MEE-303 UNIT: II

DR. H. R. PRAJAPATI
MMV. BHU
CONTENT

 Models of the Oil Market:

 Competitive Models:
a. Property Rights Model (Nationalization),
b. Supply Shocks Model,
c. Target Revenue Model.
 Non-Competitive Models:
a. OPEC Cartel model,
b. Oligopoly Model.
MODELS OF THE OIL MARKET:

 ‘There is much interesting literature on exploration for oil fields and on the
consequences of uncertainty about the size of reserves for the optimal extraction of
a resource pool, or for the behavior of a competitive industry.
 However, these elements are not typically embedded in theoretical models of the oil
market.
 Existing models have a much simpler structure: a certain number of countries own
pools of resources, of diverse sizes, that can be extracted at some cost.
 The most basic models try to understand how the owners of larger stocks would
exploit their market power.
CONTD.

 There are two types of Competitive Models and Non-Competitive Models oil
market models found in economic literature.
 The competitive models are again classified into three sub-categories; Property
Rights Model (Nationalization), Supply Shocks Model, and Target Revenue Model.
 Further Non-Competitive Models are also classified into two OPEC Cartel
model and Oligopoly Model.
 CONTD.

 In any market, before answering questions about market structure, economists try to
identify the competitive supply curve.
 In the case of the market for oil, the analysis of supply depends crucially on whether
or not we decide that oil is exhaustible.
 If oil is treated as a renewable resource, its supply price would simply be its marginal
production cost and the supply curve the marginal cost curve.
 This implies, among other things, that there is a well-defined, unique competitive
equilibrium, and that a price above marginal cost signals imperfect competition.
 CONTD.

 But if oil is treated as a non-renewable resource, as we think it should be, the problem is substantially
more complex as individual supply curves are determined by complex intertemporal optimization
problems, and
 The supply price (opportunity cost) in any period will differ from the marginal cost of production.
 The amount supplied will depend not only on the current price but also on future prices and on the
investment opportunities available to producers
 Two characteristics of the demand curve for oil have played an important role in the informal
literature on the oil market. First, the short-run elasticity is very low.
 A limited supply shock, such as the 1973 cutbacks by Arab producers, can lead to a sharp increase in
the spot market price.
 CONTD.

 The long-run elasticity is considerably larger due to the substitution of other energy
sources and conservation.
 Second, the demand for oil has a high-income elasticity, generally believed to be
around unity; everything else equal, the rate of growth of demand for oil is equal to
the rate of growth of world GNP.
 Rapid expansion in the world economy increased consumption in the industrialized
countries by 5.2% per year between 1965 and 1973
COMPETITIVE MODELS

 A competitive oil market is one where there is a large number of oil producers that compete with one
another to increase their oil sales and production.
 The basic assumptions of competitive models are; product homogeneity, no individual buyer or seller can dictate
the market
 Competitive’ models do not resort to restrictions on the behavior of individual countries imposed either by
explicit agreements, implicit agreements, or implied threats of retaliation.
 In one form or another other they argue that there is no excess supply at the high price.
 Most of these competitive descriptions of the oil market appeared in response to the apparent lack of output
restrictions by OPEC before 1982.
EXAMPLE

 Case Study – Oil Markets

 Consider the following producer theory model for a single firm producing oil, and the
aggregate supply and demand.What is the firm’s equilibrium price and quantity?
 To find the price, we look at the aggregate market, where supply = demand. In this case, we find the
intersection, labeled E1, occurs at a quantity of 50 million barrels/day and a price of $50/barrel.
 Remember that in order to maximize profits, the firm will produce until MB = MC.
 Since the market is perfectly competitive, MB = MC when P = MC.
 This means we must find where our price of $50 intersects our marginal cost curve.
 Looking at our producer theory diagram, we see that P = MC when the individual firm is producing 20
million barrels/day.
 This means our equilibrium price is $50 and our equilibrium quantity is 20 million barrels/day.
CONTD.
1- PROPERTY RIGHTS MODEL (NATIONALIZATION)

 The property rights model was developed in direct response to the 1973 price
increase.
 The countries have lower discount rates than the oil companies.
 Indeed, their rights to oil are more secure (companies fear nationalization), and,
because their access to capital markets is limited, they have less use for oil revenues.
 As a consequence, for a given price, the countries wish to produce less than the
companies, and the transfer of control over production during the 1960s shifted the
supply curve to the left.
 Thus the equilibrium price increased.
 CONTD.

