CHAPTER SIXTEEN

Oligopoly
OLIGOPOLY
 It is the study of strategic market interactions
with only a few sellers.

 Firms might offer similar or homogenous products,

or product differentiation.

 Strategic behavior in oligopoly:

A firm’s decisions about P or Q depends on its beliefs
about other firms’ decisions.
A firm knows that its decisions can affect other firms
and cause them to react. The firm will consider
these reactions when making its decisions.
OLIGOPOLY
 How do we analyze markets in which the supplying
industry is oligopolistic?

 Consider the duopolistic case of two firms supplying

the same product.
OLIGOPOLY
 Game theory is a good way of studying
oligopoly.

 Game theory models strategic behavior

by agents who understand that their
actions affect the actions of other
agents.
WHAT IS A GAME?
A game consists of
 a set of players
 a set of strategies for each player
 the payoffs to each player for every possible
list of strategy choices by the players.
Game Theory Components
Players: agents participating in the game (You and Your
friend

Strategies: Actions that each player may take under any

possible circumstance (soccer game, ballet)

Outcomes: The various possible results of the game

(four, each represented by one cell of the payoff matrix)

Payoffs: The benefit that each player gets from each

possible outcome of the game (the profits entered in
6
each cell of the payoff matrix)
AN EXAMPLE OF A TWO-PLAYER GAME
Player B

L R

U (3,9) (1,8) This is the

game’s
Player A payoff matrix.
D (0,0) (2,1)

Player A’s payoff is shown first.

Player B’s payoff is shown second.

7
OLIGOPOLY
 Game theory is a good way of studying
oligopoly.
 It analyzes oligopoly decisions as if they were
games by looking at,
 Rules players must follow
 Payoffs they are trying to achieve
 Strategies they can use to achieve them
OLIGOPOLY
 Oligopoly theories
 Cournot (1838) → quantity competition
 Bertrand (1883) → price competition
 Not competing but complementary theories
 Relevant for different industries or
circumstances
OLIGOPOLY
 Oligopoly theories
 Cournot (1838) → quantity competition
 Bertrand (1883) → price competition
 Not competing but complementary theories
 Relevant for different industries or circumstances
COURNOT – BASIC SET-UP
▪ Two firms
• assumed to be profit-maximizers
• each is fully described by its cost function

▪ Price of output determined by demand

• determinate market demand curve
• known to both firms
▪ Each chooses the quantity of output
• single homogeneous output
• neither firm knows the other’s decision when making its own
• firms choose quantity simultaneously

▪ Each firm makes an assumption about the other’s

decision
• firm 1 assumes firm 2’s output to be a given number
• likewise for firm 2
▪ How do we find an equilibrium?

11
COURNOT MODEL FRAMEWORK

 There are two firms, each firm produces yi level

 Aggregate output is Y=y1+y2

 The unified market price associated with Y is

determined p(Y)=p(y1+y2)
 Each firm has its cost function ci(yi)

 Firm’s 1 profit maximization problem;

max Π 1 (y 1 ; y 2 ) = p(y 1 + y 2 )y 1 − c 1 (y 1 ).
y1
COURNOT MODEL FRAMEWORK

 The profit function of firm 1 signifies that its

profits depend on the amount of firm 2’s output,
which in turn mean that firm 1 has to expect,
forecast and have some beliefs about firm 2’s
output decision.
 This way, a Cournot model is like a one-shot
game
 Firms’ profits are their payoffs
 Firms’ outcome is the possible strategies firms might
take
COURNOT MODEL FRAMEWORK
 Assuming an interior optimum for each firm, this
means that a Nash Cournot equilibrium must
satisfy the two first-order conditions:

 Π1  p(y 1 + y 2 ) 
= p(y 1 + y 2 ) + y 1 − c1 (y1 ) = 0
 y1  y1
 Π1  p(y 1 + y 2 ) 
= p(y 1 + y 2 ) + y 2 − c 2 (y1 ) = 0
 y2  y2
 The second-order conditions for both firms should
be less than or equal to 0.
COURNOT MODEL FRAMEWORK

 This equilibrium is called “Nash equilibrium”.

