Essay on Oligopoly, Perfect Competition, Cournot's and Bertrand's Models

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Essay on Oligopoly, Perfect Competition, Cournot’s and Bertrand’s Models

Oligopoly is one of the four market structures in the world and the other three are perfect competition, monopoly, and monopolistic competition. All these market structures have different features and characteristics that set them apart, but among them is a perfect competition that often serves as a benchmark for others. Indeed, perfect competition, in addition to promoting economic efficiency, provides a good basis for the comparison of different types of markets in the real world. Oligopolistic markets have two main models which are Bertrand’s competition model (BCM) and Cournot’s competition model (CCM). This essay aims to explain oligopoly and its corresponding features regarding perfect competition as a benchmark and also the difference between the two models of the oligopolistic market.

Key Features of Oligopoly Versus Perfect Competition as a Reference

An oligopoly is a market structure that involves few producers and suppliers (www.oecd.org). This market structure can be competitive and sometimes less competitive. Some of its fundamental characteristics include the existence of a small number of firms, differentiated or homogeneous products, and barriers to entry. Examples of oligopoly include cell phones (Huawei, Apple, and Samsung have over 50% market share) and motor vehicles in the United States (Toyota, Ford, General Motors, and Chrysler collectively have almost 60% market share. To identify an oligopoly, the Herfindahl-Hirschman index or concentration ratio can be used (boycewire.com).

On the other hand, is a perfect competition where the market has many sellers with no individual advantage over each other as they sell the same product at the same price. Here, firms engage in the production of identical goods, market share is not a price determining factor, barriers to entry or exit don’t apply, and buyers have perfect or complete knowledge of what they want in terms of purchase. Examples of perfectly competitive industries include agriculture, online shopping, and foreign exchange markets (boycewire.com).

While competition in an oligopolistic market is legal, collusion is generally considered illegal. Compared to monopolies, oligopolistic firms produce larger quantities and charge a lower price to advance their interests. However, companies may sometimes collude to set prices or production levels for the market to maximize industry profits. When this happens, the colluding firms act like a monopoly. Moreover, such actions are difficult to coordinate, and companies caught in such compromised practices can be severely sanctioned (Fershtman and Pakes, 1999; Besanko et al., 2013).

Moreover, firms in an oligopolistic market compete, driving down the prices of products (Bertrand’s competition model) in the market. In this sense, oligopoly resembles perfect market competition, and as such competition is a key feature of oligopoly (Besanko et al., 2013).

Furthermore, an oligopolistic market is characterized by the presence in the market of a limited number of large and small companies that determine supply and demand. In contrast, the perfect competition market involves many producers. Again, in an oligopolistic market, the number of firms often ranges from two to ten and together control more than 50% of the market share. This high percentage gives oligopolistic firms the power to control and dictate prices and supply, so companies follow the actions of competitors to maintain their position in the market. For example, if one company lowers its prices, all the others will follow (Besanko et al., 2013).

Additionally, an oligopolistic market has high entry barriers, unlike the perfect competition which has free entry and exit. In the economic context, these barriers will allow an already existing oligopolistic company (incumbents) to benefit from an economic profit and at the same time cause losses for new companies (entrants) entering this sector of activity. These barriers can be strategic or structural to entry such as patents, startup costs, and brand loyalty. These barriers to entry cause the oligopolies to maintain their position and in doing so make more gains due to insufficient competition hence the difference between oligopoly and perfect competition (Besanko et al., 2013).

Another factor that marks the difference between the oligopolistic market and that of perfect competition is the mode of operation of market prices. Indeed, in the latter, prices are slightly higher than marginal cost, which leads to low or zero profits for the companies operating there. However, due to strong market power, oligopolies can raise prices, which gives them the advantage of earning more profits. Whereas a reduction in prices in this leads to a reduction in prices by competitors, thus, most oligopolies, don’t lower their prices due to fear of not making enough profit.

Interdependence is another essential characteristic of an oligopoly. Often a company’s decision on price and quantity affects the entire industry (its competitors). In this scenario, game theory is often used to analyze the market. Even though oligopolies are interdependent, they hold shares of market power, which means that a single firm cannot dictate price or supply, although this can sometimes lead to collusion. Oligopolies are often afraid to raise their prices so as not to lose their customers to other competitors just like in perfect competition (boycewire.com).

Overview and Comparison of Bertrand’s and Cournot’s Competition Models in Oligopolistic Markets

Cournot’s Competition Model (Product)

The demand curve in the oligopolistic market is downward sloping which implies that price is related to the quantity produced and that a firm’s output affects its prices and those of its competitors. The result is a strategic environment where the profit-maximizing level of production is relative to the level of production of competitors. This analysis is based on an 1838 model introduced by Antoine Augustin Cournot, which is like the 1949 Nash equilibrium concept introduced by John Nash (Vives, 1989).

The CCM considers two firms producing identical goods which will enable them to levy the same prices for their products. In CCM, each firm chooses the quantity Q1 and Q2 to produce based on the output of the other firm and maximizes its profits by taking it as given. Price equilibrium occurs when demand equals supply (price clears the market). In this model, all companies can sell their products thanks to their commitment to producing, and this does not generate any additional cost. However, in a situation where a company cannot sell all its products, it may continue to reduce its selling price until all the products are sold. A key feature here is that this model is based on assumptions by both firms about how much product a rival firm should produce (Besanko et al., 2013).

Nash equilibrium similar to CCM is the solution concept in game theory that describes how two or more players can achieve equilibrium if they each know the equilibrium strategies of the other player (Nadav and Piliouras, 2010).

Bertrand’s Competition Model (Price Setters)

Bertrand’s model assumes that each firm sets its price based on its rival’s price and that each firm stands ready to sell the quantity demanded at that price. As a result, each firm appropriates its rival’s price and sets its price to maximize its profits. When all firms reach equilibrium, they correctly predict the prices of their rivals. An example of a Bertrand oligopoly is Coke and Pepsi in the soft drink industry.

Bertrand’s equilibrium requires only two firms to achieve zero profit and zero marginal cost. Indeed, each company will always be motivated to undercut its rival and there will always be a balance. In today’s economic environment, companies produce identical products that are perfect substitutes, and the capacity of the company is not limited. Below is a graph illustrating a BCM.

In summary, the main difference between Cournot’s competition model and Bertrand’s competition model is the fact that they use quantity and price respectively as strategic variables. The interesting thing is that even though BCM uses price as a strategic variable, the prices of their products in the market are still lower than those of CCM which uses quantity (Darrough, 1993). Although CCM and BCM are different, it is an advantage for companies considering that the two models can be used over two distinct periods (Besanko et al., 2013). Also, unlike CCM, BCM has been heavily criticized for its lack of generality given that the model depends on constant marginal cost theory. CCM is seen to be applied in most businesses, where companies decide ahead of time on the quantity of production. These companies are obligated to sell all products and are adamant to react regardless of the rise or fall of their competitors’ production levels (Besanko et al., 2013).

Conclusion

Considering this discussion, it can be said that regarding perfect competition as a benchmark, the oligopolistic market has certain distinctive characteristics. Thus, different models are used to determine them. In real-world experiments, BCM is often used because competition is price-driven, unlike CCM which is quantity-driven. Furthermore, both BCM and CCM are used in both the short run and the long run respectively. Moreover, although these two models are more important and more common in oligopolistic markets, we also find the Stackelberg.

Reference

Besanko, D., Dranove, D., Shanley, M. and Schaefer, S., 2013. Economics of Strategy. John Wiley.

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