Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Oligopoly Market Structure
Amit Bubna
Managerial Economics
Amit Bubna Oligopoly Market Structure Managerial Economics 1 / 43
Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Where are we in this course?
1 Basic Economic Concepts and Applications
2 Demand, Elasticity, Consumer Surplus, Aggregate Demand
3 Monopoly and Price Discrimination
4 Costs and cost dynamics, Supply
5 Cost Dynamics and Perfect Competition
6 Market Efficiency, Market Distortions
7 Individual Behavior and Risk
8 Information asymmetry - adverse selection, moral hazard
9 Oligopoly
10 Game Theory
Amit Bubna Oligopoly Market Structure Managerial Economics 2 / 43
Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Today’s game plan
Alternative Oligopoly Frameworks
Cournot (Simultaneous move)
Stackelberg (Sequential move)
Bertrand (Simultaneous or sequential move)
Dominant Firm Price Leadership (Sequential move)
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Market competition
In commodities industries like oil, cement and sugar, building capacity is
difficult and expensive. Prices are determined by the market while firms
compete in capacity.
In technology-intensive industries, firms realize large gains from being
first-movers into unexplored markets.
In consumer industries like retail gas, food, capacity is relatively inexpensive,
so firms compete on price.
In the FMCG and clothing industries, goods are very similar, and firms
compete on both price, and features.
The objective of today’s class is to analyze different types of oligopoly
markets, and firms’ strategic behaviour within these.
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Oligopoly Markets
Virtually no examples of perfectly competitive markets
Most true monopolies are government mandates
Ex: Railways, National defense, Police etc.
Market price and structure is less important
⇒ Most actual markets have a few firms competing with each other with similar
products
Amit Bubna Oligopoly Market Structure Managerial Economics 5 / 43
Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Oligopoly
Definition
An oligopoly is a market with a small number of firms which is
Protected by barriers to entry such as government fiat, economies of scale or
control of strategic resources
Characterized by interdependence, i.e., managers explicitly consider reactions of
rivals
Final outcome depends on
Information available
Mindsets of players
Players’ skill in playing games
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Duopoly
Definition
A duopoly is a market with only two sellers.
Example
Colas (Coca Cola and Pepsi)
Wide-body jets (Airbus and Boeing)
Bank-issued credit cards (Mastercard and Visa)
Political parties in the US, France, Germany, Israel and Japan
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Different Ways to Compete in Oligopoly
Markets
Cournot competition
Compete in capacities
Stackelberg competition
Compete in capacities, with sequential moves
Bertrand competition
Compete in prices with simultaneous or sequential moves
Compete in prices with slightly different products
Dominant and fringe firms
Dominant firm sets prices
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Competition in Capacity
In commodities businesses, capacity is very expensive to set up
Oil rigs and refineries
Aluminium plants
Hydro-power (dams)
New drug development
Prices are market-determined
Firms are price-takers
An oil rig cannot easily shut down production
Hydro power production responds to reservoir levels, not market conditions
⇒ Firms have to make critical decisions on capacity
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition
definition
In Cournot competition, two or more firms compete by simultaneously determining the
amount of output they will produce and supply at a market determined price.
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition
More than one firm
Fixed number of firms
Firms compete in capacity
Make capacity decisions before they enter the market
Choose quantities simultaneously
All firms produce homogeneous product
Firms do not cooperate (No collusion)
Each firm’s output decision affects price
Firms have market power
Firms are economically rational
Seek to maximize profit given their competitors’ decisions
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition in the Cement Industry
Market demand curve
Q = 5 − P(Q)
Two firms: ACC and JK Cement
ACC’s marginal cost of production is Rs. 1 per unit (MCA )
JK Cement’s marginal cost of production is Rs. 2 per unit (MCJ )
Q = qA + qJ
Compete in capacity, not price
Firms choose capacity privately first
What will happen in this market?
What is each firm’s production?
What is market price?
What are the profits earned by each firm?
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition in the Cement Industry
Analysis for ACC
TRA = qA ∗ P = qA ∗ (5 − qA − qJ )
⇒ MRA = 5 − 2qA − qJ
Set MRA = MCA
⇒ 5 − 2qA − qJ = 1
⇒ 2qA = 4 − qJ
Analysis for JK Cements
TRJ = qJ ∗ P = qJ ∗ (5 − qA − qJ )
⇒ MRJ = 5 − qA − 2qJ
Set MRJ = MCJ
⇒ 5 − qA − 2qJ = 2
⇒ qA = 3 − 2qJ
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Best Response Function
definition
A firm’s best response (or reaction) function is its profit maximizing action as a
function of actions by the rival firm(s).
