Oligopolies

WHY OLIGOPOLIES ARE PECULIAR MARKETS

We can divide markets according mainly on two important criteria: the homogeneity of products and the number of firms in it. We can have perfectly competitive markets where there are a lot of firms selling the same commodity, monopolies where there is only one firm in the market and oligopolies where the market is shared by a small number of firms. What differs oligopolies from the other types of markets is the fact that firms competing in it influence each other in their choices. This does not happen in monopolies because there is no firm that could in any way influence the monopolist. Firms competing in perfectly competitive markets are not influenced by the actions of other firms in it because each one of them has not enough market power in order to do so. When deciding how much to produce and the price at which to sell goods, an oligopolist must take into account the choices and strategies that his competitors can pursue. When analysing oligopolies, we have various methods to do so depending on the model used to describe them. To make things simple we will assume that all the firms produce the exact same good.

THE COURNOT MODEL

Suppose we have two identical firms. Because of that, both the firms will have the exact same cost structure meaning that they will charge the same price and therefore the only thing they will have to care about is the quantity they produce. According to the Cournot model, both the firms choose the quantity of output they want to produce simultaneously and without any communication with the other. After both of them have chosen their output quantity, the price in the market is determined automatically in order to sell the goods on the market. Because the choice of the firms on how much to produce depends on the market price but the market price depends on the choices of both firms, when deciding how much to produce, firms must decide on expectations about the other’s plans. This is the reason why firms in this model are called quantity takers. In order to make its production choice, a firm does not consider the market demand curve but the market residual demand curve which is simply the market demand curve shifted to the left because of the assumption about the other firm’s production.

When a firm decides how much to produce using the residual demand curve, by summing the quantity that the other is assumed to produce, we get exactly the market demand curve. After the firm has made an assumption about the other’s production quantity it has to react to it and, at the same time, trying to maximize its own interests. The firm’s response that maximizes profits is called the firm’s best response. By putting together the various best responses to various quantities we can determine the firm’s reaction function. A reaction function is represented as a curve in a graph where on the x-axis there is the quantity produced by firm 1 and on the y-axis the quantity produced by firm 2. Any reaction function must be downward sloping because, as the quantity produced by the competitor increases, the quantity available for production decreases. An equilibrium is reached when no one in the market has any incentive to deviate meaning. This situation, in a Cournot model, is reached when the best response of a firm is the best response for the other. Graphically this condition happens when the firms’ reaction functions intersect.

WHY COURNOT OLIGOPOLISTS CAN NOT ORGANISE

The Cournot equilibrium we found does not correspond to a perfectly competitive one or to a monopolistic one. A Cournot duopolist makes some profits unlike a perfectly competitive firm but a monopolistic firm is obviously more profitable. We could ask ourselves why the two firms do not organize and share production behaving like a single monopolist. This situation would imply higher profits for both of them and, in order to be realized, it is required that both reduce their production in order to increase the market price. Now suppose that the two firms agree so that they produce the quantities relative to point M. Notice that if each firm produces as agreed each firm’s could increase its own profits by increasing the quantity produced as displayed by the reaction functions. This means that each firm has an incentive to deviate from the quantity they agreed on and so both of them will. When this happens, each firm will be obliged to take into account also the fact that the counterpart is unfaithful and therefore the endpoint will always be the Cournot equilibrium point where is not convenient for anyone to deviate. The willingness of each firm to be selfish in order to realize its own interests prevented both of them to obtain higher profits.

THE BETRAND MODEL

In the Bertrand model firms choose the prices of their commodities and not the quantities produced. Let’s consider once again a duopoly formed by identical firms. In this market each firm has to take into account the price choices made by the other firm. This happens because we are assuming that all firms produce the same exact commodity and therefore clients will buy products from the firm which sells the products for less. Because of that, in this kind of markets there is a price war. When cutting prices each firm will lose some profits because it sells products for less (area A is lost because of that) but would sell more units (and profits increase by area B). Each firm will continue to undercut the price until it has incentives to do so. The equilibrium in this market is therefore reached when the price asked for commodities is exactly equal to the marginal cost in order to produce them: if the firm decided to produce more or to cut prices, it would incur in a loss. As you may notice, the condition P=MC is the same applied by a firm in a perfectly competitive environment meaning that, even thought we consider a duopoly, firms exhibit no market power.

THE DIFFERENCES BETWEEN COURNOT AND BERTRAND MODELS

The most important difference among the two models is the fact that in the Cournot firms choose the quantities to be produced and then the price is adjusted automatically while, in the Bertrand one, firms start by choosing the price at which to sell and then adjust the quantity to satisfy the equilibrium condition. Another difference among the two is the fact that the competition is much harder in the Bertand model because in this model in order to increase profits each firms has to try stealing clients from the competitor. This is the reason why, in the end, the profitless equilibrium reached is the same as the one obtained considering perfectly competitive firms.

THE STACKELBERG MODEL

The Stackelberg model is similar to the Cournot one because firms choose the quantity to produce and not the price to ask on the market. However, the two models differ in the fact that in the Cournot model the two firms picked their choices simultaneously while, in the Stackelberg model they do not. When considering a Stackelberg model of oligopoly in fact we have to distinguish two types of firms: leaders and followers. Let’s consider once again a duopoly but this time we have a firm acting as a leader and therefore choosing first and a firm acting as a follower choosing second and thus reacting to the choice of the second. The follower will try to maximize its own profits given the choice of the other firm. We can therefore represent the best responses to the choices of the leader thanks to a best response function as we did in the Cournot model. Because the leader is aware of that, he can decide which quantity to produce knowing what the other will do in response. If the leader uses that function in the market demand it obtains its residual demand function, by doing so, it can know in advance how the market price changes with the quantity it produces and therefore, can freely choose the quantity that maximizes its own profits. In order to do so the leader must find the quantity that makes its marginal revenues equal to marginal cost. This time, even if the firms are perfectly equal, the result is not symmetric (unlike a Cournot equilibrium where it is symmetric) and the leader will produce more than the follower.