Oligopoly, Collusion, and Product

Differentiation

Business Economics (MECO 6303)

Bernhard Ganglmair

ganglmair@utdallas.edu
SOM 3.619

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Key Words

Reading: Chapter 11.2/11.4/11.5 in Landsburg

oligopoly Leader-follower competition

contestable markets collusion and cartles
Cournot competition repeated Prisoners Dilemma
Bertrand competition product differentiation

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Central Questions

1 How much do firms produce and what prices do they set if they
are neither monopolist nor perfect competitors; i.e., if their
decisions affect other firms decision, and vice versa?
2 Under what conditions do firms collude?
3 Do firms always produce the same products? When do they
differentiate?

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Imperfect Competition: Assumptions
Market environment with imperfect competition: neither
monopoly nor perfect competition, but Oligopoly (two firms:
Duopoly).
Market with few firms whose decisions affect each others payoffs
Strategic interaction: Firms do not behave in isolation but take
other firms decisions into account

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Contestable Markets (Variable Number of Firms)

Contestable Market
A market in which firms can enter and exit costlessly.

In contestable market: A single firm may not be able to engage

in monopoly pricing due to the threat of entry.
The market price in a contestable market cannot be higher than
the break-even price.
Firms behave as competitors, even if there are very few firms.

Contestable Market
In a contestable market, the threat of entry will force firms to behave
as competitors, even if there are very few firms.

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 Each (identical) firm supplies Q0
Price
Q1 /Q0 firms are in the market
6

Q MC
@ Q
@Q
@QQ AC
@ Q
@ Q
Q
@ Q
@ Q
Q
@ Q
Q
P0 @ Q
@ Q
@ Q D
MR
@
-
Q0 Q1
Quantity

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Oligopoly with Fixed Number of Firms

We assume a fixed number of firms.

What can we say about firms quantity and pricing behavior?
I First reaction: They will collude!
I Suppose collusion is not feasible: What are the outcomes of
price and quantity competition?
We study a duopoly: 2 firms!

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The Cournot Model: Competition in Quantities

Cournot: Assumptions
Firms decide simultaneously how much to produce; price is
determined by a downward-sloping demand curve.
Firms make their quantity decision only once.
Firms are identical with constant marginal cost.

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The Cournot Model

2 firms: A and B
Firms choose output quantities: QA and QB
Market demand: Q(P) = 100 P or P(Q) = 100 Q; marginal
cost of identical firms MC = 40.
I Monopoly (e.g., after merger): QM = 30, PM = 70
I Perfect competition: QC = 60, PC = 40 = MC .
Market price in Cournot duopoly: P(QA + QB ).
Firms profits:

A = QA P(QA + QB ) 40QA

B = QB P(QA + QB ) 40QB

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Cooperation?

Recall: a monopolist maximizes profits for a single entity.

Cooperation means firms behave as if they were a monopolist.
When firms cooperate, they jointly produce the monopoly
quantity and thus maximize their joint profits.

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Solving Cournot: Numerical Reaction Functions

Firm A chooses QA to maximize profits

A (QA , QB ) = QA P(QA + QB ) 40QA

= QA [100 QA QB ] 40QA

Firm B chooses QB to maximize profits

B (QA , QB ) = QB P(QA + QB ) 40QB

= QB [100 QA QB ] 40QB

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Best-Response or Reaction Function
The best-response or reaction function of player A describes how
much player A produces when he believes player B will produce a
quantity QB .

Reaction/Best-response functions: Find firm As optimal QA

given QB .
60 QB 60 QA
QA (QB ) = and QB (QA ) =
2 2
In a Nash equilibrium (QA , QB ): QA is best response to firm Bs
best response to QA : QA (QB (QA ))

Nash Equilibrium in Cournot Competition

In the described model of Cournot competition, the Nash equilibrium
quantities are QA = QB = 20. The price is P = 60.
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Solving Cournot: Graphical Reactions Functions
1 Given QB 0, any
QB QA > QM = 30 is strictly
(3) (1)
dominated.
6
QC
A
A QA (QB ) 2 For B, any QB < QB (30) = 15
A is strictly dominated.
A
A 3 A anticipates QB 15: For A,
A
QM H A any QA > QA (15) = 22.5 is
HH A strictly dominated.
HAH
(4)
A HH (2) 4 For B, QB < QB (22.5) = 18.75 is
HH Q (Q )
A B A
A HH strictly dominated.
HH -
A QA
QM QC 5 ...
6 Nash eq.: QA (QB (QA )).