 A pure strategy Nash equilibrium is a set of

outputs (y1*, y2*) in which each firm is choosing
its profit-maximizing output level given its
beliefs about the other firm’s choice, and each
firm’s beliefs about the other firm’s choice are
actually correct.

15
COURNOT MODEL FRAMEWORK

 The 1st order condition for firm 1 determines

firm1’s optimal output as a function of its beliefs
about firm2’s output choice.

 This relationship is known as firm1’s reaction

curve “shows how firm 1 will react given various
beliefs it might have about firm2’ choice.
COURNOT MODEL FRAMEWORK

 Assuming sufficient regularity,

 Π 1 (f1 (y 2 ), y 2 )
0
 y1
where f1(y2) is the reaction curve.
OUTPUT CHANGE DUE BELIEFS CHANGE
 How would firm1 optimally change its output as
its beliefs about firm2’s output changes?

 2 Π 1 (f1 (y 2 ), y 2 )  y 1 y 2
f1(y 2 ) = − 2 0
 Π 1 (f1 (y 2 ), y 2 )  y 12

 This is simply the slope of the reaction curve.

 Is the reaction curve’s slope positive or negative?
 The denominator is negative
 The mixed partial nominator could be negative or
positive;
18
NOTE!!!!
 If the mixed partial is negative, goods 1 and 2 are
strategic substitutes.
 If the mixed partial is positive, goods 1 and 2 are
strategic complements.

 However, it is natural to assume that the mixed

partial is negative because y1 and y2 are different
outputs for the same products, so they are
substitutes.

19
FIRMS’ REACTION CURVES

 Suppose the inverse demand function is linear, so

the slope of firm1’s reaction curve is negative.
The intersection
is the Cournot
Nash equilibrium
NASH EQUILIBRIUM
 Inequilibrium, each player chooses a
strategy that gives him the highest payoff,
given the strategy chosen by the other
player(s) in the game ("rational self-
interest").
 It
occurs when each player's strategy is
optimal given the strategies of all other
players. So, beliefs of both players are
mutually consistent.
A play of the game where each strategy is
a best reply to the other.
NASH EQUILIBRIUM
 A natural consistency requirement is that each
player’s beliefs about the other player’s choices
coincides with the actual choices of the other
player intends to make.
 Expectations that are consistent with actual
frequencies are rational expectations.
NASH EQUILIBRIUM
 In Nash Equilibrium, there is no unilateral
profitable deviation from any of the players
involved.
 It is self-enforcing; when players are at a Nash
Equilibrium they have no desire to move because
they will be worse off.
 A dominant strategy solution is a Nash
Equilibrium, but not vise versa.
NASH EQUILIBRIUM
 It consists of probability beliefs over strategies (π r , π c ) ,
and probability of choosing strategies ( p r ,p c ), such that:
1. Beliefs are correct

p r =  r and p c =  c  r and c
2. Each player is choosing pr and pc, so as to maximize his
expected utility given his beliefs.
COURNOT STABILITY SYSTEM
 What is about this model in dynamic terms?
 In this case, there is a learning process in which
each firm refines its beliefs about the other firm’s
behavior by observing its actual choice of output.
COURNOT MODEL’S ASSUMPTIONS:
1. Each firm suppose that the other firm will not
change its observed output level.
so, in general, the firm output choice of firm i in
period t is
y ti = f i(y tj−1 ); where i  j representi ng firms
This gives a difference
equation in output that
traces out a “cobweb” .
COURNOT STABILITY SYSTEM
 In this case, the firm1’s reaction curve is steeper
than firm 2, and the cobweb converges to the
Cournot Nash equilibrium.
 So this is a stable equilibrium.

