CHAPTER TWO:-OLIGOPOLY

 oligopoly is a market structure dominated by few

sellers of homogenous or differentiated product. As a
result, the action of each firm affects the other firm’s
decision in the industry.
 A beer industry in Ethiopia is a good example of such
type of industry. Each of the major beer producers takes
in to account the reaction of others when they formulate
their price and output policies.
 Example :-Bedele or Dashen in this case know that its
own action will have significant impact on the rest of
the beer producers.
 2.1.Characteristic of Oligopoly market
Few dominant firms: there are few firms although the
exact number of firms is undefined. Each firm produces a
significant portion of the total output.
 Interdependence: since few firms hold a significant
share in the total output of the industry, each firm is
affected by the price and output decisions of rival firms.
Therefore, the distinguishing characteristic of oligopoly is
the interdependence among firms in the industry.
 Entry barrier: there are considerable obstacles that
hinder a new firm from producing and supplying the
product. The barriers may include economies of scale,
legal, control of strategic inputs, etc.
 Cont’d………
 Products may be homogenous or differentiated. If the
product is homogeneous, we have a pure oligopoly. If the
product is differentiated, it will be a differentiated
oligopoly.
 Lack of uniformity in the size of firms: Firms differ
considerably in size. Some may be small, others very large.
Such a situation is asymmetrical.
 Non-price competition: firms try to avoid price
competition due to the fear of price wars and hence depend
on non-price methods like advertising, after sales services,
warranties, etc. This ensures that firms can influence
demand and build brand recognition.
 A special type of oligopoly in which there are only two
firms in the market is known as duopoly.
 Causes of Oligopoly
• There are many cause of oligopoly market.
1.Economies of scale: low costs cannot achieved in
some industries unless a few firms are producing
output that account for substantial percentages of the
total market demand. Economies of scale in sales
promotion and advertising may also promote
oligopoly.
2. Barriers to entry: - there are varieties of barrier
that did not allow the entry of some firms in to the
industry. This barrier may be technological, skill, cost,
and size of the market in relation to economies of
scale, patent right and different activities of
government such as licensing and marketing quota.
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 Cont’d…….
• 3. Collusion (merger of small firms): Small
firms collide to get market power and
overcome their competitor’s pressure. If they
gain market power, firms set higher price and
restricts output supply that maximizes their
profit. Such firms develop to oligopoly while
other removed from the market.

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 Causes of Oligopoly
• There are many cause of oligopoly market.
1.Economies of scale: low costs cannot achieved in
some industries unless a few firms are producing
output that account for substantial percentages of the
total market demand. Economies of scale in sales
promotion and advertising may also promote
oligopoly.
2. Barriers to entry: - there are varieties of barrier
that did not allow the entry of some firms in to the
industry. This barrier may be technological, skill, cost,
and size of the market in relation to economies of
scale, patent right and different activities of
government such as licensing and marketing quota.
3/30/2024 Eyob. (Msc) 6
 Cont’d…….
• 3. Collusion (merger of small firms): Small
firms collide to get market power and
overcome their competitor’s pressure. If they
gain market power, firms set higher price and
restricts output supply that maximizes their
profit. Such firms develop to oligopoly while
other removed from the market. From our
pervious section discussion you have some
idea about the general features of oligopoly
market structure and its cause.
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 2.2.Oligopoly Firms
There are two types of oligopoly firms:
A.Non-collusive
– Cournot's Duopoly Model (simultaneous quantity setting)
– Bertrand’s Duopoly Model (simultaneous price setting)
– Stackelberg’s Duopoly Model (quantity leadership)
– The Kinked Demand Model (sticky price model)
B. Collusive Oligopoly firms.
 Cartel (perfect collusion)
 price leadership
There are two forms of cartel. These are:
 Cartel aiming at joint profit maximization
 Cartels aiming at the sharing of the market
There are three forms of price leadership. These are:
 The low cost firm,
 The dominant firm, and
 The barometric price leadership models)
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 1. Cournot Equilibrium
 In this section we will examine a one-period model in
which each firm has to forecast the other firm's output
choice.

