Oligopoly MATHS/DERIVATIONS REQUIRED IN THIS ESSAY/TOPIC

An oligopolistic industry can be described as one dominated by a small number of large firms the degree of concentration within such a industry can thus be assumed to be relatively high. While this is important to know, the most fundamental feature of oligopoly is interdependence which effectively characterises the industry and makes the behaviour of firms difficult to model. As mentioned, interdependence plays a crucial role in oligopoly. A more formal definition of it is that the actions of all the individuals firms in the industry are affected by the actions of the other firms and it is for this reason why interdependence makes it difficult to observe oligopoly behaviour conjectures on the behalf of firms will therefore be present in this industry. The main focus of the essay is to effectively see how entry conditions can determine prices; such a thing can happen for the simple reason that incumbents (established firms) will alter their behaviour if there is the possibility of potential entry they do so in an attempt to preserve their industry share or dominance within the industry. I will focus on the Limit Pricing and Dominant Firm-Price Leadership as well as the possibility of collusion and an example using a game theory approach. Sources of barriers to entry: o Product differentiation long established preferences of buyers for existing products, sometimes sustained by continuous advertising, patent protection, product innovation through R&D. o Absolute cost advantages superior production techniques, cheaper funds because existing firms represent lower risks than new ones. o Economies of scale if these are important, a new entrant faces the dilemma of going in at a small scale and suffering a const disadvantage or taking a very large risk by entering on a large scale. Large scale entry will disturb the existing situation and may cause excess supply, lower prices, and retaliation. These effects will be emphasises if (a) minimal optimal scale is a significant proportion of total industry demand and/or (b) the elasticity of demand is low (addition to industry supply will depress prices further). Effectively impeded entry involves a firm sacrificing short-run profits to prevent entry and the diminution of future profits. o Involves long-run profit maximising behaviour.

Cournot Assumptions: Homogenous goods market Market is served by firms that are identical with respect to costs, information, and the objectives they wish to pursue. All firms face constant marginal costs of production

Zero conjectural variation. Firms set output. Assumes that each firm considers that the other firms output will not change as a result of the firm in question changing his output (even though his own output will influence the industry output level) zero conjectural variation.

Fig. 2.1 - Duopoly example, Waterson, M (1984) Start with firm 1 producing the monopoly output q1m and firm 2 producing nothing. Firm 2 reacts to firm 1 producing q1m and therefore adjusts its output in order to operate at point F on its respective reaction function (firm 2 is now producing a positive amount). Firm 2 moves to point F since it is the maximum amount of profit that firm 2 can make given the output being produced by firm 1, q1m. Firm 1 then reacts to firm 2, now producing at point G on its respective reaction function. This process continues until the reaction functions of the two firms meet such a point is the Cournot-Nash equilibrium, (C, C). o This point would be achieved starting from anywhere on either reaction function.

Stackelberg (one leader, and many followers) The aim of the Stackelberg leader is to choose that point on the other firms reaction function offering maximum profits. Such a point is (S, C) for firm 1 in Fig. 2.1, and firm 1 would get more profits compared to the Cournot point. If firm 2 were the leader, the point (C, S) would be chosen. If both firms attempted to lead, the result is point (S, S) which may involve substantial losses for both parties. The leader, knowing the reaction function(s) of the other firm(s), uses them to obtain a more favourable position for himself.

Collusion Each firm knows that, if he raises or lowers output, the others will do likewise. Therefore, if the firm in question has a particular share of the market, he expects the others to react to any expansion or contraction according to the ration of their shares of the market compared to his. The results for both the firm and the industry is equivalent to the result for a monopolist which would seem preferable to the Cournot outcome from the firms point of view. However, if the firms have very different cost functions, their shares of the market will also be very different more inefficient (higher cost) firms will tend to have smaller shares (as in the Cournot model).

Bertrand Bertrand (1883) asserted that even in duopoly, price would fall to the competitive level the reason is that he assumes that each firm chooses a price rather than an output level. Each firm also has enough capacity to fulfil the entire market demand at a price equal to marginal cost. Since the products are identical (homogenous goods market), the firm with the lowest price makes all the sales. o If firm 1 charges a price p1 > mc, firm 2 would undercut him slightly to make all the sales and gain the market. The only equilibrium would be at price equal to marginal cost (p* = mc), where no firm has an incentive to either lower or to raise prices BUT no profits are made.

