FINC304

Managing Uncompetitive
Markets

Session 10– Oligopoly

Lecturer: Dr. Agyapomaa Gyeke-Dako, UGBS

Contact Information: agyeke-dako@ug.edu.gh

College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
 Session Overview
• Our analysis on the different markets so far has not considered the
impact of firm interdependence on managerial decision making. At
one extreme, we have considered firms with many sellers (that is
perfect competition and monopolistic competition). With these
markets, because many firms are competing, interdependence does
not exist because each firm is so small that its decision cannot
impact and be impacted on the decisions of other firms. At the
other extreme is monopoly which has only one firm in the industry
and therefore gives no room to interdependence. When firms are
interdependent, their actions can affect and are affected by the
behavior of other firms. This session examines managerial
decisions of firms that are interdependent. We focus on basic
output and pricing decisions in four different types of Oligopolies.
We use different models to explain oligopoly behavior because
strategic behavior takes different forms. We focus on the Sweezy,
Cournot, Stackelberg and Bertrand models.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 2

 Session Outline
The key topics to be covered in the session are as follows:
• Characteristics of Oligopoly
• Cournot Model
• Stackelberg Model
• Sweezy Model

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 3

 Reading List
• Baye Michael and Price Jeffery: Managerial
Economics and Business Strategy, 8th Edition

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 4

 Oligopoly
Relatively few firms, usually less than 10.
Duopoly - two firms Triopoly - three firms
The products firms offer can be either differentiated or
homogeneous.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 5

 Role of Strategic Behaviour
Strategic interactions play an important role in Oligoply
models

Strategic interactions acknowledges two key facts

Your actions affect the profits of your rivals. Your rivals’ actions affect your
profits.

Strategic reaction of rival firms is a central element in

Oligopoly analysis

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 6

 You and another firm sell differentiated products.

How does the quantity demanded for your product

change when you change your price?

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 7

 An example of Strategic Behaviour

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 8

 Key Issues
The effect of a price reduction on the quantity
demanded of your product depends upon whether
your rivals respond by cutting their prices too!

The effect of a price increase on the quantity

demanded of your product depends upon whether
your rivals respond by raising their prices too!

Strategic interdependence: You are not in complete

control of your own destiny!

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 9

 Oligopoly
Quantity-setting oligopoly models
Cournot model Stackleberg model

Price-setting oligopoly models

Sweezy model Bertrand model

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 10

 Cournot
A few firms produce goods that are either perfect
substitutes (homogeneous) or imperfect substitutes
(differentiated).

Firms set output, as opposed to price.

Key assumption on strategic response: each firm believes

their rivals will hold output constant if it changes its own
output (The output of rivals is viewed as given or “fixed”).

Barriers to entry exist.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 11

 Inverse Demand in a cournot
• Market demand in a homogeneous-product Cournot
duopoly is
• P = a − b(Q1 + Q2)

• Thus, each firm’s marginal revenue depends on the

output produced by the other firm. More formally,
• MR1 = a − bQ2 − 2bQ1
• MR2 = a − bQ1 − 2bQ2

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 12

 Best Response Function
Since a firm’s marginal revenue in a homogeneous Cournot
oligopoly depends on both its output and its rivals, each
firm needs a way to “respond” to rival’s output
decisions.

Firm 1’s best-response (or reaction) function is a schedule

summarizing the amount of Q1 firm 1 should produce in
order to maximize its profits for each quantity Q2 of
produced by firm 2.

Since the products are substitutes, an increase in firm 2’s

output leads to a decrease in the profitmaximizing
amount of firm 1’s product.
Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 13
 Introduction
Review of Last Cournot Oligopoly model Stackelberg
Class Oligopoly Model Bertrand Oligopoly Model
Basic Oligopoly Sweezy (Kinked-Demand) Oligopoly Model
Introduction to Game Theory

Best-Response Function for a Cournot

Duopoly

To find a firm’s best-response function, equate its marginal

revenue to marginal cost and solve for its output as a
function of its rival’s output.

