Lecture 9: Oligopoly - Business Economics for Accountants PDF

MN12217 Business Economics for Accountants Lecture 9 Oligopoly Dr Tim Wakeley [email protected]  Oligopoly Recall the spectrum of market structures… many rivals no rivals Perfect Oligopoly P...

MN12217 Business Economics for Accountants Lecture 9 Oligopoly Dr Tim Wakeley [email protected]  Oligopoly Recall the spectrum of market structures… many rivals no rivals Perfect Oligopoly Pure Competitio Monopoly n This market structure is often described as ‘competition among the few’ Products can be differentiated or non-differentiated Combines elements of competition and monopoly Lies towards the pure monopoly side of the spectrum; often has above normal profits and shelters behind significant barriers to entry  Oligopoly Many real-world firms are oligopolies DUOPOLY (2 dominant OLIGOPOLY rivals) Airbus vs Tobacco Boeing AMD vs Intel Cars Coca-Cola vs PepsiCo Petrol (e.g. Tesco vs Microsoft vs Apple Shell vs BP vs Esso vs (computer operating Sainsbury’s vs systems) Morrison’s had a joint Google vs Apple market share of 75.8% (smartphone operating in 2023*) systems) Most utilities Unilever vs Procter & Banking Gamble (various Insurance Coffee(UKshops consumer goods e.g. *Statista data) (Costa vs detergents) Greggs vs Starbucks vs  Oligopoly The examples given suggest that we are often talking about large markets dominated by a few firms, but oligopoly can exist on a smaller scale too e.g. 2 or 3 rival convenience stores in a remote/isolated catchment area  Oligopoly The Oligopolist’s Problem… If I have only a handful of rivals with whom I am competing for market share, then every decision I make about quantity of output, price, advertising expenditure, product characteristics, R&D expenditure, etc… will induce a reaction from my Similarly, when my rivals rivals,make because my decision decisions, will impact their choices will their impactprofits. my profits, so I will react to their choices STRATEGIC (N.B. this is not a problem for firms in perfect competition, INTERDEPENDENCE monopolistic competition, or monopoly) The oligopoly firm will need to anticipate rivals’ reactions  Oligopoly Oligopoly is the only market structure where there are no simple solutions to the firm's decision-making problems Evaluating the potential actions and reactions of rivals is an important component of the decision-making process of firms, but there are often several “sensible” strategic reactions to any given action The practical implication of this is that economics has a number of models of oligopoly each of which provides a framework of analysis for some plausible real-world circumstances Kinked demand Betrand’s model Cournot’s model  The kinked demand curve model (Sweezy, Relatively elastic 1939) portion: because £ rivals will not match price 100 increases MC 90 80 Tacit 70 Relatively inelastic collusion 60 portion: because outcome rivals will match 50 price cuts 40 30 D 20 10 M 0 10 20 30 40 50R60 70 80 90 100 Q a very limited model! (because it doesn’t tackle how to cope with strategic  Cournot’s model (1838) £ 100 Given this state of 90 affairs how might 80 competition 70 between two 60 identical firms 50 evolve? 40 ATC, MC 30 20 10 Market Demand 0 10 20 30 40 50 60 70 80 90 100 Q 8  Cournot’s model The £ Residual Demand Curve 100 then this part of the market demand curve is 90 served 80 70 & this part of the 60 market demand curve 50 remains for other firms » ‘the residual 40 demand curve’ 30 20 10 Dresidual D 0 10 20 30 40 50 60 70 80 90 100 Q if one this if other firm chooses firmindustry output then total choosesoutput = 40 + 20 = 60, &this output market price = £40 9  Cournot’s model Key assumption of this model “The Cournot Conjecture” When a firm makes its own profit- maximising output decision it assumes that its rival(s) will produce the same level of output this period that they did in the previous period In other words, the firm calculates its best response to the observed output decision its rival made last period 10  Cournot’s model Firm A is the only £ Firm A; Period 1 firm in the market in this 100 π A= period 90 £900 80 Residual demand P=£7 70 curve available 