 Given its forecast, each firm then chooses a profit-

maximizing output for itself.

 Each firm acts on the assumption that its competitor will

not change its output, and decides its own output so as to
maximize profit.

 This model is known as the Cournot model, after the 19th -

century French mathematician who first examined its
implications.
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 Four assumptions:
(1) there are two firms and no other firms can enter the
market,
(2) the firms have identical costs,
(3) they sell identical products, and
(4) the firms set their quantities simultaneously
 Consider two firms which produce a homogeneous product
with output levels yl and y2, and thus an aggregate output
of Y = yl +y2
 The market price associated with this output (the inverse
demand function) is taken to be

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 We begin by assuming that firm 1 expects that firm 2 will
produce ye2 units of output (e stands for expected output).

 If firm 1 decides to produce yl units of output, it expects

that the total output produced will be Y = yl + ye2, and

 output will yield a market price of p(Y) = p(yl + ye2).

 The profit-maximization problem of firm 1 is then:

 Or simply,

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 Clearly, firm 1's profits depend on the amount of output
chosen by firm 2, and in order to make an informed decision
firm 1 must forecast firm 2's output decision.

 each player must guess the choices of the other players

 the profit of firm “i” is its payoff, and the strategy space of
firm i is simply the possible outputs that it can produce.

 The functional relation ship (Reaction function):

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• The profit-maximization problem for the leader
therefore becomes:
Max P(y1+y2)y1 – C1(y1)
such that y2 = f2 (y1).
• Substituting the second equation into the first gives
us: Max P(y1+ f2 (y1))y1 – C1(y1)
NB: the leader recognizes that when it chooses output
y1, the total output produced will be y1 + f2 (y1):

• Solving the FOC for y1 and y2, we get the reaction

function of both firms:

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 The intersection of the two reaction /equations/curves is a
Cournot-Nash equilibrium.
 A (pure strategy) Nash equilibrium is then a set of outputs
(y*1, y*2)in which each firm is choosing its profit maximizing
output level given its beliefs about the other firm's choice,
and each firm's beliefs about the other firm's choice are
actually correct.

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3/30/2024 Eyob. (Msc) 15
 Example 1
 Assume that the market demand and the costs
of the duopolists are
P(Y) = 60-2y, c1 = y12, c2 = 4y2
Find
a. Profit function for each firm & their reaction
b. Cournot equilibrium
c. Market price and the profit of each duopolies'
d. Graph

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 Solution

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 Cont’d….

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 C.Market price and the profit of each duopolies

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 d.Graph

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 2. BERTRAND EQUILIBRIUM
 Bertrand’s duopoly model (which was developed in 1883)
derives from Cournot’s duopoly model we saw above.
 In the Cournot model we have assumed that firms were
choosing their quantities and letting the market determine the
price.
 Another approach is to think of firms as setting their prices and
letting the market determine the quantity sold (Simultaneous
Price Setting).
 When a firm chooses its price, it has to forecast the price set by
the other firm in the industry.
 Each firm then assumes that the rival firm will not change its
price.
 we want to find a pair of prices such that each price is a profit-
maximizing choice given the choice made by the other firm.
 Suppose that we have two firms with costs of c1and c2 that face a
market demand curve of D(p)Eyob. (Msc)
3/30/2024 21
 When firms are selling identical products, as we have been
assuming, the Bertrand equilibrium turns out to be the
competitive equilibrium, where price equals marginal cost!
 Thus, In equilibrium, both firms set their price equal to
the marginal cost: p1= p2 = c and earn zero profit.
 Neither firm can gain by rising its price because it will then
make no sales (thereby still earning zero); and by lowering
its price below c a firm increase it sales but incurs losses.

