CHAPTER 9

Basic Oligopoly Models

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Overview
Chapter Outline
• Conditions for Oligopoly
• Role of beliefs and strategic interaction
• Profit maximization in four oligopoly settings
– Sweezy oligopoly
– Cournot oligopoly
– Stackelberg oligopoly
– Bertrand oligopoly
• Comparing oligopoly models
• Contestable markets
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 Chapter Overview
Introduction
• Chapter 8 examined profit-maximizing behavior in
perfectly competitive, monopoly, and monopolistically
competitive markets. One distinguishing feature is the
absence of strategic interaction among the firms (in
monopoly markets, strategic interaction is irrelevant
since only one firms exists).
• This chapter focuses on how managers select the
optimal price and quantity in the following market
oligopoly market environments:
– Sweezy
– Cournot
– Stackelberg
– Bertrand

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 Conditions for Oligopoly
Key Conditions
• Oligopoly market structures are characterized by
only a few firms, each of which is large relative to
the total industry.
– Typical number of firms is between 2 and 10.
– Products can be identical or differentiated.
• An oligopoly market composed of two firms is
called a duopoly.
• Oligopoly settings tend to be the most difficult to
manage since managers must consider the likely
impact of his or her decisions on the decisions of
other firms in the market.

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 Role of Beliefs and Strategic Interaction
Strategic Interaction: Price Change Response

Price
Demand if rivals
C match price changes

Demand if rivals do not

A
B match price changes
𝑃0

Demand2
Demand1

0 𝑄0 Output

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 Profit Maximization in Four Oligopoly Settings

Conditions for Sweezy Oligopoly

• There are few firms in the market serving
many consumers.
• The firms produce differentiated products.
• Each firm believes its rivals will cut their prices
in response to a price reduction but will not
raise their prices in response to a price
increase.
• Barriers to entry exist.

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 Profit Maximization in Four Oligopoly Settings

Sweezy Oligopoly
Price

Sweezy Demand MC0

A
B
𝑃0
MC1
C Demand1
(rival holds price
constant)

E MR1
MR Demand2
(rival matches price change)

0 𝑄0 F Output
MR2

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 Profit Maximization in Four Oligopoly Settings

Conditions for Cournot Oligopoly

• There are few firms in the market serving
many consumers.
• The firms produce either differentiated or
homogeneous products.
• Each firm believes rivals will hold their output
constant if it changes its output.
• Barriers to entry exist.

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 Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Reaction Functions

• Consider a Cournot duopoly. Each firm makes
an output decision under the belief that is rival
will hold its output constant when the other
changes its output level.
– Implication: Each firm’s marginal revenue is
impacted by the other firms output decision.
• The relationship between each firm’s profit-
maximizing output level is called a best-
response or reaction function.

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 Profit Maximization in Four Oligopoly Settings
Cournot Oligopoly:
Reaction Functions Formula
• Given a linear (inverse) demand function
𝑃 = 𝑎 − 𝑏 𝑄1 + 𝑄2
and cost functions, 𝐶1 𝑄1 = 𝑐1 𝑄1 and
𝐶2 𝑄2 = 𝑐2 𝑄2 the reactions functions are:
𝑎 − 𝑐1 1
𝑄1 = 𝑟1 𝑄2 = − 𝑄2
2𝑏 2
𝑎 − 𝑐2 1
𝑄2 = 𝑟2 𝑄1 = − 𝑄1
2𝑏 2

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 Profit Maximization in Four Oligopoly Settings

Cournot Reaction Functions

Quantity2

Firm 1’s Reaction Function

𝑄1 = 𝑟1 𝑄2

𝑄2 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦
Cournot equilibrium
𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 C
Firm 2’s Reaction Function
D A 𝑄2 = 𝑟2 𝑄1
B

𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦 Quantity1

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 Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Equilibrium

• A situation in which neither firm has an
incentive to change its output given the other
firm’s output.

