Lecture 22

Chapter 9 (conti….)

Profit maximization under

imperfect market
 9.3. Oligopoly
Oligopoly is the study of market interactions with a small
number of firms.
The modern study of this subject is grounded almost entirely in
the theory of games.
Thus, we make extensive application of game theory to
characterize the strategic interaction of firms under this market in
the coming chapter.
In oligopoly the producers must consider the response of
competitors when choosing output and price.
There are several models that are relevant since there are several
different ways for firms to behave in an oligopolistic
environment.
Thus, it is unreasonable to expect one grand model since many
different behavior patterns can be observed in the real world.
 Choosing a Strategy
If there are two firms in the market and they are producing a
homogeneous product, then there are four variables of interest:
the price that each firm charges and the quantities that each firm
produces ( P1, P2, Y1 Y2).
When one firm decides about its choices for prices and
quantities it may already know the choices made by the other.
If one firm gets to set its price before the other firm, we call
it the price leader and the other firm the price follower.
Similarly, one firm may get to choose its quantity first, in
which case it is a quantity leader and the other is a quantity
follower.
The strategic interactions in these cases form a sequential
game.
On the other hand, it may be that when one firm makes its
choices, it doesn't know the choices made by the other firm.
In this case, it has to guess about the other firm's choice in
order to make a sensible decision itself. This is a
simultaneous game.
Again there are two possibilities: the firms could each
simultaneously choose :
prices or
quantities.
This classification scheme gives us four possibilities: quantity
leadership, price leadership, simultaneous quantity setting,
and simultaneous price setting.
Each of these types of interaction gives rise to a different set of
strategic issues.
There is also another possible form of interaction that we
will examine.
Instead of the firms competing against each other in
one form or another they may be able to collude.
In this case the two firms can jointly agree to set
prices and quantities that maximize the sum of their
profits.
This sort of collusion is called a cooperative game.
 Oligopoly Firms
There are two types of oligopoly firms:
• Non-collusive
– The Kinked Demand Model (sticky price model)
– Cournot's Duopoly Model (simultaneous quantity setting)
– Bertrand’s Duopoly Model (simultaneous price setting)
– Stackelberg’s Duopoly Model (quantity leadership)
• Collusive Oligopoly firms.
Cartel (perfect collusion)
There are two forms of cartel. These are:
Cartel aiming at joint profit maximization
Cartels aiming at the sharing of the market
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 Oligopoly Firms
Price leadership (Imperfect collusion)
one firm sets the price and others follow it because it is
advantageous to them or because they prefer to avoid
uncertainty about their competitors’ reactions even if this
implies departure of the followers from their profit
maximizing position.

Types (forms) of price leadership:

– price leadership by a low cost firm;

– price leadership by a large (dominant) firm and

– Barometric price leadership.

7
 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.
 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
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,
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: Is a one-shot game

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):

Assuming an interior optimum for each firm, this means that
a Nash Cournot equilibrium must satisfy the two first-
order conditions:

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

function of both firms:
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.
 Adjustment to Equilibrium

Given an arbitrary pattern of outputs at time 0, (y10, y20), firm 1

guesses that firm 2 will continue to produce y20 in period 1,
and therefore choose the profit-maximizing output consistent
with this guess, namely y11 = f1(y20).

Firm 2 at the same time conjectures that firm 1 will maintain

the output level y10.:

Firm 2 therefore chooses y21 = f2(y10)

Suppose that at time t the firms are producing outputs (y1t,

y2t), which are not necessarily equilibrium outputs.

If firm 1 expects that firm 2 is going to continue to keep its

output at y2t, then next period firm 1 would want to choose the
profit-maximizing output given that expectation, namely f1(y2t).
Thus, firm 1's choice in period t + 1 will be given by

Firm 2 can reason the same way, so his choice next period will be

These equations describe how each firm adjusts its output in the
face of the other firm's choice.
In general, the output choice of firm i in period t is given by

Each firm is assuming that the other's output will be fixed from
one period to the next, but as it turns out, both firms keep
changing their output.
Only in equilibrium is one firm's expectation about the other
firm's output choice actually satisfied.
 Example
Assume that the market demand and the costs of the duopolists are

P =100−0.5(X1 + X2 )
C1 = 5X1
C2 = 0.5X22

The isoprofit and reaction functions of firm 1and 2?

