OligopolySlide 2Features of oligopolyMeasures of seller concentrationSlide 5Slide 6Seller interdependencePrice-Output Determination in Oligopolistic Market StructuresDominant firm price leadershipThe modelFigure 10.1: Dominant Firm Price LeadershipExampleSlide 13Cournot Model1AssumptionsSlide 16Monopoly caseFinding equilibriumSlide 19Best reply functionSlide 21Slide 22Cournot duopoly solutionImplications of the modelTheory of 2 demand curvesSlide 26Slide 27Which demand curve is relevant?Slide 29Slide 30Slide 31Marginal cost can vary in a wide range and the results do not changeOligopolyOutline:•Salient features of oligopolistic market structures.•Measures of seller concentration•Dominant firm oligopoly•Rivalry among symmetric firms (The Cournot model) •The kinked demand curveOligopoly is a market structure featuring a small number of sellers that together account for a large fraction of market sales.Oligopoly is derived from the Greek work “olig” meaning “few” or “a small number.”Features of oligopoly•Fewness of sellers•Seller interdependence•Feasibility of coordinated action among ostensibly independent firmsMeasures of seller concentrationThe concentration ratio is the percentage of total market sales accounted for by an absolute number of the largest firms in the market.The four-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top four firms in the market.The eight-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top eight firms in the market.Industry or ProductCR4CR8Refrigerators 94 98Motor vehicles 94 98Soft drinks 94 97Long distance telephone 92 97Laundry machines 91 NABreakfast foods 88 93Vaccuum cleaners 80 96Running shoes 79 97Beer 77 94Aircraft engines 72 83Domestic air flights 68 82Tires 66 86Aluminum 64 88Soap 60 73Pet food 52 71Concentration Ratios: Very Concentrated IndustriesSource: U.S. Bureau of the Census, Census of ManufacturersIndustry or ProductCR4CR8Fast food 44 57Personal computers 45 63Office furniture 45 59Toys 41 58Bread 34 47Lawn equipment 40 57Machine tools 30 44Paint 24 36Newspapers 22 34Furniture 17 25Boat building 14 22Concrete 8 12Women's dresses 6 10Concentration Ratios: Less Concentrated IndustriesSource: U.S. Bureau of the Census, Census of ManufacturersSeller interdependence•If Kroger offers deep discounts on soft drinks, will Wal-Mart follow suit?•Northwest Airlines “perks” miles do not expire—how did United, Delta, et al react?•Verizon carries unused minutes over the to next month—implications for Cingular, et. al.?•Some ISP’s now pledge not to sell information to database companies—will this affect AOL? •Alcoa’s decision to add production capacity is conditioned upon the investment plans of rival aluminum producers.Price-Output Determination in Oligopolistic Market StructuresWe have good models of price-output determination for the structural cases of pure competition and pure monopoly. Oligopoly is more problematic, and a wide range of outcomes is possible.Dominant firm price leadership•This is a system of price-output determination we sometimes see in oligopolistic market structures in which there is one firm that is clearly dominant.•General Motors was once the price leader in the U.S. auto industry.•Other “dominant” firms include Du Pont in chemicals, US Steel (now USX), Phillip Morris, Fedex, Boeing, General Electric, AT&T, and Hewlett Packard.The modelThe dominant firm sets the market price and remaining firms sell all they wish at this price.The demand curve for the price leader is found by subtracting the market demand curve from the supply curve of the remaining sellers in the market.Figure 10.1: Dominant Firm Price LeadershipP'P*dLneader'set demandIndustry demandSupply curvefor small firmsDSdMCMRQ*QsDollars per Unit of OutputOutputDP* is the price established by the dominant firmQ* + QSExampleLet the market demand curve be given by:QD = 248 – 2PThe supply curve for 10 small firms in the market is given by:QS = 48 + 3PThe dominant firm’s “residual” or net demand curve is given by the market demand curve minus the supply of the 10 other firms, or:Q = QD – QS = 248 – 2P – (48 + 3P) = 200 – 5PThe inverse (residual) demand curve facing the dominant firm is given by:P = 40 - .2QAssume the dominant firm has a marginal cost function given by:MC = .1QThe dominant firm would maximize its own profits by setting MR = MC. To derive the MR, find the revenue (R) function and take the first derivative with respect to Q:R = P • Q = (40 - .2Q)Q = 40Q - .2Q2MR = dR/dQ = 40 - .4QNow set MR = MC and solve for Q40 - .4Q = .1Q.5Q = 40  Q = 80 Units  P = 40 – (.2)(80) = $24At the price established by the dominant firm, the remaining 10 firms collectively supply 120 units (or 12 units each).Cournot Model11 Augustin Cournot. Research Into the Mathematical Principles of the Theory of Wealth, 1838•Illustrates the principle of mutual interdependence among sellers in tightly concentrated markets--even where such interdependence is unrecognized by sellers.•Illustrates that social welfare can be improved by the entry of new sellers--even if post-entry structure is oligopolistic.Assumptions1. Two sellers2. MC = $403. Homogeneous product4. Q is the “decision variable”5. Maximizing behavior Let the inverse demand function be given by:P = 100 – Q [1]The revenue function (R) is given by:R = P • Q = (100 – Q)Q = 100Q – Q2 [2]Thus the marginal revenue (MR) function is given by:MR = dR/dQ = 100 – 2Q [3]Let q1 denote the output of seller 1 and q2 is the output of seller 2. Now rewrite equation [1]P = 100 – q1 – q2 [4]The profit ( ) functions of sellers 1 and 2 are given by:1 = (100 – q1 – q2)q1 – 40q1 [5] 2 = (100 – q1 – q2)q2 – 40q2 [6]Mutual interdependence is revealed by the profit equations. The profits of seller 1 depend on the output of seller 2—and vice versaMonopoly caseLet q2 = 0 units so that Q = q1—that is, seller 1 is a monopolist. Seller 1 should set its quantity supplied at the level corresponding to the equality of MR and MC. Let MR – MC = 0100 – 2Q – 40 = 02Q = 60  Q = QM = 30 unitsThusPM = 100 – QM = $70Substituting into equation [5], we find that: = $900Finding equilibriumQuestion: Suppose that seller 1 expects that seller 2