 But, if firm1’s reaction curve is flatter than firm

2, equilibrium is unstable.
COURNOT STABILITY SYSTEM
ALTERNATIVELY,
 Suppose firms adjust their outputs aiming at
increasing their profits, assuming that the other
firm keeps its output fixed.

where alphas’ coefficients represent the speed of

adjustment.
INTERPRETATION OF COURNOT DYNAMICAL
SYSTEM

 Consider firm 1, this dynamical system indicates

that if at the previous period, the market did not
reach an equilibrium and assuming firm2’s
output remains constant, if firm1 can increase its
profits by increasing its output, it will increase it.

 The speed (alpha coefficient) with which the

firm1 reacts to such a situation and increases its
output level is what will determine its profit.

 If both firms think the same and both increase

their output, the firm that will succeed to
increase its profits is the one that has a higher
speed of adjustment parameter and can increase
its output level faster.
COURNOT MODEL: N FIRMS
 The first order-condition for firm i; where i=1,2,3,…,n;

p(Y ) + p(Y ) yi = ci( yi )

 Rearrange to get it in terms of elasticity;

 dp yi 
p (Y ) 1 +  = ci ( yi )
 dY p 
let s i = yi Y
 si 
p (Y ) 1 +  = ci ( yi )
 
where  is the elasticity of market demand.
COURNOT MODEL: N FIRMS
 This equation shows that the Cournot model is
between the monopoly and perfect competitive
markets, according to si.
 If si =1, we have monopoly condition

 If si approaches 0, Cournot equilibrium

approaches perfect competition.

31
COURNOT MODEL: N FIRMS
 There are two special cases: first, assume firms has
constant marginal cost of ci.
 Adding the equation across all n firms;
n n
np(Y ) + p(Y ) yi =  ci ( yi )
i =1 i =1
n
np(Y ) + p(Y )Y =  ci
i =1
 Hence, industry output depends on the sum of MC and
not their distribution across firms.
COURNOT MODEL: N FIRMS
 Second, consider the same MC for all firms, then
in a symmetric equilibrium si=1/n;

 1 
p (Y ) 1 +  =c
 n 
 In addition, if elasticity is constant, the price is a
constant markup on marginal cost.
 If n approaches infinity, price must approach the
MC.
QUANTITY COMPETITION; PRICE DETERMINATION

▪ Now take output quantity as the firms’ choice

variable
▪ Price is determined by the market once total
quantity is known
COLLUSION
COLLUSION
 It is a market structure when an industry reaches an
open or secret agreement to
 fix price
 divide up or share the market
 or other ways of restricting competition b/w themselves.

 A cartel is an organization of firms and countries that

openly or secretly acts together to control industry prices.
Collusion is any other action taken by firms to coordinate
prices in order to maximize their joint profit.
COLLUSION
Why collude?
 removes uncertainty
 no price wars
 increase profits
 barrier to entry
 Types of collusion
 Explicit
 centralised cartel (OPEC)
 Implicit
 price leadership model
COLLUSION
 Difficulties:
 Difference in cost structures
 Large number of firms in the market
 Cheating
 Falling demand
 Legal barriers
COLLUSION
 Q: Are the Cournot-Nash equilibrium profits the
largest that the firms can earn in total?
COLLUSION
y2
(y1*,y2*) is the Cournot-Nash
equilibrium.
Are there other output level
pairs (y1,y2) that give
higher profits to both firms?
y2*

y1* y1
COLLUSION
y2
(y1*,y2*) is the Cournot-Nash
equilibrium.
Are there other output level
pairs (y1,y2) that give
higher profits to both firms?
y2*

y1* y1
COLLUSION
y2
(y1*,y2*) is the Cournot-Nash
equilibrium.
Are there other output level
pairs (y1,y2) that give
higher profits to both firms?
y2*

y1* y1
COLLUSION
y2
(y1*,y2*) is the Cournot-Nash
equilibrium.
Higher P2

y2* Higher P1

y1* y1
 COLLUSION
y2

Higher P2

y2*
y2’
Higher P1

y1* y1
y1’
 COLLUSION
y2

Higher P2

y2*
y2’
Higher P1

y1* y1
y1’
 COLLUSION
y2
(y1’,y2’) earns
Higher P2 higher profits for
both firms than
y2*
does (y1*,y2*).
y2’
Higher P1

y1* y1
y1’
COLLUSION
 So there are profit incentives for both firms to
“cooperate” by lowering their output levels.
 This is collusion.