 Mabro (1975b) was the first person who give the importance of property rights in oil
supply, and Johany (1980) and Mead (1979) developed the full model.
 Mabro pointed out that producers may want to increase the price if ‘present prices
diverge from expected future prices properly discounted.
 The oil price increase of 1973 may have been partly motivated by such considerations
and thus may be construed as an attempt by oil-producing countries to react to long-
term interests endangered by non-economic rates of production.’ (p. 14).
 For Mabro the ‘proper’ rate of discount is the rate reflecting the governments’
preferences, and ‘non-economic’ refers to rates of extraction that are too high.
CONTD.

 Johany (1980) emphasized the companies’ fear of expropriation as the source of

divergence between the rates of extraction of the companies and the governments.
 Implicitly, he argued that governments, living in an infinite horizon world, would want
to produce at the rate implied by the market rate of interest which exceeded the
rate at which the companies, fearing nationalization, discounted future profits from
their oil concessions.
 Mead (1979) noted that the change in control of oil resources also placed the
production decision in the hand of the parties with fewer opportunities for profitable
investment.
CONTD.

 Johany (1980) and Mead (1979) have identified an important determinant of supply:
property rights.
 However, these property rights are only one of the determinants of the incentives of
the suppliers, and the existing expositions have not dealt with the following problems:
 1. Before 1970, the governments did have some influence over production at the time
of renegotiation of the contracts.
 2. In the same period, the actual terms of the contracts and competition with other
governments actually gave the countries incentives to pressure companies to
increase production, contrary to the predictions of the model.
CONTD.

 Thus, in 1966, to gain a 20% increase in production, the Iranian Prime Minister
threatened the companies that, ‘We cannot stand by idly while our own oil resources
are kept unexploited underground and not utilized for the country’s development.’
(Stocking, 1970, p. 140, see also Adelman, 1982, p. 39).
 3. Although the property rights of the countries are permanent, some governments
have shorter horizons, as their tenure may be limited and uncertain.
 4. More careful attention should be paid to the timing of the first price increase.
 As noted the change in control over supply was gradual between 1970 and 1975,
whereas the price increase in December 1973 was very sudden.
 CONTD.

 In conclusion, the property rights hypothesis falls short of providing a complete

model of the oil market, while proposing a very interesting interpretation of the 1973
oil price revolution.
 Other equally important events, such as the price changes in 1979-80 and 1986,
cannot be explained by changes in control of supply, and require more detailed
modeling of the supply behavior of the governments.
 Nationalization of international oil companies was a
necessary condition to create a strong OPEC
 National vs. international oil companies within
OPEC 1960-1981
 Property Rights Model
 A lower discount
Price
rate implies a Supply - 2
longer time
horizon for the Supply - 1
exploitation of the P2
resource.
 Less will be
produced now to P1

the benefit of
more production Demand
tomorrow
Q2 Q1 Quantity
SUPPLY SHOCKS MODEL
 The supply shock model explains all oil price increases since 1973 by supply
disruptions (MacAvoy, 1982,Verleger, 1982a), and we label them supply shock models.
 These disruptions (the embargo and cutbacks of 1973, the Iranian oil strike of 1979,
and the Iran-Iraq war of 1980) are considered exogenous, consequences of
essentially political events.
 These models assume upward-sloping supply curves, and therefore, in contrast with
the backward-bending supply curve model, have only one equilibrium price for each
set of supply and demand curves.
 They explain price changes through shifts in these curves, focusing principally on the
supply side.
CONTD.