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 Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Isoprofit Curves

• A function that defines the combinations of
outputs produced by all firms that yield a
given firm the same level of profits.

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 Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly In Action: Problem

• Suppose the inverse demand function in a
Cournot duopoly is given by
𝑃 = 10 − 𝑄1 + 𝑄2
and their costs are zero.
– What are the reaction functions for the two firms?
– What are the Cournot equilibrium outputs?
– What is the equilibrium price?

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 Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly In Action: Answer

• The reaction functions are: 𝑄1 = 𝑟1 𝑄2 =
10 1 10 1
− 𝑄2 and 𝑄2 = 𝑟2 𝑄1 = − 𝑄1 .
2 2 2 2
• Equilibrium output is found as:
1 1 10
𝑄1 = 5 − 5− 𝑄1 ⟹ 𝑄1 = . Since the
2 2 3
10
firms are symmetric, 𝑄2 = .
3
10
• Total industry output is 𝑄 = 𝑄1 + 𝑄2 = +
3
10 20
= . So, the equilibrium price is: 𝑃 = 10 −
3 3
20 10
= .
3 3
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 Profit Maximization in Four Oligopoly Settings

Firm 1’s Best Response to Firm 2’s Output

Quantity2

𝑟1 (Firm 1’s reaction function)

A B C
∗
𝑄2 𝜋1 𝐴
𝜋1 𝐵
𝜋1 𝐶
Firm 1’s profit increases as isoprofit
curves move toward 𝑄1 𝑀

𝑄1 𝐴 𝑄1 𝐵 𝑄1 𝐶 𝑄1 𝑀 Quantity1

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 Profit Maximization in Four Oligopoly Settings
Firm 2’s Reaction Function and Isoprofit Curves

Quantity2
Monopoly
point for
firm 2

𝑄2 𝑀
Firm 2’s profit increases as isoprofit
curves move toward 𝑄2 𝑀

𝜋3 𝐶 𝑟2 (Firm 2’s reaction function)

𝐵
𝜋2
𝜋1 𝐴
Quantity1

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 Profit Maximization in Four Oligopoly Settings

Cournot Equilibrium
Quantity2
𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡

𝑄2 𝑀 Cournot Equilibrium

𝑄2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡

𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡

𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀 Quantity1

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 Profit Maximization in Four Oligopoly Settings

Effect of Decline in Firm 2’s Marginal Cost on

Cournot Equilibrium
Quantity2
𝑟1

F
∗∗
𝑄2
Due to decline in
firm 2’s marginal cost

E
𝑄2 ∗ 𝑟2 𝑟2 ∗∗

𝑄1 ∗∗ 𝑄1 ∗ 𝑄1 𝑀 Quantity1

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 Profit Maximization in Four Oligopoly Settings

Cournot Oligopoly: Collusion

• Markets with only a few dominant firms can
coordinate to restrict output to their benefit at
the expense of consumers.
– Restricted output leads to higher market prices.
• Such acts by firms is known as collusion.
• Collusion, however, is prone to cheating
behavior.
– Since both parties are aware of these incentives,
reaching collusive agreements is often very difficult.

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 Profit Maximization in Four Oligopoly Settings

Incentive to Collude in a Cournot Oligopoly

Quantity2 𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝜋2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛

Collusion outcome
𝑄2 𝑀

𝑄2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝜋1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛

𝑄1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛 𝑄1 𝑀 Quantity1

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 Profit Maximization in Four Oligopoly Settings
Incentive to Renege on Collusive
Agreements in Cournot Oligopoly
Quantity2
𝜋2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
𝜋21𝐶ℎ𝑒𝑎𝑡

𝑄2 𝑀

𝑄2 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛

𝜋1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛
𝜋1 𝐶ℎ𝑒𝑎𝑡

𝑄1 𝐶𝑜𝑙𝑙𝑢𝑠𝑖𝑜𝑛𝑄1 𝐶ℎ𝑒𝑎𝑡 𝑄1 𝑀 Quantity1

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 Profit Maximization in Four Oligopoly Settings

Conditions for Stackelberg Oligopoly

• There are few firms serving many consumers.
• Firms produce either differentiated or
homogeneous products.
• A single firm (the leader) chooses an output
before all other firms choose their outputs.
• All other firms (the followers) take as given the
output of the leader and choose outputs that
maximize profits given the leader’s output.
• Barriers to entry exist.

