Actual Oligopolies Athletic Shoes, Soft Drinks & Airlines Five Oligopoly Models

Basic Oligopoly Models Baye – Chapter 9 • Actual Oligopolies • Athletic Shoes, Soft Drinks & Airlines • Five Oligopoly Models • Sweezy (Kinked Demand Curves) • Cournot • Stackelberg (Followers & a Leader) • Bertrand (ends up like competition) • Matching Oligopoly (Collusion) Note: Contestable Markets already discussed (see page 42 of notes).

Conditions for Oligopolistic Market Structures • Few Firms • Consequently, each firm must consider the reaction of rivals to price, production, or product decisions • These reactions are interrelated • Heterogeneous or Homogeneous Products • Athletic shoe market(Heterogeneous) • Nike has 33% of market; Adidas as 15%; Reebok has 10% • Soft Drinks(relatively Homogeneous drinks including water) • Coke & Pepsi – alternating price cuts • Airlines • Market concentration differs in different markets • Empirical evidence reflects the impact on market structure

Non-cooperative Oligopoly Models The Sweezy Model - Kinked Oligopoly Demand Curve Figure 9-1 • What to we assume reaction will be a price cut? • Price cuts lead to everyone following • highly inelastic (A-B) • Price increases, no one follows • highly elastic (B-D) • Belief in price rigidityfounded on experience of the great depression no one follows a price increase A B P everyone follows price cuts D a kink at the price

A Kink Leads to Breaks in the MR Curve P Figure 9.2 • Although MC rises, the optimal price remains constant • Expect to find price rigidity in markets with kinked demand • QUESTION: • Where would we more likely find KINKS and where NOT? D MC2 MC1 D MR

The GREATER the number of firms, likely more kinked Prices Likely More Rigid The more HOMOGENEOUS, likely more kinked Prices More Rigid Which industries are likely to have kinks and which have no kinks? N = 2 heterogeneous N = 10 homogeneous

The more EQUAL SIZED are the firms, likely more kinked Prices Likely More Rigid The existence of a Dominant Firm creates a price leader With a price leader, there is no need to imagine a kink in the demand Which industries are likely to have kinks and which have no kinks? DOMINANT Firm Exists Equal Sized Firms

Oligopolies with few firms were more rigid in FACT Oligopolies with homogeneous produces were MORE rigid in FACT Empirical Evidence vs. Predictions of the Model FACT s 2 FACT s 2 prediction prediction heterog. homogeneous N

Oligopolies with Dominant Firms were actually more rigid in FACT Empirical Evidence vs. Predictions of the Model FACT s 2 prediction Dom. Firm Equal Sized

Are these Empirical Findings Surprising? • A Kink is a barrier to profitability • Firms are in business to make profits • Simple Alternative Explanations Exist: • More Firms are More competitive • More Homogenous Products are more competitive • More equal-sized are more Competitive

2. Cournot Oligopoly Pages 320 - 325 1801-1877 • Oligopoly -- just a few firms • Models vary depending on assumptions of actions of rivalsto pricing and output decisions. • Augustin Cournot (1838) created a model that is the basis of Anti-trust Policy in the US. • Model with a more appealing result.

Cournot Duopoly described as “rounds” ROUND q1 q2 Q worksheet 0 450 --- 450 monopoly 1 450225 675 MR = 500 - 2q2 =50 2 338 225 563 MR = 725 - 2q 1=50 3338 281619MR = 612 - 2q2 =50 4 310281591 MR = 669 - 2q1 =50 5 310 295 605 MR = 640 - 2q2 =50 infinite • • • 300 • • • • 300 • • • • • 6002/3 of competitive output

Cournot Reaction Functions (p. 333) • Baye finds what is optimal for duopolists with a linear demand P = a – b(Q1 + Q2), but we could do this also for a specific demand curve: P = 950 - (Q1 + Q2) and specific cost curve TC1 = 50·Q1 and TC2 = 50·Q2 • Profit1 = PQ1 = 950Q1 –Q1Q2 – 50Q1. : MR = MC, implies • 950 – Q2 – 2Q1 = 50 • 950 – Q1 – 2Q2 = 50 • Hence, Q1 = 450 - .5Q2 comes from eqn. 1 • And , Q2 = 450 - .5Q1 comes from eqn. 2 • Equations 3 & 4 are called REACTION FUNCTIONS or best response functions. • When one selects and output, such as Q2 = 0, then Q1 selects its best response. In equation 2, that would be Q1 = 450, the monopoly output. • With this output, firm 2 says, if Q1 = 450, then my best response in equation 4 is Q2 = 225. • We follow the same path of corrections as described in the “rounds” approach.

