Oligopoly 1

Oligopoly For a Market to be Described as Oligopolistic, it must satisfy the following conditions: Few Sellers Mutual Interdependence The Firm’s products may be identical or unique (Homogeneous or Differentiated) The are Barriers to Entry (like monopoly) non-price competition 19

Where Does Oligopoly “fit in?” Perfect Competition Monopoly Monopolistic Competition Oligopoly 20

Oligopoly Model Oligopoly is a market in which a small number of firms supply the entire market and where natural barriers to entry prevent other firms from entering Examples: beer, breakfast cereals, automobiles, long-distance telephones, airplanes, database software,...

Concentration Ratios One Way to Determine Whether a Market is Oligopolistic is to look at a Concentration Ratio A Concentration Ratio Let’s Us Know if the Whole Industry’s Sales are Dominated by the Sales of a Few Firms. 21

Oligopolies and Collusion Overt Collusion OPEC Cartel Covert Collusion Electrical Equipment Price Fixing Tacit Collusion Price Leadership

Models of Oligopoly 1 - Kinked Demand Curve 2 - Collusive Pricing No Standard Model due to... Diversity Interdependence 1 - Kinked Demand Curve 2 - Collusive Pricing 3 - Price Leadership

Kinked Demand Curve Each Oligopolist believes that if it raises its price, other firms will keep their prices constant, so the quantity demanded will fall by a large amount (demand is elastic). Each firm also believes that if it cuts its price, other firms will cut their prices too, so the quantity demanded will rise by a small amount (demand is inelastic).

Kinked Demand Curve Effectively creating P a kinked demand curve This is an attempt to explain the “sticky prices” in oligopoly industries. P P D2 D1 Q Quantity

The Kinked Demand Curve Theory The current price is P And at this price, the firm is selling the quantity Q P

The Kinked Demand Curve Theory The marginal revenue curve from “b” down. The marginal revenue curve for a price increase runs from “a” up.

The Kinked Demand Curve Theory Between a and b, there is no marginal revenue curve Cost can increase considerably without causing the firm to increase price. So long as the MC curve passes through the break in the MR curve, the firms keeps its price and quantity constant.

The Kinked Demand Curve Theory Summary: The demand curve has a kink at the current price The marginal revenue curve is discontinuous Price is sticky and remains at the kink point unless a large enough change in marginal cost occurs The elasticity of demand indicates a decrease in TR for any price change.

Cartels and Collusion Oligopoly is conducive to collusion If a few firms face identical or highly similar demand and costs... They will seek joint profit maximization...

Collusive Pricing Model The Cartel Model: The Oligopolists Get Together (Since There are So Few of Them) and Act As If They Were One Monopolist. Collectively Produce the Monopolistic Quantity (establish quotas) - Thus Maximizing Profit as a group. Example: OPEC 23

Cartel Model Collusive agreement --a cartel--is an agreement between two (or more) producers to restrict output in order to raise prices and make bigger profits (act like a monopoly). Strategies for a firm in a cartel comply with the agreement cheat on the agreement

Problems With Cartels 10 sellers produce oils 150 barrels/day (Total 1,500 b/day) If each firm is in perfect competitive market Each firm will get normal profit But if they decide to collude as one monopoly such as OPEC 24

Maximizing OPEC Profits Market Single producer $ $ MC MC AC 20 20 MR D = AR MR Q Q 1,500 Firm 150 Oil (Barrels/Day) Oil (Barrels/Day) 27

Maximizing OPEC Profits Single producer Market If one seller cheats $ $ MC MC AC 30 30 a b 22 20 20 MR D = AR MR Q 1,000 Q 1,500 1,800 Qquota =100 150 Qcheater = 180 Firm Oil (Barrels/Day) Oil (Barrels/Day) 27

Problems With Cartels Generally, They Are Not Legal (Price Fixing) They Are Difficult to Organize and Monitor Can’t Force New Firms to Join Usually there is Cheating 24

The Incentive to Cheat On A Cartel If the Cartel Maintains the Monopoly Price, The Individual Member of the Cartel Can Act Like a Price Taker (They Can Sell the Quota amount at the Market Price) As a Price Taker, They Maximize Profit Where MC = MR. This Quantity is Greater Than the Cartel Wants the Individual Firm to Produce. All Firms in the Cartel Do This and the Cartel Falls Apart 25

Obstacles to Collusion Demand & Cost Differences Number of Firms Cheating Recession Potential Entry (or new)Entry Legal Obstacles: Antitrust

Dominant Firm Price Leadership One dominant firm (largest or lowest cost) and several other rival firms Dominant firm determines price to maximize profit Other firms take price and sell what they can at that price. All firms watch output to prevent excess supply and the need to reduce price.

Dominant Firm Oligopoly A dominant firm oligopoly may exist if one firm: Has a big cost advantage over the other firms. Sells a large part of the industry output. Sets the market price. Other firms are price takers. 38

Dominant Firm Oligopoly Let’s use Big-G as an example. Big-G is the dominant gas station in a city. 39

Dominant Firm Oligopoly Ten small firms and market demand Big-G’s price and output decision S10 MC 1.50 1.50 MR Price (dollars per gallon) a b a b 1.00 1.00 D 0.50 Instructor Notes: The other 10 firms take this price and each firm sells 1,000 gallons per week. 0.50 XD 10 20 10 20 Quantity (thous. of gal./week) Quantity (thous. of gal./week) 43

G A M E T H O R Y

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 Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

The Prisoners’ Dilemma The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation. 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.

The Prisoners’ Dilemma Nisit’ s Decision Confess Remain Silent Nisit gets 8 years Dom gets 8 years Nisit gets 20 years Dom goes free Confess Dom’s Decision Nisit goes free Dom gets 20 years gets 1 year Nisit Dom gets 1 year Remain Silent

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

Figure shows Warm Up and Monkey Club play Oligopoly Game 350 person 300 person WU gets $1,600 profit MKC gets $1,600 profit WU gets $1,500 profit MKC gets $2,000 profit 350 person Monkey ‘s Club WU gets $2,000 profit MKC gets $1,500 profit WU gets $1,800 profit MKC gets $1,800 profit 300 person