 MacAvoy argues that OPEC did not control the production in the 1970s, and therefore
is not responsible for the price increases of 1973 and 1979-80.
 He simulates a model in which OPEC countries behave according to his supply
specification and finds that the actual price path can be approximated without assuming
cartel action.
 He generates lasting effects from temporary supply shocks, such as the embargo and
cutbacks of 1973, by introducing lagged output and reserves, themselves dependent on
past output, in the supply function.
 Thus, the embargo of 1973 reduced supply for several years, and explains the stability
at the high price during the 1970s.
CONTD.

 This effect is reinforced by stockpiling behavior on the part of consumers. In

response to an (unforeseen) cut in supply, consumers increase their demand for
inventory, causing a shift in demand and a larger price increase than is otherwise
justified by the original shift in supply.
 Verleger argues that OPEC followed price increases rather than lead them.
 Supply shocks first affect the spot market and, with some delay, OPEC adjusts its
official price to reflect the changed market circumstances.
 He argues, rather unconvincingly, that OPEC prices which were too low compared to
spot prices delayed consumer adjustment and encouraged speculative behavior which
contributed, in 1973 and 1979, to larger price increases than were necessary
TARGET REVENUE MODEL

 A popular, non-collusive explanation for oil pricing is the target revenue theory (Ali
Ezzati, 1976; Cremer-Isfahani; and Teece).
 This theory argues that internal investment needs effectively determine "oil revenue
needs."
 The former is constrained by the economy's ability to absorb investments and, for
given prices, determine oil production.
 Once oil revenues satisfy the investment target, there is no incentive to produce
more.
 CONTD.

 Three critical assumptions underlie this model:

 (i) a fixed and slowly expanding set of investment projects;
 (ii) the acceptability of foreign investment
 (iii) oil revenues are the sole source of investment funds.
CONTD.

 The target revenue theory argues that production cutbacks occur in response to
rising oil prices to equate oil revenues with investment needs.
 More formally, let Ii* represent investment needs, the target revenue proponents
postulate:
Ii* = Pt Qit----------(1)
 By assumption, oil prices are exogenous to the producer as are investment needs, so
we take logarithms and rearrange equation (1):
CONTD.

 In Qit = αi + γi ln Pt + δi ln Iit* + εit where i=1..n; t =1,.,.T.

 Increases in investment needs, ceteris paribus, result in proportionate (δi =1)
increases in production.
 For given investment needs, a price increase implies a proportionate out- put
decrease (γi = -1).
 This constitutes the "strict version" of the target revenue theory.
 If OPEC countries are heavily influenced by target revenue considerations, but
occasionally produce in excess of investment needs, I also test for a "partial version"
of the theory (δi > 0, γi < 0).
Target Revenue Model:
Lower prices give higher Price Negative
production supply
elasticity..

Supply curve

Quantity
NON-COMPETITIVE MODELS:

 A market is not competitive when the agents acting in such a market have the power
to influence the price, directly or indirectly, something that does not occur under
perfect competition.
 Generally, these agents have market power because they are few in number, have
access to relevant information, and can foresee the interdependence between their
strategies and those of others.
 Competitive models are;
1. Oligopolistic Market.
2. Cartel
B. COLLUSIVE OLIGOPOLY

▪ One way of avoiding the uncertainty arising from oligopolistic interdependence is to enter
into collusive agreements.
▪ There are two main types of collusion:
▪ cartels and price leadership.
▪ These forms may represent (imply) tacit (secret) agreements or open collusion.
▪ It is usually the case that cartels are overt (open) and formal while price leadership is tacit.
CARTEL

▪ Cartel is an organization of suppliers of a commodity aimed at restricting competition and

increasing profits.
▪ It may take an open form of collusion, the member firms entering into an enforceable
contract pertaining to price and possibly other variables.
▪ In other words, a cartel may be formed by secret collusion among sellers.
 There are two typical forms of cartels:
1. Cartels aiming at joint-profit maximization, and
2. Cartels aiming at the sharing of the market.
A. CARTELS AIMING AT JOINT-PROFIT MAXIMIZATION (CENTRALIZED CARTELS)

▪ In this form of a cartel, the aim is to maximize the industry (joint) profit.
▪ The situation is identical to that of a multi-plant monopolist who seeks the maximization of
his profit.
▪ Consider a pure oligopoly – an oligopoly where all firms produce a homogeneous product.
(This is often the case with centralized cartels).
▪ The firms in the cartel appoint a central agency to which they delegate the authority to
decide on:
▪ - The total quantity to be produced by the industry,
▪ - The price at which the output is sold,
▪ - The allocation of production, and
▪ - The distribution of the maximum joint profit among the members.
CONTD.
CONTD.