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 Numerical example:
• To illustrate the extension we proposed to
Bertrand’s model, assume that the two duopolists
have: fixed costs of 10 and 15 (i.e., TFC1 = 10
and TFC2 = 15),

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 Solution:

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 Cont’d……………

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 Cont’d………

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 Cont’d………..

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 Cont’d…………

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 3. STACKELBERG MODEL
 There are alternative methods for characterizing the outcome
of an oligopoly.
 One of the most popular of these is that of quantity
leadership, also known as the Stackelberg model.
 In this model, it is assumed that one duopolist is sufficiently
sophisticated to recognize that his competitors act on the Cournot
assumption.
 This recognition allows the sophisticated firm to determine the
reaction curve of his rival and incorporates it in his own profit
function, which he then proceeds to maximize like a monopolist.
 The leader may, for example, be the larger firm or may have
better information.
 The Stackelberg equilibrium occurs where one reaction curve
is tangent to the iso-profit lines
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3/30/2024 Eyob. (Msc) 30
 Suppose that firm 1 is the leader and firm 2 is the follower
 Then firm 2's problem is straightforward:
 given firm 1's output, firm 2 wants to maximize its profits

 The first-order condition for this problem is simply:

 we can use this equation to derive the reaction function of

firm 2, f2(yl) just as before.
 firm 1 now wants to choose its level of output, looking
ahead and recognizing how firm 2 will respond.
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  i.e. Firm 1, the leader, accounts for the reaction of
firm 2 when originally selecting y1.
 In particular, firm 1 selects y1 to maximize :

 This leads to the FOC:

 Note that a Stackelberg equilibrium does not yield a system

of equations that must be solved simultaneously.
 Once the reaction function of firm 2 is found, firm 1’s
problem can be solved directly.
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Eg. Consider the demand and cost function used for cournot
model
P= 60-2Y, (Y = y1 + y2 )
C1= y12, C2= 4y2
Find
a) Stackleberg equilibrium assuming firm – 1 is a leader
b) Stackleberg equilibrium assuming firm – 2 is a leader.

Soln.
If firm-1 is a leader, it is the one which chooses output level that
maximizes its profit first by incorporating reaction function of
its follower in to its own iso-profit function:
Follower’s profit function,
╥2 = [60-2(y1+y2)]y2 - 4y2
╥2 = 60y2 - 2y1 y2 - 2y22 - 4y2
╥2 = 560y2 - 2y1 y2 - 2y22
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 • Take first order partial derivative of the profit function with
respect to y2 to determine the reaction function of follower
firm;
  56 y  2 y y  2 y 0 2
2
2 2 1 2

y 2 y 2

56  y1  4 y 2  0
 y 2  14  0.5 y1

The reaction function of follower firm

Leader’s profit function can define as:

 1  60  2 y1  y 2 y1  y12 2
 1  60 y1  3 y12  2 y1 y2
 1  60 y1  3 y12  2 y1 (14  0.5 y1 )
 1  32 y1  2 y12
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 • Then take first order condition to determine the level of
output that maximizes the profit of the leader.
 1  4 y1  32
 32  4 y1  0
y1 y1 
32
 8
4

y1  8

 To determine follower’s optimal choice substitute leader’s

output level in the reaction function of the follower firm.
y2  14  0.5 y1
y2  14  0.5  8   10
y   10
p  60  2  y1  y 2 
 60  36  24
p   24
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Profit of the leader Profit of follower
 1  60 y1  3 y12  2 y1 y2  2  56 y2  2( y1 y2  2 y22 )
 60(8)  3(64)  2(8  10)  56(10)  2(80)  2(100)
 480  352  300
 1  128  2  300

Q. what if firm-2 is a leader and firm-1 is a

follower?

