Download Oligopoly

ECP 6701
Competitive Strategies in Expanding Markets
Oligopoly
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Readings
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BDSS Chapter 6 pages191-198 and 208-217
Competition
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If one firm’s strategic choice adversely
affects the performance of another they are
competitors
A firm may have competitors in several input
markets and output markets at the same time
Competition can be either direct or indirect
Direct and Indirect Competitors
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Direct competitors: Strategic choice of one
firm directly affects the performance of the
other
Indirect competitors: Strategic choice of one
firm affects the performance of the other
because of a strategic reaction by a third firm
Characteristics of Substitutes
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Two products tend to be close substitutes
when
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They have similar performance characteristics
They have similar occasion for use and
They are sold in the same geographic area
Performance Characteristics
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Empirical Approaches to Competitor
Identification
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Cross price elasticity of demand
Pattern of price changes over time
Product characteristics
Products that belong to the same genre or the
same SIC need not be substitutes
Occasion for Use
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Products may share characteristics but may
differ in the way they are used
Orange juice and cola are beverages but
used in different occasions
Another example: Hiking shoes versus court
shoes
Geographic Area
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Identical products in two different geographic
markets will not be substitutes due to
“transportation costs”
Bulky products like cement cannot be
transported over long distances to benefit
from geographic price difference
Geographic Competitor
Identification
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When a firm sells in different geographical
areas, it is important to be able identify the
competitor in each area
Rather than rely on geographical
demarcations, the firm should look at the flow
of goods and services across geographic
regions
Two Step Approach to Identifying
Competitors in the Area
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First step is to find out where the customers
come from (the catchment area)
The second step is to find out where the
customers from the catchment area shop
With the technological innovations, some
products like books and drugs are sold over
the internet bringing in virtual competitors
Market Structure
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Markets are often described by the degree
of concentration
Monopoly is one extreme with the highest
concentration - one seller
Perfect competition is the other extreme with
innumerable sellers
Oligopoly involves few sellers engaging in
strategic competition
Measuring Market Structure
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A common measure of concentration is the
N-firm concentration ratio - combined market
share of the largest N firms
Herfindahl index is another which measures
concentration as the sum of squared market
shares
Entropy could be another measure of
concentration
Four Classes of Market Structure
Structure
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
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Herfindahl Index
Usually < 0.2
Intensity of Price Competition
Fierce
Usually < 0.2
Depends on the degree of
product differentiation
Depends on inter-firm rivalry
Light unless there is threat of
entry
0.2 to 0.6
> 0.6
Oligopoly
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Market has a small number of sellers
Pricing and output decisions by each firm
affects the price and output in the industry
Oligopoly models (Cournot, Bertrand) focus
on how firms react to each other’s moves
Cournot Duopoly
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In the Cournot model each of the two firms
pick the quantities Q1 and Q2 to be produced
Each firm takes the other firm’s output as
given and chooses the output that maximizes
its profits
The price that emerges clears the market
(demand = supply)
Cournot Reaction Functions
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Cournot Equilibrium
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If the two firms are identical to begin with,
their outputs will be equal
Each firm expects its rival to choose the
Cournot equilibrium output
If one of the firms is off the equilibrium, both
firms will have to adjust their outputs
Equilibrium is the point where adjustments
will not be needed
Cournot Equilibrium
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The output in Cournot equilibrium will be less
than the output under perfect competition but
greater than under joint profit maximizing
collusion
As the number of firms increases, the output
will drift towards perfect competition and
prices and profits per firm will decline
Bertrand Duopoly
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In the Bertrand model, each firm selects its
price and stands ready to sell whatever
quantity is demanded at that price
Each firm takes the price set by its rival as a
given and sets its own price to maximize its
profits
In equilibrium, each firm correctly predicts its
rivals price decision
Bertrand Reaction Functions
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Bertrand Equilibrium
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If the two firms are identical to begin with,
they will be setting the same price as each
other
The price will equal marginal cost (same as
perfect competition) since otherwise each
firm will have the incentive to undercut the
other
Cournot and Bertrand Compared
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If the firms can adjust the output quickly,
Bertrand type competition will ensue
If the output cannot be increased quickly
(capacity decision is made ahead of actual
production) Cournot competition is the result
In Bertrand competition two firms are
sufficient to produce the same outcome as
infinite number of firms
Bertrand Competition with
Differentiation
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When the products of the rival firms are
differentiated, the demand curves are
different for each firm and so are the reaction
functions
The equilibrium prices are different for each
firm and they exceed the respective marginal
costs
Bertrand Competition with
Differentiation
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When products are differentiated, price
cutting is not as effective a way to stealing
business
At some point (prices still above marginal
costs), reduced contribution margin from
price cuts will not be offset by increased
volume by customers switching