In the Cournot model, each firm believes the others will not react to its output changes (and they do not at equilibrium), but we known that in fact their reactions have a non-zero slope everywhere. In Stackelbergs model, the leader knows the others reactions, but not vice versa. In Bertrands model, the reaction is to the other firms price rather than output. Comments: Stackelberg leader-follower equilibrium is the least probable outcome. The difficulty with this solution is that the theory is incomplete. It does not specify which firm will be the leader, and why the other firm should accept the passive role of the follower. For the follower, profits will be less than those obtainable at the Nash-Cournot equilibrium no firm will therefore be willing to accept the followers role. An attempt by both firms to lead would lead to a very poor profit outcome for both firms as output is expanded. A collusive solution could provide more profits for both firms than a solution at the Cournot-Nash equilibrium. However, a collusive equilibrium also offers considerable incentives for a firm to renege on its rivals. Therefore, if the collusive point is agreed upon at a specific point, firm 1 can improve its profit by cheating and producing at an appropriate points on its respective reaction function on the presumption that firm 2 was playing fair by the agreement firm 2 would find is own profit greatly reduced by such a manoeuvre by firm 1. Therefore, in a one period model, the outcome of any attempt to collude would be a failure collusion is not a credible way of proceeding; they will do better by not trying to collude. The Nash-Cournot (non-cooperative) solution represents a determinant equilibrium identifying the output levels of both firms in homogenous oligopolistic competition with each other. It represents a true equilibrium in the sense the q1 is produced in response to q2 and q2 is produced in response to q1.

Possible solution to the oligopoly problem: if the firms products are indeed identical, the choice of competitive weapon (e.g. price, quantity, conjecture) is of great importance in determining the outcome.

Extensions of the basic model (Pages 62 66), Hay and Morris Zero conjectural variations are inconsistent. Limit Pricing Model The Sylos-Labini Postulate I will first of all talk about a limit pricing strategy which is adopted by the incumbent in an attempt to prevent entry. An important feature of this is referred to as the Sylos-Labini Postulate which assumes that potential entrants will expect firms already in the industry to maintain output levels if new entry occurs; this implies that the potential entrants have a conjecture of value zero since they do not expect any changes in output post-entry. Nevertheless, firms will react to potential entry, and in this case, the incumbent may choose an entry-preventing price which would make entry unprofitable for the potential entrant. Diagram of Limit Pricing strategy, Fig. 3.8, page 87, Oligopoly: the game theoretic approach. With reference to the diagram above, the entry-preventing price is given by the intersection of OP and the DD line, labelled PEP. At this price, the current output is OO and only output beyond O is available for the new entrant. Therefore, if the entrant enters the industry, it will expand total industry output which will result in a fall in the price level. Consequently, the industry will move down its demand curve where the new firm will meet the increase in demand. However, the limit price of PEP and output O have been specifically chosen by the incumbent to ensure that no level of demand for the new entrant is sufficient to cover its cost, resulting in the entrant making potential losses and thus result in the entrant deciding not to enter the industry. A higher price, achieved by reducing existing industry demand, would have made more demand available to the potential entrant since OP and LRAC would have been further to the left. Such a situation would have resulted in profitable entry for the entrant since profit could have been made at any level of output where DD was above LRAC. For these reasons, PEP is the limit price. As an additional note, a lower price would still discourage entrant but would needlessly sacrifice profit. Problems/Difficulties associated with the Limit Price Model o If entry did actually occur it might be better (more profitable) for incumbents to lower outputs and accommodate the entrant than to keep output fixed (at the pre-entry level). If the potential entrant knows this then entry will not be deterred (from slide 46 of lectures).

1. Requires a uniform price in a homogenous product industry with significant differences in firms costs.

This implies either a collusive group of firms or a dominant firm one which sets price and then meets all the demand not taken up by other firms in the industry at that price. 2. Difficulty with the Sylos Postulate if the potential entrant does enter, then the rational action for the existing firms is to include the new firm in its cartel or price leadership policy and to contract output somewhat. 3. New entry involves someone making losses whether it is the new entrant or not depends on whether it can capture any of the existing firms demand. 4. It may be asked why the price-setter should not maximize profits most of the time, reducing price to the limit level only when the threat of entry occurs. Dominant Firm-Price Leadership Model Combines dominance and price-leadership. Embodies elements of collusion and competition. Highlights the significance of price setting as a reflection of market power.