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 4.The Kinked Demand Curve Model
• Paul Sweezy introduced the kinked-demand model in
1939
• If costs and demand rise, firms do not increase price
because they are afraid that their competitors
may not raise their price.
• demand curve facing each firm in oligopoly market is
kinked at prevailing market price
• Rivalry firms expected to follow decrease in price but
ignore price increase.
• if a firm increases its price, due to increase cost or
increase demand for its product, it would loss most of
its customer and cause total revenue to decrease.
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• an oligopolist firm faces two demand curves for
different ranges of prices.
• Thus, their demand curve is kinked at the
intersection point of market and individual
demand curve to reflect the rigidity of prices.
• So the marginal revenue curve associated to
kinked demand curve is discontinues at the level
of output corresponds to the kinked point
• Thus profit of the firm maximized at the point of
the kink.
• However, this equilibrium is not necessary
defined by the intersection of MC and MR curve.
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 Cont’d…………

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 2.3.Collusive oligopoly
 All of the models described up until now are examples of
non-cooperative games.
 Each firm maximizes its own profits and makes its
decisions independently of the other firms.
 What happens if they coordinate their actions?
 If collusion is possible, the firms would do better to choose
the output that maximizes total industry profits and then
divide up the profits among themselves.
 When firms get together and attempt to set prices and
outputs so as to maximize total industry profits, they are
known as a cartel.
 cartel is simply a group of firms that jointly collude to
behave like a single monopolist and maximize the sum of
their profits.
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 2.3.1.Cartel Model
• There are two typical forms of cartels:
A. cartels aiming at joint-profit maximization, and
B. cartels aiming at sharing of the market.
The assumption of price-taking behavior may be
inappropriate in oligopolistic industries.each firm can
recognize that its output decision will affect price.
• An alternative assumption would be that firms act as a group
and coordinate their decisions so as to achieve monopoly
profits.
• In this case, the cartel acts as a multi-plant monopoly and
chooses qi for each firm so as to maximize total industry
profits:  = PQ – [C1(q1) + C2(q2) +…+ Cn(qn)]

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 Cartel Model

• The first-order conditions for a maximum

are that
 P
 P  ( q1  q 2  ...  q n )  M C(q i )  0
q i q i

• This implies that

MR(Q) = MCi(qi)
• At the profit-maximizing point, marginal revenue
will be equal to each firm’s marginal cost.
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 Cartel Model
If the firms form a group and act as a
monopoly, MR = MCi so QM output is
Price
produced and sold at a price of PM

MC
PM

MR
D
Quantity
QM

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 A.Joint profit maximizing cartel
At the same time central agency, allocate production between
the two firms similar to Multi-plant monopoly by equating
the MR to individual marginal cost. Mathematically the
profit maximization of cartel can be derived as
Max  = R1+R2-C1-C2
= p(y1+y2) (y1+y2) – C1 (y1) –C2 (y2)
= P(y1+y2) (y1+y2) – C1 (y1) –C2 (y2)

R1 R1 R
MR= MC1 = MC2 Since  
y1 y 2 y
Cartels aiming at joint profit maximization determine the
amount of output produced by each member firm using the
above condition (MR= MC1 = MC2 )

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Eg Assume that the Market demand facing the members of a cartel is
P = 60-2 (y1+y2) and their cost of production is given by C1= Y12 ,
C2= 4y2.
Find the level of output and price that maximizes the industry’s
profit.
Soln:
We derive profit maximization condition for cartel aiming at joint
profit maximization as MR= MC1 = MC2

TR  60  2 y . y
MR    60  4 y
y y
c1 y 12
MC1    2y
y1 y1
c1  4 y2
MC 2   4
y 2 y 2

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MR = MC1
MR = MC2
 60-4y = 2y1 Where y = y1+y2
60 – 4(y1+y2) = 2y1
60 – 4y1-4y2 = 2y1
60 – 6y1- 4y2 = 0 ……………………………………………………….………………..1
From Equation (3)
60 – 4y = 4
60 – 4y1- 4y2 = 4
56 – 4y1- 4y2 = 0 ………………………………………………………………………………..…………..……2
Solve simultaneously equation 1 and 2
56 - 4y1- 4y2 = 0
60 - 6y1- 4y2 = 0
4-2y1 = 0
Y1 = 2

