2005, Southwestern

Slides by Pamela L. Hall

Western Washington University
Industrial
Organization
Chapter 15
2
Introduction
Firms with some degree of monopoly power can control
their product price and influence their output by advertising
and differentiating their product
Resulting enhanced profit is not necessarily caused by advertising
and product differentiation
Profits may be high because product coincidentally was offered in right
place at right time
However, in general, improvements in effective marketing can boost profit
significantly
Marketing efficiency of a firm may be characterized in terms
of attempting to satisfy customer preferences by
Acquiring information on these preferences
Determining competing firms strategies
Efficiently allocating marketing resources
3
Introduction
Applied economists are actively working
Either within firms or
As consultants to provide empirical analysis on marketing efficiency
For example, economists provide
Market share movement analysis
Mapping of alternative marketing strategies
Sales force size and productivity determination
Advertising expenses and mix optimization
Sales analysis and targeting
Economic consulting firms will develop a quantitative measure of
alternative marketing strategies
Provide scores indicating which strategy action yields most profit
enhancement
Scores can be used by a firms management to allocate resources where largest
payoff in terms of profits will occur
Management will then attempt to equate marginal revenue with marginal cost in
marketing its output
4
Introduction
Degree of monopoly power and how firms interact determine strategies
offered by applied economists
Alternative economic models for developing strategies are employed
Based on degree of monopoly power and firm interactions
For determining economic efficiency, we contrast imperfectly competitive
models of firm behavior with perfectly competitive and monopoly models
Standard for judging imperfectly competitive markets is perfect competition
Which is Pareto efficient
Equilibrium occurs where price equals marginal cost
Firms operate at full capacity
However, there are some desirable features of imperfect competition
Consumers may desire firms to product differentiate, advertise, and innovate
All of which have limits under perfect competition
Under perfect competition, characteristics of homogeneous products
and perfect knowledge preclude firms from advertising and innovating
5
Introduction
Aim in this chapter
Investigate how price, output, sales promotion, and product differentiation are
determined under various market conditions
We begin with product differentiation
Present a model to determine optimal level of product differentiation and advertising
(selling expenses)
Assess advertising for its information versus persuasive characteristics
We examine classical models of monopolistic competition and oligopolies
Cournot model assumes firms do not realize that their individual output decisions
affect output decisions of their competitors
Stackelberg model--one firm realizes interdependence of output decisions and
determines its optimal output decision based on this
Also consider Stackelberg disequilibrium
Each firm realizes output interdependence but believes other firms do not
Bertrand model assumes firms compete in terms of price rather than through output
We contrast these with Cournot conditions
We investigate economics of collusion in oligopoly markets
We briefly discuss formal cartel arrangements and legal provisions
6
Product Differentiation
Wide range of product differentiation offers consumers a great deal of
choice in determining their optimal selection
For example, toothbrushes
Demand for product differentiation is derived by consumers receiving some
level of utility for having products differentiated
Firms respond to this demand by differentiating their products
Possibly by quality and style, guarantees and warranties, services provided, location
of sales
Product differentiation by firms may be either real or imaginary
How differentiated a product is in the eyes of the beholder
Heterogeneous nature of products due to differentiation provides firms with
some degree of monopoly power
Individual firms face a downward-sloping demand curve for their product
No longer a market with firms producing identical products
A group of firms are producing a number of closely-related but not identical products
Law of One Price for a market no longer exists
Replaced with each firm having a partial monopoly and setting its own price
7
Advertising (Selling Cost)
Selling costs (also called information differentiation) are marketing
expenditures
Include advertising, merchandising, sales promotion, and public relations
Designed to adapt buyer to product
Distinguishes them from production costs
Designed to adapt product to buyer
Firms advertise to shift market demand for their commodity upward
Increases market share and short-run pure profits
A firms advertising objective
Convince consumers that its product is not sharply different from competing
products
Yet is somehow superior
When deciding on optimal strategy to pursue, a firm will weigh
Additional revenues generated by shifts in demand curve against cost of
differentiating its product
8
Maximizing Profit
Assume costs and revenue depend on
dollar measure of extent of product differentiation
Ameasure of advertising expenditures
qoutput
Objective of firm is to maximize profit
F.O.C.s are
9
Maximizing Profit
For profit maximization, marginal revenue from each activity must equal
marginal cost for that activity
For example, a firm will produce additional advertising messages up to point at which
the marginal revenue from additional demand generated by a message is equal to
messages marginal cost
Messages that spark greatest reaction from consumers will receive a larger share of
expenditures
Firms generally engage in both product differentiation and advertising
Indicates at least some positive increment to profit for these two activities
Advertising services is a major industry within U.S.
Accounts for 2% to 3% of GNP
Determining marginal revenue for each activity is difficult
Market for advertising messages is not separate from market for commodity
For example, beer is a joint product where beer and advertising for beer are both produced
Firms that do not account for joint production and contribute all of any increase
in revenue to advertising will overinvest in advertising
Must remember that commodity itself has some value
Some individuals will consume product regardless of level of advertising
10
Maximizing Profit
Marginal revenue being generated by advertising reflects consumers
willingness-to-pay for
Commodities being purchased
Information provided by advertising
In terms of product differentiation, firms will differentiate their products to
soften price competition
