oligopoly chapter 16. imperfect competition oimperfect competition refers to those market structures...

Oligopoly

Chapter 16

Imperfect Competition

o Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.

o Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

o Types of Imperfectly Competitive Marketso Oligopoly

o Only a few sellers, each offering a similar or identical product to the others.

o Monopolistic Competitiono Many firms selling products that are similar but not

identical.

The Four Types of Market Structure

Monopoly Oligopoly Monopolistic

Competition

Perfect Competitio

n

• Tap water

• Cable TV

• Tennis balls

• Crude oil

• Novels

• Movies

• Wheat

• Milk

Number of Firms?

Type of Products?

Many firms

One firm Few

firms Differentiated products

Identical products

Markets With Only a Few Sellers

o Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

o Characteristics of an Oligopoly Marketo Few sellers offering similar or identical productso Interdependent firmso Best off cooperating and acting like a

monopolist by producing a small quantity of output and charging a price above marginal cost

A Duopoly Example: Demand Schedule for Water

Quantity Price Total Revenue 0 $120 $ 0

10 110 1,100 20 100 2,000 30 90 2,700 40 80 3,200 50 70 3,500 60 60 3,600 70 50 3,500 80 40 3,200 90 30 2,700

100 20 2,000 110 10 1,100 120 0 0

A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

A Duopoly Example: Price and Quantity Supplied

The price of water in a perfectly competitive market would be driven to where the marginal cost is zero:

P = MC = $0Q = 120 gallons

The price and quantity in a monopoly market would be where total profit is maximized:

P = $60Q = 60 gallons

The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water.

So what outcome then could be expected from duopolists?

Competition, Monopolies, and Cartels

The duopolists may agree on a monopoly outcome. Collusion

The two firms may agree on the quantity to produce and the price to charge.

Or, the firms may end up not trusting each other. They will compete by lowering prices to gain

customers. Consumers benefit from the competition.

Cartels

A Cartel is an organization of firms. The purpose is to act together like a monopoly.

Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among

oligopolists as a matter of public policy, e.g. legally binding contracts not available to firms.

Incentive to cheat (Examples: OPEC, class curve).

Cartels II

Cartels are more effective when: The number of firms is small because of

barriers to entry. Good is homogeneous. Demand is inelastic. Firms can avoid antitrust laws.

OPEC has all these characteristics Sometimes it still falls apart.

The Equilibrium for an Oligopoly

When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.

The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

Summary of Equilibrium for an Oligopoly

Possible outcome if oligopoly firms pursue their own self-interests: Joint output is greater than the monopoly

quantity but less than the competitive industry quantity.

Market prices are lower than monopoly price but greater than competitive price.

Total profits are less than the monopoly profit.

A Duopoly Example: Demand Schedule for Water

Quantity Price Total Revenue0 $120 $ 0

10 110 1,10020 100 2,00030 90 2,70040 80 3,20050 70 3,50060 60 3,60070 50 3,50080 40 3,20090 30 2,700

100 20 2,000110 10 1,100120 0 0

How the Size of an Oligopoly Affects the Market Outcome

How increasing the number of sellers affects the price and quantity: The output effect: Because price is above

marginal cost, selling more at the going price raises profits.

The price effect: Raising production lowers the price and the profit per unit on all units sold.

How the Size of an Oligopoly Affects the Market Outcome

oAs the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. oThe price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Public Policy Towards Oligopoly

The public benefits if the government sets up laws to encourage competition, not cooperation between firms.

Price fixing is illegal. Phase of the Moon Antitrust case Tucker

1948 Tucker Torpedo Automobile

An illegal phone call

In the early 80s, Howard Putman, President of Braniff Airways and Robert Crandall, the President of American Airlines had the following telephone conversation.

An illegal phone call 2

Crandall: I think it’s dumb as hell…to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime.

Putnam: Do you have a suggestion for me?

Crandall: Yes, I have a suggestion for you. Raise your #$%& fares 20%. I’ll raise mine the next morning.

An illegal phone call 3

Putnam: Robert, we…Crandall: You’ll make more money, and I

will too.Putnam: We can’t talk about pricing!Crandall: Oh, #$%&, Howard. We can talk

about any #$%& thing we want to talk about.

An illegal phone call 4

This phone call violated the Sherman Antitrust act.

At the time, some argued the government was wrong to get involved in a private telephone conversation. (But what if they had been planning a murder?)

Cradall didn’t go to jail but he had to sign an agreement with the government that he wouldn’t talk to the competition anymore.

