OLIGOPOLY
Managerial Economics
Lecturer: Jack Wu
SAMSUNG ELECTRONICS
Oligopoly: Market with a small number of sellers
who behave strategically
 Samsung
 How to adjust pricing and capacity as Korean
Won appreciates against U.S. dollar?

(c) 1999-2012, I.P.L. Png
2
OUTLINE
Price competition
 Limit pricing
 Capacity competition
 Capacity leadership

3
STRATEGIC VARIABLE FOR OLIGOPOLISTIC
SELLERS
In the short run, the strategic variable for
oligopolistic sellers is price.
 In the long run, the strategic variable for
oligopolistic sellers is production capacity.

PRICE COMPETITION

The outcome of oligopolistic competition on price
depends on whether the product is homogeneous
or differentiated.
BENCHMARK: MONOPOLY
PRICE COMPETITION:
HOMOGENEOUS PRODUCT
•
•
Simple Case: Duopoly in Wireless Telecommunication
Luna Cellular and Mercury Wireless
– Produce at constant marginal cost with unlimited
capacity
– Compete on price to sell a homogeneous product.
7
BERTRAND MODEL
•
•
•
Under these conditions, the market equilibrium
is perfectly competitive. Even though the
industry is duopoly, the outcome is the same as
with perfect competition. Demand curve is
infinitely elastic with respect to a price cut.
Extreme competition – selling undifferentiated
commodities
Game in strategic form – competing sellers set
prices simultaneously.
PRICE COMPETITION:
HOMOGENEOUS PRODUCT
Marginal cost = $30 per subscriber per month
 Suppose that Luna charges $32.
 Mercury has three choices:
 Price > $32: no customers
 Price = $32: split the market demand in half
 Price < $32: gain the whole market – the best
strategy.
 Nash equilibrium: Both sellers charge price = $30
(marginal cost).

9
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS
•
Case: Luna Cellular and Mercury Wireless
– Produce at constant marginal cost with unlimited
capacity
– Compete on price to sell a product differentiated by
distance from consumer.
– The price cutter’s demand is not infinitely elastic.
10
HOTELLING MODEL
•
•
•
Suppose that consumers are located uniformly
along a street one mile long, with the Luna and
Mercury dealers at each end of the street.
Assumption: Differentiation is due to the
difference in the consumer’s distances from the
two dealers. The competing products are
differentiated by location.
Game in strategic form – competing sellers set
prices simultaneously
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS
Residual demand: Demand given the actions of
competing sellers.
 Given Mercury's price and any price that Luna
could set
 Consumers relatively closer to Luna would buy
from Luna
 Consumers relatively closer to Mercury would
buy from Mercury
 Residual demand curve slopes downward
 If Luna raises price, some consumers (located
relatively far from Luna) would switch to
Mercury

12
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS
Luna’s profit maximum
 Produce at scale where residual marginal revenue =
marginal cost
 Set price accordingly – as function of Mercury’s
price
 Best response function: Seller’s best action as a
function of the actions of competing sellers.

14
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS
15
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS




In fact, Hotelling model applies to differentiation in terms
of any attribute on which consumers have differing
preferences.
“Transport cost” = consumer’s disutility from consuming
any attribute that differs from the ideal or most preferred=
strength of consumer preference
Extreme case: : zero transport cost => consumers consider
that products are homogeneous => Hotelling model
collapses to Bertrand model
Higher transport cost (stronger consumer preference)
 Residual demand more inelastic => higher price
 Best-response function shifts toward higher prices
 Nash Equilibrium: Higher prices
16
PRICE COMPETITION:
DIFFERENTIATED PRODUCTS
Higher demand
 Higher residual demand
 Best-response function shifts toward higher prices
 Nash Equilibrium: Higher prices
 Higher marginal cost
 Best-response function shifts toward higher prices
 Nash Equilibrium: Higher prices

17
STRATEGIC COMPLEMENTS
Strategic complements: Adjustment by one party leads
other parties to adjust in the same direction
 Hotelling model: Prices are strategic complements
 Best-response functions slope upward

18
LIMIT PRICING
What if one seller can act before others?
 Game in extensive form – competing sellers set prices
in sequence

19
LIMIT PRICING

Limit pricing
Entrant must incur fixed cost of production
 Set such price so low that potential competitor’s residual
demand is so low that potential competitor cannot break
even.

20
LIMIT PRICING
LIMIT PRICING
Luna’s average cost curve is “U” shaped because
of fixed cost
 Mercury (incumbent, first-mover) sets its price so
that:

•
Luna’s (entrant) residual demand curve is below its
average cost curve
LIMIT PRICING

Limit pricing – Necessary conditions
 Production requires substantial fixed cost
 Leader’s price must be credible
Potential competitors must believe that leader will not
change price if potential competitor enters
 For leader, must be more profitable to produce at
entry-deterring price than to accommodate entry and
produce an equal share with competitors.

23
CAPACITY COMPETITION:
HOMOGENEOUS PRODUCT
Luna Cellular and Mercury Wireless
 Produce at constant marginal cost
 Compete on capacity to sell a homogeneous product
 Game in strategic form – competing sellers set
capacities simultaneously
 Cournot Model: The market price equates the
demand with the total capacity offered by the two
providers.

24
CAPACITY COMPETITION:
HOMOGENEOUS PRODUCT
Residual demand: Demand given the actions of
competing sellers.
 Given Mercury’s capacity, Luna’s residual
demand curve slopes downward
 Luna’s profit maximum
 Produce at scale where residual marginal
revenue = marginal cost
 Set capacity accordingly – as function of
Mercury’s capacity

25
CAPACITY COMPETITION:
HOMOGENEOUS PRODUCT
CAPACITY COMPETITION:
HOMOGENEOUS PRODUCT
Best response function: Seller’s
best action as a function of the
actions of competing sellers.
CAPACITY COMPETITION:
HOMOGENEOUS PRODUCT
Higher demand
 Higher residual demand
 Best-response function shifts toward higher
capacity
 Nash Equilibrium: Higher capacities
 Higher marginal cost
 Best-response function shifts toward lower
capacity
 Nash Equilibrium: Lower capacities
 Seller with lower cost gains
 Directly, from lower cost
 (Strategic response) Forces competitor to
reduce capacity

28
STRATEGIC SUBSTITUTES
Strategic substitutes: Adjustment by one party leads
other parties to adjust in opposite direction
 Cournot model: Capacities are strategic substitutes
 Best-response functions slope downward

29
STRATEGIC COMPLEMENTS OR
SUBSTITUTES?

Generally , there may be either strategic
complements or strategic substitutes depending
on the relevant demand and cost conditions.
 Examples: Advertising & R&D
 Increased R&D spending can have a similar
effect to increasing capacity. On the other
hand, an increase in one seller’s R&D spending
may drive competitors to increase R&D as well,
particularly when they compete for patents. So,
R&D spending might be strategic complements
or strategic substitutes depending on
circumstances.
CAPACITY LEADERSHIP
What if one seller can act before others?
 Game in extensive form – competing sellers set
capacities in sequence
 Stackelberg model: Leader commits to capacity to
grab larger share.
 Trade-off

Larger market share => higher profit
 Larger total capacity (all producers) => Lower profit


Leader does not drive out competitor, simply
reduces the follower’s share
31
CAPACITY LEADERSHIP
CAPACITY LEADERSHIP
First mover advantage
 Necessary conditions -- Leader’s capacity must be
credible
 Potential competitors must believe that leader will
not change capacity if potential competitor enters
 For leader, must be more profitable to produce at
Stackelberg capacity than to accommodate entry
and produce an equal share with competitors.

33