Chapter 9

Basic Oligopoly Models

 Learning Objectives

Explain Explain how beliefs and strategic interaction shape optimal decisions in oligopoly environments.

Identify the conditions under which a firm operates in a Sweezy, Cournot, Stackelberg, or
Identify Bertrand oligopoly, and the ramifications of each type of oligopoly for optimal pricing decisions,
output decisions, and firm profits.

Apply reaction (or best-response) functions to identify optimal decisions and likely competitor
Apply responses in oligopoly settings.

Identify the conditions for a contestable market and explain the ramifications for market power
Identify and the sustainability of long-run profits.
 Conditions for Oligopoly
• Oligopoly market structures are characterized by only a few firms, each
of which is large relative to the total industry.
– Typical number of firms is between 2 and 10.
– Products can be identical or differentiated.
• An oligopoly market composed of two firms is called a duopoly.
• Oligopoly settings tend to be the most difficult to manage since
managers must consider the likely impact of his or her decisions on the
decisions of other firms in the market.
Strategic Interaction: A Firm’s Demand Depends on
Actions of Rivals (Figure 9-1)

Price
Demand if rivals
C match price changes

Demand if rivals do not

A
B match price changes
𝑃0

Demand2
Demand1

0 𝑄0 Output
 Sweezy Oligopoly
The Sweezy model is based on a very specific assumption regarding how
other firms will respond to price increases and price cuts.
Sweezy oligopoly characteristics:
• There are few firms in the market serving many consumers.
• The firms produce differentiated products.
• Each firm believes its rivals will cut their prices in response to a price
reduction but will not raise their prices in response to a price increase.
• Barriers to entry exist.
 Sweezy Oligopoly (Figure 9-2)
Price

Sweezy Demand MC0

A
B
𝑃0
MC1
C Demand1
(rival holds price
constant)

E MR1
MR Demand2
(rival matches price change)

0 𝑄0 F Output
MR2
 Cournot Oligopoly
Cournot oligopoly characteristics
• There are few firms in the market serving many consumers.

• The firms produce either differentiated or homogeneous products.

• Each firm believes rivals will hold their output constant if it changes its
output.
• Barriers to entry exist.
 Cournot Oligopoly: Reaction Functions
Consider a Cournot duopoly. Each firm makes an output decision under
the belief that its rival will hold output constant when the other
changes its own output level.
– Implication: Each firm’s marginal revenue is impacted by the other firm’s output
decision.

The relationship between each firm’s profit-maximizing output level is

called a best-response or reaction function.
 Cournot Oligopoly:
Reaction Functions Formula
Given a linear (inverse) demand function
𝑃 = 𝑎 − 𝑏 𝑄1 + 𝑄2
and cost functions, 𝐶1 𝑄1 = 𝑐1 𝑄1
𝐶2 𝑄2 = 𝑐2 𝑄2
the reaction functions are:
𝑎 − 𝑐1 1
𝑄1 = 𝑟1 𝑄2 = − 𝑄2
2𝑏 2
𝑎 − 𝑐2 1
𝑄2 = 𝑟2 𝑄1 = − 𝑄1
2𝑏 2
 Cournot Reaction Functions (Figure 9-3)
Quantity2

Firm 1’s Reaction Function

𝑄1 = 𝑟1 𝑄2

𝑄2 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦
Cournot equilibrium
𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 C
Firm 2’s Reaction Function
D A 𝑄2 = 𝑟2 𝑄1
B

𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀𝑜𝑛𝑜𝑝𝑜𝑙𝑦 Quantity1

Cournot Equilibrium: A situation in which neither firm has an incentive to

change its output given the other firm’s output.
Cournot Oligopoly: Isoprofit Curves
A function that defines the combinations of outputs produced by all firms that yield a
given firm the same level of profits.
Isoprofit Curves for Firm 1 (Figure 9-4)
1. Every point on a given isoprofit curve
yields Firm 1 the same level of
profits.
2. Isoprofit curves that lie closer to Firm
1’s monopoly output 𝑄1𝑀 are
associated with higher profits for that
firm.
3. The isoprofit curves for Firm 1 reach
their peak where they intersect Firm
1’s reaction function.
4. The isoprofit curves do not intersect
one another.
Firm 1’s Best Response to Firm 2’s Output
(Figure 9-5)
Quantity2