By differentiating their products firms can possibly satisfy a market niche and
create monopoly power with potential of increasing profit
However, firms generally do not seek maximum level of product
differentiation
Instead, they offer products that are not too different from their competitors
products yet have some unique features
Idea of not maximizing product differentiation is related to Law of the Obvious
Better to be a half-step ahead and understood than a whole step ahead and ignored
11
Assessing Advertising
In general, it is not possible to determine overall social value
or loss associated with advertising
Advertising is not a composite commodity where prices
associated with all forms of advertising move together
Empirical evidence on precise effect of advertising in general is not
available
An economic assessment is only undertaken when
advertising is disaggregated across types and commodities
Such disaggregation has yielded some general implications
Advertising can affect consumer choices among commodities that are
close substitutes
But it may or may not have any effect on overall consumption choices
For example, cigarette advertising can have a major effect on
consumers choice of brands
However, there is little evidence that cigarette advertising has
increased demand for cigarettes among adults
12
Assessing Advertising
Two major types of advertising
Informational
Persuasive
Informational advertising educates consumers
Provides information on product price, location, and characteristics
Can make markets more efficient by
Reducing consumers search costs
Enabling them to make rational choices
Informational advertising is generally found in newspapers
Such as weekly grocery ads
By familiarizing consumers with products, this type of advertising broadens market for
commodities
Results in economies of scale and more efficient markets
Advertising also encourages competition by
Exposing consumers to competing products
Enabling firms to gain market acceptance for new products more rapidly than they
could without advertising
13
Assessing Advertising
Persuasive advertising
Firm is attempting to modify consumers preferences by creating
wants
Little information concerning product is generally provided
Television advertising is generally persuasive
Can encourage artificial product differentiation among
commodities that are physically similar
Persuasive advertising among competing firms tends to have a
canceling effect (examples are colas and detergents)
Duplication of effort results in wasted resources, inefficiencies, higher
production costs, and higher prices
Also facilitates concentration of monopoly power
Large firms can usually afford continuous heavy advertising whereas
new or smaller firms cannot
14
Assessing Advertising
National Advertising Division of the Council of Better Business Bureaus
was created by advertising industry in 1971 to
Provide a system of voluntary self-regulation
Minimize government intervention
Foster public confidence in credibility of advertising
Advertisers, advertising agencies, and consumers rely on this division to
maintain high standards of principles in advertising
By 2001, over 3200 advertising cases had been successfully handled
through this self-regulatory process
Has reduced inefficiencies associated with advertising
Mitigated pressure for government regulation
A problem with any type of regulation is determining what is true and
false in advertising and who should determine it
Documentation supporting advertising claims and litigation costs associated
with regulation may increase product price
Laws governing regulation must be enforced
Requires government appropriations
15
Monopolistic Competition
Monopolistic competition (first described by Edward H. Chamberlin in 1933) is
a market structure characterized by
Product differentiation
Relatively large number of firms
Easy entry into market
Examples include service stations, convenience stores, and fast-food franchises
Key difference between perfect competition and monopolistic competition
Product differentiation is in the eye of the beholder (buyer)
Monopolistically competitive firms produce similar but not identical products with
relatively easy entry into industry
Products may be differentiated only by brand name, color of package, location of the
seller, customer service, or credit conditions
Results in each firm having a partial monopoly of its own differentiated product
Possible to have wide differences among firms in price, output, and firm profit
Because each firm has a partial monopoly, each firm has its own output demand curve
Demand curves are downward sloping
Indicates a seller can increase its price without losing all of its sales
No industry supply curve
16
Monopolistic Competition
Concept of an industry becomes somewhat clouded and vague in
monopolistic competition as a result of product differentiation
Instead a product group exists
Products of competitors are close but not perfect substitutes
Elasticity will vary inversely with degree of product differentiation
The smaller the degree of product differentiation and greater the number
of sellers
Closer market will be to perfect competition
In contrast to perfect competition, sellers under monopolistic competition
can
Vary nature of their product
Employ product promotion
Change their output to influence profit
Makes monopolistic-competition model very useful for describing decentralized
allocations in presence of producing with excess capacity
17
Monopolistic Competition
A monopoly produces with excess capacity but,
unlike monopolistic competition, allocation
decisions are centralized into one firm
In contrast, perfectly competitive allocation decisions are
decentralized into many firms
However, perfectly competitive firms are operating at
minimum point of long-run average cost
Are at full (rather than excess) capacity
Monopolistic competition focuses market implications of
operating with excess capacity without worry of strategic
interactions among firms
18
Short- and Long-Run Equilibrium
under Monopolistic Competition
Long-run equilibrium position for a monopolistically
competitive firm is illustrated in Figure 15.1
Given large number of firms, effect from a firms change in
output on price of any particular competitor is negligible
Firm acts as if its actions have no effect upon its competitors
Results in Q
d
demand curve
Competitors prices remain fixed
However, a firms individual profit-maximizing decisions will
be replicated by all other firms within this market
Causing a change in total output beyond its small output change
Effective demand curve is Q
D
Firms competitors prices do change
19
Figure 15.1 Long-run equilibrium for
a monopolistically competitive firm
20
Short- and Long-Run Equilibrium
under Monopolistic Competition
With all other firms changing their output
At a particular price firm will not sell expected level of output based on Q
d