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 Profit Maximization in Four Oligopoly Settings

Stackelberg Equilibrium
Quantity Follower
𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑟 𝐿𝑒𝑎𝑑𝑒𝑟 𝜋2 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝑟 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟
𝑄2 𝑀

𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝜋1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟
𝑄1 𝑀 𝑄1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟 Quantity Leader

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 Profit Maximization in Four Oligopoly Settings
Stackelberg Oligopoly:
Equilibrium Output Formulae
• Given a linear (inverse) demand function
𝑃 = 𝑎 − 𝑏 𝑄1 + 𝑄2
and cost functions 𝐶1 𝑄1 = 𝑐1 𝑄1 and 𝐶2 𝑄2 =
𝑐2 𝑄2 .
– The follower sets output according to the reaction
function
𝑎 − 𝑐2 1
𝑄2 = 𝑟2 𝑄1 = − 𝑄1
2𝑏 2
– The leader’s output is
𝑎 + 𝑐2 − 2𝑐1
𝑄1 =
2𝑏
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 Profit Maximization in Four Oligopoly Settings

Stackelberg Oligopoly In Action: Problem

• Suppose the inverse demand function for two
firms in a homogeneous-product, Stackelberg
oligopoly is given by
𝑃 = 50 − 𝑄1 + 𝑄2
and their costs are zero. Firm 1 is the leader,
and firm 2 is the follower.
– What is firm 2’s reaction function?
– What is firm 1’s output?
– What is firm 2’s output?
– What is the market price?
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 Profit Maximization in Four Oligopoly Settings

Stackelberg Oligopoly In Action: Answer

• The follower’s reaction function is: 𝑄2 =
1
𝑟2 𝑄1 = 24 − 𝑄1 .
2
50+2−4
• The leader’s output is: 𝑄1 = = 24.
2
1
• The follower’s output is: 𝑄2 = 24 − 24 =
2
12.
• The market price is: 𝑃 = 50 − 24 + 12 =
$14.

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 Profit Maximization in Four Oligopoly Settings

Conditions for Bertrand Oligopoly

• There are few firms in the market serving many
consumers.
• Firms produce identical products at a constant
marginal cost.
• Firms engage in price competition and react
optimally to prices charged by competitors.
• Consumers have perfect information and there
are no transaction costs.
• Barriers to entry exist.

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 Profit Maximization in Four Oligopoly Settings

Bertrand Oligopoly: Equilibrium

• The conditions for a Bertrand oligopoly imply
that firms in this market will undercut one
another to capture the entire market leaving
the rivals with no profit. All consumers will
purchase at the low-price firm.
• This “price war” would come to an end when
the price each firm charged equaled marginal
cost.
• In equilibrium, 𝑃1 = 𝑃2 = 𝑀𝐶.
– Socially efficient level of output.
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 Comparing Oligopoly Models

Comparing Oligopoly Outcomes

• Consider the following inverse market demand
function:
𝑃 = 1,000 − 𝑄1 + 𝑄2
and the cost function for each firm in this
market is identical, and given by
𝐶𝑖 𝑄𝑖 = 4𝑄𝑖
• Under these condition, the different oligopoly
outputs, prices and profits are examined.

