Oligopoly and Industrial Organization

OligopolyandIndustrialOrganizationElmarWolfstetter1March1996Humboldt{UniversitatzuBerlinInstitutf.WirtschaftstheorieWirtschaftswissenschaftlicheFakultatSpandauerstr.110178Berlin,Germanye{mail:[e-mail]1ResearchsupportbytheDeutscheForschungsgemeinschaft(DFG),Sonder-forschungsbereich373,\QuantikationundSimulationOkonomischerProzesse,Humboldt{UniversitatBerlin,isgratefullyacknowledged.CommentsbyUweDul-leck,WalterElberfeld,PeterKuhbier,BerndLucke,andPeterLutzaregratefullyacknowledged.AbstractThisisachapterofabookmanuscriptentitledTopicsinMicroeconomics.Comments,criticismandrecommendationsarewelcome.Thechapterstartswithanelementaryintroductiontothethreebasicoligopolytheories,asso-ciatedwiththenamesofCournot,BertrandandStackelberg.Thesetheoriesarethencoveredindepth,includinggeneralizations,extensionstoentry,exit,andcapacitychoice,andapplications.ThechapterconcludeswithajusticationoftheCournotmodelfromamoreplausiblemultistagegamethatbuildsuponEdgeworth’smodelofcapacityconstrainedpricecompeti-tion.Thechapterisrestrictedtothebasic,completeinformationtheoryofoligopoly.Theroleofincompleteinformationinoligopolytheoryiscoveredinaseparatechapter.filename:oligo-p.tex1\Whereareyougoing?\ToMinsk.\Shameonyou!YousaythistomakemethinkyouaregoingtoPinsk.ButIhappentoknowyouaregoingtoMinsk.|AJewishAnecdote11IntroductionHavinglookedatperfectcompetitionanditsantipode,monopoly,itisabouttimetoturntomorerelevantmarkets.Mostoftheproductsthatwebuyaremanufacturedbyrmsthathaveonlyfewcompetitors.Forexample,thereareonlyahandfulofdierentbrandsofautomobiles,householddeter-gents,breakfastcereals,andevencannedtomatosoup,tonamejustafew.Typically,inmostmarketsasmallnumberofsupplierscompeteforalargenumberofpotentialbuyers.Amarketenvironmentthathasfewsuppliersbutmanybuyersiscalledan‘oligopoly’.Insuchanenvironment,eachbuyertakesmarketconditionsasgiven,buteachsellerisawarethathisactionshaveasignicantimpactuponhisrivals’payos,andviceversa.Apartfromlargermswhoseproductsaretradedallovertheentireeconomy,evensmallrmsareoftenpartofoligopolies.Manymarketsaregeographicallylocalized,composedofmoreorlessinsulatedmarketareas.Localbanks,supermarkets,barsandrestaurantsinsmallcommunitiesorontheUniversitycampusareacaseinpoint.Mostpeopleliveinsmalltowns,suburbsorvillages.Therefore,theimportanceofsmallsizeoligopoliesshouldnotbeunderrated.GametheoreticfoundationsComparedtoacompetitivermoranuncontestedmonopoly,thetypicaloligopolistfacesaconsiderablycomplicateddecisionproblem.Strategicin-terdependencyistheissue.Whenaprice{takeroramonopolistdetermineshisoptimalsupplyorfactordemand,hemayfaceataskthatiscomplicatedenough,butatleastheneednotbeconcernedwithhowotherssolvesimilardecisionproblems.Notsotheoligopolist.Hecannotmakeagooddecisionunlesshedoesagoodjobanticipatingthedecisionsofallrivalrms.Hence,eacholigopolistfacesthedoublecomplicatedtasktosolvehisowndecisionproblem,andatthesametimeformrationalexpectationsabouthowrivalsdoit.1QuotedfromRapoport,A.[1974].Fights,Games,andDebates.UniversityofMichi-ganPress.filename:oligo-p.tex2Atrstglance,theseproblemsseemtoleadintoahopelesscycleofcir-cularreasoning,ofthekind:\ifyoudothis,thenIdothat,butthenyoudotheother,etc.:::.Luckily,gametheorytaughtushowtoavoidthistrap.Keymethodologicalconceptsare:noncooperativegames,underimperfectandcompleteinformation,andthesolutionconceptsknownas:noncooperativeNashequilibrium,self{enforcingagreement.Agameiscallednoncooperative,ifitsplayerscannotwritebindingagree-ments,becausetheyhavenoaccesstoanexternalenforcementmechanism.Usually,oligopolygamesareviewedasnoncooperative,becauseoligopolistscannotusethemachineryoflawenforcementtoenforcecartelagreements,simplybecausetheseareprohibitedbyantitrustlaw.2Anoncooperativeoligopolygameisoneunderimperfectinformationifeacholigopolistchooseshisstrategywithoutknowinghisrivals’choices.Also,wesaythatitissubjecttocompleteinformationifeachrmknowsthemarketdemandandthecostfunctionsofallrms,ifeachrmknowsthateveryoneelseknowsallofthis,andknowsthateveryoneelseknowsthatthisrmsknows,etc.3Thefundamentalsolutionconceptofnoncooperativegamesisthatofaself{enforcingagreement.Suppose,forthemoment,thatoligopolistsmakeanagreement,constrainedbyantitrustlaw.Sincenoexternalen-forcementmechanismisavailable,suchanagreementisuselessunlessev-eryonehasabuilt{inincentivetosticktoit,ifeverybodyelseupholdstheagreement.Agreementsthathavethiskindofbootstrappropertyarecalledself{enforcing.Acloselyrelated|andinsimpleone{stagegamesidentical|conceptisthatofanoncooperativeNashequilibrium.Forthetimebeingwewillnotdistinguishbetweenthetwo,untilwedealwithmorecomplicatedmultistagegames.Analternativeinterpretationofthesolutionconceptthatdoesnotassumecommunicationandagreementsisintermsofself{fulllingexpectations.In2Thisrulehas,however,moreexceptionsthanyoumaythink.IntheU.S.manyformerlyregulatedindustrieswerederegulatedduringtheReaganyears,butinothercountries,likeinGermany,industriesliketelecommunications,insurance,publicutilitiesandairtransportationareexemptfromthedomainofant