 Firms that collude are said to have formed a

cartel.
 If firms form a cartel, how should they do it?
COLLUSION: OUTPUT DETERMINATION
 Suppose the two firms want to maximize their
total profit and divide it between them. Their
goal is to choose cooperatively output levels y1
and y2 that maximize the industry joint profit
function;

Π c (y 1 , y 2 ) = p(y 1 + y 2 )(y 1 + y 2 ) − c 1 (y 1 ) − c 2 (y 2 )

48
COLLUSION: OUTPUT DETERMINATION
 The first order conditions are

 This means that firms must equate their

marginal cost of production to each other in
collusion.

49
COLLUSION
 The firms cannot do worse by colluding since they
can cooperatively choose their Cournot-Nash
equilibrium output levels and so earn their Cournot-
Nash equilibrium profits. So collusion must
provide profits at least as large as their
Cournot-Nash equilibrium profits.
 COLLUSION
y2
(y1’,y2’) earns
Higher P2 higher profits for
both firms than
y2*
does (y1*,y2*).
y2’
Higher P1

y1* y1
y1’
 COLLUSION
y2
(y1’,y2’) earns
Higher P2 higher profits for
both firms than
y2*
does (y1*,y2*).
y2’
y2” Higher P1
(y1”,y2”) even
earns
higher profits for
y1” y1* y1
both firms.
y1’
COLLUSION EQUILIBRIUM STABILITY
 Is such a cartel stable?
 Does one firm have an incentive to cheat on the
other?
COLLUSION
y2
~1,y~2) maximizes firm 1’s
(y
profit, while leaving firm
2’s profit at the Cournot-
Nash equilibrium level
(same isoprofit curve for
y2*
firm 2).

~
y2

y1* y1
~
y1
COLLUSION
y2 ~ ~
(y1,y2) maximizes firm 1’s profit
while leaving firm 2’s profit at
the Cournot-Nash equilibrium
level.
y2* _ _
_ (y1,y2) maximizes firm
y2
~
y
2’s profit while leaving
2
firm 1’s profit at the
Cournot-Nash
equilibrium level.
_
y1 ~ y*
1 1 y

y1
COLLUSION
y2

The path of output pairs that

maximize one firm’s profit
while giving the other firm at
y2* least its CN equilibrium
_ profit.
y2
~
y2

_
y2 ~ y*
1 y1

y1
 The path of output
COLLUSION pairs that maximize
y2
one firm’s profit while
giving the other firm
at least its CN
equilibrium profit.
y2*
One of these output
_ pairs must maximize
y2 the cartel’s joint
~
y2 profit. The tangency
point of both
firms’ isoprofit curves.
_
y2 ~ y*
1 y1

y1
COLLUSION • (y1m,y2m) denotes the
y2 output levels that
maximize the cartel’s total
profit.
• It is at the tangency point
of both firms’ isoprofit
y2*
curves.
y2m

y1m y1* y1
COLLUSION EQUILIBRIUM STABILITY
 Does one firm have an incentive to cheat on the
other?
 I.e. if firm 1 continues to produce y1m units, is it
profit-maximizing for firm 2 to continue to
produce y2m units?
 Firm 2’s profit-maximizing response to y1 = y1m is
y2 = R2(y1m).

59
 COLLUSION
y2
y1 = R1(y2), firm 1’s reaction curve

y2 = R2(y1m) is firm 2’s

best response to firm
R2(y1m)
1 choosing y1 = y1m.
y2m

y2 = R2(y1), firm 2’s

reaction curve

y1m y1
COLLUSION
 Firm 2’s profit-maximizing response to y1 = y1m is
y2 = R2(y1m) > y2m.
 Firm 2’s profit increases if it cheats on firm 1 by
increasing its output level from y2m to R2(y1m).
 Similarly, firm 1’s profit increases if it cheats
on firm 2 by increasing its output level from y1m
to R1(y2m).