𝑟1 (Firm 1’s reaction function)

A B C D
∗ 𝑄2 ∗ is the output firm 1 thinks firm 2 will choose
𝑄2
𝜋1 𝐴
𝜋1 𝐵
𝜋1 𝐶

𝑀
𝑄1 𝐴 𝑄1 𝐵 𝑄1 𝐶 𝑄1 𝐷 𝑄1 Quantity1
 Firm 2’s Reaction Function and Isoprofit Curves
(Figure 9-6)

Quantity2

Monopoly point
for firm 2
𝑄2 𝑀
C G Firm 2’s profit increases as isoprofit
B curves move toward 𝑄2 𝑀
A
𝜋3 𝐶
𝜋2 𝐵 𝑟2 (Firm 2’s reaction function)
𝜋1 𝐴 F

Quantity1
 Cournot Equilibrium (Figure 9-7)
Quantity2
𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
r1

𝑄2 𝑀 Cournot Equilibrium

𝑄2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡

𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡

r2

𝑄1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡 𝑄1 𝑀 Quantity1
 Effect of Decline in Firm 2’s Marginal Cost
on Cournot Equilibrium (Figure 9-8)
Quantity2
𝑟1

F
∗∗
𝑄2
Due to decline in
firm 2’s marginal cost

E
𝑄2 ∗ 𝑟2 𝑟2 ∗∗

𝑄1 ∗∗ 𝑄1 ∗ 𝑄1 𝑀 Quantity1
 Cournot Oligopoly: Collusion

• Markets with only a few dominant firms can coordinate to restrict

output to their benefit at the expense of consumers.
- Restricted output leads to higher market prices.

• Such acts by firms are known as collusion.

• Collusion, however, is prone to cheating behavior.

- Since both parties are aware of these incentives, reaching collusive agreements is often very
difficult.
Incentive to Collude in a Cournot Oligopoly (Figure 9-9)
Incentive to Renege on Collusive Agreements in Cournot
Oligopoly (Figure 9-10)
 Stackelberg Oligopoly
Stackelberg oligopoly characteristics:
• There are few firms serving many consumers.
• Firms produce either differentiated or homogeneous products.
• A single firm (the leader) chooses an output before all other firms
choose their outputs.
• All other firms (the followers) take as given the output of the leader
and choose outputs that maximize profits given the leader’s output.
• Barriers to entry exist.
 Stackelberg Equilibrium (Figure 9-11)
Quantity Follower
𝜋2 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑟1 𝐿𝑒𝑎𝑑𝑒𝑟 𝜋2 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟

𝑟2 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟
𝑄2 𝑀
C
.

𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝜋1 𝐶𝑜𝑢𝑟𝑛𝑜𝑡
𝑄2 𝐹𝑜𝑙𝑙𝑜𝑤𝑒𝑟 S

𝜋1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟

𝑄1 𝑀 𝑄1 𝑆𝑡𝑎𝑐𝑘𝑒𝑙𝑏𝑒𝑟𝑔 𝐿𝑒𝑎𝑑𝑒𝑟 Quantity Leader

 Stackelberg Oligopoly:
Equilibrium Output Formulae
Given a linear (inverse) demand function
𝑃 = 𝑎 − 𝑏 𝑄1 + 𝑄2
and cost functions 𝐶1 𝑄1 = 𝑐1 𝑄1 and 𝐶2 𝑄2 = 𝑐2 𝑄2 .

