Both Cournot and Bertrand competition are modelled as strategic games. In addition, in both models a firm’s revenue is the product of a firms part of the market multiplied by the price. Furthermore, a firm incurs a production cost, which is dependant on its production level. In the simplest model of oligopolistic competition firms play a single game, where actions are taken simultaneously. All firms produce homogenous goods and demand for this good is linear and the cost of production is fixed per unit. In this market a Nash equilibrium in pure strategies exists in both the Cournot and Bertrand models. However, despite the many parallels between the models, the Nash equilibrium points are extremely different. In Bertrand competition, Nash equilibrium drives prices down to the same level they would be under perfect competition (p=MC), while in Cournot competition, the price at Nash equilibrium is unquestionably above the competitive level.
Part II. Cournot and Bertrand Competition In 1838 Augustin Cournot published ‘Recherches sur les Principes Mathematiques de la Theorie des Richesses’, a paper that laid out his theories on competition, monopoly, and oligopoly. However Joseph Louis François Bertrand concluded that Cournots equilibrium for duopoly firms was not accurate. He went on to argue ‘whatever the common price adopted, if one of the owners, alone, reduces his price, he will, ignoring any minor exceptions, attract all of the buyers, and thus double his revenue if his rival lets him do so’.
Cournot had originally arrived at his equilibrium by assuming that each firm took the quantity set by its competitors as given, evaluated its residual demand and then put its profit maximizing quantity on the market. Here, each firms profit function is stated in terms of the quantity set by all other firms. Next, Cournot would partially differentiate each firms profit function with respect to the original firms quantity then set each of the resulting expressions to zero. In the case of a duopoly, Cournot could plot the equations in rectangular coordinates. Here, equilibrium is established where the two curves intersect. By plotting the first order conditions for each firm (i.e. the profit maximizing output of each firm given the quantities set by rivals) Cournot was able to solve for functions that gave the best reaction for each firm depending on the other firms’ strategies. In game theory this is known as a ‘best response function’. At the intersection of the best response functions in Cournot competition, each firm’s assumptions about rival firm’s strategies are correct. In game theory this is know as a Nash equilibria.
Therefore in modern literature market rivalries based on quantity setting strategies are referred to ‘Cournot competition’ whereas rivalries based on price strategies are referred to as ‘Bertrand competition.’ In each model, the intersections of the best response functions are referred to ‘Cournot-Nash’ and ‘Bertrand Nash’ equilibria consecutively, representing a point where no firm can increase profits by unilaterally changing quantity (in the case of Cournot) or price (in the case of Bertrand). The major conflict between Bertrand and Cournot Competition therefore lies in how each one determines the competitive process which leads to different mechanisms by which individual consumers’ demands are allocated by competing firms. That is, Cournot assumes that the market allocates sales equal to what any given firm produces but at a price determined by what the market will bear, but Bertrand assumes that the firm with the lowest price is allocated all sales.
Being that Bertrand Competition and Cournot competition are both models of oligopolistic market structures, they both share many characteristics. Both models have the following assumptions; that there are many buyers, there are a very small number of major sellers, products are homogenous, there is perfect knowledge, and there is restricted entry. Nonetheless, despite their similarities, their findings pose a stark dichotomy. Under Cournot competition where firms compete by strategically managing their output firms are able to enjoy super-normal profits because the resulting Market price is higher than that of marginal cost. On the other hand, under the Bertrand model where firms compete on price, the limited competition is enough to push down prices to the level of marginal cost. The idea that a duopoly will lead to the same set of prices as perfect competition is often referred to as the ‘Bertrand paradox.’
In Bertrand competition, firms 1’s optimim price depends on where it believe firm 2 will set its prices. By pricing jus below the other firm it can obtain full market demand (D), while maximizing profits. However if firm 1 expects firm 2 to set price a price that is below marginal cost then the best strategy for firm 1 is to set price higher at marginal cost. In basic terms, firm 1’s best response function is p1?(p2). This provides firm 1 with the optimal price for ever possible price set by firm 2.
The diagram below shows firm 1’s reaction function p1?(p2), with each firms strategy show on both the axis’s. From this we can see that when p2 is less than marginal cost (i.e. firm 2 chooses to price below marginal cost), firm 1 will price at marginal cost (p1=MC). However, when firm 2 prices above marginal cost firm 1 sets price just below that of firm 2.
In this model both firms have identical costs. Therefore, firm 2’s reaction function is symmetrical to firm 1’s with respect to a 45degree line. The result of both firms strategies is a ‘Bertrand Nash equilibrium’ shown by the intersection of the two reaction functions. This represents a pair or strategies (in this case price strategies) where neither firm can increase profits by unilaterally changing price.
