Oligopoly A

Patents cannot be entry barriers.

Patent protection last only 17 years. They cannot be permanent barriers.

Oligopoly arises from large capital costs or economies of scale.

Some firms overcome the hurdle while others don't. Accordingly, only a few firms survive.

Homogeneous oligopoly

Product differentiatiation is not easy in fruits and vegetables.

Three firms, Chiquita, Dole and Del Monte, own huge banana plantations in Central America, and control 65% of world banana exports.

Most oligopolies differentiate their products from the competition.

Most air routes are served by only two or three airlines.

Most cola beverages are sold by Coca-cola and Pepsi.

How do oligopolists split the market demand? 

There is much uncertainty, because the behaviors of other firms are not predictable.

Certain assumptions are made about the behavior of oligopolists to predict prices and outputs. 

One's price and output cannot be predicted independent of the prices and outputs of other oligopolists. 

An oligopolist's demand and MR depend on what the rival firms do.

Thus, it is important to make assumptions about what the rivals will do.

 Examples of oligopolies

Commercial airplanes: Boeing, Airbus, McDonell Douglas, Lockheed

Cereals: Kellogg's, General Mills, Quaker Foods, Posts

soft drinks: Coca-cola, Pepsi, 7-up.

beer

price, output are main tools

Quality, innovation, industrial spying, bribes, and other illegal means, etc.

Oligopoly is like an Olympic game without rules.

Others do not cooperate. 

Some agree on policies and cheat.

Noncooperative oligopoly is like a war among states, and anything goes.

If Pepsi introduces diet cola, it has to consider the reaction of Coca-cola in a noncooperative game.

 How do we differentiate oligopoly from competitive markets?

There are more than 100 oil companies in the US.

Is the US oil industry oligopolistic or competitive?

The 4-firm concentration ratio is the percentage of industry output produced by the industry's largest 4 firms.

This ratio varies from 0 to 100. If it is almost zero, the industry is competitive.

If it is 100, the four firms comprise the entire industry.

The higher the index, the less competitive the industry is.  

 Paul Krugman received a Nobel Prize in economics for his contribution to the theory of monopolistic competition.

(i) Oligopoly exists because of significant entry barriers, e.g., economies of scale.

Accordingly, relatively few sellers dominate the industry.

In monopolistic competition, entry is free, and a large number of firms compete one another. 

(ii) In theory, there are homogeneous oligopoly and differentiated oligopoly.

In practice, there are few industries in which oligopolists sell homogenous products.

In a monopolistically competitive market, products are differentiated. 

 (iv) In oligopoly, prices are relatively stable; they do not change frequently, except when there are price wars or when there is collusive price fixing.

In a monopolistically competitive market, prices can change frequently.

 The French mathematical economist Antoine Cournot published his theory of duopoly in 1838.

Although most of his models were crude and involved very unrealistic assumptions, his method of analysis has been useful for subsequent theoretical development in the area of oligopoly.

Cournot’s model is an example of games in which players make moves sequentially. If there are two players, A and B, A makes the first move, A1, then B responds by B1. In the second round, A2 and B2, and so on. It is like playing chess.

In the real world, a player can make several moves at a time, as in boxing.

If several actioins can be combined as one move, the model applies.  

 When the game is played many times, the players will soon learn that rivals almost always respond.

The last assumption is very naïve because it implies that the duopolists do not learn from experience. But this assumption gives a deterministic solution to the problem.

In Cournot's example, two firms produce mineral water from two adjacent springs, produced at zero marginal cost.

First Round,

morning and afternoon

In the afternoon, Firm #2 inspects the market and assumes Firm #1’s output is ½. Thus, he sees the remaining (blue) area as his demand curve. His MR curve intersects MC curve at q = ¼. His price is also ¼.

 In the afternoon, Firm #2 notices that Firm #1 reduced his output by 1/8.

Accordingly, Firm #2 perceives his demand curve increased to 5/8 (= 1 –3/8).
Equating the new MR curve with MC, he produces q2 = 5/16.

II: 1/4 + 1/16 + 1/64 + 1/256 + ...

Equilibrium output of firm 2

y = b + b² + b³ + ...

by = b² + b³ + b⁴ + ...

Thus, firm 2’s output is y = b/(1 - b) = 1/4 ÷ 4/3 = 1/3.

Since the two firms are symmetric with zero costs, industry output is Q = 2/3.

When there are n firms, an oligopolist's output is:

1/(N + 1).

The industry output is: N/(N + 1).

If N is very large, then as N approaches ∞, N/(N + 1) approaches 1.

That is, as the number of firms approaches infinity, industry output approaches 1, which is the output of a perfectly competitive market.

RF is also called the best response function.

Due to interdependence, firm 1's profit depends not only on its output but also on its rival's output, π(X,Y). Likewise, firm 2's profit depends on the outputs of both firms, Π(X,Y).

For instance, firm 1's reaction function X(Y) is its best response to firm 2's output Y. That is, for any given output Y, firm 1 chooses its best output, which maximizes firm 1's profit. This implies that firm 1's isoprofit curve is tangent to horizontal line.

Note that X(Y) is negatively sloped. That is,

firm 1 reduces its output X as Y increases.

Likewise, we can derive firm 2's reaction curve Y(X), which is also negatively sloped.

That is, firm 2 reduces its output Y as X increases.

When a player changes his output, the rival always responds and changes his output.

Nevertheless, each player assumes his rival does not change his output. Neither player learns anything from experience.

(i) Bertrand argued that a more realistic assumption is that each firm believes that the rival firm will not change its price.

(ii) He further added the assumption that each duopolist has sufficient capacity to satisfy the entire market.

To make the story more interesting, assume that the duopolists have constant costs, i.e., average cost is equal to marginal cost. In this case, firm I starts with the monopoly price. Firm II then enters the market reducing the price somewhat, and captures the whole market.

Firm I then lowers the price below that of Firm II, and captures the market and so on. Finally, the price war ends at point B (Bertrand point), where price is MC for both firms, and the total output is equal to the competitive market. Once price is equal to marginal cost, neither firm can undercut its rival, because it would be incurring a loss.

Reaction curve q(p) is slightly below the 45 degree line (not drawn) as Firm 1 charges a price slightly below that of its rival. Similarly, p(q) is slightly above the 45 degree line.