If the firms have small levels of market power, then the deadweight loss and excess capacity inefficiencies are likely to be small. Second, the benefit provided by monopolistic competition is product diversity. The gain from product diversity can be large, as consumers are willing to pay for different characteristics and qualities. Therefore, the gain from product diversity is likely to outweigh the costs of inefficiency. Evidence for this claim can be seen in market-based economies, where there is a huge amount of product diversity.
The next chapter will introduce and discuss oligopoly: strategic interactions between firms! An oligopoly is defined as a market structure with few firms and barriers to entry. There is often a high level of competition between firms, as each firm makes decisions on prices, quantities, and advertising to maximize profits. Thus, there is a continuous interplay between decisions and reactions to those decisions by all firms in the industry.
Each oligopolist must take into account these strategic interactions when making decisions. Since all firms in an oligopoly have outcomes that depend on the other firms, these strategic interactions are the foundation of the study and understanding of oligopoly.
If Ford lowers prices relative to other car manufacturers, it will increase its market share at the expense of the other automobile companies.
When making decisions that consider the possible reactions of other firms, firm managers usually assume that the managers of competing firms are rational and intelligent. These strategic interactions form the study of game theory, the topic of Chapter 6 below. John Nash , an American mathematician, was a pioneer in game theory.
Economists and mathematicians use the concept of a Nash Equilibrium NE to describe a common outcome in game theory that is frequently used in the study of oligopoly. In the study of oligopoly, the Nash Equilibrium assumes that each firm makes rational profit-maximizing decisions while holding the behavior of rival firms constant. This assumption is made to simplify oligopoly models, given the potential for enormous complexity of strategic interactions between firms.
The concept of Nash Equilibrium is also the foundation of the models of oligopoly presented in the next three sections: the Cournot, Bertrand, and Stackelberg models of oligopoly. Augustin Cournot , a French mathematician, developed the first model of oligopoly explored here. This is the basis for strategic interaction in the Cournot model: if one firm increases output, it lowers the price facing both firms.
The inverse demand function and cost function are given in Equation 5. This will result in a Nash Equilibrium, since each firm is holding the behavior of the rival constant. Firm One maximizes profits as follows. This is as far as the mathematical solution can be simplified, and represents the Cournot solution for Firm One. Oligopolists are interconnected in both behavior and outcomes. The two firms are assumed to be identical in this duopoly. The two reaction functions can be used to solve for the Cournot-Nash Equilibrium.
There are two equations and two unknowns Q 1 and Q 2 , so a numerical solution is found through substitution of one equation into the other.
This is the Cournot-Nash solution for oligopoly, found by each firm assuming that the other firm holds its output level constant. The Cournot model can be easily extended to more than two firms, but the math does get increasingly complex as more firms are added. Economists utilize the Cournot model because is based on intuitive and realistic assumptions, and the Cournot solution is intermediary between the outcomes of the two extreme market structures of perfect competition and monopoly.
This can be seen by solving the numerical example for competition, Cournot, and monopoly models, and comparing the solutions for each market structure.
The competitive solution is given in Equation 5. The competitive, Cournot, and monopoly solutions can be compared on the same graph for the numerical example Figure 5. The Cournot price and quantity are between perfect competition and monopoly, which is an expected result, since the number of firms in an oligopoly lies between the two market structure extremes.
Assume two firms in an oligopoly a duopoly , where the two firms choose the price of their good simultaneously at the beginning of each period. Consumers purchase from the firm with the lowest price, since the products are homogeneous perfect substitutes. If the two firms charge the same price, one-half of the consumers buy from each firm. The Bertrand model follows these three statements:. A numerical example demonstrates the outcome of the Bertrand model, which is a Nash Equilibrium.
Firm Two has the lower price, so all customers purchase the good from Firm Two. After period one, Firm One has a strong incentive to lower the price P 1 below P 2. Firm One has the lower price, so all customers purchase the good from Firm One.
After period two, Firm Two has a strong incentive to lower price below P 1. The price cannot go lower than this, or the firms would go out of business due to negative economic profits.
The Bertrand results are given in Equation 5. The Bertrand model of oligopoly suggests that oligopolies are characterized by the competitive solution, due to competing over price. There are many oligopolies that behave this way, such as gasoline stations at a given location.
Other oligopolies may behave more like Cournot oligopolists, with an outcome somewhere in between perfect competition and monopoly. Heinrich Freiherr von Stackelberg was a German economist who contributed to game theory and the study of market structures with a model of firm leadership, or the Stackelberg model of oligopoly. A numerical example is used to explore the Stackelberg model.
Assume two firms, where Firm One is the leader and produces Q 1 units of a homogeneous good. Firm Two is the follower, and produces Q 2 units of the good. This model is solved recursively, or backwards. Mathematically, the problem must be solved this way to find a solution.
All of this is shown in the following example. This is the reaction function of the follower, Firm Two. We have now covered three models of oligopoly: Cournot, Bertrand, and Stackelberg. By signing up, you agree to our Terms of Use and Privacy Policy. Forgot Password? This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy.
By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy. Popular Course in this category. Course Price View Course. Free Investment Banking Course. These two cases provide examples of markets that are characterized neither as perfect competition nor monopoly. Instead, these firms are competing in market structures that lie between the extremes of monopoly and perfect competition. How do they behave? Why do they exist?
We will revisit this case later, to find out what happened. Perfect competition and monopoly are at opposite ends of the competition spectrum. A perfectly competitive market has many firms selling identical products, who all act as price takers in the face of the competition.
If you recall, price takers are firms that have no market power. They simply have to take the market price as given. Skip to main content. This service is more advanced with JavaScript available. Advertisement Hide. Authors Authors and affiliations Frank Livesey. This is a preview of subscription content, log in to check access. Bain, J. CrossRef Google Scholar. Cambridge, Mass. Batchelor C. Google Scholar.
Baumol W. Bothwell, J. Brown-Humes, C. Brozen, Y. Carlton, D. Caves, R. Clarke, R. Collins, N. Berkeley: University of California Press.
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