Firm A will determine the output of Firm B, hold it constant, and then determine the remainder of the market demand for toasters. Firm A will then determine its profit-maximizing output for that residual demand as if it were the entire market, and produce accordingly. Firm B will be conducting similar calculations with respect to Firm A at the same time. The Bertrand model describes interactions among firms that compete on price.
Firms set profit-maximizing prices in response to what they expect a competitor to charge. The model rests on the following assumptions:. Pricing just below the other firm will obtain full market demand, though this choice is not optimal if the other firm is pricing below marginal cost, as this would result in negative profits. If Firm B is setting the price below marginal cost, Firm A will set the price at marginal cost.
If Firm B is setting the price above marginal cost but below monopoly price, then Firm A will set the price just below that of Firm B. If Firm B sets the price above monopoly price, Firm A will set the price at monopoly level.
Bertrand Duopoly : The diagram shows the reaction function of a firm competing on price. Imagine if both firms set equal prices above marginal cost. Each firm would get half the market at a higher than marginal cost price. However, by lowering prices just slightly, a firm could gain the whole market. As a result, both firms are tempted to lower prices as much as they can.
However, it would be irrational to price below marginal cost, because the firm would make a loss. Therefore, both firms will lower prices until they reach the marginal cost limit. According to this model, a duopoly will result in an outcome exactly equivalent to what prevails under perfect competition.
Colluding to charge the monopoly price and supplying one half of the market each is the best that the firms could do in this scenario. However, not colluding and charging the marginal cost, which is the non-cooperative outcome, is the only Nash equilibrium of this model. The accuracy of the Cournot or Bertrand model will vary from industry to industry. If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. If output and capacity are difficult to adjust, then Cournot is generally a better model.
A cartel is an agreement among competing firms to collude in order to attain higher profits. Cartels usually occur in an oligopolistic industry, where the number of sellers is small and the products being traded are homogeneous. Cartel members may agree on such matters are price fixing, total industry output, market share, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits.
Each member of a cartel would be able to make a higher profit, at least in the short-run, by breaking the agreement producing a greater quantity or selling at a lower price than it would make by abiding by it. However, if the cartel collapses because of defections, the firms would revert to competing, profits would drop, and all would be worse off. Whether members of a cartel choose to cheat on the agreement depends on whether the short-term returns to cheating outweigh the long-term losses from the possible breakdown of the cartel.
It also partly depends on how difficult it is for firms to monitor whether the agreement is being adhered to by other firms.
If monitoring is difficult, a member is likely to get away with cheating for longer; members would then be more likely to cheat, and the cartel will be more unstable. In members of OPEC reduced their production of oil. In the mid s, however, OPEC started to weaken.
Around the same time OPEC members also started cheating to try to increase individual profits. Privacy Policy. Skip to main content. Search for:. Oligopoly in Practice. Collusion and Competition Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable.
Key Takeaways Key Points Firms in an oligopoly may collude to set a price or output level for a market in order to maximize industry profits.
At an extreme, the colluding firms can act as a monopoly. Oligopolists pursuing their individual self-interest would produce a greater quantity than a monopolist, and charge a lower price. Collusive arrangements are generally illegal. Moreover, it is difficult for firms to coordinate actions, and there is a threat that firms may defect and undermine the others in the arrangement.
Price leadership, which occurs when a dominant competitor sets the industry price and others follow suit, is an informal type of collusion which is generally legal. Key Terms Price leadership : Occurs when one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following.
Game Theory Applications to Oligopoly Game theory provides a framework for understanding how firms behave in an oligopoly. The outcome of this situation is uncertain. How should a prisoner proceed? One way is to work through all of the possible outcomes, given what the other prisoner chooses.
This is called a Dominant Strategy , since it is the best choice given any of the strategies selected by the other player. If they could only cooperate, they could both be better off with much lighter sentences of three years.
A second example of a game is the decision of whether to produce natural beef or not. Natural beef is typically defined as beef produced without antibiotics or growth hormones. The definition is difficult, since it means different things to different people, and there is no common legal definition.
There are two players in the game: Cargill and Tyson. Each firm has two possible strategies: produce natural beef or not. In this game, profits are made from the premium associated with natural beef. If only one firm produced natural beef,. Dominant Strategy for the Natural Beef Game. Both firms choose to produce natural beef, no matter what, so this is a Dominant Strategy for both firms.
The outcome of this game demonstrates why all beef processors have moved quickly into the production of natural beef in the past few years, and are all earning higher levels of profits.
If all oligopolists in a market could agree to raise the price, they could all earn higher profits. Collusion, or the cooperative outcome, could result in monopoly profits. In the USA, explicit collusion is illegal.
For example, if gas stations in a city such as Manhattan, Kansas all matched a higher price, they could all make more money. However, there is an incentive to cheat on this implicit agreement by cutting the price and attracting more customers away from the other firms to your own gas station. Firms in a cooperative agreement are always tempted to break the agreement to do better. The Nash Equilibrium calculated for the three oligopoly models Cournot, Bertand, and Stackelberg is a noncooperative equilibrium, as the firms are rivals and do not collude.
In these models, firms maximize profits given the actions of their rivals. Module: Oligopoly. Search for:. Reading: Collusion or Competition? Collusion versus cartels: How can I tell which is which? Licenses and Attributions. CC licensed content, Shared previously.
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