Economics of Industry Revision Pack on Oligopolies & Collusion, Entry, Product Differentiation, Advertising, Innovation
Oligopolies & Collusion
Topic Takeaway Diagram
Features of an • Natural barriers of entry due to economies of scale and lower cost
Oligopoly curves
• Unnatural barriers of entry due to reputation for fighting, brand
loyalty & limit pricing
• Kinked demand due to assumption that firms expect rivals not to
match a price increase only a price decrease
o BUT does not explain how firms arrive at collusive price
• Non- price competition with AC pricing
Cournot • n firms, homogenous good (perfect substitutes) & price clears market
Competition o Quantity competition is a choice of scale that determines the
firm’s cost functions and thus determines the conditions of
price competition e.g. capacity choice or general investment
decisions
• Firm’s MC are constant but may vary between firms
• Assumes: Homogenous goods/ perfect substitutes, No capacity
constraints, Identical constant AC function & Linear, well-behaved
demand curve so the Demand is downward sloping (P’(Q) < 0) and not
too convex P’(Q) + Q.P’’(Q) < 0
• To find the Nash Equilibrium, need to find BR curves by differentiating
profit function with respect to quantity
o Profit Function:
▪ Firm i acts as a monopolist on its residual demand
o BR:
• With the BR, both firms form an expectation of rival’s quantity and
take it as fixed and then choose their own q to maximise profit
, • Firms with higher MC produce less (less efficient) than those with low
MC (efficient)
o Observed firm size distribution is reflection of underlying
efficiency difference
• BR depends on sum of rivals’ quantities: If another firm produces more
output, firm i will produce less output (strategic choices go in opposite
directions.
• If MC decreases, BR shifts out & starts producing more whilst
competitor produces less (indirect (strategic) effect) due to downward
sloping BR.
• Linear Cournot model with homogeneous goods: firm’s equilibrium
profits increase when firm becomes relatively more efficient than
rivals (ceteris paribus, when its marginal cost decreases or when the
marginal cost of any of its rivals increases)
Cournot • As firm number grows, Cournot equilibrium converges to perfectly
Competition competitive equilibrium.
as n grows • An increase in the number n of firms reduces each firm’s equilibrium
output q* (assuming constant costs) as
• A larger n increases aggregate output Q* = nq*and , if P(Q) < c for Q
sufficiently large, then P(Q*) → c as n → infinity as the mark-up falls
• Intuition: As the number of firms increases, each firm sees its
influence on the market price diminish and is therefore willing to
, expand its output & so the market price diminishes and prices
approach MC
Cournot • Cournot is not socially efficient because Lerner Index is positive BUT it
General is better than monopoly price & quantity levels (collusion)
Evaluation • There is a negative externality between firms: firm i takes into account
only the adverse effect of market price change on its own output
when choosing its output & not the aggregate output
o Therefore, each firm chooses output that exceeds the optimal
output from the industry’s PoV but not from a welfare PoV
• In real settings, we observe price setting which makes it hard to
provide a literal interpretation of Cournot competition BUT market
clearing of large quantities may be organised by an auctioneer (but
these don’t really exist)
Stackelberg • Stackelberg: Sequential model of quantity competition- Firm 1 sets
Competition quantity based on what Firm 2’s BR is that will allow it to maximise
profits
o Leaders produce more and followers less
• Stackelberg supplies the marketplace with largest amount of output
and with smallest market profits = better for social welfare.
o It provides a piece of info missing in Cournot- the order of the
players.
o This allows Cournot to be more “abusive” against the
consumers and charge a higher price.
, Comparisons
between
Cournot-Nash-
Stackelberg &
Collusion
Equilibriums
The Bertrand • Assumptions (which can be criticised): No capacity constraints (each
Trap firm can supply the entire market), One-shot game (no scope of
reactive pricing), Perfect product substitutability
• n firms compete on prices for a homogenous product with a
downward sloping inverse market demand P(Q), constant marginal
costs and consumers only buy from firms with the lowest price
• BR calculated by differentiating profit function with respect to price
• Assuming firms have same MC, the unique pure-strategy equilibrium is
both set prices equal to MC, p= c as, for all other price combinations,
there is at least one firm with an incentive to deviate.