0 60 for firm B (in period 2) 50 40 ATC, MC 30 20 10 MR D 0 10 20 30 40 50 60 70 80 90 100 Q QA=3 0 11  Cournot’s model Firm B enters the market & calculates its profit £ maximising output this Firm B; Period 2 period on the assumption 100 that QA = 30 & maximises 90 π B= profits on the residual £225 demand curve 80 BUT, this makes firm A’s output 70 calculation wrong this period – 60 because the market price falls P=£5 below A’s profit maximising 5 50 price, so A reacts… 40 ATC, MC 30 20 10 MR’ Dresidual 0 10 20 30 40 50 60 70 80 90 100 Q QB=1 5 12  Cournot’s model …firm A recalculates its £ profit maximising output Firm A; Period 3 this period on the 100 assumption that QB = 15. πA= So uses a new residual 90 £506.25 demand curve » reduces 80 BUT,output this makes firm B’s output 70 calculation wrong this period – P=£62. 60 because the market price rises 5 above B’s profit maximising 50 price (£55), so B reacts… 40 ATC, MC 30 20 10 MR’ Dresidual 0 10 20 30 40 50 60 70 80 90 100 Q QA=22.5 13  Cournot’s model …firm B recalculates its £ profit maximising output Firm B; Period 4 this period on the 100 assumption that QA = 22.5. πB= £351.563 So uses a new residual 90 demand curve » increases 80 BUT, asoutput before, this makes firm 70 A’s output calculation wrong this period – because the market price P=£58.7 falls below A’s profit maximising 5 50 price (£62.50), so A reacts… 40 ATC, MC 30 20 10 MR’ Dresidual 0 10 30 40 50 60 70 80 90 100 Q QB=18.7 5 14  Cournot’s model Final Period (diagram £ applies to each firm) 100 90 π A = π B= 80 £400 Eventually the “Cournot conjecture” 70 made by each firm will P=£60 prove to be correct and 50 the market will reach equilibrium 40 ATC, MC 30 20 10 MR’ Dresidual 0 10 30 40 50 60 70 80 90 100 Q QA=QB=2 0 15  Cournot Duopoly Firm B’s reaction QUANTITY PRODUCED BY FIRM A BEST 30 function (a.k.a. best RESPO PERIO FIRM NSEOU response function) D TPUT 1 A 30 Firm A’s reaction function (a.k.a. best 2 B 15 20 response function) 3 A 22.5 4 B 18.75 Cournot 5 A 20.625 Equilibrium 6 B 19.685 10 0 10 20 30 QUANTITY PRODUCED BY FIRM B  Cournot’s model Summary PERIOD FIRM OUTPUT PRICE (£) PROFIT (£) 1 A 30 70 900 2 B 15 55 225 3 A 22.5 62.50 506.25 4 B 18.75 58.75 351.563 5 A 20.625 60.625 425.391 6 B 19.6875 59.6875 387.598 7 A 20.15625 60.15625 406.274 8 B 19.921875 59.921875 396.881 9 A 20.0390625 60.0390625 401.564 10 B 19.9801875 59.9801875 399.208 11 A 20.00990625 60.0099062 400.396 5 12 B 19.99504688 59.9950468 399.802 8 13 A 20.00247656 60.0024765 400.099 6 14 B 19.99876172 59.9987617 399.950 17 2  Cournot’s model Time profiles of the key variables 80 70 Output & £ 60 Price 50 40 30 20 QA 10 QB 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Time (Period number) 18  Cournot’s model Comparing Cournot Equilibrium with Monopoly £ Total industry profits 100 under monopoly 90 (collusion) = £900 80 70 Total industry profits 60 under oligopoly (duopoly) = £800 50 40 ATC, MC 30 20 10 MR D 0 10 20 30 40 50 60 70 80 90 100 Q rnot duopoly equilibrium » each firm produces 20 units so total Q19 = 40 u  Cournot’s model modern economists have criticised this model because the Cournot conjecture means that firms are consistently naive the solution in modern economics is to postulate that firms are clever enough to solve the model for its equilibrium and go straight to their respective equilibrium outputs this allows us to use the Cournot outcome in a game theoretic formulation of the oligopoly problem 20  Game Theory & Oligopoly assume a firm has to decide on its level of output – we say, ‘the firm’s strategic variable is output’ we shall restrict its choice to one of two options its half share of the the Cournot monopoly equilibrium equilibrium level of level of output output (e.g. QA=15) (e.g. QA=20) collusion cheating on the collusive agreement 21  Game Theory & Oligopoly Collusion versus Competition £ total industry profits under monopoly (collusion) = 100 £900 so each firm earns 90 £450 80 the firm that 70 total industry profits at ‘cheats’ 60 Cournot equilibrium = earns £800 so each firm 50 £500 earns £400 the firm 40 ATC, MC that 30 ‘sticks’ 20 earns £375 10 MR D 0 10 20 303540 50 60 70 80 90 100 Q ‘Cheat’s 20 15 ‘Sticker’ ’ output s’ 22 output  Game Theory & Oligopoly The Prisoner’s Dilemma Firm B’s output choices Cournot- Nash Q=20 Q=15 equilibrium Q=20 πA= £400; πB= πA= £500; πB= Firm £400 £375 A’s output choice Q=15 πA= £375; πB= πA= £450; πB= s £500 £450 if you were in charge of firm A what level of output would you produce? 