Cournot’s equilibrium?
Market price and the profit of each duopolist ?
 2. BERTRAND EQUILIBRIUM
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)
For definiteness, assume that c1= c2 (each has identical
marginal costs and average costs)
As before, we assume a homogeneous product so that the
demand curve facing firm 1, say, is given by

That is, firm 1 believes that it can capture the entire

market by setting a price smaller than the price of firm
2.
Of course, firm 2 is assumed to have similar beliefs
This leads to a payoff to firm 1 of the form:

Note that the Cournot game and the Bertrand game have a
radically different structure.
In the Cournot game, the payoff to each firm is a
continuous function of its strategic choice;
in the Bertrand game, the payoffs are discontinuous
functions of the strategies.
What is the Nash equilibrium?
There is a unique Nash equilibrium (p1, p2) in the Bertrand
duopoly.
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 rasing 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.
What remains is to show that there can be no other Nash
equilibrium.
e.g. , p = 30-Q & both firms have a MC of 3. Q* = ?, Q*1=?,
Q*2=?
 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 of the other firm
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.
 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 Π:

Since Y2=f2(y1)
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.
 Example
Taking the previous market demand function and cost functions,
the Stackelberg’s equilibrium can be done.

P =100−0.5(X1 + X2 )
C1 = 5X1
C2 = 0.5X22

assuming firm 1 is the leader

Derive the reaction function of firm 2?
derive the sophisticated firm new profit function?
X1 , X2 and market price =?
the profit of each duopolist ?
 Collusion
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.
 Cartel Model
• 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 π = PQ – [C1(q1) + C2(q2) +…+ Cn(qn)]

0r n
π = f ( p1 , p2 , p3 ,.......pn )(q1 , q2, , qn .......qn ) − ∑Ci (qi )
i =1 29
 Cartel Model

• The first-order conditions for a maximum

are that
∂π ∂P
= P + (q1 + q 2 + ... + q n ) − MC(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.
30
 Cartel Model

If the firms form a group and act as a

Price
monopoly, MR = MCi so QM output is
produced and sold at a price of PM
ΣMC
PM

MR
D
Quantity
QM

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32
 Cartel example
• Assume the market demand is
Px = 100 − 0.5 X where X = X1 + X 2
And the two colluding firms have costs given by
C1 = 5 X 1 and C 2 = 0.5 X 22

The central agency of the cartel aims at the maximization of the total profit
π =π1 +π2
Where
π1 = R1 −C1 andπ2 = R2 −C2
Thus, π = (R1 + R2 ) − C1 − C2

R = R1 + R2 = P × X1 + P × X 2 = P( X1 + X 2 ) = P × X substituting the demand function for P

R = (100− 0.5X ) X
R = 100X − 0.5X 2

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 Cartel Model
• There are three problems with the cartel solution:
– these monopolistic decisions may be illegal
– it requires that the directors of the cartel know:
• the market demand function and
• each firm’s marginal cost function
– the solution may be unstable
• each firm has an incentive to expand output because
P > MCi

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 Price Leadership Model (Dominant firm)
• In this model, it is assumed that there is a large dominant
firm which has a considerable share of the total market and
smaller firms, each of them having a small market share.
– firms 2,…,n would be price takers
– firm 1 would have a more complex reaction function,
taking other firms’ actions into account.
• The market demand is assumed to be known to the
dominant firm.
• In addition, the dominant firm knows the supply function of
small firms and can derive the market supply curve of small
firms.
• With this knowledge, the leader can obtain his own
demand curve as follows. 35
 Price Leadership Model
D represents the market demand curve
Price
SC

SC represents the supply decisions

of all of the n-1 firms in the
competitive fringe

Quantity
36
 Price Leadership Model
We can derive the demand curve facing the
Price industry leader
SC

For a price of P1 or above, the

P1 leader will sell nothing

For a price of P2 or below, the

P2 leader has the market to itself

Quantity
37
 Price Leadership Model

Between P2 and P1, the

Price
demand for the leader (D’)
SC
is constructed by subtracting
what the fringe will supply
P1 from total market demand

PL
D’
The leader would then set
P2
MC’
MR’ = MC’ and produce QL
at a price of PL
MR’ D

QL Quantity
38
 Price Leadership Model

Price
SC
Market price will then be PL

P1

The competitive fringe will

PL
D’
produce QC and total
P2
industry output will be QT
MC’
(= QC + QL)
MR’ D

QC QL QT Quantity
39
40
 Price Leadership Model
• This model does not explain
how the price leader is chosen or
what happens if a member of the fringe decides to
challenge the leader.
• The model does illustrate one tractable example of the
dominant firm model that may explain pricing behavior
in some instances.

41
 Price Leadership example
• Assume: S = 0.2P
• The dominant firm is assumed to know the market
demand
• The dominant firm obtains its own demand function by
taking the difference between the market demand and
the small firms supply:

• the dominant firm maximizes its own profit given its

total cost function via MR =MC condition
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