 There are factors that militate against the achievement of the joint-profit maximization of the cartel.
1. Mistakes in the estimation of market demand and costs.
 The central agent might commit mistakes while estimating and aggregating the demands and costs of
individual firms.
 Or, the firms may purposely report incorrect figures to influence their shares of total profit.
 2. The slow process of cartel negotiations.
 By the time agreement is reached market conditions may have changed, and the chosen quantity and price
may no more be those that result in monopoly profit.
 3. Fear of government interference.
 The cartel may purposely operate not to attract the eyes of the government particularly if the monopoly
price yields too high profits.
CONTD.

 4. Fear of entry.

 The fear of attracting new firms to the industry by too high profits is another reason why
monopoly profit may not be realized.
 5. The stickiness of the negotiated price.

 Even if the cartel is aware of changes in market conditions, it needs new negotiation to
change the already agreed-on price (and quantity) so that profit deviates from the monopoly
profit.
B. MARKET – SHARING CARTELS

▪ In this type of cartel, firms agree to share the market, but keep a considerable degree of freedom
concerning the style of their product, their selling activities, and other decisions.
▪ Thus, this type of collusion is more common than a centralized cartel.
▪ There are two basic methods for sharing the market: non-price competition and determination of
quotas.
▪ i. Non-Price Competition Agreements
▪ The member firms agree on a common price, at which each firm can sell any quantity demanded.
▪ The price is set by bargaining, with the low-cost firms pressing for a lower price and the high-cost
firms for a higher price.
▪ The agreed-on price must be such as to allow some profits to all members.
CONTD.

▪ The firms agree not to charge a price below the cartel price, but they are free to vary the style of their
product and/ or their selling activities.
▪ This form of a cartel is indeed ‘loose’ in the sense that it is more unstable than the complete cartel aiming
at joint profit maximization.
▪ If all firms have the same costs, the cartel could be stable.
▪ With cost differences, the cartel will be inherently unstable, because the low-cost firms will have a strong
incentive to cheat the other members by cutting their prices secretly.
CONTD.
▪ ii. Sharing of the Market by Agreement on Quotas

▪ Firms may make an agreement on quotas, i.e. the quantity that each firm may sell at the agreed-on price.

▪ If all firms have identical costs, the monopoly solution will emerge with the market being shared equally
among the members.
▪ If costs are different, the final quota of each firm depends on the level of its costs as well as on its bargaining
skill.
▪ During the bargaining process two main statistical criteria are most often adopted: past levels of sales and
production capacity.
▪ Another popular method of sharing the market is the definition of the region in which each firm is allowed
to sell.
▪ In this case of geographical sharing of the market, the price, as well as the style of the product, may differ.
OPEC CARTEL

 What is a cartel?
 A cartel is a formal agreement among firms in an oligopolistic industry.
 It is a formal organization of producers that agree to fix prices, marketing, and
productions
 Cartel members may agree on prices, total industry output, market shares, allocation
of customers, allocation of territories, bid-rigging, the establishment of common sales
agencies, and the division of profits or a combination of these
 Cartel usually occurs in an oligopoly market structure.
 CARTEL THEORY OF OLIGOPOLY

 A cartel is defined as a group of firms that gets together to make output and price decisions.
 The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel;
in particular, cartels tend to arise in markets where there are few firms and each firm has a significant
share of the market.
 In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation.
 The organization of petroleum‐exporting countries (OPEC) is perhaps the best‐known example of an
international cartel;
 OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to
produce.
CONTD.