23  Game Theory & Oligopoly Nash Equilibrium* A set of strategies, one for each player, such that each player is choosing the best strategy given the strategies of others. So, no player has an incentive unilaterally to change their strategy *John Nash – Nobel Prize in Economics 1994  The Bertrand duopoly model In 1883, Bertrand criticised Cournot’s model for focusing on quantity of output as the firm’s strategic variable, when it was clear that real- world firms set prices and then let the market determine the quantity that would sell at Instead, Bertrand proposed a duopoly model in the chosen prices which each firm sets its price based on the assumption that its rival will not change its price from that observed in the previous period (so, it’s Cournot’s logic applied to prices rather than quantity of output)…  The Bertrand duopoly model Assu me2 symmetrical firms; Firm 1 & Firm 2 (e.g. EasyJet and RyanAir) product Homogeneous Linear demand Constant unit costs (so MC = AC) Each firm has the capacity to supply the quantity demanded at any chosen price Customers are fully mobile and will buy from the lowest-priced firm What is the Nash equilibrium in this scenario?  The Bertrand duopoly model Numerical example Imagine EasyJet & RyanAir selling one-way tickets for seats on flights between London & Malaga (or any other route you can imagine!) Demand for seats is P = 1000 -Q Marginal cost of adding one more passenger to a one- way flight = £70 If EasyJet assumes that RyanAir always maintains its price at its current level, pR , then EasyJet’s demand is dependent on the current relationship between EasyJet’s price, pE , and pR Given that passengers will always purchase a ticket from the lowest-priced carrier, if pE > pR then qE = 0  The Bertrand duopoly model If pE < pR then, EasyJet captures the whole market & qE = 1000 - pE If pE = pR then, the 2 firms split the market equally and EasyJet’s demand becomes qE = ½(1000 - pE) = 500 - ½ pE What is EasyJet’s optimal pricing strategy? Assume RyanAir’s current price is £400 per ticket If EasyJet charges pE = pR- ɛ, where ɛ is just greater than zero, it will capture the entire market. To simplify, let’s assume ɛ = £1. EasyJet’s demand curve if RyanAir charges £400 per£ticket If pE > £400 then 1100 q =0 1000 IfEpE = pR = £400 then qE = 500 900 - ½ pE = 300 800 If pE = £399 then qE = 700 1000 – pE = 601 600 £400 pE = £399 500 400 300 601 200 100 MC = AC = £70 0 qE 1000 1100 100 200 300 400 500 600 700 800 900  So, is charging £399 EasyJet’s optimal pricing strategy? If EasyJet lowers its fare from £400 to £399: TR at £400 per ticket = £400 x 300 = £120,000 TR at £399 per ticket = £399 x 601 = MRE = ΔTR £239,799 E/ΔqE = (239,799 - 120,000)/(601 – 300) = £119,799/301 = £398 So, MRE > MCE (recall, MC = £70) confirming that EasyJet should indeed charge £399. But should EasyJet cut its fare further, to £398, to sell more tickets? MRE = ΔTRE/ΔqE = (239,596 – 239,799)/(602 – 601) = - 203/1 = -£203 NO! It should NOT cut its fare further, because now MRE < MCE  What should RyanAir do in response to EasyJet? If RyanAir reduces its price from £400 to £398 it will increase its sales from zero to 602 tickets, where MRR = ΔTRR/ΔqR = (£239,596 – 0)/(602 – So now,0) = £398 MRR > MCR (recall, MC = £70) meaning RyanAir should charge £398 in response to EasyJet’s price move Where will this process end up? The back and forth will end up with each firm setting p = MC = £70 and each having 50% market share, but earning normal profits only  The Bertrand duopoly model (1883) Bertrand- pR EasyJet’s BRF 45o Nash equilibrium 40 with 39 0 homogeneo 39 8 6 RyanAir’s BRF us products 7 0 pE 0 7 39 39 39 9 5 7 0  The Bertrand duopoly model (1883) The Nash equilibrium is pE = pR= MC BUT, this is the same outcome we would get in perfect competition “The Bertrand paradox” 33 The END