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition in the Cement Industry
Best response functions
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition in the Cement Industry
Best response functions
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Cournot Competition in the Cement Industry
Production, market price and profits for each firm
Solve two linear equations in two variables
2qA = 4 − qJ
qA = 3 − 2qJ
Solution
qA∗ = 5/3
qJ∗ = 2/3
⇒ Q ∗ = qA∗ + qJ∗ = 7
3
⇒ P ∗ = 5 − 73 = 83
Firms’ profits
ACC’s profits = qA∗ (P ∗ − MCA ) = 53 ( 83 − 1) = 25
9
JK Cement’s profits = qJ∗ (P ∗ − MCJ ) = 23 ( 83 − 2) = 4
9
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
N-firm Cournot Oligopoly
Q = q1 + q2 + . . . + qn
Set MRi = MCi for each firm i
Solve
What happens to qi∗ as n increases?
What happens to market quantity, Q, as n increases?
What happens to market price, P, as n increases?
What happens to firm profits, Πi , as n increases?
What happens to consumer welfare as n increases?
What happens to social welfare as n increases?
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Stackelberg Model of Competition
definition
In Stackelberg competition, one firm acts as a capacity leader, choosing its quantity
first, with all other firms acting as followers, making quantity decisions after the leader
has moved.
The Stackelberg model explains “first-mover advantage” in market entry
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Stackelberg Competition
Firms sequentially make capacity decisions
DRAM market
Samsung acts as a Stackelberg leader and LG is a Stackelberg follower
Analysis
First consider follower’s profit-maximization problem
LG observes quantity chosen by leader (qS ) and chooses quantity (qS ) to
maximize profit
Next consider leader’s profit-maximization problem
Samsung will solve LG’s problem and choose qS to maximize profits
Source: Adapted from Besanko and Braeutigam’s Microeconomics textbook.
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Stackelberg Competition
Analysis
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Stackelberg Competition
Analysis
Market demand curve
P = 100 − qS − qL
Market values products from each firm the same
MCS = MCL = 10 (no cost advantage for either firm)
LG’s reaction function is qL = 45 − qS
2
(Work it out!)
Demand curve for Samsung: P = 100 − qS − (45 − qS
2
)
⇒ MRS = 55 − qS
Set MRS = MCS
Solve as qS = 45
qL = 22.5
P = 32.5
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Competition in the Cement Industry
With A CHANGE
Market demand curve
Q = 5 − P(Q)
Two firms: ACC and JK Cement
ACC’s marginal cost of production is Rs. 1 per unit (MCA )
JK Cement’s marginal cost of production is Rs. 2 per unit (MCJ )
Q = qA + qJ
Compete in capacity, not price
Firms choose capacity privately first. NO
Firm J (JK) chooses capacity first, Firm A (ACC) follows, and they know it
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Competition in the Cement Industry
With A CHANGE
What will happen in this market?
What is each firm’s production?
What is market price?
What are the profits earned by each firm?
In addition,
Would the first mover produce more or less than under Cournot model? Why?
What is the value of moving first?
What would ACC pay to be the leader?
What if both JK and ACC try to be the leader?
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Stackelberg Competition in the Cement
Industry
Analysis for ACC - as before in Cournot
TRA = qA ∗ P = qA ∗ (5 − qA − qJ )
⇒ MRA = 5 − 2qA − qJ
Set MRA = MCA
⇒ 5 − 2qA − qJ = 1
⇒ 2qA = 4 − qJ
Analysis for JK Cements - different now
Demand curve for JK: P = 5 − 4−qJ
2
− qJ
⇒ MRJ = 3 − qJ (Work it out!!)
Set MRJ = MCJ
⇒ 3 − qJ = 2
qJ = 1
qA = 32 ; P = 52
ACC’s profit = 94 (less than Cournot)
JK Cement’s profit = 12 (more than Cournot)
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Stackelberg Model of Competition
Stackelberg vs. Cournot
These results are different from simultaneous decision Cournot model
Profits for Stackelberg leader are greater, and Stackelberg follower are lower,
compared to Cournot outcomes
Advantage to being a Stackelberg leader (i.e. first to market), but not as great as
being a monopolist (i.e. barriers to entry are valuable too!)
But the Stackelberg results depend on:
Follower believes that leader has committed to that capacity
Leader expects follower to see capacity and react accordingly
Is there any ponit to secretly adding capacity?