An essential Assumption of the Cournot model is that each firm will aim to maximize its profits based on the understanding that its own output decisions will not have an effect on the decisions of its rival firms. In this model price in a commonly know decreasing function of total output. Furthermore, each firm knows N, the total number of firms operating in the market. They take the output of other firms as given. All firms have a cost function ci(qi), which may be the same of different amongst firms. Market price is set at a level so that demand is equal to the total quantity produced by all firms and every firm will take the quantity set by its rivals as a given, evaluate its residual demand, and then behaves a monopoly.
Like in Bertrand competition, we can use a best response function to show the quantity that maximizes profit for a firm for every possible quantity produced by the rival firm. We observe a Cournot equilibrium when a quantity pair exists so that both firms are maximizing profits given the quantity produced by the rival.
Part III. Conclusion In reality, neither model is ‘more accurate’ than the other as there are many different types of industry. In some industries output can be adjusted quickly, therefore Bertrand competition is more accurate at describing firm behaviour. However, if output cannot be adjusted quickly because of fixed production plans (i.e. capacity decisions are made ahead of actual production) then quantity-setting Cournot is more appropriate.
The Oligopolistic Market Model Structure Of Opec Economics Essay
The main focus in this essay is to explain the characteristic of the Oligopoly Market Model and explain how the dynamics of the Oligopolistic market can influence the price of a product and different strategies used by firms together to create an inelastic demand for the product to optimize profits
The second part of the essay concentrates on how OPEC as organizations has control on the world’s Oil prices. Different scenarios are enumerated in the following report, where OPEC has used strategies to control the market and capitalized on the Oligopoly model
Table of Contents 1.0 Introduction Microeconomics entails the economic activity of consumers, producers or group of producers and consumers and the market in which they interact. It is study of buyers, sellers, prices and profits. Market economy refers to the developed and the industrialized economies in the world. Market economy is in which people specialize in the production of array of goods and services and meet their food and material needs through exchange. (Simley)
Market economies can vary based on the supply and demand and it is the best determinant to analyze the Market. While most of the developed nations can be classed as having a mixed economies because they allow market forces to drive most of their activities like the government interactions in order to provide stability
There are a number of market structures like: Perfect Competition Model; Monopolistic Model; Monopoly and Oligopoly with each having their own characteristics for the economists to understand why each business behaves differently in that market. However the objective of this assignment is to understand what happens in Oligopoly market structure.
The latter part of the assignment, we are going to analyze how the OPEC is acting as oligopoly in the petroleum industry and the impact it has on the oil prices and how it has impacted the economy of the world.
2.0 Characteristics of the Oligopoly Market Model An oligopoly is a market dominated by a few producers, each of them has control over the market. The word ‘Oligopoly’ is derived from Greek words oligio, meaning ‘few’ and polein, meaning ‘to sell’. The few leading dominant firms have a high level of market concentration in the Oligopoly structure. Oligopoly is best defined by the behavior of the firms within a market than its market structure. Generally an oligopoly exists when the few leading firms have nearly 60% of the market share and when the demand is inelastic and accounts for the maximum sales.
2.1 Main features of an oligopoly Although there is no definite method to predict how firms determine the price and the output in Oligopoly, but generally an oligopoly exhibits the following features:
Product branding: Each firm in the market sells a differentiated product and has its own niche in the market.
Entry barriers: There are significant entry barriers for smaller firms in an oligopoly market, which prevents the dilution of competition in the long run and maintain enomorous amount of supernormal profits for the dominant firms. Smaller firms generally operate on the periphery of the market, but is not significant enough to make the impact on output and market prices.
Interdependent decision-making: Dominant firms collude with each other and determine the price and taken into account the reaction of their rivals to change in market price or output
Non-price competition: Non-price competitions are a consistent characteristic of the competitive strategies of oligopolistic firms.
2.2 Types of oligopoly There are two types of Oligopoly namely collusive and un collusive oligopoly. In collusive oligopoly, Firms directly collude with each other and forms cartels to have a control on the market price. In Tacit collusion, firms have a mutual understanding to cut out competition. Price leadership is where the dominant firm has the power tro change the price and then the rest of the market follows suit. In un-collusive oligopoly Game Theory is used where the firm makes a strategic decision to either make immediate profits or destroy the rivals market share, which in turn has a huge effect on the market.