demand curve
Instead, firm will sell lesser output associated with Q
D
curve
Since response of price to an output change by one firm will be less
when all other prices are fixed
Q
D
demand curve will be more inelastic than Q
d
curve
For profit maximization, firm will equate MR associated with Q
d
demand
curve to marginal cost
Long-run equilibrium will result where
Long-run average cost curve, LAC, is tangent to Q
d
curve and
Q
d
and Q
D
curves intersect
Results in equilibrium output q
e
and price p
e
At this tangency point, firm cannot vary output to enhance its profit
21
Short- and Long-Run Equilibrium
under Monopolistic Competition
Long-run pure profit for monopolistically competitive firms will be zero
In short-run, monopolistically competitive firms earning pure profits will attract new firms
supplying similar products
Consumers will perceive these new products as possible substitutes
Demand curves for original firms will shift downward and eventually squeeze out any pure profits
In long-run, costs will also adjust and squeeze profits
However, as indicated in Figure 15.1, production is not at minimum of LAC, p > LMC
There is deadweight loss in consumer and producer surplus
However, because firms only have a partial monopoly, their aggregate level of output will be
greater than that for a pure monopoly
In Figure 15.1, Q
D
demand curve cuts above short-run average total cost curve
Creates an area where a monopoly can earn a short-run pure profit by reducing output to within
this area
Thus, monopolistically competitive firms level of resource misallocation is less than if a monopoly
was sole supplier in industry
Consumers may view greater degree of product differentiation (more choices) as a
desirable characteristic
Which mitigates this inefficiency
22
Oligopoly
A major market characterized as an oligopoly in U.S. is the media
landscape
Dominated by giant firms such as Bertelsmann, Disney, General Electric,
Liberty Media, Rupert Murdochs News, Seagram, Sony, Time-Warner, and
Viacom
To a large extent these firms furnish your television programs, movies,
videos, radio shows, music, and books
In general, an oligopolistic market is characterized by existence of a
relatively small number of sellers with interdependence among sellers
Firms produce either a homogeneous product (called perfect oligopoly)
or heterogeneous products (imperfect oligopoly)
An example of a homogeneous oligopoly market is steel industry
Automobile, cigarette, gasoline, and cola industries are heterogeneous
markets
If there are only two sellers, it is called a duopoly
23
Oligopoly
Relatively small number of sellers in an oligopoly is result of
barriers to entry which may result from
Product differentiation
May result in brand identification
Difficult for new firms to break through this attachment
Economies of scale
May result where total market size permits only a few optimally-sized
plants
Control over indispensable resources
Prevents entry on technological grounds
Exclusive franchises
Present legal barriers to entry
Oligopoly markets are also characterized by mutual
dependence
Necessary for each firm to consider reactions of its competitors
24
Price and Output Determination
Oligopolistic firms must determine an associated price and
output policy based on some objective
Firm may have a pricing policy that results in less-than-
maximum profit to discourage potential entrants
An example of contestable markets
Even threat of entry will prevent firms from maximizing profit
Thus, instead of maximizing profit, a firm might attempt to maximize
sales in an effort to maintain control over a share of market
To determine price and output of an oligopolistic firm,
consider a duopolist market selling an undifferentiated
product (perfect duopolist)
In terms of politics, this may be Democrats and Republicans selling
alternative solutions for providing public goods
25
Price and Output Determination
Let p denote a common selling price
q
1
and q
2
are output of first and second firm, respectively
Determine common selling price, p, by total market output of
the two firms, Q, where q
1
+ q
2
= Q
Then, p = p(Q)
An increase in either output will result in a decrease in price
p q
1
< 0, p q
2
< 0
Total revenue for j
th
firm is then
TR
j
= p(Q)q
j
, j = 1, 2,
Total cost for j
th
firm is
j(q
j
)
Assuming firms objectives are maximizing their own profit, profit for
each firm is
26
Price and Output Determination
Firm j must predict the other firms output decision
as its profit depends on amount of output chosen
by other firm
If one firm changes its output, other firm may react
to this change by adjusting its output
Each player (firm) must predict strategies of other players
A one-shot game where profit of firm j is its payoff and strategy
set of firm j is the possible outputs it can produce
An equilibrium is a set of outputs (q
1
*, q
2
*) in which each firm is
choosing its profit-maximizing output level, given
Its beliefs about other firms choice
And each firms belief about other firms choice is actually correct
Called a Nash equilibrium
27
Price and Output Determination
Assuming an interior optimum for each firm, F.O.C. for firm
1, using product rule for differentiation, is

1
/q
1
= p(Q*) + (p(q)/q
1
)q*
1
MC(q*
1
) = 0
Employing chain rule for second term on right-hand side,
where Q is a function of q
1
and q
2
and q
2
is a function of q
1
,
yields
This results in
28
Price and Output Determination
To solve F.O.C.s for optimal level of outputs, q
1
* and q
2
*, we require the
functional forms of
dq
2
/dq
1
and dq
1
/dq
2
Called conjectural variations
Represent one firms conjecture or expectation of how other firms output will alter
as a result of its own change in output
A variety of different duopoly models result
Depending on what economic assumptions are made regarding conjectural
variations
The F.O.C. for firm 2 is
29
Cournot Model
Developed by French mathematician Augustin Cournot in 1838
Assumes conjectural variations are zero
dq
2
dq
1
= dq
1
dq
2
= 0
A firm, setting its own output, assumes other firms output will not change
Firms make their independent output decisions simultaneously
Simultaneous output decision by firms is directly related to Nash equilibrium associated with
simultaneous-moves games
For example, a firm may determine its output capacity without regard to capacity of other firms
Firms do not realize interdependence of their output decisions in their attempts
at maximizing profit
Cournot duopoly solution implies that each firm equates its own MR to MC without
regard to any possible reaction by other firm
p(Q*) + [p(Q) Q]q*
j
= MC(q*
j
), j = 1, 2
Even with zero conjectural variations, solution for (q
1
, q
2
) still involves simultaneous solution of each
firms F.O.C.
Firms may not realize their decisions affect their competitor
But since output price is determined by each firms output level
Their decisions do affect other firms output determination
30
Cournot Model
An example of Cournot firms is commercial real estate
market in large metropolitan cities
When market for commercial real estate is very tight (limited
supply of commercial buildings), price per square foot for
office space increases
Increase in price stimulates speculative building of office buildings by
a number of firms
However, each individual firm does not consider effect on its total
revenue of other firms building office space
When additional office space becomes available, market is flooded and price
drops
Result is magnified when high price for office space is during an
economic boom period in citys cyclical economy
If citys economy is in a slump when office space becomes available,
price drop can be substantial
31
Cournot Model, Perfect
Competition, and Monopoly
Factoring out p(Q*) from F.O.C. for profit maximization and multiplying
second term by 1 = Q*/Q*, yields
Since elasticity of demand is
D
= (Q/p)Q*/p* < 0, then
P(Q*)(1 +
j
/
D
) = MC(q*
j
)
P(Q*)(1 + 1/(
D
/
j
)) = MC(q*
j
)
Where
j
= q
j
/Q is share of total output by firm j
If there is only one firm in this industry, then
j
= 1
F.O.C.s reduce to monopoly solution
As number of firms increases, each firms share of total output declines
Results in
D
/
j
declining toward -
Firms are facing a more elastic demand curve as number of firms increase
In the limit, as number of firms approaches infinity, perfectly competitive
solution of p = MC results
At this perfectly competitive solution, Cournot assumption of zero conjectural
variations is correct
32
Cournot Model, Perfect
Competition, and Monopoly
As an example of price and output determination by Cournot
firms, consider inverse linear market demand function for a
duopoly market
p = a b(Q), a > 0, b > 0
Where Q = q
1
+ q
2
is combined output of the two firms
Cost functions for these firms are
STC
1
= cq
1
+ TFC and STC
2
= cq
2
+ TFC
Where c > 0 and a > c
With a greater than firms SAVC, they will each supply a positive level of
output
Assuming each firm maximizes profit
F.O.C. for firm 1 is
33
Cournot Model, Perfect
Competition, and Monopoly
F.O.C. for firm 2 is
Since Cournot firms conjectural variations are both zero, Firm 1s F.O.C.
reduces to
a = b(q
1
+ q
2
) bq
1
c = 0
Solving for q
1
gives
q
1
= (a c bq
2
)/2b
This is firm 1s reaction function
States how firm 1s output changes (reacts) when firm 2s output changes
Similarly, firm 2s reaction function is
q
2
= (a c bq
1
)/2b
Reaction functions are illustrated in Figure 15.2
Cournot equilibrium level of outputs for firms 1 and 2 result at their intersection
34
Figure 15.2 Cournot equilibrium
35
Cournot Model, Perfect
Competition, and Monopoly
Nash equilibrium can be found by substituting firm 2s
reaction function into firm 1s and solving for q
1
Substituting this equilibrium level of output, q
1
C
into firm 2s reaction
function yields Nash equilibrium output for firm 2
36
Cournot Model, Perfect
Competition, and Monopoly
Market output, Q
C
, and price, p
C
, are
37
Isoprofit Curves
Dynamics of Cournot approach can be analyzed using reaction curves
that show optimal profit-maximizing output for each firm, given output of
competitor
Consider some profit level for firm 1

1
= [a b(q
1
+ q
2
)]q
1
cq
1
TFC = aq
1
bq
2
1
q
1
q
2
cq
1
- TFC
Equation for firm 1s isoprofit curve for

1
level of profit
Isoprofit curve represents an equal level of profit for alternative levels
of a firms output
As illustrated in Figure 15.3, isoprofit curves radiate out from firm 1s
monopoly solution
When firm 2s output is zero, firm 1 is sole supplier
As a monopoly will maximize profit at Q = q
1
= (a c)/2b
Represents highest possible level of profit for firm 1
As firm 2 increases its output from zero, profit for firm 1 declines
Illustrated by isoprofit curves with lower levels of profit as q
2
increases
38
Figure 15.3 Dynamic adjustment
to the Cournot equilibrium
39
Isoprofit Curves
Firm 1 will maximize its profit for a given level of q
2

by shifting to isoprofit curve with highest profit
As illustrated in Figure 15.3, isoprofit curve tangent
to constraint of firm 2s output equaling q
2

is firm
1s profit-maximizing level given q
2

At tangency point, slope of lowest possible isoprofit curve
is equal to zero slope of constraint
F.O.C. for maximizing profit, given firm 2s level of
output, yields firm 1s reaction curve
Passes through all tangency points of isoprofit curves
and firm 2s output constraint
40
Isoprofit Curves
Similarly, firm 2 will maximize its profit for a given level of
firm 1s output
Firm 2s isoprofit curves radiate out from its monopoly solution with
profit declining as q
1
increases
Maximum profit level for firm 2, given some output level for firm 1, is
where isoprofit curve is vertical and tangent to constraint of firm 1s
output
Firm 2s reaction curve passes through this tangency
Given these isoprofit and reaction curves, firm 1 will react to firm 2s
output level q
2

Results in a movement to point A
Firm 2 will then react to this positive output level by firm 1 by decreasing
output, yielding point B
These Cournot firms have no capacity for learning
Adjustment process continues until Cournot equilibrium is established
41
Stackelberg Model
Stackelberg model
Developed by German economist Heinrich von Stackelberg
A duopoly quantity leadership model where one firm (leader) takes likely
response of competitor (follower) into consideration when maximizing profit
Model allows for leader to have a nonzero conjectural variation on
follower
Follower behaves exactly as Cournot firm, so its conjectural variation is still
zero
Leader then takes advantage of assumption that other firm is behaving as a
follower
A sequential game-theory problem where leader has advantage of
moving first
Industries with one dominant large firm and a number of smaller firms
are examples of markets with possible Stackelberg characteristics
For example, in personal computer operating systems industry Microsoft is
dominant leader firm with a number of smaller follower firms
42
Stackelberg Model
As an example of Stackelberg model, reconsider Cournot
linear demand function example
Firm 1 is leader and firm 2 is follower
Suppose firm 1 believes that firm 2 would react along
Cournot reaction curve
q
2
= (a c bq
1
)/2b
Firm 1s conjectural variation is
q
2
q
1
= -b 2b = -1/2
Given F.O.C. associated with firm 1