 Oligopolistic firms join a cartel to increase their market power, and members work
together to determine jointly the level of output that each member will produce
and/or the price that each member will charge.
 By working together, the cartel members are able to behave like a monopolist.
 For example, if each firm in an oligopoly sells an undifferentiated product like oil, the
demand curve that each firm faces will be horizontal at the market price.
 If, however, the oil‐producing firms form a cartel like OPEC to determine their
output and price, they will jointly face a downward‐sloping market demand curve, just
like a monopolist.
CONTD.

 In fact, the cartel's profit‐maximizing decision is the same as that of a monopolist, as

Figure reveals.
 The cartel members choose their combined output at the level where their
combined marginal revenue equals their combined marginal cost.
 The cartel price is determined by the market demand curve at the level of output
chosen by the cartel.
 The cartel's profits are equal to the area of the rectangular box labeled abcd in
Figure.
 Note that a cartel, like a monopolist, will choose to produce less output and charge a
higher price than would be found in a perfectly competitive market.
CONTD.

 Once established, cartels are difficult to maintain.

 The problem is that cartel members will be tempted to cheat on
their agreement to limit production.
 By producing more output than it has agreed to produce, a cartel
member can increase its share of the cartel's profits.
 Hence, there is a built‐in incentive for each cartel member to
cheat. Of course, if all members cheated, the cartel would cease
to earn monopoly profits, and there would no longer be any
incentive for firms to remain in the cartel.
 The cheating problem has plagued the OPEC cartel as well as
other cartels and perhaps explains why so few cartels exist.
CONTD.

 The Organization of Petroleum Exporting Countries (OPEC) is an example of

an international cartel. The organization was created at a conference in Baghdad, Iraq on
September 10th-14th, 1960.
 The founding members which include Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela agreed to
create an organization that could bring some degree of stability to the world oil market.
 OPEC agreed to coordinate energy policies to ensure a fair price for their exported oil and a
steady supply to the market.
 The governments of the OPEC countries agreed to coordinate with petroleum firms (both state-
owned and private) in order to manipulate the worldwide oil supply and therefore the price of oil.
CONTD.

 When firms agree to collude, that is they agree to a certain price and quantity for a
good or service, they create a cartel. A cartel is a type of oligopoly.
 As cartels are formed and operate in secret, it is up to the members of the cartel to
keep their agreement intact.
 The firms must trust each other not to drop their price to undercut the others or
increase their output.
 This is difficult to ensure as firms may have different production costs and therefore
require more profit to meet their costs.
 Because of this, there is less control over the market than there would be under
a monopoly structure.
CONTD.

 Problems of OPEC
 Although OPEC has the structure and intent of a cartel, it fails to function properly to achieve its
objective of influencing global oil supply.
 There are a series of problems that plague OPEC and make it inefficient as a cartel structure:
1. Market Share
2. Cooperation & Coordination
3. Effect on Non-OPEC Producers
4. OPEC Reserves
 1-MARKET SHARE

 The first problem that OPEC suffers from is that they do not control the majority of
the oil supply in the world, that is they don't have the market power.
 The share of the global oil supply that OPEC controls have fluctuated over time, while
it has 81% (1213.4 billion barrels, 2015) of the world’s proven crude oil reserves it
only produces about 40% of crude oil today (this number has fluctuated since its
creation).
 Without control of the market, OPEC has to compete with non-OPEC nations such as
Canada, the U.S, Norway, Mexico, Brazil, and others.
 This means that OPEC countries have to compete with other global players who are
free to operate in the market as they please, whereas OPEC nations have to
coordinate with each other.
2-COOPERATION & COORDINATION

 Since its inception, OPEC has had problems dealing with the inherent problem of
coordinating its policies.
 The nature of a cartel depends on the members agreeing and coordinating their
policies to ensure an equal share of the market and to discourage competition.
 Many of the OPEC countries inhabit an area that is prone to geopolitical strife and
conflict.
 There is an extensive list of events that affected OPEC and its cooperation since its
existence such as numerous wars, assassinations, ongoing political conflicts, terrorism,
etc.
CONTD.