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Cournot Competition: Results
Cournot quantity (QA + QB = 40) is higher the monopoly
quantity (QM = 30) and lower than total competitive quantity
(QC = 60)
Cournot price (P = 60) is lower than monopoly price
(PM = 70) and higher than the competitive price (PC = 40).
If firm could cooperate and produce QA + QB = QM = 30 they
would maximize joint profits (A + B = 900); instead Cournot
profits are A + B = 800.
Given the production of its rival, it is optimal for a firm to defect
and produce more than half of the monopoly quantity.
Note: A defector receives the full gains from such deviation, but
shares the cost of lower price with its rival.

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The Stackelberg Model: Leader and Follower

Stackelberg: Assumptions
Firms decide sequentially how much to produce. Firm A
produces first, then firm B produces.
Once both firms have produced, price is determined by a
downward-sloping demand curve.
Firms make their quantity decision only once.
Firms are identical with constant marginal cost.

Who is better off? The leader, or the follower?

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The Stackelberg Model

The game: Players A and B

1 Firm A chooses quantity QA
2 Firm B observes QA and chooses quantity QB (QA ).
3 Payoffs:

A = QA P(QA +QB )40QA , B = QB P(QA +QB )40QB

Solution concept: subgame perfect Nash equilibrium! We solve

by backwards induction (Look ahead and reason back!)

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Solving Stackelberg: Backwards Induction
When making her quantity decision, firm A will anticipate firm
Bs decision.
Firm B reaction function: QB (QA ) = 30 Q2A .
Firm A chooses quantity QA to maximize

A = QA [100 QA QB (QA )] 40QA , or

 
QA
A = QA 70 40QA
2

Equilibrium in Stackelberg Model

QA = 30, QB = 15 (joint quantity higher than in Cournot)
A = 450, B = 225, A + B = 675.
Leader is better off than in Cournot competition.
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The Bertrand Model: Competition in Prices

Cournot: Assumptions
Firms simultaneously set prices; quantity is determined by a
downward-sloping demand curve.
Firm with the lower price serves the entire market; if prices are
equal, firms have equal market shares.
Firms make their pricing decision only once.

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Bertrand/Price Competition with Identical Firms

Marginal costs are equal

Any prices higher than the marginal cost cannot be a Nash
equilibrium, because both firms will always have an incentive to
undercut the other firms price.
Both firms will set the price equal to marginal cost (Nash
equilibrium).

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Bertrand/Price Competition with Different Firms

Marginal costs are not equal

The firm with lower marginal cost will set the price equal to
marginal cost of other firm minus one cent.
Firm with higher marginal cost cannot undercut that price and
still make nonnegative profits.
Firm with lower marginal cost serves entire market at price
higher than marginal cost.

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Price or Quantity Competition?

Price competition in industries with capacity constraints (short

run)
Quantity competition without capacity constraints or in a
long-run picture.
Combine: First stage with quantity/capacity competition,
second stage with price competition.

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Cartel Collusion

Quantity and Price Collusion

If in simultaneous (Cournot) or sequential (Stackelberg) quantity
competition firms collude, then the joint quantity is equal to
monopoly quantity and the joint profits maximized.
If in simultaneous price competition (Bertrand) firms collude,
then the price is equal to the monopoly price and joint profits
maximized.

In the examples considered, competitive pressure/strategic

interaction prevents collusion (see: Prisoners Dilemma!).
When and how can firms collude? Repeated Prisoners
Dilemma

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Repeated Price/Quantity Competition Game

In real life, firms engage in price or quantity competition not

once, but every single day.
Such repeated interaction allows for reputation and punishment
to enter the picture.
Reputation: In period t the firm cooperates because it thus
earns reputation of cooperator in period t + 1 and
beyond.
Punishment: In some period t the firm cooperates because if it
defects, then the other firm will punish in period
t + 1 by defecting.