1
/ q
1
= a b(q
1
+q
2
) bq
1
+ bq
1
c = 0
Reaction curve for firm 1 is
a bq
1
bq
2
bq
1
+ bq
1
- c = 0
3/2bq
1
= a c bq
2
q
1
= (a c bq
2
)/(3/2)b
43
Stackelberg Model
The way we calculated firm 1s conjectural variation and substituted it
into firm 1s F.O.C. is
Same as maximizing firm 1s profit subject to firm 2s reaction function
In a sequential game, this corresponds to firm 1 setting its output first
Firm 1 will set its output level by considering how firm 2 will react to it
Given firm 2s reaction function, we can determine subgame perfect Nash equilibrium
for Firm 1
Specifically
Substituting the constraint into objective function results in the same
F.O.C. for firm 1

1
/q
1
= a b(q
1
+q
2
) bq
1
+ bq
1
c = 0
Outcome for both firms depends on behavior of firm 2
If firm 2 is using Cournot reaction curve, as firm 1 believes
Solution is Stackelberg equilibrium for firm 1
q
S
1
= (a c)/2b, q
S
2
= (a c)/4b
44
Stackelberg Model
Solution is derived from F.O.C.s of profit
maximization (reaction functions) for the two
firms
Equating these F.O.C.s yields
a b(q
1
+ q
2
) bq
1
+ bq
1
c = a b(q
1
+ q
2
) bq
2

c
-bq
1
+ bq
1
= -bq
2
bq
1
= bq
2
q
1
= q
2
45
Stackelberg Model
Substituting this solution into firm 1s reaction function results in solution
for firm 1
a b(q
1
+ q
1
) - bq
1
c = 0
a bq
1
- bq
1
- bq
1
c = 0
a 2bq
1
c = 0
q
S
1
= (1 c)/2b
Results in firm 1 earning a higher profit and firm 2 earning a lower profit than at Cournot
equilibrium
As illustrated in Figure 15.4, firm 1 maximizes profit subject to firm 2s
reaction curve
Results in a tangency of firm 1s isoprofit curve with firm 2s reaction function
Firm 1 is able to increase its profit with knowledge of Firm 2s reaction function
Similarly, as illustrated in Figure 15.4, if firm 2 is the Stackelberg firm facing Cournot
firm 1
Equilibrium output and profit levels are reversed
46
Figure 15.4 Stackelberg equilibria
and disequilibrium
47
Stackelberg Disequilibrium
Suppose firm 2 is using Stackelberg reaction
curve instead of Cournot reaction curve
Each firm incorrectly believes the other is a
follower using naive Cournot assumption
Firms each set their output at (a - c)/2b
Expecting their competitor will be a follower and
set its output at (a - c)/4b
Result is Stackelberg disequilibrium
Illustrated in Figure 15.4
Both firms earn lower profit than Cournot equilibrium
48
Collusion
Rather than attempt to guess reactions of competing firms
Firms can increase their profit by colluding and maximizing joint profit
F.O.C.s are
/q
1
= /q
2
= a b(q
1
+ q
2
) b(q
1
+ q
2
) c = 0
Solving for Q = (q
1
+ q
2
) gives
Q = (q
1
+ q
2
) = (a c)/2b
Firms set total output equal to the monopoly solution
Then determine how to divide this output among themselves
49
Collusion
Alternative divisions of this total output yield Pareto-optimal
surface in Figure 15.4
At any point off this optimal surface one firm can be made better off
without making other firm worse off
On this optimal surface, one firm cannot be made better off without
making the other firm worse off
For the firms to be on the optimal surface, their marginal profit must
be equal
If they are not equal, joint profit could be increased by shifting production
toward firm with higher marginal profit
Equality of marginal profit is illustrated in Figure 15.4
By tangency of isoprofit curves along optimal surface
Given that costs of two firms are the same, one possible division would
be for total output to be divided evenly
Results in symmetric joint maximization position (also illustrated in Figure
15.4)
q
1
= q
2
= (a c)/4b
50
Collusion
How this maximum joint profit is distributed among members of the
collusion is not yet determined