61
COLLUSION
y2
y1 = R1(y2), firm 1’s reaction curve

y2 = R2(y1m) is firm 2’s

best response to firm
1 choosing y1 = y1m.
y2m

y2 = R2(y1), firm 2’s

reaction curve

y1 m R1(y2m) y1
COLLUSION
 So a profit-seeking cartel in which firms
cooperatively set their output levels is fundamentally
unstable.
 e.g. OPEC’s broken agreements.
COLLUSION: CHEATING
 Hence, when firm 1 cheats and produces more
than agreed output by some small amount dy1,
assuming that firm 2 will stick with the cartel
agreement, the change on firm 1’s profits,
evaluated at the cartel solution is:
COLLUSION: CHEATING
 If one firm believes the other firm will stick to the
cartel agreement, it has an incentive to deviate
and cheat.

 Even, its beliefs the other firm to cheat and

produce more, it has an incentive to produce
more than its agreed-quota given that it has a
higher speed of adjustment.
HOW TO PUNISH CHEATER?
 Suppose firm 1 announces that if firm 2 increases
its output by dy2, then firm 1 will respond by
increasing its output (change) by dy1=(y1/y2)dy2.
 If firm 2 believes this threat, then the expected
profit from this change is

 If firm 2 expects this response from firm 1, it will

not deviate from the cartel agreement.
HOW TO PUNISH CHEATER?
 Suppose an asymmetric market shares between
firms.
 Suppose firm 1 produce twice as much as firm 2
in the cartel equilibrium (agreement),
Then, firm 2 would expects firm 1 to punish its
cheating by producing twice as much as its rival
(change).
On the other hand, if firm 1 cheats, firm 2 can
only threat and punish by producing half of its
rival’s output change.
GAME THEORY
 Repeated Games
 Most real-world games get played repeatedly.
 Repeated games have a larger number of
strategies because a player can be punished for
not cooperating.
 This suggests that real-world duopolists might
find a way of learning to cooperate so they can
enjoy monopoly profit.
 The larger the number of players, the harder it
is to maintain the monopoly outcome.
REPEATED OLIGOPOLY GAMES
 If the Cournot game is considered in repeated
game setup,
 The cooperative game is the cartel solution
 The punishment is the Cournot output choice.
 Hence, the strategies supporting the cartel
solution are of the following form: choose the
cartel output unless your opponent cheats, if he
cheats choose the Cournot output.
COLLUSION AND REPEATED GAMES
 Many models of oligopoly give at least reasonably
competitive outcomes in a one-shot game. Knowing that the
game is only played once, players have incentive to increase
output or cut prices in order to increase market share. How
then can we explain concerns about collusive or cartel
behavior?
 In the real world, firms are constantly interacting with each
other over time, making pricing decisions on an annual,
monthly, weekly daily or even shorter basis (eg electricity
market bids every 20 minutes).
 There is much more scope for all kinds of behavior in such a
repeated context. In particular, firms may be able to
sustain collusive behavior in a repeated setting because
they have the ability to punish deviation from a collusive
strategy in future periods.
 Now, its not worth always undercutting the other player,
because they can punish you in future periods.
EXAMPLE
QUANTITY COMPETITION; AN EXAMPLE
 Suppose that the market inverse demand
function is
p( yT ) = 60 − yT
and that the firms’ total cost functions are