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 Comparing Oligopoly Models

Comparing Oligopoly: Cournot Outcome

• The Cournot oligopoly reaction functions are
1
𝑄1 = 498 −
2
1
𝑄2 = 498 −
2
• These reaction functions can be solved for the
equilibrium output. These quantities can be used
to compute price and profit.
– 𝑄1 = 𝑄2 = 332
– 𝑃 = $336
– 𝜋1 = 𝜋2 = $110,224
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 Comparing Oligopoly Models

Comparing Oligopoly: Stackelberg Outcome

• The Stackelberg leader’s output is
1,000 + 4 − 2 × 4
𝑄𝑙𝑒𝑎𝑑𝑒𝑟 = = 498
2×1
1
𝑄𝑓𝑜𝑙𝑙𝑜𝑤𝑒𝑟 = 498 − × 498 = 249
2
• The market price is: 𝑃 = 1,000 − 498 − 249 = $253
• 𝜋𝑙𝑒𝑎𝑑𝑒𝑟 = $124,002
• 𝜋𝑓𝑜𝑙𝑙𝑜𝑤𝑒𝑟 = $62,001

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 Comparing Oligopoly Models

Comparing Oligopoly: Bertrand Outcome

• Since 𝑃 = 𝑀𝐶, 𝑃 = $4.
• Total output is found by: $4 = 1,000 − 𝑄
– Solving yields: 𝑄 = 996
– Given symmetric firms, each firm gets half the
market, or 498 units.
– 𝜋1 = 𝜋2 = $0

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 Comparing Oligopoly Models

Comparing Oligopoly: Collusion Outcome

• Since the output associated with collusion is the
same as monopoly output, the inverse market
demand function implies that monopoly marginal
revenue function is:
𝑀𝑅 = 1,000 − 2𝑄
• Setting marginal revenue equal to marginal cost
yields:
1,000 − 2𝑄 = 4
– Solving this: 𝑄 = 498 units. Each firm will produce half
of these units.
• Price is: 𝑃 = 1,000 − 498 = $502
• Each firm earns profits of $124,002.

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 Contestable Markets

Key Conditions
• Contestable markets involve strategic
interaction among existing firms and potential
entrants into a market.
• A market is contestable if:
– All producers have access to the same technology.
– Consumers respond quickly to price changes.
– Existing firms cannot respond quickly to entry by
lowering price.
– There are no sunk costs.
• If these conditions hold, incumbent firms have
no market power over consumers.
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 Conclusion
• Different oligopoly scenarios give rise to
different optimal strategies and different
outcomes.
• Your optimal price and output depends on …
– Beliefs about the reactions of rivals.
– Your choice variable (P or Q) and the nature of the
product market (differentiated or homogeneous
products).
– Your ability to credibly commit prior to your rivals.

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Computational Question: Assignment
• Two firms compete in a market to sell a
homogeneous product with inverse demand
function P=600-3Q. Each firm produces at a
constant marginal cost of $300 and has no fixed
costs. Use this information to compare the
output levels and profits in settings
characterized by 1) Cournot, 2) Stackelberg,
3) Bertrand and Collusive equilibrium.

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 Demand :P=600-3Q
• Cournot:
Q = Q 1 + Q2
P = 600 – 3 (Q1 + Q2)
TR1 = 600Q1 – 3 Q12 – 3Q1Q2
MR1 = 600 - 6Q1 – 3Q2 = 300 = MC
Q1 = (300 - 3Q2 )/6 = 50 – 0.5Q2
Q2 = 50 – 0.5 Q1
Q1 = 50 – 0.5(50 – 0.5 Q1) = 50 -25 +0.25 Q1
0.75 Q1 = 25 ; Q1 = 33.33 ; Q2 = 33.33
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 Demand :P=600-3Q
Model Output Profits

Cournot Q1 = Q2 = 33.33 π1 = π2 = $3,333.33

Stackelberg QL = 50; QF = 25 πL = $3,750; πF = $1,875

Bertrand Market output = 100 units Zero

Collusion Market output = 50 units Industry Profits = $7,500

Bertrand: P = 600 -3Q = 300

3Q = 300 ; Q = 100 units.
Monopoly: TR = 600Q -3Q2
MR = 600 – 6Q = 300
300 = 6Q ; Q = 50 units

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