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When is Collusion Possible?

Whether or not a cartel (collusion) can survive depends on how often

firms play the game, i.e., how effective reputation and punishment
are.
When is Collusion Possible?
When firms interact finitely often (finitely repeated games) then
a cartel does typically not survive.
When firms interact infinitely often, or when there is no
predetermined end (infinitely repeated games) then cartels can
survive.

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Finitely Repeated Games End-of-Game Problem

If there is a finite period T : Neither reputation nor punishment

are effective in this period, because there is no need for
reputation in T + 1 and no threat of punishment in T + 1.
In the last period T : Both firms have an incentive to defect and
not cooperate.
In penultimate period T 1: Firms anticipate defection in last
period; no need for reputation or threat of punishment
Defection in T 1
. . . Firms will defect and not cooperate in the first period.
Collusion is not sustainable in equilibrium!

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Infinitely Repeated Games

There is no pre-determined last period T .

The end-of-game problem does not arise as there is always a next
period in which a defector can be punished for not cooperating.
Strategies that allow for collusion/cartel to survive:
I Tit-for-tat strategy: Start with cooperation; then play in t what
the other player played in t 1.
I Trigger strategy: Start with cooperation; play cooperation as
long as other player plays cooperation; if other player defects,
then defect forever [very strong punishment; no forgiving]
Collusion is sustainable in equilibrium!

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Enforcing a Cartel (see chapter 11.2)
To enforce a cartel: enforcement mechanism and monitoring
Examples:
I NCAA
I Dairy farmers (legal cartel!)
I International Salt Company:
F Lixator to dissolve rock salt.
F Lixator rental contract: You can buy salt elsewhere if you find it
a lower price Monitoring!
By the way: Price fixing and cartelization is illegal!
Every contract, combination in the form of trust or
otherwise, or conspiracy, in restraint of trade or commerce
among the several States, or with foreign nations, is
declared illegal. (Sherman Act of 1890, Section 1)

No explicit collusion: tacit collusion (e.g., price leadership; or

Fare Warning: How Airlines Trade Price Plans)
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Lysine Antitrust Litigation (1996)
June 27, 1995: FBI raids Archer-Daniels-Midland Company
world headquarters; and four other companies.
Documents and secret tape recordings of the conspirators
meetings and conversations built strong collusion case (fixing
lysine prices for three years).
Result of undercover investigation; beginning in November 1992
with undercover cooperation of ADMs lysine division president
(Matt Damon!)
On top of DOJ charges, more than 40 civil antitrust suits were
filed by direct buyers of lysine.
Monetary penalties totaled $305 million.
Criminal charges against three of four lysine executives. One
managing director of a Japanese cartelist remains a fugitive (as
of 2009).
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Product Differentiation (see chapter 11.5)

Product Differentiation
The production of a product that is unique but has many close
substitutes.

Should firms exaggerate or minimize their differences?

The answer depends on the market conditions.
We consider two extreme cases:
1 Regulated prices
2 Price competition

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Product Differentiation With Regulated Prices

Suppose you can order consumers according to their tastes.

They have addresses on this line; with lowest and highest
address.
A consumer prefers goods closer to her address over goods
farther away. Consumers incur transportation costs.
Firms can locate anywhere on this line.
Where do they locate in equilibrium?
The only possible equilibrium is for the firms to locate next to
each other, in the center.

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Product Differentiation With Price Competition
Hotellings main street location model
1 First stage: firms locate, choose degree of product
differentiation
2 Second stage: firms engage in price competition over
differentiated products
Let the marginal transportation costs increase in distance.
Firms will not locate right next to each other, but differentiate
their products to minimize price competition and thus increase
their profits.
I If not differentiated, firms compete for the same customers.
I If differentiated, then customers closer to firm As location will
incur lower transportation costs for As than Bs product.
I In order to reach customers close to A, firm B has to set an
unprofitably low price.

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