 OPEC, like all cartels, has to overcome the urge to compete with other members within the cartel.
 Quotas are one method that OPEC uses to limit competition and output in order to raise prices.
 OPEC countries often, if not always, agree to these quotas and then break them by ramping up
production in an attempt to capture more of the market for themselves.
 This practice both disrupts the cohesion of the cartel and reduces the amount of trust between the
member nations.
 Essentially, member nations 'cheat' to make more money.
 Proof of this is the defections of Ecuador and Gabon which both suspended their membership in OPEC
for periods of time (1992-2007 and 1995-2016 respectively) seeking a release from the terms of the
cartel.
 Both sought to increase their production levels free from quotas.
3-EFFECT ON NON-OPEC PRODUCERS

 Cartels are normally considered to be a negative aspect of a market, they discourage competition,
restrict supply and raise prices for consumers.
 In the case of OPEC, non-OPEC producers do not necessarily oppose the cartel activities.
 Because OPEC attempts to keep the price of oil artificially high, the non-OPEC producers benefit as
well as they can sell their oil at the same price.
 While there are different grades of crude oil when crude hits the market it is essentially the same and
they are all sold for more or less the same price.
 Some crude is more expensive to refine for market sales such as Canadian crude from the Alberta oil
sands and some are cheaper however, the grade that makes it to the market is undifferentiated from
different crude of different origins.
 4-OPEC RESERVES

 The map below shows the sizes of the oil reserves held by the OPEC member nations (Selected are
member nations: Algeria, Angola, Ecuador, Gabon, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar,
Saudi Arabia, United Arab Emirates,Venezuela)
 Press the play button in the lower left-hand corner to see how these reserves change with time
(watch Venezuela specifically):
 OLIGOPOLY MODEL

▪ Oligopoly is a market structure that is dominated by a few large producers of a homogeneous or

differentiated product.
▪ Crucially, these few firms recognize their rivalry and interdependence.
▪ fully aware that any action on their part is likely to induce counter-actions by their rivals.
▪ This leads us to consider strategies and counter-strategies between market participants.
CONTD.

 Few large firms dominate the entire industry

 Either homogeneous or differentiated products
 Interdependence of firms - decisions of one firm affect the decisions of other firms – potential for
collusion or competition
 Substantial barriers to entry: may be due to economies of scale, patents, mergers, access to
resources, etc.
 prices in oligopoly tend to be ‘sticky’ or rigid

 Duopoly: a special case of oligopoly in which there are only two firms in the industry.
CONTD.

 In general, the oligopoly market is divided into two:

1. Non-collusive oligopoly 2. Collusive oligopoly

▪ There are different models to explain the behavior of oligopolistic firms.
▪ There are non-collusive models and collusive models.
▪ The classification of oligopoly firms as collusive or non-collusive is based upon whether there
exist some agreements between firms or not.
▪ When firms enter into some form of agreement as to the price level they charge or the quantity
of output they produce, such firms are said to be a collusive oligopoly.
▪ On the other hand, if there is no form of agreement between firms, firms are said to be a non-
collusive oligopoly.
A. NON-COLLUSIVE OLIGOPOLY

▪ In a non-collusive type of oligopoly market, there is no collusion – there is no cooperation among

rivals.
▪ Hence, the common feature of non-collusive oligopoly models is there is no cooperation among rival
firms.
▪ Thus, under a non-collusive oligopoly, each firm develops an expectation about what the other firms
are likely to do.
▪ Since firms are mutually interdependent, a firm expects some reaction from its rivals when it decides
to take a given course of action.
CONTD.