Firm 1’s best-response function is (c1 is firm 1’s MC)

Q1 = r1(Q2) = a−c2b
1 = 1Q )
2

Firm 2’s best-response function is (c2 is firm 2’s

MC)
Q2 = r2(Q1) = a−c2 = 1Q1)
2b
 Cournot
Situation where each firm produces the output that
maximizes its profits, given the the output of rival
firms.

No firm can gain by unilaterally changing its own

output to improve its profit.
A point where the two firm’s best-response functions intersect.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 15

 Cournot Equilibrium Example

• Suppose the inverse demand function for two Cournot

duopolists is P = 200 − 2(Q1 + Q2) and the marginal cost
for each firm is 4

• What is the marginal revenue of each firm?

• What are the reaction functions for the two firms? What

are the Cournot equilibrium outputs?

• What is the equilibrium price?

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 16
 Answer

Cournot Equilibrium Outputs

Q1 = Q2 = 65.34
price= 69.32

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 17

 Summary of Cournot Equilibrium
The output Q1 * maximizes firm 1’s profits, given that firm
2 produces Q2 *

The output Q2 * maximizes firm 2’s profits, given that firm

1 produces Q1 *

Neither firm has an incentive to change its output, given

the output of the rival.

Beliefs are consistent:

In equilibrium, each firm “thinks” rivals will stick to their current output – and
they do!

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 18

 Stackelberg
Firms produce differentiated or homogeneous products.

Barriers to entry

Firm one is the leader.

The leader commits to an output before all other firms

Remaining firms are followers.

They choose their outputs so as to maximize profits, given the

leader’s output.
•

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 19

 Solution to Stackelberg
First, solve for the reaction function of the follower.

Solve for the profit function of the leader, and substitute

reaction function of the follower into the profit function

Maximize the profit function of the leader and substitute

the optimal output into the reaction function of the leader

Substitute both quantities into the demand function to

solve for the price

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 20

 Stackelberg Equilibrium Example
• Consider once again the situation described earlier
where the demand equation for two profit
maximizing firms in a duopolistic industry is

• P=200-2(Q1+Q2) and the firm’s total cost functions

are

TC1 = 4Q1
TC1 = 4Q2

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 21

 Stackelberg Equilibrium Example
• Where Q1 and Q2 represent the output levels of firm
1 and firm 2, respectively. Assume that firm 2 is a
Stackelberg leader and firm 1 is a Stackelberg
follower. What are the equilibrium price, profit-
maximizing output levels and profits for each firm?

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 22

 Stackelberg
Stackelberg model illustrates how commitment can
enhance profits in strategic environments.

Leader produces more than the Cournot equilibrium

output.
Larger market share, higher profits. First-mover advantage.

Follower produces less than the Cournot equilibrium

output.
Smaller market share, lower profits.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 23

 Bertrand
Few firms that sell to many consumers.

Firms produce identical products at constant marginal

cost. Each firm independently sets its price in order to

maximize
profits.

Barriers to entry. Consumers enjoy

Perfect information. Zero transaction costs.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 24

 Bertrand Equilibrium
• P1 = P2 = MC ! Why

• Suppose MC < P1 < P2

• Firm 1 earnsP1 − MC on each unit sold, while firm 2 earns nothing.

• Firm 2 has an incentive to slightly undercut firm 1’s price to capture

the entire market.

• Firm 1 then has an incentive to undercut firm 2’s price. This

undercutting continues...

• Equilibrium: Each firm charges P1 = P2 = MC

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 25

 Sweezy Model

Few firms in the market serving many consumers Firms

produce differentiated products

Barriers to entry

Each firm believes rivals will match (or follow) price

reductions, but won’t match (or follow) price increases

Key feature of Sweezy Model

Price-Rigidity.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 26

 Sweezy Model and Marginal Revenue

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 27

 Sweezy Profit Maximising

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 28

 Sweezy Oligopoly Summary
Firms believe rivals match price cuts, but not price increases.
Firms operating in a Sweezy oligopoly maximize profit by
producing where

So MRS = MC
The kinked-shaped marginal revenue curve implies that there exists a
range over which changes in MC will not impact the profit-maximizing
level of output.
Therefore, the firm may have no incentive to change price provided that
marginal cost remains in a given range.

Agyapomaa Gyeke-Dako(PhD) 4/27/2018 Slide 29