If producers have identical cost functions
Seems plausible for profit to be evenly distributed
In contrast, if producers have different cost functions
May divide up output based on setting their marginal costs equal to overall
marginal revenue
Decision on how to allocate resulting profit is still required
Ultimately allocation depends on bargaining power of the firms
Leads to game theory discussed in Chapter 14
Although collusion offers highest joint profit for firms
Firm can increase its individual profit if the other firm does not deviate from
agreed upon output limits
Called cheatingeach firm has a profit incentive to cheat
51
Collusion
Suppose firms agree to evenly divide total
monopoly output
If firm 1 assumes firm 2 will abide by this agreement
Firm 1 can increase its output and shift to lower isoprofit curves
yielding higher profit
Firm 2 has an equal incentive to cheat by also increasing
output
Both firms now believe other firms output decision is
independent of theirs
Underlying assumption of Cournot model
Collusion collapses (when firms increase their output) in a failed
attempt to further increase their individual profit
52
Bertrand Model
Cournot and Stackelberg models assume firms determine
their output
Based on total output supplied, market determines the price
However, in many markets the reverse behavior is observed
Firms determine their price and market then determines quantity sold
Examples include commercial airlines in pricing tickets, hotels in setting
room rates, and automobile firms in setting sticker prices for their
vehicles
A model incorporating this pricing behavior is Bertrand
model
Named after French mathematician Joseph Bertrand
Proposed model as an alternative to Cournot model
Bertrand model assumes simultaneous instead of sequential
decision making
Results in a Nash equilibrium set of prices for the firms
53
Perfect Oligopoly
In Bertrand model, assuming homogeneous products (perfect oligopoly)
Each firm has an incentive to undercut price of its competitors
Thus would capture all the sales
A firm will undercut its competitors prices as long as its price remains above marginal cost
If all firms have identical marginal costs
Any firm setting a price higher than marginal costs will be undercut by another firm offering a slightly lower price
Thus, perfectly competitive solution that yields a Pareto-efficient allocation will exist with
each firm setting price equal to marginal cost
With as few as two firms, result is a consequence of the firms setting their bid price equal to
marginal cost
Firms are in effect auctioning off their output in a first-bid common-value auction
Yields a Pareto-efficient allocation
Note that this Bertrand model Pareto-efficient solution for as few as two firms contrasts
with Cournot solution
Only when number of firms approach infinity will Cournot model yield a Pareto-efficient solution
Efficiency depends on how firms strategically interact
Bertrand, Cournot, and Stackelberg models illustrate how equilibrium outcomes and
efficiency in an oligopoly industry depend on type of strategic interaction engaged in by
firms
54
Imperfect Oligopoly
Bertrand solution only holds for a perfect oligopoly
If consumers perceive differences among products offered
by firms
Product differentiation exists
Thus, an imperfect oligopoly market exists with each firm
having some monopoly power
With this monopoly power, a profit-maximizing firm will set price in
excess of marginal cost and thus operate inefficiently
Specifically, consider two firms each with constant marginal
cost c
Demand for firm js output is
q
j
= q
j
(p
1
p
2
), j = 1, 2,
An increase in p
1
lowers quantity demanded q
1
and raises q
2

