Master in Engineering Policy and Management of Technology MicroEconomics Oligopoly Presented by Students João Pita Francis by u8ONa2

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									Master in Engineering Policy and Management of Technology



MicroEconomics

Oligopoly

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

Oligopoly
 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.
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Oligopoly
 This is, realistically, the regimen most
 current in the not controlled economies.


      Easiness of communications
                      Information   Selection of the most
                       Transports   capable firms
        Technological competition



  Automobile Market, Energy, Microprocessors, Photograph, etc
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Types of Oligopoly
- Cooperative Oligopoly            - With indifferentiated
  Implicit and explicit              products
  agreements about prices,            With identical prices and equally
  amounts and types of product.       available techniques of
  Eventual barriers to the            production for all the companies
  entrance of other companies in      of the oligopoly - pure oligopoly
  the market

- Concorrencial                    - With differentiated
  oligopoly                          products
  When the companies compete       - When the companies
  between themself, having or        differentiate its products, in
  not in consideration the           order to create a search that
  reaction of the other              specifically is directed them
  companies in the market.
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Cournot Model
•   Static Game: Players act simultaneously

•   Strategies: Any Price between 0 and infinity denoted p1 and p2


 Developed by Antoine Augustin Cournot 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.
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Cournot Model

Description:

Firm 1 excepts that firm 2 production will be y2e units of output,
Then decides to produce y1,

The total production will be

                    Y= y1+y2e
 and market price

                 p(Y) = p( y1 + y2e )
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 Properties of the Cournot-Nash
 Equilibrium for Duopoly

 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.
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     Cournot Model: Water’s Reaction
Firm 1          Curve
    q1
           120
(litres)




                             Water´s reaction curve
           60



           20



                        30     50    60               120   Firm 2
                                                                q2
                                                            (litres)
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   Cournot Model
Firm 1
    q1
           120
(litres)
                        reaction curve



           60


           40                             reaction curve




                               40    60             120    Firm 2
                                                               q2
                                                           (litres)
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 Cournot Model
Firm 1
    q1
           120    reaction curve
(litres)




           60
                                         Cournot
                                         Equilibrium
           40

                                                       reaction curve


                               40   60            120     Firm 2
                                                              q2
                                                          (litres)
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Properties of the Cournot-Nash
Equilibrium for Duopoly
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.
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     Bertrand-Nash equilibrium
 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
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Bertrand-Nash equilibrium
Graphical demonstration of Why P1=P2> MC is not a Nash Equilibrium
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Sequential Models
  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
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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)
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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 P is 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…
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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
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Sequential Models - Stackelberg

Follower's profit-maximization problem
                    y2



             P2 max
                                 Isoprofit lines – Firm 2
          (Monopolist)

            y2 = f2(y’1)



                                               Reaction Curve f2(y1)


                           y’1
                                                  y1
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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,
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Sequential Models - Stackelberg

Stackelberg model - Equilibrium
   Mathematical deduction: http://josemata.org/ee/17/stackelberg2/

                        y2
                                     Reaction Curve Firm 1


                                                  Isoprofit lines – Firm 1

                                                          Cournot Equilibrium

                        y*2                                     Stackelberg Equilibrium


                                                                       Reaction Curve Firm 2 f2(y1)


                                                    y*1               y1
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Sequential Models - Stackelberg
Stackelberg model compared

                          Bertrand < Stackelberg < Cournot
         Price
                        Competitive < Stackelberg < Monopoly

                        Monopoly < Stackelberg < Competitive
      Total Output
                         Cournot < Stackelberg < Bertrand

   Consumer Surplus        Cournot < Stackelberg < Bertrand
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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
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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.
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     Factors that affect the ability to
                collude:
 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
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Tacit Collusion
 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
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                 Price Leadership
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Oligopoly isn’t a problem unless it
becomes a Cartel
 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.
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 Cartels
OPEC
Colombian Drug Cartel
Mafia or Crime Syndicate
Ivy League Schools
Government enforced cartels: market
 intervention to raise prices!
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  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.
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Some illegal Cartels get caught:

 Electrical equipment manufacturers in the 1950s

 Pharmaceutical companies more recently




                      Some don’t…
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Cheating
   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
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                                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
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OPEC Illustrates Cartel Difficulties
   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
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             and of Petroleum Exporting Countries
OPECOrganizationCIPEC
OPEC is the
   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                                           MCopec

                   P2

                                                                    Dmkt
                                                MRopec
                                      Q                  Qtotal                     Qc+c
                                  Qfringeopec                      Output
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 OPEC and CIPEC
 CIPEC (Chile, Peru, Zambia, Zaire)
 MCCIPEC is not much less than MCnon-              Price      Copper Market
   cipec
 Why has OPEC been successful in
  raising its price, but CIPEC has not?                                               MCnon-cipec
 CIPEC as a dominant firm
 Why can’t CIPEC increase                    P1
                                                                                    MCcipec
  copper prices much?
     D for copper is more elastic         Pcipec
                                           Pcomp
       (aluminum is a good substitute)
     Comp’ve supply more elastic           P2
       than for oil (if P rises, simply go                                                    Dmkt
                                                                           MRopec
       to scrap heap)
 Successful cartel needs relatively                                       Qtotal
                                                                Q
  inelastic D.                                              Qfringecipec                Output
                                                                               Qc+c
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Obstacles to Collusion
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.
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OLIGOPOLY MODELS
                            COMPARISON OF THE SOLUTIONS
                   One firm leads by setting its output, and the other firm
   Stackelberg     follows. When the leader chooses an output, it will take
 (Quantity-leader) into account how the follower will respond
                     One firm sets its price and the firm chooses how much
      Cournot        it wants to supply at that price. Again the leader has to
   (Price-leader)    take into account the behavior of the follower when it
                     takes its decision
      Bertrand       Each firm chooses its prices given its beliefs about the
   (Simultaneous     price that the other firm will choose. The only
    price setting)   equilibrium price is the competitive equilibrium

                     A number of firms colluding to restrict output and to
     Collusion       maximize industry profit. A cartel will typically be
     (Cartel)        unstable in the sense that each firm will be tempted to
                     sell more than its agreed upon output if it believes that
                     the other firms will not respond
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Sweezy Model
- It tries to explain the rigidity of
  the price, many times
  observed in oligopolistc
  markets;                              P


- If a companie increases its
  price, the other companies will
  not, making the first one to                     mC’
  lose its customers;
                                                    mC

- On the other hand, if a
  company lower the prices, the
  other companies also will
  lower the price, for that it will           mR         D
  not have advantage to do that.                             Q
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Conclusions - Balance in the Long
               Run
 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, product project,
  advertisement, services, innovation
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Bibliography
    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

								
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