c1 ( y1 ) = y12 and c 2 ( y 2 ) = 15 y 2 + y 22 .
QUANTITY COMPETITION; AN EXAMPLE
Then, for given y2, firm 1’s profit function is
2
P( y1 ; y 2 ) = ( 60 − y1 − y 2 ) y1 − y1 .
QUANTITY COMPETITION; AN EXAMPLE
Then, for given y2, firm 1’s profit function is
2
P( y1 ; y 2 ) = ( 60 − y1 − y 2 ) y1 − y1 .
So, given y2, firm 1’s profit-maximizing
output level solves
P
= 60 − 2y1 − y 2 − 2y1 = 0.
 y1
QUANTITY COMPETITION; AN EXAMPLE
Then, for given y2, firm 1’s profit function is
2
P( y1 ; y 2 ) = ( 60 − y1 − y 2 ) y1 − y1 .
So, given y2, firm 1’s profit-maximizing
output level solves
P
= 60 − 2y1 − y 2 − 2y1 = 0.
 y1  Π
= 60 − 4y 1 − y 2 = 0.
 y1
I.e., firm 1’s best response to y2 is
1
y1 = R1 ( y 2 ) = 15 − y 2 .
4
QUANTITY COMPETITION; AN EXAMPLE
y2
Firm 1’s “reaction curve”
1
60 y1 = R1 ( y 2 ) = 15 − y 2 .
4

15 y1
QUANTITY COMPETITION; AN EXAMPLE

Similarly, given y1, firm 2’s profit function is

2
P( y 2 ; y1 ) = ( 60 − y1 − y 2 ) y 2 − 15 y 2 − y 2 .
QUANTITY COMPETITION; AN EXAMPLE

Similarly, given y1, firm 2’s profit function is

2
P( y 2 ; y1 ) = ( 60 − y1 − y 2 ) y 2 − 15 y 2 − y 2 .
So, given y1, firm 2’s profit-maximizing
output level solves
P
= 60 − y1 − 2y 2 − 15 − 2y 2 = 0.
 y2
QUANTITY COMPETITION; AN EXAMPLE
Similarly, given y1, firm 2’s profit function is
2
P( y 2 ; y1 ) = ( 60 − y1 − y 2 ) y 2 − 15 y 2 − y 2 .
So, given y1, firm 2’s profit-maximizing
output level solves
P
= 60 − y1 − 2y 2 − 15 − 2y 2 = 0.
 y2 Π
= 45 − y 1 − 4y 2 = 0.
 y2
I.e., firm 2’s best response to y1 is
45 − y1
y 2 = R 2 ( y1 ) = .
4
QUANTITY COMPETITION; AN EXAMPLE
y2

Firm 2’s “reaction curve”

45 − y1
y 2 = R 2 ( y1 ) = .
4
45/4

45 y1
QUANTITY COMPETITION; AN EXAMPLE
 An equilibrium is when each firm’s output level is
a best response to the other firm’s output level,
for then neither wants to deviate from its output
level.
 A pair of output levels (y1*,y2*) is a Cournot-Nash
equilibrium if

y = R 1 (y ) and y*2 = R 2 ( y*1 ).

*
1
*
2
 QUANTITY COMPETITION; AN EXAMPLE
*
* * 1 *
y1 = R1 ( y 2 ) = 15 − y 2 45 − y
and y*2 = R 2 ( y*1 ) = 1.
4 4
 QUANTITY COMPETITION; AN EXAMPLE
*
* * 1 *
y1 = R1 ( y 2 ) = 15 − y 2 45 − y
and y*2 = R 2 ( y*1 ) = 1.
4 4
Substitute for y2* to get
1  45 − y*
y*1 = 15 −  1
4 4 
 QUANTITY COMPETITION; AN EXAMPLE
*
* * 1 *
y1 = R1 ( y 2 ) = 15 − y 2 and y*2 = R 2 ( y*1 ) = 45 − y1.
4 4
Substitute for y2* to get
1  45 − y*
y*1 = 15 −  1  y*1 = 13
4 4 
45 − 13
Hence *
y2 = = 8.
4
 QUANTITY COMPETITION; AN EXAMPLE
*
* * 1 *
y1 = R1 ( y 2 ) = 15 − y 2 45 − y1
and * *
y 2 = R 2 ( y1 ) = .
4 4
Substitute for y2* to get