q
1
/p
1
< 0 and q
2
/p
1
> 0
An increase in p
2
has the reverse effect
55
Imperfect Oligopoly
Each product is a gross substitute of the other
In Bertrand model, each firm takes its competitors price
as given for maximizing profit
Where c is constant marginal cost
In an imperfect-oligopoly market characterized by
product differentiation
Equilibrium prices will be set above marginal cost
Results in an inefficient allocation
56
Imperfect Oligopoly
As an example, consider again firms 1 and 2 and assume
each firm faces the following linear demand functions
q
1
= a bp
1
+ dp
2
, q
2
= a bp
2
+ dp
1
Where q
1
and q
2
are substitutes (but not perfect substitutes)
Some degree of product differentiation exists
In this Bertrand model, each firm attempts to maximize profit by
choosing its own price
Given that the price of its competitor does not change
For simplicity, assume firms have zero cost
Firm 1s profit-maximization problem reduces to maximizing total
revenue
The F.O.C. is

1
/p
1
= a 2bp
1
+ dp
2
= 0
57
Imperfect Oligopoly
Solving for p
1
results in firm 1s reaction function to a change in firm 2s price
p
1
= a/2b + d/2bp
2
Similarly, maximizing profit for firm 2, holding firm 1s price constant, yields Firm
2s reaction function
p
2
= a/2b + d/2bp
1
These reaction functions are illustrated in Figure 15.5 with Bertrand equilibrium corresponding
to where they intersect
Thus, equilibrium prices are determined by solving simultaneously the two
reaction functions
Setting reaction functions in implicit form and equating yields
1 = 2bp*
1
+ dp*
2
= a 2bp*
2
+ dp*
1
= 0
p*
1
= p*
2
Substituting equality of prices into either of the firms reaction functions and solving for
price results in equilibrium prices
p*
1
= p*
2
= a/(2b d) > AC = MC = c = 0
Firms will maximize profits by setting price above marginal cost
At p
1
* = p
2
* an equilibrium is obtained
58
Figure 15.5 Bertrand equilibrium
59
Collusion
As with Cournot model, firms could improve their Bertrand profits by
colluding
Instead of setting their prices independently
They collude and jointly determine the same price
Maximizing joint profit yields
F.O.C. is
d/dp = 2a 4bp
J
+ 4dp
J
= 0 so
p
J
= a/(2(b d))
Results in the firms jointly increasing their prices and associated profit
As discussed in Chapter 14, repeatedly-played games can be directly
applied to firm behavior involving strategic interactions
For example, Bertrand model in game theory yields the same results as
Prisoners Dilemma when it also is played repeatedly
60
Collusion
Assumptions of Bertrand model result in the
impossibility of collusion over a finite time
period
In contrast, over a horizon of infinitely repeated
games, no final period exists
Prevents punishment in ensuing rounds
Thus, as in Prisoners Dilemma, cooperation can be
the optimal strategy
This type of cooperation is termed tacit collusion
Firms behave as a cartel without ever developing a joint
marketing strategy
61
Generalized Oligopoly Models
Other combinations of assumptions exist concerning firms actions, reactions, and
conjectures about other firms behavior
There are other decision variables besides output and price
Including advertising expenditures, market shares, and new market penetration
In each case, an alternative model of firms interaction would be required
Major difficulty with these models is determining conjectural variations
No general agreement among economists that any existing oligopoly model is appropriate
for analyzing firm behavior in a specific industry
Difficult to predict equilibrium solution for a particular oligopolistic market
Economic models are generally weak in predicting expected reactions of individual agents
to market prices, output and input levels, shifts in demand and supply, technological
change, and variations in tax rates
Thus, economists have developed models that dont focus on these reactions and then measure
the conjectural variation terms
One approach is to consider these interactions by employing game-theory models
A summary of characteristics associated with these oligopoly models, along with other
market structures, is provided in Table 15.1
62
Table 15.1 Market Structures
63
Generalized Oligopoly Models
In all these market structures we assume transaction costs to be small
or zero
Distinguishing feature between perfect competition and monopolistic
competition
Assumption of heterogeneous products under monopolistic competition
Results in advertising and product promotion
Oligopoly markets are distinguished from monopolistic competition by
Relatively large size and small number as a consequence of barriers to entry
Results in interdependence among firms within oligopoly markets
Oligopoly models vary according to their assumptions concerning how firms
respond to this interdependence
In the polar case, the monopoly is the industry
In reality, markets for differentiated products represent a continuum across these market
structures
For applied research, an economist will investigate characteristics of a
particular market
Select appropriate market model with modifications to use for analysis
64
Collusion in Oligopoly Markets
The idea of oligopoly firms engaged in collusive production
or pricing agreements has always existed in economics
Generally, there is an incentive for members of a collusive
arrangement (called a cartel) to cheat
Can apply game theory to investigate behavior of firms
involved with collusive arrangements
For example, consider the payoff matrix in Table 15.2
The establishment of a cartel by these two firms will yield a payoff of 10
for each firm
However, this is not a pure Nash equilibrium outcome
Each member can cheat by defecting from cartel and increase its payoff
Thus, there is an incentive for both firms to cheat and defect
For this reason, it is generally thought that cartels are inherently unstable in
the absence of some binding constraints on participants
65
Collusion in Oligopoly Markets
Economists have suggested that purpose of many
government regulatory agencies and minimum-price laws
Is to institutionalize cartels to prevent cheating
Even without binding constraints, long-run viability of a
cartel may be supported
By establishment of a firms reputation for cooperation
Encouraging other firms to also cooperate
With repeated opportunities for showing this cooperation
through regular cartel meetings on price and output
determination
Cooperative equilibrium may result
66
Table 15.2 Cartel
67
Legal Provisions
Antitrust restrictions attempt to make cartels illegal
However, some cartels are actively supported by
governments
For example, within U.S. for certain industries, Section 1 of
Sherman Antitrust Act (1890) prohibits contracts, combinations,
or conspiracies in restraint of trade
Section 2 declares it is unlawful for any person to monopolize,
attempt to monopolize, or conspire to monopolize trade
Clayton Act (1914) prohibits price discrimination where it
substantially lessens competition or creates a monopoly in any
line of commerce
Federal Trade Commission (FTC) Act (1914) supplements
Sherman and Clayton acts
Prohibits unfair and anticompetitive practices such as deceptive
advertising and labeling
68
Legal Provisions
Either government or private agencies, including
firms and households, can bring suit against a
cartel
However, a number of U. S. industries are not covered by
these acts
For example, by the Capper-Volstead Act (1922), agriculture is
not included under antitrust acts
Section 7 of Taft-Hartley Act (1935) allows labor unions, which
are a type of collusive activity, to form
In terms of export markets, Webb-Pomerence Act (1918)
allows price fixing and other forms of collusion for
exporting commodities