– The follower sets output according to the reaction function

𝑎 − 𝑐2 1
𝑄2 = 𝑟2 𝑄1 = − 𝑄1
2𝑏 2
– The leader’s output is
𝑎 + 𝑐2 − 2𝑐1
𝑄1 =
2𝑏
 Stackelberg Oligopoly In Action: Problem
Suppose the inverse demand function for two firms in a homogeneous-product,
Stackelberg oligopoly is given by
𝑃 = 50 − 𝑄1 + 𝑄2
Cost functions for the 2 firms are
𝐶1 𝑄1 = 2𝑄1
𝐶2 𝑄2 = 2𝑄2
Firm 1 is the leader, and firm 2 is the follower.

– What is firm 2’s reaction function?

– What is firm 1’s output?
– What is firm 2’s output?
– What is the market price?
 Stackelberg Oligopoly In Action: Answer

1
The follower’s reaction function is: 𝑄2 = 𝑟2 𝑄1 = 24 − 𝑄
2 1

50+2−4
The leader’s output is: 𝑄1 = = 24
2

1
The follower’s output is: 𝑄2 = 24 − 24 = 12
2

The market price is: 𝑃 = 50 − 24 + 12 = $14

 Bertrand Oligopoly
Bertrand oligopoly characteristics
• There are few firms in the market serving many consumers.

• Firms produce identical products at a constant marginal cost.

• Firms engage in price competition and react optimally to prices charged by
competitors.
• Consumers have perfect information and there are no transaction costs.

• Barriers to entry exist.

 Bertrand Oligopoly: Equilibrium
• The conditions for a Bertrand oligopoly imply that firms in this market
will undercut one another to capture the entire market leaving the
rivals with no profit. All consumers will purchase at the low-price firm.

• This “price war” would come to an end when the price each firm
charged equaled marginal cost.

• In equilibrium, 𝑃1 = 𝑃2 = 𝑀𝐶.
– Socially efficient level of output.
 Comparing Oligopoly Models
Consider the following inverse market demand function:
𝑃 = 1,000 − 𝑄1 + 𝑄2
and the cost function for each firm in this market is identical, and given
by
𝐶𝑖 𝑄𝑖 = 4𝑄𝑖

Under these condition, the different oligopoly outputs, prices and profits
are examined.
 Comparing Oligopoly: Cournot
The Cournot oligopoly reaction functions are
1
𝑄1 = 498 −
2
1
𝑄2 = 498 −
2
These reaction functions can be solved for the equilibrium output. These
quantities can be used to compute price and profit.
– 𝑄1 = 𝑄2 = 332
– 𝑃 = $336
– 𝜋1 = 𝜋2 = $110,224
 Comparing Oligopoly: Stackelberg
The Stackelberg leader’s output is

1,000 + 4 − 2 × 4
𝑄𝑙𝑒𝑎𝑑𝑒𝑟 = = 498
2×1
1
𝑄𝑓𝑜𝑙𝑙𝑜𝑤𝑒𝑟 = 498 − × 498 = 249
2

• The market price is: 𝑃 = 1,000 − 498 − 249 = $253

• 𝜋𝑙𝑒𝑎𝑑𝑒𝑟 = $124,002
• 𝜋𝑓𝑜𝑙𝑙𝑜𝑤𝑒𝑟 = $62,001
 Comparing Oligopoly: Bertrand
Since 𝑃 = 𝑀𝐶, 𝑃 = $4

Total output is found by: $4 = 1,000 − 𝑄

– Solving yields: 𝑄 = 996
– Given symmetric firms, each firm gets half the market, or 498 units.
– 𝜋1 = 𝜋2 = $0
 Comparing Oligopoly: Collusion
Since the output associated with collusion is the same as monopoly
output, the inverse market demand function implies that monopoly
marginal revenue function is:
𝑀𝑅 = 1,000 − 2𝑄
Setting marginal revenue equal to marginal cost yields:
1,000 − 2𝑄 = 4

– Solving this: 𝑄 = 498 units. Each firm will produce half of these units.
𝑃 = 1,000 − 498 = $502
Each firm earns profits of $124,002