Figure 9.3 Cournot Reaction Functions - page 321 Q2 450 225 Reaction for firm 1 {Q1 = 450 - .5Q2 } E Reaction for firm 2 {Q2 = 450 - .5Q1 } A B 225450 Q1

N-Firm Cournot Model • For 3 firms: • Q = q 1 + q 2 + q 3 • the solution is higher output and lower price • QCournot = {N / (N+1)}QCompetition QC N THEREFORE, Increasing the Number of Firms Increases Competition. This is the historical basis for Anti-trust Policies PC N

If N = 3 Triopoly P = 950 - Q & MC=50 Then, Q = (3/4)(900) Q = 675 P =$275 If N = 5 P = 950 - Q and MC = 50 Then Q = (5/6)(900) Q = 750 P = $200 Examples of Oligopolies of Different Number of Firms N = 3 N = 5

P = 950 - Q and MC =50 IN COMPETITION P = MC, so 950 - Q = 50 PC = $50 and QC = 900 Solution is also for Bertrand Oligopoly IN COLLUSIVE DUOPOLY MR = MC, so 950 -2Q = 50 QM = 450 so PM = 950 - 450= $500 IN COURNOT DUOPOLY Q = q1 + q2 = 600 & P =$350 Cournot is Between Monopoly & Competition $500 PM Pcournot PC $350 $50 D QMQCournot QC 450 600 900

A few words on Isoprofit Curves Q2 • Can briefly examine isoprofit curves • Along a reaction function, profit rises Firm 1’s reaction function p1 p2 p3 p4 p5 Isoprofits rise from p1 to p5 Q2* Q1 Figures 9-4 & 9.5 The best Firm 1 can do if it thinks firm 2 will produce Q2* is p4.

Cournot Equilibrium & Isoprofit Curves Q2 • At E, highest Isoprofit lines cross at Cournot equilibrium, C. • But, if both cut output, there is a cross-hatchedregion of higher profits for both firms. • This is the incentive to have collusion. Firm 1’s reaction function p2 Isoprofits rise from p1 to p5 p1 C Q2* Q1 Figures 9.7 and 9.9 with both maximizing, we Reach point C.

Stackleberg Oligopoly Heinrich Freiherr von Stackelberg 1905-1946 • Some oligopolies are characterized with a major historic industry leader, and other firms act as followers • All conditions of oligopoly exist, a few firms, but one is this leader. • We can view this both as a FIRST MOVER model and like a Cournot Model with one firm picking output first.

First Mover Games B civilian military • Andrew Carnegie: The first person gets the oyster, the second person gets the shell. • Some markets are too small for many firms. • Game with Military and Civilian markets for “water-land vehicles” (DUCKS) -10, -10 30, 15 15, 30 -10, - 10 civilian military A Both firms would want the civilian market. But the first to get the civilian market preempts it. The other firm takes the military market.

Stackleberg with Q1 as the Leader Q2 Leader’s reaction function • Leader know, whatever it picks, the follower will max profits along their reaction line, R2. • The highest profit is at point S, for Stackleberg. • Firm 1 produces more and the followers less than in Cournot. p2 Isoprofits rise from p1 to p5 p1 C Q2* S S R2 p6 Q1 Figure 9.11 Higher profits for the Leader.

Clearly being first is no guarantee of high profits Xerox didn’t stay on top Neither did Wang Computers But, first movers can pre-empt others South African telecommunication firm, Telkom Diamond cartel, de Beers US Steel for a time Stackleberg in the RW

Bertrand Oligopoly Joseph Bertrand1822-1900 One firm enters as a monopoly. Second firm, believes that the first firm will maintain his monopoly price. Viewed as “rounds” we get to competition Same as a PRICE WAR

Bertrand Duopoly described as “rounds” Example:P = 950 - Q andMC =50 ROUND q1 q2 Q worksheet 0 450 --- 450 monopoly 1 0451 451 firm 2 cuts price 2 460 0 460 firm 1 cuts price 3 0 500500 firm 2 cuts price 4 5005001000 Losses 5 450 450 900 Zero economic Profits infinite • • • 450 • • • • 450 • • • • • 900 competitive output

Matching Duopoly described as “rounds” ROUND q1 q2 (matcher) Q worksheet 0 450 --- 450 Monopoly 1 450 450 900 Zero profits 2 455 455 910 Losses 3400 400800 Positive Profits 4 310 310610 Better Profits 5 230 230 460 Higher Profits infinite • • •225 • • • • 225 • • • • •450MONOPOLY PROFITS !!!

Matching Results • Can “teach” the rival the likely response, to achieve mutually acceptable outcome • Example in Pricing: Time & Newsweek • Suppose Time matches the price set by Newsweek • If Newsweek lowers price, so does Time • If Newsweek raises price, so does Time • Through trial and error Newsweek finds the profit maximizing price for both.

Sherman Act outlawed contract, combinations, or conspiracies to restrain trade. Price fixing is a violation of Antitrust laws Sotheby & Christie are auction houses who fixed the price of their take in an auction. They had a large share of the up-scale auction business Substitutes were relatively poor They were long time, stable competitors in a mature industry They see themselves as having solidarity – fighting off the likes of eBay. Contracts, Combinations, and ConspiraciesMBN Chapter 17

Actual Oligopolies Athletic Shoes, Soft Drinks & Airlines Five Oligopoly Models