The Dominant Firm-Price Leadership model assumes that the dominant firm sets the industry price and then all the other firms in the industry behave as if they are perfectly competitive price-taking firms (competitive fringe) and will act according to a supply function relating their sales (QS) to industry price MATHEMATICAL DERIVATIONS REQUIRED REFER TO WATERSON, M (1984) The model itself implies that the dominant firm (or group) sets his price as a monopolist, taking into account the completive supply at each price, and the competitive fringe will follow that price. As it is assumed that the dominant firm is likely to have a larger share of the market, is actions can effectively affect the market price. Thus, the possibility that the other firms might try the same strategy as the dominant firm is excluded due to the fact that each firm is individually small and therefore cannot on its own affect the behavior of the leader. We can also consider the possibility of a Collusive Price Leadership where instead of a single dominant firm, we could have a few firms where each firm has a substantial market share. Therefore, given the inelastic industry demand, the actions of each firm could affect the price. A price leader in this situation could accurately reflect the conditions facing each firm, and so would be accepted by the other firms. Details regarding collusion on pages 82 85. Problems associated with the model (slide 28)

Post-entry collusion (pages 92 94) Game theory

Entry deterrence over time (pages 94 96) Problem: two-period models are static. 1. First-period capacity decisions and second-period entry and output decisions are once and for all. This is oversimplified. Investment in a market will normally be an extended process over time and thus alter the final outcome the one that is ahead in the process of convergence to a Nash-Cournot equilibrium can achieve a better outcome for itself by continuing to invest beyond that point. The investment presents a credible threat of overcapacity if the other firm does not respond by reducing its final capacity level.

Dixits Model: It predicts two firms entering a market but involves the second being forced to remain smaller in other words, there is a barrier not to entry but to mobility in the sense that the second firms growth is restrained. The second firm is forced to act like a follower. The leader will invest up to the point of tangency of the second firms reaction function and his own isoprofit lines Stackelberg Outcome. Being the first mover restrains the other firm to be a follower, and the latter cannot seize the advantage due to a precommitment to go to Nash-Cournot. 2. An incumbent might choose to permit entry but act to slow the rate at which entry occurs. Limit pricing depresses current profits but, by reducing the eventual number of firms in the industry, gives rise to a higher stream of profits eventually. Firms will maximize profits and permit entry until the present value of future gains of limit pricing outweighs the current profit sacrifice, and will then shift to limit pricing. Both factors result in a short-run maximizing strategy and some entry. Over time, both effects diminish making rapid entry more probable and a switch to the limit price more profitable. Likely that firms may adopt some intermediate price strategies to deter some entry, thus hoping to retain market share and a more manageable industrial structure.

3. In practice, all types of sunk cost that an incumbent might incur will be investments in some form of durable capital. At some point, the entry-deterring capital will be fully depreciated at which point the basic asymmetry between incumbent and potential entrant disappears. The problem facing an incumbent monopolist is that, at the end of T periods, when its capital fully depreciates, the market is up for grabs. o This possibility might prompt the incumbent to invest early.

There is still fundamental asymmetry if the entrant invests first, it has to contend with the fact that the incumbents plan still has a number of periods of life this will imply losses for the entrant.

Multiple firms (page 96) The incentive for the first entrant to enter is reduced because it faces erosion of its potential profit by further subsequent entry. It is easier for the incumbent firm to deter entry if there are several potential entrants.

Multiple markets (page 97) Taking each market on its own, the rational strategy fir the monopolist is to accommodate entry rather than fight, since the payoff to fighting is negative, or the incumbent and the entrant. Intuition suggests that the incumbent might be willing to fight in the first markets to be threatened in order to establish a reputation and to persuade potential entrants to stay out of remaining markets.

Additional Barriers to entry (page 98) The main focus has been on sunk costs in the form of physical investment as the weapon of strategic entry deterrence. Others include advertising, research and development costs, and patenting. Fluctuating demand. o The incumbent is more capable of adjusting and meeting demands. Experience there will be a strong incentive for any potential entrant to act first. o The fear of other firms (entrants) will lead to less pre-entry learning however the first mover will obtain earlier experience of the market the return is very risky but tends to be high when the risk pays off. o Post-entry learning effects would put a limit to the number of firms that could profitably enter. o If the first entrant suffers, the second entrant is alerted by this and may thus decide not to enter.