Game Theory and the Economics of Cooperation

Game theory is the study of how people behave in strategic situations.Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

Game Theory and the Economics of Cooperation

o Because the number of firms in an oligopolistic market is small, each firm must act strategically.

o Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce.

Playing the Game

We will consider a 2x2 game There are 2 players or firms Each player has a choice of 2 strategies Games can be expanded to NxN case

2x2 Game

Player 1

Strategy A Strategy B

Strategy A

Strategy B

Player 2

Payoff for Player 2

Payoff for Player 1

Payoff for Player 1

Payoff for Player 1

Payoff for Player 1

Payoff for Player 2

Payoff for Player 2

Payoff for Player 2

“Payoff” indicates the result that the player receives if the outcome ends up being in that box.

Important Concepts in Game Theory

Dominant Strategy-Best strategy a player can pick regardless of what the other player does.

Nash Equilibrium-An outcome where neither player has an incentive to change strategy, given the other player’s strategy.

Important Concepts in Game Theory II

Prisoner’s Dilemma: A game where there is a Nash equilibrium, but both players would be better off at the same time with a different outcome or square.

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

Does either player have a dominate strategy?

First, let’s look at the game from Clyde’s point of view.

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

Clyde’s dominant strategy is to confess.

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

What about Bonnie? Does she have a dominate strategy?

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

Bonnie’s dominant strategy is to confess.

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

The Confess, Confess box is a Nash equilibrium.

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

The Confess, Confess box is a Nash equilibrium.

The Prisoners’ Dilemma

Bonnie’s Decision

Confess Remain Silent

Confess

Remain Silent

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Bonnie gets 20 years

Bonnie gets 1 year

Bonnie goes free

Clyde gets20 years

Clyde gets 1 year

Clyde goes free

Both players would have been better off if they had kept their mouths shut, but they didn’t trust each other. The police benefited from this lack of trust.

Another Game

Circuit City

Low Price High Price

Low Price

High Price

Good Guys

Good Guys gets $45 million

Circuit City gets $45 million

Circuit City gets

$40 million

Circuit City gets $50 million

Circuit City gets $65 million

Good Guys gets $40 million

Good Guys gets

$50 million

Good Guys gets

$65 million

Oligopolies as a Prisoners’ Dilemma

Circuit City

Low Price High Price

Low Price

High Price

Good Guys

Good Guys gets $45 million

Circuit City gets $45 million

Circuit City gets

$40 million

Circuit City gets $50 million

Circuit City gets $65 million

Good Guys gets $40 million

Good Guys gets

$50 million

Good Guys gets

$65 million

It’s the same as with Bonnie and Clyde. Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. The consumer benefits from the competition and lack

of trust between firms.

Not all games are the same

A player doesn’t necessarily have a dominant strategy.

There can be 0, 1, or more than 1 Nash equilibrium in a game.

A game may or may not be a Prisoner’s Dilemma game.

Let’s Do Another One

Mazda

Advertise a lot Don’t Advertise as Much

Advertise a lot

Don’t advertise as much

Honda

Honda gets $100 million

Mazda gets $60 million

Mazda gets $30 million

Mazda gets $40 million

Mazda gets $90 million

Honda gets $70 million

Honda gets $180 million

Honda gets $140 million

From Honda’s Viewpoint

Mazda

Advertise a lot Don’t Advertise as Much

Advertise a lot

Don’t advertise as much

Honda

Honda gets $100 million

Mazda gets $60 million

Mazda gets $30 million

Mazda gets $40 million

Mazda gets $90 million

Honda gets $70 million

Honda gets $180 million

Honda gets $140 million

No dominant strategy for Honda

From Mazda’s Viewpoint

Mazda

Advertise a lot Don’t Advertise as Much

Advertise a lot

Don’t advertise as much

Honda

Honda gets $100 million

Mazda gets $60 million

Mazda gets $30 million

Mazda gets $40 million

Mazda gets $90 million

Honda gets $70 million

Honda gets $180 million

Honda gets $140 million

Mazda’s Dominant Strategy is to Advertise a lot.

End GameEnd Game

Mazda

Advertise a lot Don’t Advertise as Much

Advertise a lot

Don’t advertise as much

Honda

Honda gets $100 million

Mazda gets $60 million

Mazda gets $30 million

Mazda gets $40 million

Mazda gets $90 million

Honda gets $70 million

Honda gets $180 million

Honda gets $140 million

The Nash equilibrium is where both firms advertise. (It doesn’t always have to be in the upper left-hand corner). This game is not a prisoner’s dilemma.