacity of the 1st as an input for decision • Depending on fixed costs, 2nd may not be able to enter the market (monopoly) • If seond enters the market  Stackelberg model

Master in Engineering Policy and Management of Technology Collusion Model Types of Cooperative Behaviour When firms agree to cooperate in order to restrict output and raise prices, their behaviour is called collusion. • Tacit collusion occurs when firms act without explicit agreement to achieve the cooperative outcome. Can take the form of a verbal ‘gentleman’s agreement’ to fix prices and output. • Explicit collusion occurs when firms ostensibly agree to maintain their joint-profit-maximizing output. Cartels -- such as DeBeers and OPEC -- are obvious examples.

Factors that affect the ability to collude: Master in Engineering Policy and Management of Technology • Number and size distribution of sellers • Similar  easier to collude • Product heterogeneity • Homogeneous  easier to collude • Cost structures • Similar  easier to collude • Size and frequency of orders • Frequent smaller  easier to collude • Secrecy and retaliation • Less secrecy, easier retaliation  easier to collude • Social structure of the industry • Social interaction  easier to collude

Tacit Collusion Master in Engineering Policy and Management of Technology • Price Leader (Barometric Firm) • Largest, dominant, or lowest cost firm in the industry • Demand curve is defined as the market demand curve less supply by the followers • Followers • Take market price as given and behave as perfect competitors

Price Leadership Master in Engineering Policy and Management of Technology

Oligopoly isn’t a problem unless it becomes a Cartel Master in Engineering Policy and Management of Technology • Cartel – a formal or informal agreement among firms in an oligopolistic industry • Cartel members may agree on such issues as prices, total industry output, market shares, and division of profits • Cartels or collusive agreements are illegal in most cases.

Cartels Master in Engineering Policy and Management of Technology • OPEC • Colombian Drug Cartel • Mafia or Crime Syndicate • Ivy League Schools • Government enforced cartels: market intervention to raise prices!

Master in Engineering Policy and Management of Technology Cartel as a Monopolist D is the market demand curve, MR the associated marginal revenue curve, and MC the horizontal sum of the marginal cost curves of cartel members (assuming all firms in the market join the cartel). Cartel profits are maximized when the industry produces quantity Q and charges price p.

Some illegal Cartels get caught: Master in Engineering Policy and Management of Technology • Electrical equipment manufacturers in the 1950s • Pharmaceutical companies more recently Some don’t…

Cheating Master in Engineering Policy and Management of Technology Perhaps the biggest obstacle to keeping the cartel running smoothly is the powerful temptation to cheat on the agreement By offering a price slightly below the established price, a firm can usually increase its sales and economic profit Because oligopolists usually operate with excess capacity, some cheat on the established price

Master in Engineering Policy and Management of Technology How can either of the firms be sure that the other firm isn’t cheating on their agreement, and selling the product for lower price? “BEAT ANY PRICE” One way is to offer to beat any price a costumer can find. That way, the costumer report any attempt to cheat on the collusive arrangement

OPEC Illustrates Cartel Difficulties Master in Engineering Policy and Management of Technology • Incentive to Cheat Cheating increases individual profits Cheating decreases cartel profits • Different Members Have Different Goals High prices encourage substitutes Supply expansion by non-members Development of alternative products More important to some members than to others

MCopec Dmkt MRopec Qopec Qtotal Qfringe Output Master in Engineering Policy and Management of Technology OPEC and CIPEC • OPEC is the Organization of Petroleum Exporting Countries • CIPEC is the French acronym for Int’l Council of Copper Exporting Countries • Why has OPEC been successful in raising its price, but CIPEC has not? • OPEC as a dominant firm Price MCnon-opec P1 Oil Market Popec Pcomp P2 Qc+c

Master in Engineering Policy and Management of Technology OPEC and CIPEC • CIPEC (Chile, Peru, Zambia, Zaire) • MCCIPEC is not much less than MCnon-cipec • Why has OPEC been successful in raising its price, but CIPEC has not? • CIPEC as a dominant firm Copper Market Price MCnon-cipec • Why can’t CIPEC increase copper prices much? • D for copper is more elastic (aluminum is a good substitute) • Comp’ve supply more elastic than for oil (if P rises, simply go to scrap heap) • Successful cartel needs relatively inelastic D. P1 MCcipec Pcipec Pcomp P2 Dmkt MRopec Qtotal Qcipec Qfringe Output Qc+c

Obstacles to Collusion Master in Engineering Policy and Management of Technology • Demand and cost differences between firms. • Higher numbers of firms, particularly if a number of firms outside collusive agreement. • Incentives to cheat. • Recession. • Legislative obstacles: Trade Practices Law.

Master in Engineering Policy and Management of Technology OLIGOPOLY MODELS COMPARISON OF THE SOLUTIONS

It tries to explain the rigidity of the price, many times observed in oligopolistc markets; If a companie increases its price, the other companies will not, making the first one to lose its customers; On the other hand, if a company lower the prices, the other companies also will lower the price, for that it will not have advantage to do that. Sweezy Model Master in Engineering Policy and Management of Technology P mC’ mC D mR Q

Conclusions - Balance in the Long Run Master in Engineering Policy and Management of Technology • Profits, equilibrium or damage • In the long run, the oligopolist will leave the industry if has no profits. • It prepares its company to present the very best level of production in the long run. • If it will have some profits, other companies will try to enter in the sector, if the entrance will not be restricted. • Competition based on strategy, quality, productproject, advertisement, services, innovation

Bibliography Master in Engineering Policy and Management of Technology • Lipsey & Chrystal • Mata, José, “Economia da empresa”, Fund. Calouste Gulbenkian, Lisboa, 2nd edition, 2002 • Mata, José in http://josemata.org/ee, 2006 • Pindyck, Robert S., Rubinfield, Daniel L., “Microeconomics”, 5th edition, ch. 12, pgs. 429 to 451 • Samuelson • Salvatore, Dominick, “Microeconomy”, Schaum, MacGraw-Hill, 1984 • Sousa, Alfredo de, “Análise Económica”, Universidade Nova de Lisboa, Faculdade de Economia, 1988 • “The Home of Economics on the Internet” in www.tutor2u.net, 2006 • Varian, Hal R., “Intermediate Microeconomics”, 6th edition, ch. 26, pgs. 459 to 479

MicroEconomics Oligopoly