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition in Colas
Image source: Company websites.
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand competition in retail petroleum
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition
definition
In Bertrand competition, two or more firms compete by simultaneously setting
prices. Each firm is committed to providing consumers with the quantity of the
firm’s product they demand, given these posted prices.
Few firms
Perfect (close) substitutes
Promise to meet demand at offered price
Simultaneously set prices
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition in Colas
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition in Colas
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition in Colas
Firms price at marginal cost
Firms do not make profits, even with few firms
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition
Different Marginal Cost Curves
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Solutions to Bertrand Paradox
Capacity constraints
Compete on capacity as well as price
Temporal dimension
Firms enter market sequentially
Product differentiation
Create new markets where each firm has monopoly power over customers
Collusion
Collude to earn monopoly profits
Post-collusion distribution of profits
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition with Product
Differentiation
In most markets, competing products are slightly different from each other
Horizontal product differentiation
Consumers differ in their preferences along one dimension of a good
Ex. Some consumers prefer hot salsa, others prefer mild
Vertical product differentiation
Consumers have the same ordinal preferences, but not the same cardinal
preferences
Ex. All consumers want cars with better fuel efficiency, but their willingness to pay
differs
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition with Product
Differentiation
Firms seek to be unique along some dimension that is valued by consumers.
Differentiation can be based on product itself, delivery system, or marketing
approach.
If firm or product is unique in some respect, then firm can command price greater
than cost.
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition with Product
Differentiation
Analysis of the beer industry
Two products: Carlsberg and Kingfisher
Each beer is slightly different from each other, customers are loyal but will
switch if price is too high
Carlsberg’s demand curve: qC = 50 + PK − 2PC
Carlsberg’s marginal cost of production is Rs. 2 per unit (MCC )
Kingfisher’s demand curve: qK = 64 − PK + 2PC
Kingfisher’s marginal cost of production is Rs. 8 per unit (MCK )
Compete in price, not capacity
What will happen in this market?
What is each firm’s production?
What is price at which each is sold?
What are the profits earned by each firm?
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition with Product
Differentiation
Analysis of the beer industry
Profits are (profit margin) x (quantity)
Analysis for Carlsberg
Profit function is ProfitC = (PC − MCC ) ∗ qC = (PC − 2) ∗ (50 + PK − 2PC )
Differentiate w.r.t. PC and set equal to zero
⇒ 50 + PK − 4PC + 4 = 0
⇒ PC = 14 + P4K
Analysis for Kingfisher
Profit function is ProfitK = (PK − MCK ) ∗ qK = (PK − 8) ∗ (64 − PK + 2PC )
Differentiate w.r.t. PK and set equal to zero
⇒ 64 − 2PK + 2PC + 8 = 0
⇒ PC = PK − 36
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition with Product
Differentiation
Reaction functions
Note: Not to scale.
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Bertrand Competition with Product
Differentiation
Solution
Solve two equations in two variables to get prices for each firm
PC∗ = 30 and PK∗ = 66
Put into demand functions to get quantities for each firm
⇒ qC∗ = 56 and qK∗ = 58
Calculate profits for each firm
⇒ Carlberg’s profits (PC∗ − MCC ) ∗ qC∗ = 1568
and Kingfisher’s profits (PK∗ − MCK ) ∗ qK∗ = 3364
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Dominant Firm Price Leadership Model
Definition
In Dominant Firm Price Leadership, a dominant firm (or group) leads the price
setting, with other “fringe” firms (who produce close substitutes) acting as
followers, taking the price as given and making quantity decisions.
Example
OPEC Cartel
Walmart and mom-and-pop stores
Show Slide
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Lessons
Profitable
P = MC but not leader’s MC
Stable if leader has a cost advantage
Optimal to sacrifice some market share to get higher margins
Usually not profitable to drive competition out fully
Maximize profit NOT market share
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Motivation Capacity Competition Stackelberg Competition Bertrand Competition Dominant Firm Model
Take-aways
Most markets are oligopoly markets
In oligopoly markets, firms have to consider the actions of other firms
Four kinds of oligopoly markets
Cournot: Firms compete simultaneously in capacity
Stackelberg: Firms compete sequentially in capacity
Bertrand: Firms compete in price with the same products or slightly
differentiated products
Dominant Firm Price Leadership: Dominant firm sets price and fringe firms
(price takers) decide on capacity
NEXT SESSION: Game Theory
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