▪ In Cournot competition firms simultaneously compete in

terms of quantity supplied to the market.
▪ In Stackelberg competition one or more firms are able
to initially predominant themselves to a particular output
level.
▪ The remaining firms observe this level of output and then
simultaneously determine their own optimal output levels.
▪ Finally, in Bertrand competition firms simultaneously
compete in terms of the price they charge consumers.
▪ These differences fundamentally alter the underlying
structure of the game between firms and dramatically
change the predicted behavior of the firms involved.
SWEEZY’S KINKED DEMAND CURVE MODEL OF OLIGOPOLY

▪ This model is developed by Paul Sweezy to explain why prices in oligopoly markets
are stable or rigid, even when costs rise.
▪ If you closely look at the prices of products produced by oligopoly firms,
▪ You may easily see that prices are more stable as compared to the prices of products
in other market structures.
▪ For Example, the prices of soft drinks, beer, cigarettes, and other similar products,
you come to realize that once the price is set it remains relatively for a long period
of time.
CONTD.

▪ This is because firms come to believe that

▪ If they cut prices their rivals will follow the price cut and, as a result, the price cut will
not produce much of an increase in sales.
▪ However, a price increase will not be followed and will, therefore, result in a
significant loss of sales to the firm raising its price.
▪ As a result, once a price is reached, it tends to remain in effect for long periods.
CONTD.

▪ An oligopoly firm will face two demand curves for different ranges of prices.
▪ Suppose a firm knows that any time it raises its prices, all other firms in the industry
will do the same.
▪ In this case it faces AB, which is a relatively inelastic curve.
▪ If, on the other hand, no other firms follow its changes in prices the firm will instead
find itself on CD, a much more elastic demand curve.
▪ If the firm is the only one to raise prices, it will experience a large drop in sales.
CONTD.
THE KINKED DEMAND CURVE
AND THE CORRESPONDING MR CURVE

P*
MR

D
Q* quantity
THE MC CURVE INTERSECTS THE MR CURVE
IN THE VERTICAL SEGMENT.

$
MC
P*
MR

D
Q* quantity
CONTD.

▪ If costs shift up slightly,

$ MC’ but MC still intersects
MR
▪ In the vertical segment,
MC There will be no change
P* in price.
▪ This price rigidity is seen
in real-world oligopoly
markets.

D
Q* MR quantity
CONTD.

$
MC ATC▪ The ATC curve can
be added to the
P* graph.
To show positive
profits, part of the
ATC curve must lie
under part of the
D demand curve.
Q* MR quantity
CONTD.

PROFIT = TR - TC
$
MC ATC
P* profit

ATC*

D
Q* MR quantity
COURNOT'S DUOPOLY MODEL

▪ Cournot’s model is the earliest duopoly model (developed in 1838).

▪ The original version of the model makes the following “heroic” assumptions:
▪ o The duopolists have identical (homogeneous) products and identical costs,
▪ o The marginal (additional) cost is zero for both firms,
▪ o The firms fully know their linear demand curve, and
▪ o Each firm acts (decides on its own output to maximize profit) on the assumption
that the competitor will not change its output level.
CONTD.

▪ Assume that firm A is the first to start

producing and selling mineral water (Fig 2.1).

▪ It will produce quantity A and sells at a price

of P1

▪ because MR = MC (= 0) at point A – the

mid-way between O and D'.
CONTD.

▪ Now, firm B enters into the industry and assumes that A will keep its output fixed at OA and
hence considers that its own demand curve is CD’.
▪ It produces AB (=1/2AD’) and charges price P2 in order to maximize profit.
▪ Firm A, faced with this situation, assumes that, B will retain its quantity constant in the next
period.
▪ Therefore, A will produce ½ of the market that is not supplied by B [=1/2(1- 1/4) OD’].
▪ B (again) reacts and will produce ½ of the unsupplied market [=1/2(1-3/8) OD’].
▪ This action-reaction pattern continues until equilibrium is reached.
▪ At equilibrium, each firm produces one-third (1/3) of the total market (a total of 2/3); one–
third of the market remains unsupplied
CRITIQUES OF THE COURNOT’S MODEL

1. It is assumed that firms do not learn from past miscalculations of competitors’ reactions.
2. Firms are assumed so naïve that each assumes that its rival will keep its output constant
from time to time though its assumption doesn’t materialize.
3. It is a closed model in the sense that entry is blocked.
4. The number of firms assumed in the first period (two) remains the same throughout the
adjustment process.
5. Even if it does not impair (take away) the validity of the model, the assumption of zero
production costs is unrealistic.
6. Variables of competition other than quantity are not included in the model.
STACKELBERG’S DUOPOLY MODEL

▪ This model was developed by Heinrich von Stackelberg and is an extension of Cournot’s model.