• No firm enjoys any market power, and both make zero profits. Two
firms are sufficient to induce perfectly competitive outcome as both
correctly anticipate what the other firm will set
• Upward Sloping BR Curves due to strategic complementarity
• Complementarity runs the risk of price wars: if one firm decreases
price, other follows
Asymmetric • Firms have different costs due to different technologies (patents)
Costs &
Oligopolies & Collusion
Topic Takeaway Diagram
Features of an • Natural barriers of entry due to economies of scale and lower cost
Oligopoly curves
• Unnatural barriers of entry due to reputation for fighting, brand
loyalty & limit pricing
• Kinked demand due to assumption that firms expect rivals not to
match a price increase only a price decrease
o BUT does not explain how firms arrive at collusive price
• Non- price competition with AC pricing
Cournot • n firms, homogenous good (perfect substitutes) & price clears market
Competition o Quantity competition is a choice of scale that determines the
firm’s cost functions and thus determines the conditions of
price competition e.g. capacity choice or general investment
decisions
• Firm’s MC are constant but may vary between firms
• Assumes: Homogenous goods/ perfect substitutes, No capacity
constraints, Identical constant AC function & Linear, well-behaved
demand curve so the Demand is downward sloping (P’(Q) < 0) and not
too convex P’(Q) + Q.P’’(Q) < 0
• To find the Nash Equilibrium, need to find BR curves by differentiating
profit function with respect to quantity
o Profit Function:
▪ Firm i acts as a monopolist on its residual demand
o BR:
• With the BR, both firms form an expectation of rival’s quantity and
take it as fixed and then choose their own q to maximise profit
, • Firms with higher MC produce less (less efficient) than those with low
MC (efficient)
o Observed firm size distribution is reflection of underlying
efficiency difference
• BR depends on sum of rivals’ quantities: If another firm produces more
output, firm i will produce less output (strategic choices go in opposite
directions.
• If MC decreases, BR shifts out & starts producing more whilst
competitor produces less (indirect (strategic) effect) due to downward
sloping BR.
• Linear Cournot model with homogeneous goods: firm’s equilibrium
profits increase when firm becomes relatively more efficient than
rivals (ceteris paribus, when its marginal cost decreases or when the
marginal cost of any of its rivals increases)
Cournot • As firm number grows, Cournot equilibrium converges to perfectly
Competition competitive equilibrium.
as n grows • An increase in the number n of firms reduces each firm’s equilibrium
output q* (assuming constant costs) as
• A larger n increases aggregate output Q* = nq*and , if P(Q) < c for Q
sufficiently large, then P(Q*) → c as n → infinity as the mark-up falls
• Intuition: As the number of firms increases, each firm sees its
influence on the market price diminish and is therefore willing to
, expand its output & so the market price diminishes and prices
approach MC
Cournot • Cournot is not socially efficient because Lerner Index is positive BUT it
General is better than monopoly price & quantity levels (collusion)
Evaluation • There is a negative externality between firms: firm i takes into account
only the adverse effect of market price change on its own output
when choosing its output & not the aggregate output
o Therefore, each firm chooses output that exceeds the optimal
output from the industry’s PoV but not from a welfare PoV
• In real settings, we observe price setting which makes it hard to
provide a literal interpretation of Cournot competition BUT market
clearing of large quantities may be organised by an auctioneer (but
these don’t really exist)
Stackelberg • Stackelberg: Sequential model of quantity competition- Firm 1 sets
Competition quantity based on what Firm 2’s BR is that will allow it to maximise
profits
o Leaders produce more and followers less
• Stackelberg supplies the marketplace with largest amount of output
and with smallest market profits = better for social welfare.
o It provides a piece of info missing in Cournot- the order of the
players.
o This allows Cournot to be more “abusive” against the
consumers and charge a higher price.
, Comparisons
between
Cournot-Nash-
Stackelberg &
Collusion
Equilibriums
The Bertrand • Assumptions (which can be criticised): No capacity constraints (each
Trap firm can supply the entire market), One-shot game (no scope of
reactive pricing), Perfect product substitutability
• n firms compete on prices for a homogenous product with a
downward sloping inverse market demand P(Q), constant marginal
costs and consumers only buy from firms with the lowest price
• BR calculated by differentiating profit function with respect to price
• Assuming firms have same MC, the unique pure-strategy equilibrium is
both set prices equal to MC, p= c as, for all other price combinations,
there is at least one firm with an incentive to deviate.
• No firm enjoys any market power, and both make zero profits. Two
firms are sufficient to induce perfectly competitive outcome as both
correctly anticipate what the other firm will set
• Upward Sloping BR Curves due to strategic complementarity
• Complementarity runs the risk of price wars: if one firm decreases
price, other follows
Asymmetric • Firms have different costs due to different technologies (patents)
Costs &