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Substitute in equation (1)
60-6y1 - 4y2 = 0
60 - 12- 4y2 = 0
48-4y2 = 0
Y2 = 12
Total output that maximizes industry’s profit is the sum of individual
firm’s output
Y= y1 + y2 = 12 + 2
Y = 14
P = 60 -2 (y)
= 60 -2 (14) = 22
P= 22

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Joint profit of the industry:
(y1 + y2) = [p (y1 + y2)] [y1 + y2] - [C1(y1) – C2(y2)]
= 60y1 + 56y2 – 3y12 – 2y22 -4y1y2
= 60y1 + 56y2 – 3y12 – 2y22 -4y1y2
= 60(2) + 56 (12) – 3 (2)2 – 2 (12)2- 4 (2) (12)
= 120 + 672 – 12 – 288 -96
= 792 – 396
= 396

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 Factors in centralized cartel
• A centralized cartel is very attractive theoretically.
In practice, however, this monopoly equilibrium
(maximization of industry profit) may not be
achieved. These reasons include:
A. Mistakes in the estimation of market demand and
costs
B. Slow process of cartel negotiations.
C. Fear of government interference
D. Fear of entry
E. Stickiness of the negotiated price
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 2.3.1.2 Market-Sharing Cartels
• In this type of cartel, firms agree to share the
market, but keep a considerable degree of freedom
concerning the style of their product, their selling
activities and other decisions.
• Thus, this type of collusion is more common than
centralized cartel.
• There are two basic methods for sharing the
market:
A. Non-price competition and
B. Determination of quotas.
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 Summary types of cartels

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 2.3.2 Price Leadership
• The second form of collusion is price leadership.
Price leadership is a coordinated behavior of
oligopolists where one firm sets the price and
the others follow it.
• There are various forms of price leadership. The
most common types are:
A. The low-cost price leadership,
B. The dominant-firm price leadership, and
C. The barometric price leadership.
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 The Low-Cost Price Leadership
• The important condition for this model is that firms
have unequal costs.
• It is assumed that there are two firms that produce a
homogeneous product at different costs. Clearly, the
product (of the two firms) must be sold at the same
price.
• Then, the firm with low cost charges a lower price
and its price will be followed by high-cost firm
although the price doesn’t maximize the profit of the
follower.
• The follower would obtain a higher profit by
producing a lower output and selling it at a higher
price. But the follower prefers to follow the leader
sacrificing some of its profit.
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 The Dominant-Firm Price Leadership
• In this model, it is assumed that there is a large
dominant firm that has a considerable share of the
market, and some smaller firms, each of them
having a small market share.
• The model also assumes that the dominant leader
knows:-
The marginal costs of the smaller firms, which it
can add horizontally and
Find the total quantity supplied by the smaller
firms at each price, and
The market demand curve.
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 Barometric Price Leadership
• In this model, it is formally or informally agreed
that all firms will follow (exactly or approximately)
the changes of the price of a firm which is
considered to have a good knowledge of the
prevailing conditions in the market and can
forecast the future developments in the market
better than others.
• In short, the firm chosen as the leader is
considered as a barometer, reflecting the changes
in economic environment

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 2.4 Contestable Markets
• According to the theory of contestable markets
developed during the 1980s, even if an industry has
only a few sellers (or perhaps only one), it would still
operate as if it were perfectly competitive if entry is
“absolutely free” and if exit is “entirely costless”.
• The condition of absolutely free entry refers to the
situation where other firms can enter the industry and
face exactly the same costs as the existing ones.
• An entirely costless exit refers to the condition in
which there are no sunk costs so that the firm can exit
the industry without facing any loss of capital.
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 • End
• Thank you

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