1 45 − y1*
y1 = 15 − 
*   y*1 = 13
4 4 
45 − 13
Hence *
y2 = = 8.
4
So the Cournot-Nash equilibrium is
* *
( y1 , y 2 ) = ( 13,8 ).
QUANTITY COMPETITION; AN EXAMPLE
y2 Firm 1’s “reaction curve”
1
60 y1 = R1 ( y 2 ) = 15 − y 2 .
4
Firm 2’s “reaction curve”
45 − y1
y 2 = R 2 ( y1 ) = .
4
Cournot-Nash equilibrium
( )
45/4
8 y*1 , y*2 = ( 13,8 ) .
13 15 45 y1

Is the Cournot-Nash equilibrium stable?

QUANTITY COMPETITION
Generally, given firm 2’s chosen output
level y2, firm 1’s profit function is
P 1 ( y1 ; y 2 ) = p ( y1 + y 2 ) y1 − c 1 ( y1 )
and the profit-maximizing value of y1 solves
 P1  p( y1 + y 2 ) 
= p( y1 + y 2 ) + y1 − c1 ( y1 ) = 0.
 y1  y1
The solution, y1 = R1(y2), is firm 1’s
Cournot-Nash reaction to y2.
QUANTITY COMPETITION
Similarly, given firm 1’s chosen output
level y1, firm 2’s profit function is
P 2 ( y 2 ; y1 ) = p ( y1 + y 2 ) y 2 − c 2 ( y 2 )
and the profit-maximizing value of y2 solves
 P2  p( y1 + y 2 ) 
= p( y1 + y 2 ) + y 2 − c 2 ( y2 ) = 0.
 y2  y2
The solution, y2 = R2(y1), is firm 2’s
Cournot-Nash reaction to y1.
QUANTITY COMPETITION
y2 Firm 1’s “reaction curve” y1 = R1 ( y 2 ).
Firm 1’s “reaction curve” y 2 = R 2 ( y1 ).

Cournot-Nash equilibrium
*
y2 y1* = R1(y2*) and y2* = R2(y1*)

y*1 y1
 CONCLUSION
 Oligopoly is the study of strategic market interactions
with only a few sellers.
 Game theory is a good way of studying oligopoly, as it
models strategic behavior by agents who understand that
their actions affect others’ actions.
 Oligopoly theories are focusing on either price (Bertrand) or
quantity (Cournot) competition.
 In the Cournot model, the profits of one firm depend on the
amount of the other firms’ output, which in turn mean that
each firm has to expect, forecast and have some beliefs about
other firms’ output decision.
 The equilibrium in Cournot model is called “Nash
equilibrium”, where it is a set of outputs (y1*, y2*) in which
each firm is choosing its profit-maximizing output level given
its beliefs about the other firm’s choice, and each firm’s 90

beliefs about the other firm’s choice are actually correct.

 CONCLUSION
 In Cournot dynamic model, there is a learning process in
which each firm refines its beliefs about the other firm’s
behavior by observing its actual choice of output.
 In case of several firms, the Cournot model is between the
monopoly and perfect competitive markets.
 If there are profit incentives for firms to “cooperate” by
lowering their output levels. This is collusion. Firms that
collude are said to have formed a cartel
 A cartel is an organization of firms and countries that openly
or secretly acts together to control industry prices. Collusion
is any other action taken by firms to coordinate prices in
order to maximize their joint profit.
 Collusion must provide profits at least as large as the firms’
Cournot-Nash equilibrium profits.
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 CONCLUSION
 A profit-seeking cartel in which firms cooperatively set their
output levels is fundamentally unstable, as if one firm
believes the other firm will stick to the cartel agreement, it
has an incentive to deviate and cheat.

 Even, if it beliefs the other firm to cheat and produce more, it

has an incentive to produce more than its agreed-quota given
that it has a higher speed of adjustment.

 In order to make cartel outcome viable, some way must be

found to stabilize the market, by finding an effective
punishment for firms that cheat on the cartel agreement.

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REFERENCE
 Varian, Hal “Advanced Microeconomic”. Chapter
16 “Oligopoly”.