Industrial

Organization
Chapter 15
Slides by Pamela L. Hall
Western Washington University
2005, Southwestern

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
2

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

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
4

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

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

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

Maximizing Profit

Assume costs and revenue depend on

dollar measure of extent of product differentiation
A measure of advertising expenditures
q output
Objective of firm is to maximize profit

F.O.C.s are

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

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

10

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

11

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

12

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
13

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 selfregulatory 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

14

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

15

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

16

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
17

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 Qd 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 QD

Firms competitors prices do change

18

Figure 15.1 Long-run equilibrium for

a monopolistically competitive firm

19

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 Qd

demand curve
Instead, firm will sell lesser output associated with QD curve

Since response of price to an output change by one firm will be less

when all other prices are fixed

QD demand curve will be more inelastic than Qd 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 Qd curve and
Qd and QD curves intersect

Results in equilibrium output qe and price pe

At this tangency point, firm cannot vary output to enhance its profit

20

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, QD 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

21

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

22

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

23

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-thanmaximum 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
24

Price and Output Determination

Let p denote a common selling price

q1 and q2 are output of first and second firm, respectively
Determine common selling price, p, by total market output of
the two firms, Q, where q1 + q2 = Q
Then, p = p(Q)
An increase in either output will result in a decrease in price

p q1 < 0, p q2 < 0

Total revenue for jth firm is then

TRj = p(Q)qj, j = 1, 2,

Total cost for jth firm is

j(qj)

Assuming firms objectives are maximizing their own profit, profit for
each firm is
25

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 (q1*, q2*) 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

26

Price and Output Determination

Assuming an interior optimum for each firm, F.O.C. for firm

1, using product rule for differentiation, is
1/q1 = p(Q*) + (p(q)/q1)q*1 MC(q*1) = 0
Employing chain rule for second term on right-hand side,
where Q is a function of q1 and q2 and q2 is a function of q1,
yields

This results in

27

Price and Output Determination

The F.O.C. for firm 2 is

To solve F.O.C.s for optimal level of outputs, q1* and q2*, we require the
functional forms of

dq2/dq1 and dq1/dq2

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

28

Cournot Model

Developed by French mathematician Augustin Cournot in 1838

Assumes conjectural variations are zero

dq2 dq1 = dq1 dq2 = 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, q2) 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

29

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

30

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 = qj/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

31

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 = q1 + q2 is combined output of the two firms

Cost functions for these firms are

STC1 = cq1 + TFC and STC2 = cq2 + 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

32

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(q1 + q2) bq1 c = 0

Solving for q1 gives
q1 = (a c bq2)/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

q2 = (a c bq1)/2b
Reaction functions are illustrated in Figure 15.2

Cournot equilibrium level of outputs for firms 1 and 2 result at their intersection

33

Figure 15.2 Cournot equilibrium

34

Cournot Model, Perfect

Competition, and Monopoly

Nash equilibrium can be found by substituting firm 2s

reaction function into firm 1s and solving for q1

Substituting this equilibrium level of output, q1C into firm 2s reaction

function yields Nash equilibrium output for firm 2

35

Cournot Model, Perfect

Competition, and Monopoly

Market output, QC, and price, pC, are

36

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(q1 + q2)]q1 cq1 TFC = aq1 bq21 q1q2 cq1 - 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 q2 increases

37

Figure 15.3 Dynamic adjustment

to the Cournot equilibrium

38

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 q2
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

39

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 q1 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 q2

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

40

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

41

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
q2 = (a c bq1)/2b
Firm 1s conjectural variation is
q2 q1 = -b 2b = -1/2
Given F.O.C. associated with firm 1
1/ q1 = a b(q1 +q2) bq1 + bq1 c = 0
Reaction curve for firm 1 is

a bq1 bq2 bq1 + bq1 - c = 0

3/2bq1 = a c bq2
q1 = (a c bq2)/(3/2)b

42

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/q1 = a b(q1 +q2) bq1 + bq1 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

qS1 = (a c)/2b, qS2 = (a c)/4b

43

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(q1 + q2) bq1 + bq1 c = a b(q1 + q2) bq2
c

-bq1 + bq1 = -bq2

bq1 = bq2

q1 = q2

44

Stackelberg Model

Substituting this solution into firm 1s reaction function results in solution

for firm 1

a b(q1 + q1) - bq1 c = 0

a bq1 - bq1 - bq1 c = 0
a 2bq1 c = 0
qS1 = (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

45

Figure 15.4 Stackelberg equilibria

and disequilibrium

46

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

47

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
/q1 = /q2 = a b(q1 + q2) b(q1 + q2) c = 0
Solving for Q = (q1 + q2) gives
Q = (q1 + q2) = (a c)/2b
Firms set total output equal to the monopoly solution
Then determine how to divide this output among themselves

48

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)

q1 = q2 = (a c)/4b

49

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 cheating each firm has a profit incentive to cheat

50

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

51

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

52

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

53

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
qj = qj(p1p2), j = 1, 2,

An increase in p1 lowers quantity demanded q1 and raises q2

q1/p1 < 0 and q2/p1 > 0

An increase in p2 has the reverse effect

54

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
55

Imperfect Oligopoly

As an example, consider again firms 1 and 2 and assume

each firm faces the following linear demand functions
q1 = a bp1 + dp2, q2 = a bp2 + dp1
Where q1 and q2 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/p1 = a 2bp1 + dp2 = 0

56

Imperfect Oligopoly

Solving for p1 results in firm 1s reaction function to a change in firm 2s price

p1 = a/2b + d/2bp2

Similarly, maximizing profit for firm 2, holding firm 1s price constant, yields Firm 2s
reaction function

p2 = a/2b + d/2bp1
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 p1* = p2* an equilibrium is obtained

57

Figure 15.5 Bertrand equilibrium

58

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 4bpJ + 4dpJ = 0 so

pJ = 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

59

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
60

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

61

Table 15.1 Market Structures

62

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

63

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

64

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

65

Table 15.2 Cartel

66

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

67

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

68