Strategic Thinking in an Oligopoly

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Strategic Thinking in an Oligopoly
Presented by:

Michael Chai
CA(M), CPA, CFP, MCSM, MMIM
1

Oligopolistic concepts/issues:
– Duopoly strategic interaction – Cournot Equilibrium – Kinked demand curve – Cartel instability

2

Cournot Model
• Interdependence between firms • Max π given what one firm believes the other will produce • Decisions made simultaneously • Firms compete on non-price techniques • Simplest model is a duopoly

3

Numerical example – Duopoly
• • • • Assume market demand is represented by: P = 30 – Q where Q = Q1 + Q2 Assume Q1 = Q2 Assume AC = MC = 12 (implies zero Fixed Cost)

4

From Firm 1’s perspective P 30
If Firm 1 believes Firm 2 will produce entire market demand (Q=18), it will produce zero If Firm 1 believes Firm 2 will produce zero, it will act like a monopolist & produce 9 units & set monopolist P = $21

21

12

MC = AC

MR 0 9 15 18

D 30 Q
5

From Firm 2’s perspective P 30
If Firm 2 believes Firm 1 will produce entire market demand (Q=18), it will produce zero If Firm 2 believes Firm 1 will produce zero, it will act like a monopolist & produce 9 units & set monopolist P = $21

21

12

MC = AC

MR 0 9 15 18

D 30 Q
6

Q1
18

If Firm 1 believes Firm 2 will produce Q2=18, it will produce Q1=0 Firm 2’s Reaction Curve Q2 = 9 – 0.5Q1 Competitive Equilibrium Cournot Equilibrium

If Firm 1 believes Firm 2 will produce Q2=0, it will produce Q1=9

9 Collusive Equilibrium 6 4.5 Firm 1’s Reaction Curve Q1 = 9 – 0.5Q2

4.5 6

9

18

Q2
7

P 30

Cournot Equilibrium compared using a traditional Monopoly diagram

Under Monopoly: Welfare Loss is ABC

21 18 15 12 C

A E G

Under 2 Firm Cournot : Welfare Loss is EFB

Under PC: No Welfare Loss

B F H

MC = AC

MR 0 9 12 15 18

D 30 Q
8

• • • • • • •

Under Perfect Competition; P = 12, Q = 18 (No welfare loss) Under Monopoly; P = 21, Q = 9 (Welfare loss is ABC) Under 2 Firm Cournot; P = 18, Q = 12 (Welfare loss is EFB) Under 2 Firm Cournot; Q = 2/3 of Perfect Competition level Under 3 Firm Cournot; Q = 3/4 of Perfect Competition level Under 4 Firm Cournot; Q = 4/5 of Perfect Competition level Under 5 Firm Cournot; Q = 5/6 of Perfect Competition level

9

P 30

Cournot Equilibrium compared using a traditional Monopoly diagram

21 18 15 12 C

A E G

Under 5 Firm Cournot : Welfare Loss is GHB

B F H

MC = AC

MR 0 9 12 15 18

D 30 Q
10

Implications of Cournot model
• Even with non-price competition, only a few firms (perhaps 7 to 8) are required for output to be close to perfect competition level. • If barriers to entry are low enough, prices can be reduced further, close to perfect competition level. • Existence of market power per se is not the problem; rather it is the abuse of market power, or the conduct of the firms that matters. 11

Another perspective (A): If Firm 1 believes that Firm 2 will supply entire industry output Q2, it will supply Q1 = 0

Market demand

Residual demand for Firm 1

AC = MC = P

Q2 Q1 = 0
12

Another perspective (B): If Firm 1 believes that Firm 2 will supply Q2 = 0, it becomes monopoly supplier &will supply Q1

Market demand

Residual demand for Firm 1

AC = MC = P

Q1 Q2
13

Q1

Another perspective of Reaction Curves

Firm 2’s Reaction Curve

Monopoly: P > MC Cournot Equilibrium Perspective B Firm 1’s Reaction Curve

Perfect Competition: P = MC

Perspective A

Q2
14

Q1

Convergence to Equilibrium
Firm 1 thinks it should be at A Firm 2 thinks it should be at B Firm 1 thinks it should be at C Firm 2 thinks it should be at D

Firm 2’s Reaction Curve

Cournot Equilibrium A C B D Firm 1’s Reaction Curve

Q2
15

Kinked Demand Curve

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Kinked demand curve model of Oligopoly
• Assume no cooperation or collusion among firms • Explain why the prices in some oligopolistic markets change very slowly over time – individual firms are basically afraid to...
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