2.3 Pictorial representation of a firm and the Market in an Oligopoly http://rds.yahoo.com/_ylt=A2KJkK4Us69NsmAABdKjzbkF/SIG=122htrmi5/EXP=1303389076/**http:/www.foolonahill.com/mbaairoligopoly.jpg
2.4 The Kinked Demand Curve Theory: Paul Sweezy, an American, developed the Kinked Demand Curve Theory in the late 1930s. Normally in an oligopoly market the firms are in consensus to maintain a standard and constant price of the product, which creates inelastic demand and generates supernormal profits. If a firm decides to increase its price, without colluding or collaborating with the other dominant firms, the other firms in the market decides retain the same price. In this case the firm that has increased the price will soon lose its market share and a considerable amount of revenue. On the other hand, if that firm in the oligopoly market decides to lower its price, the other firms in the industry too will have to do the same to retain their market share and then all firms will lose its revenue. It is then better to remain at a constant price to avoid losing revenue or market share. This is what Price Rigidity means. If there is a change in the price , the demand curve will kink around the prevailing market price as it will undergo further stabilization of the price when the firms will take care of the changes in the cost. In the figure shown below, the MR curve is discontinuous because at ‘a____b’ there will be no change in demand as the production and the price is the same. When the cost increases, the marginal cost curve moves upward from MC 1 to MC 2 and the demand curve kinks. Thus the firm can maximize profit only at price P and quantity q.
Dollars per unit MC2 p Kink curve MR¢ MR D D¢ MC MC1 b a q q/t 0 The kinked demand curve model predicts periods of relative price stability under an oligopoly and businesses will focus on non-price competition to reinforce their market position and to boost sales , revenues and profit.
2.5 Aspects of Non-price competition strategies Non-price marketing strategies have two separate aspects :
Product differentiation strategy is used by firms to convince the buyers their products are different from those of competitors.
Product variation strategy involves in creating minimal variation to the product to attract buyers
Non-price competition also involves huge amount of advertising and marketing strategies like special packaging, promotional events, sponsorship, having a Brand ambassador for the product, which will boost the brand image to attract demand and generate brand loyalty among consumers.
2.6 Price leadership Many economists, such as Stigler (1947b) , Bain ( 1960) have described various type of price leadership. These have been classified by Scherer (1970) into three types: dominant, collusive and barometric price leadership. The dominant type is considered to describe where the dominant firms, which are larger in size and has the major chunk of market share establishes the price leadership position and the other minor firms being the followers . In the collusive type, the principal firms set prices, which are then followed by the other minor firms and the price level is rather monopolistic than competitive. Scherer ( 1970 p170 ) has stated that the price leaders temper their price policies in order to suppress intra – industry conflicts in this case . Finally in the Barometric price leadership the price is set around the competitive level (Ono, Y. (n.d.). Price Leadership: A theortical Analysis. In Economica (pp. 49, 11-20). Musashi University).
2.7 Explicit collusion under oligopoly ( Behaviour of a Cartel ) In the collusive Price leadership, in order to curb market uncertainty, dominant firms engage in some form of collusive behaviour and decide to engage in price fixing agreements or cartels. The aim of this is to maximise joint profits .This behaviour is considered as illegal by the UK and European competition authorities.
Collusion is often deemed as a desire to achieve joint-profit maximisation within a market, to control supply and to prevent price fluctuations in an industry.
It can be concluded that cartel as a whole is maximising profits, but the individual firm’s output is unlikely to be at their profit maximising point and if any of the firms breaks their agreement with the cartel, there will be excess supply in the market and sharp decline in the price.
Collusion in industry is easier to achieve when:
There are only a small number of firms in the industry.
Entry barriers are protected by larger firms
Demand is fairly inelastic in price and the market demand is not too variable
Output of the firms in the cartel is easily monitored and to keep a control on the total supply and it will be easy to identify if any of the firms are trying to cheat on their output quota
Most cartel arrangements experience difficulties and tensions among them and some producer cartels collapse completely . There are several factors that can create problems within a collusive agreement between suppliers:
Falling market demand during a slowdown or recession puts pressure on individual firms to reduce prices to gain profits or least maintain their revenue.
Exposure of illegal price fixing by market regulators
Vested interest: The firm in the cartel aims finds it profitable to raise its own production to gain more profits and not adhere to the cartel output quotas. Disputes among the cartel how to share out the profits. (Riley, 2006)
3.0 Analysis on OPEC’s strategy 3.1 OPEC and its objectives The Organization of the Petroleum Exporting Countries (OPEC) is a intergovernmental organization, consisting of 12 oil producing and exporting countries. The members are Algeria, Angola, Ecuador, the Islamic Republic of Iran, Iraq, Kuwait, the Socialist People’s Libyan Arab Jamahiriya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates