Microeconomics 1000 Lecture 13 Oligopoly

BETWEEN MONOPOLY AND PERFECT COMPETITION Many markets are not monopolies, but the number of firms is relatively small, and so firms have some market power. In other markets, the products are differentiated, with each firm producing different varieties of the same product. These markets are often referred to as oligopoly and monopolistic competition, respectively.

BETWEEN MONOPOLY AND PERFECT COMPETITION Types of Imperfectly Competitive Markets Oligopoly Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition Many firms selling products that are similar but not identical.

Figure 1 Four Types of Market Structure Number of Firms? One firm Few firms Many firms Type of Products? Differentiated products Identical products • Novels Movies Monopolistic Competition (Chapter 17) Perfect • Wheat Milk Competition (Chapter 14) Football matches Rail connection Monopoly (Chapter 15) • Car tires Crude oil Oligopoly (Chapter 16) Copyright © 2004 South-Western

MARKETS WITH ONLY A FEW SELLERS Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. Firms are best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost; but cooperation is difficult to sustain A classical illustration is the prisoners’ dilemma Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

The Prisoners’ Dilemma The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Figure 2 The Prisoners’ Dilemma B’ s Decision Confess Remain Silent B gets 8 years C gets 8 years B gets 20 years C goes free Confess C’s Decision B goes free C gets 20 years gets 1 year B C gets 1 year Remain Silent Copyright©2003 Southwestern/Thomson Learning

The Prisoners’ Dilemma The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. Confess Cooperation (Remain Silent) is difficult to maintain, because cooperation is not in the best interest of the individual player.

Game theory 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.

The Equilibrium in a game A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

Oligopoly as a game In oligopoly, a firm’s profit is But price p depends on total output Thus, the optimal strategy for a firm depends on what its competitors are doing, and vice versa There is strategic interaction

A Duopoly Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. Suppose for simplicity that the two firms are symmetric (same unit cost, homogeneous product) Consider the “cooperative” outcome: both firms agree to produce a half of the monopoly quantity, so that the price equals the monopoly price

Price and output effects Recall that an increase in output has two opposite effects on the firm’s profit: The output effect: Because price is above marginal cost, selling more at the going price raises profits. The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.

Why cooperation is difficult to sustain  

Why cooperation is difficult to sustain  

Example Suppose the demand function is and the unit cost is c = 50. Then, the monopoly price is 150 and the monopoly output is 100. The monopoly profit (gross of the fixed cost) is (150 – 50) x 100 =1000 To see why this is the profit maximising solution, observe that a one percent increase (decrease) in quantity causes a one percent decrease (increase) in the price-cost margin For example, with q = 101, profit would be (149 – 50) x 101 = 9999 < 10000

Example (cont’d) Now suppose there are two symmetric oligopolists Start from the monopoly solution, assuming that monopoly output is split evenly among the two firms, and consider the incentive to increase output by one unit (i.e., from 50 to 51): Initial profit: (150 – 50) x 50 = 5000 Profit after change: (149 – 50) x 51 = 5049 (The other firm’s profit falls to 4950)

Oligopoly equilibrium Because each firm has a unilateral incentive to increase output, in the resulting equilibrium total output will be greater than under monopoly It follows that the price will be lower than under monopoly The deadweight loss will be lower than under monopoly But the profit will also be lower than under monopoly

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.

Figure 3 Industry profit as a function of total output Monopoly quantity Monopoly profit Oligopoly equilibrium somewhere here Quantity Copyright © 2004 South-Western

Figure 4 Monopoly v. Oligopoly equilibrium Price Marginal revenue Demand Oligopoly equilibrium somewhere here Quantity sold Monopoly price Profit Marginal cost Quantity Copyright © 2004 South-Western

Oligopoly equilibrium Where exactly the oligopoly equilibrium will lie depends of the fine details of the strategic interaction among the firms For example, while it is a matter of indifference to imagine to think of a monopolist as choosing the quantity or the price, under oligopoly it does make a difference If firms set price, we have the so called Bertrand equilibrium If firms set quantities, we have the Cournot equilibrium In general, competition in the Bertrand model is more intense than in the Cournot model

Figure 5 How the monopoly equilibrium is implemented Price Demand Quantity sold Monopoly price Marginal cost Quantity Copyright © 2004 South-Western

Equilibrium for an Oligopoly Summary 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.

Competition, Monopolies, and Cartels The duopolists may agree on a monopoly outcome. Collusion An agreement among firms in a market about quantities to produce or prices to charge. Cartel A group of firms acting in unison.

Competition, Monopolies, and Cartels Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. However, firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy. They also prohibit “facilitating practices”, such as information exchange

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 will increase the amount sold, which will lower the price and the profit per unit on all units sold.

How the Size of an Oligopoly Affects the Market Outcome As the number of sellers in an oligopoly grows larger, the incentive to increase output becomes stronger and stronger. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Summary The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual self-interest. The logic of the prisoners’ dilemma applies in many situations, including oligopolies.

Summary Oligopolists would maximise their total profits by forming a cartel and acting like a monopolist. However, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.