▪ Unlike Cournot’s model, where firms are naïve (do not recognize their rivalry) and where the two
firms make their output decisions at the same time.
▪ Under Stackelberg’s model, (at least) one of the two firms is sufficiently sophisticated to recognize
that its competitor is naïve and thus sets its output before the other.
▪ Consider the example below (which is the same as the example under Cournot’s model).

▪ Assume that in a duopoly market the demand function is P =100 – 0.5(X1+X2) and the duopolists’ costs
are C1 = 5 X1 and C2 = 0.5 X22.
CONTD.

 What happens if each firm knows the reaction function of the competitor? In this case, each firm
(duopolist) estimates the maximum profit it would earn (a) if it acted as a leader, (b) if it acted as a follower,
and chooses the behavior which yields the largest maximum profit.
✓ Determinate equilibrium results if one of the two firms wants to be a leader and the other wants to be a
follower.
✓ If both firms desire to be followers, their expectations do not materialize.
 One of the rivals must alter its behavior and act as a leader, or Cournot’s equilibrium will be reached if each
duopolist recognizes that its rival also wants to be a follower.
✓ If both firms want to be leaders disequilibrium arises, whose outcome, according to Stackelberg, is
economic warfare.
 Equilibrium will be reached either by collusion, or after the ‘weaker’ firm is eliminated or succumbs to the
leadership of the other.
BERTRAND’S DUOPOLY MODEL

▪ Bertrand’s duopoly model (which was developed in 1883) differs from Cournot’s in that it assumes
that firms choose to compete by setting prices instead of quantities.
▪ Each firm is faced with the same market demand and aims at the maximization of its own profit on the
assumption that the price of the competitor will remain constant.
▪ Like Cournot’s model, it applies to firms that produce the same (homogeneous) goods and make their
decisions at the same time.
▪ Thus, if the two firms charge different prices, the lower-price firm will supply the entire market and
the higher-price firm will sell nothing.
▪ Because the good is homogeneous, consumers purchase only from the lowest-price seller.
CONTD.

▪ If both firms charge the same price, consumers will be indifferent as to which firm they buy from.
▪ And, the model assumes that each firm will supply half the market.
▪ Consider the following example where the market demand for a good is P = 30 – Q(where Q =
Q1+Q2) and both firms have a marginal cost of 3 (MC1 = MC2 = 3).
▪ If the two firms charge the same price of 5 Birr, each could get a per unit margin of Birr 2.
▪ However, at least one will have the incentive to cut price and undersell the other.
▪ This means P = 5 will not be a stable (an equilibrium) price
CONTD.

▪ In general, as long as the price is above the MC, there will be an incentive to reduce price and thus, the
equilibrium will be the competitive outcome – where price equals marginal cost.
▪ Equilibrium price P* = MC = 3.
▪ Equilibrium quantity Q* is obtained by substituting P = 3 into the market demand:
▪ P = 30 – Q Þ 3 = 30 – Q Þ Q* = 27.
▪ Each firm supplies 27/2 = 13.5 units (Q1 = Q2 = 13.5).
▪ Bertrand’s model is criticized on the same grounds as that of Cournot’s (critics 1 and 2 under
Critiques of the Cournot’s Model) and on its assumption of the equal market share of total sales by
the firms.
 CONTD.

▪ It is more natural to compete by setting quantities rather than prices when firms produce a
homogenized good.
▪ Price competition is more natural when products have some degree of differentiation than when
products are identical. [Bertrand’s model didn’t go so far as to include product differentiation; this is an
extension].
 CONTD.

 The reaction curves of the firms and their equilibrium quantities.