Duopoly

Remember when you and your best friend or a sibling got in trouble? You then had to tell your parents what exactly happened. In that situation, you could cooperate and come up with a story that would get you both out of severe punishment. Or, you could fight and accuse each other, ending up with a worse outcome. Just like you and your counterpart in real life, a duopoly consists of two firms that dominate their industry. You can imagine that a slightly more complicated story unfolds based on whether the two firms team up or fight. If you are interested in discovering what duopoly structure is, what are the different types of duopolies and their characteristics, keep reading!

What is Duopoly?

A duopoly is a situation in which there are only two companies providing a particular product or service in the market. This means that consumers have limited options when it comes to choosing who they purchase from, and the two companies have a significant influence over the pricing and availability of that product or service.

Duopoly vs. Oligopoly

The key difference between duopoly vs oligopoly is the number of firms involved, with duopolies having exactly two firms and oligopolies having more than two firms. It is important to remember that a duopoly is a type of oligopoly.It has gained a particular distinction from other oligopoly types because it often occurs in the real world!

Types of Duopoly

There are two main types of duopoly Cournot Model and the Bertrand Model.

In the Cournot duopoly model, the two firms simultaneously choose how much output to produce, taking into account how their rival will react. The firms compete on quantity and attempt to maximize their own profits by producing a quantity that is less than the quantity that would be produced in perfect competition.

In the Bertrand duopoly model, the two firms set prices simultaneously, taking into account how their rival will react. Each firm assumes that its rival's price will remain constant. The firms compete on price and attempt to maximize their own profits by undercutting their rival's price. This results in a price that is equal to the marginal cost of production, similar to what would be seen in a perfectly competitive market. The Bertrand model assumes that products are homogeneous and that consumers will always choose the lower-priced product.

Types of Duopoly: Market Share

Another way to categorize duopolies is market share. The two types of duopoly based on the market share are:

1. Pure duopoly when two firms control 100% of the market.
2. Simple duopoly when firms control more than 70% of the market.

Pure duopoly is a rare situation in which the two companies have complete control over the market, effectively creating a monopoly. In a pure duopoly, the two companies often engage in intense competition, engaging in price wars and other aggressive tactics to gain market share from each other.

On the other hand, a simple duopoly is a more common scenario in which the two companies have a significant but not complete share of the market. In a simple duopoly, the two companies often have more stable pricing and may engage in cooperative behavior, such as forming agreements on production or pricing. The distinction between pure duopoly and simple duopoly is important because it can affect the behavior of the companies involved and the potential for new competitors to enter the market.

Duopoly Characteristics

There are several important characteristics of a duopoly besides the specific number of firms operating on the market:

• High barriers to entry: Due to the significant resources required to enter the market, such as capital, technology, distribution networks, and brand recognition, it can be difficult for new firms to enter and compete with the established duopoly.
• Economies of scale: Because the two firms in a duopoly dominate the market, they can often benefit from economies of scale, which refers to the cost advantages that come with producing goods or services on a large scale.
• Interdependence: Because there are only two firms, their actions are closely intertwined and interdependent. For example, if one firm lowers its prices, the other firm may have to follow suit to remain competitive.
• Pricing power: This can happen the two firms collude and set prices above what would be seen in a more competitive market.
• Innovation and product differentiation: In order to maintain their dominance and stay ahead of each other, the two firms in a duopoly often invest heavily in innovation and research and development, driving advances in technology and product design.

We will now explain the two key features of the duopoly high barriers to entry and economies of scale.

High Barriers to Entry

Duopoly is characterized by high barriers to entry.

When two firms dominate the market, they are so large that any new entrant cannot even start selling their products as the costs would make it unprofitable for them to do so. Reaching the economies of scale, in this case, is a barrier to entry to new firms.

High Economies of Scale

Economies of scale result from the falling long-run average total costs in the industry as output increases.

Consider the diagram below.

Fig. 1 - Long run average total cost curve for a duopoly

Figure 1 shows the long-run average total costs for an industry where two firms dominate the market. Each of the two firms produces 6 million units and operates at point B. They are at the optimal point in terms of their costs. If another firm tries to enter the market, its average total cost would be higher, leading the new firm to eventually leave the market because it will be unable to compete with a higher average total cost.

Figure 1 above shows the region where the two duopolists have gained an advantage from the falling long-run average total costs. After achieving economies of scale, the two firms moved from point A to point B, where their long-run average costs are the lowest. Point B is also referred to as a minimum efficient scale. It can be achieved by large firms in the duopoly as their output rises.

A collusive duopoly is likely to be so large that the outcome of prices and output may be akin to a monopoly in a way that the prices can be set above marginal cost when the products are differentiated, for example. A collusive duopoly will have a significant degree of monopoly power! Let's take a look at Figure 2 below.

Fig. 2 - Duopoly price and quantity setting

Figure 2 above shows the demand curve (also the average revenue curve) and the marginal revenue curve for the industry. Both are downward-sloping for collusive duopolists. This is because they can set prices to maximize industry profit due to a high degree of market power. They could choose to set the price where the marginal cost equals marginal revenue (MC=MR), for example, and read the price from the demand curve. They would therefore produce Qm and charge a price of Pm.

In contrast, a perfectly competitive firm would be a price-taker. It would charge a lower price at Pc and produce a higher quantity at Qc. A duopoly is less allocatively efficient than a firm in perfect competition as it prices above the marginal cost and produces less output.The three shaded areas in Figure 2 represent consumer surplus. In the case of perfect competition, consumer surplus would equal:

\(\hbox{Consumer Surplus}_1=Area_1+Area_2+Area_3\)In the case of duopoly, however, consumer surplus is only one area shaded in green:

\(\hbox{Consumer Surplus}_2=Area_2\)

This means consumer surplus is significantly smaller in a duopoly than in perfect competition. Area 1 goes to the duopolists as profits due to the lower quantity produced and the higher price charged. Area 3 is the efficiency loss.Note that in Figure 2, we assume that there are no fixed costs. In the case where there are fixed costs, a duopoly can achieve productive efficiency in the long run if it keeps producing at the minimum efficient scale, as illustrated in Figure 1 above. Suppose some of these average cost savings resulting from economies of scale are passed onto consumers. In that case, an improvement may result in higher consumer surplus and efficiency.

Duopoly Examples

Examples of duopoly include:

• soft drink industry (Coca-Cola and PepsiCo),
• credit card industry (Visa and Mastercard),
• mobile operating systems (Apple's iOS and Google's Android)

Let's take a look at them in more detail:

1. Soft drink industry: Coca-Cola and PepsiCo dominate the global soft drink industry, controlling over 70% of the market. These two companies have been rivals for decades, competing fiercely for market share through aggressive advertising and marketing campaigns.
2. Credit card industry: Visa and Mastercard are the two largest credit card companies in the world, with a combined market share of over 80%. Due to the high costs of establishing a credit card network and the complexity of the industry, new competitors face significant barriers to entry.
3. Mobile operating systems: Apple's iOS and Google's Android operating systems dominate the global smartphone market, controlling over 90% of the market share. These two companies have established themselves as the leading providers of mobile operating systems, with most smartphone manufacturers choosing to use one of these two systems on their devices.

Another to look at duopoly examples is through the two models that describe the behavior of duopolies. These are the Cournot model and the Bertrand model. We will move to discuss those very soon, so sit tight!

Duopoly Structure

The structure of a duopoly can be described through the interdependence of the two firms. The firms can be team players and cooperate, or they can compete. If they cooperate, we are talking about a collusive duopoly. If they compete, there can be two cases: they either compete in prices or quantities. If the two firms compete by setting quantities, it is the case of Cournot's competition. However, if the two firms compete by setting prices, it is the case of Bertrand's competition.

Let's consider the case of the Cournot competition first. Take a look at Figure 3 below!

Fig. 3 - Cournot duopoly example

Figure 3 above shows a structural outcome in a duopoly that produces homogeneous goods and competes in quantities.

If the firms compete, they estimate their reaction functions and settle at what is known as a Cournot equilibrium at the intersection of the two reaction functions. They either split the market equally or unequally. Regardless, each firm will be charging a price above its marginal cost. This outcome is akin to a monopoly where the firms choose both the price and quantities. This equilibrium is stable, and there are no incentives for engaging in a price war.

If the two firms collude, they will produce at the collusive equilibrium. The joint industry output will be lower compared to the Cournot equilibrium. Still, the two firms will enjoy higher profits at the expense of consumer welfare.

Let's now take a look at the case of Bertrand competition. What would a structural outcome in a duopoly that produces homogeneous goods and competes in prices be like?

If the firms compete, the resulting outcome is a price war. They bid down their prices to the marginal cost. This results in the same outcome for consumers welfare-wise as in perfect competition. Bertrand equilibrium is also a Nash equilibrium, as no firm has an incentive to increase or decrease its prices. If a firm increases its price, it will lose all its customers. Conversely, if a firm reduces its price below marginal cost, it will make losses. Hence, the Bertrand equilibrium is stable.Bertrand's model does not assume any cooperation between the two firms.