Economic Analysis for Business Session XIII: Oligopoly Instructor Sandeep Basnyat

Introduction: Between Monopoly and Competition Two extremes structures of Markets ◦ Competitive markets: many firms, identical products ◦ Monopoly: one firm In between these extremes: Imperfect competition ◦ Oligopoly: only a few sellers offer similar or identical products. ◦ Monopolistic competition: many firms sell similar but not identical products. Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

MARKETS WITH ONLY A FEW SELLERS Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest Characteristics of an Oligopoly Market ◦ Few sellers offering similar or identical products ◦ Interdependent firms ◦ Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost

A Duopoly: An Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. Book Example: ◦ Jack and Jill own wells that produce water ◦ Pump as much water as they want without cost. ◦ That is, the marginal cost (MC) = 0 ◦ Decide how many gallons of water to pump, bring the water to town, and sell it for whatever price the market will bear.

What if in Perfect Competition?  P = MC = $0  Q = 120 gallons  The price of water would reflect the cost of producing it.  Efficient quantity of water would be produced and consumed. What if in Monopoly? Total profit is maximized at a quantity of 60 gallons and a price of $60 a gallon. We know, P > MC Result would be inefficient, for the quantity of water produced and consumed would fall ( = 60) The Demand Schedule for Water What outcome then could be expected from duopolists?

Duopoly One possible duopoly outcome: Collusion Collusion: an agreement among firms in a market about quantities to produce or prices to charge Cartel: a group of firms acting in unison, e.g., Jack and Jill in the outcome with collusion Once a cartel is formed, the market is in effect served by a monopoly. Thus, the duopolists may agree on a monopoly outcome: P = $60 and Q = 60 gallons P > MC and the Result would be inefficient, for the quantity of water produced and consumed would fall ( = 60)

Duopoly If Jack and Jill agreed to split the market equally, each would produce 30 gallons, the price would be $60 a gallon, and each would get a profit of $1,800. Big question: Does this happen always?

Non-collusive (Cooperative) Oligopoly If Jack and Jill decide separately how much water to produce, tension arises among the duopolists. In the absence of a binding agreement, however, the monopoly outcome is unlikely. A non-collusive oligopoly: a market of few suppliers who do not agree on price or quantity

Competition, Monopolies and Cartels Jack may think: “Even if Jill produce 30 gallons, I produce 40 gallons, and a total of 70 gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000. Even though total profit in the market would fall, my profit would be higher, because I would have a larger share of the market.” Jill may also think the same ! Each bring 40 gallons to town. Total sales would be 80 gallons, and the price would fall to $40. If the Duopolists individually pursue their own self-interest then: Duopoly Q > Monopoly Q Duopoly P < Monopoly P Duopoly Total profit < Monopoly Total profit.

THE EQUILIBRIUM FOR AN OLIGOPOLY What would Jack decide next? Producing additional gallon or reducing production of gallon? “Right now, my profit is $1,600. Suppose I increase my production to 50 gallons., a total of 90 gallons of water would be sold, and the price would be $30 a gallon. Then my profit would be only $1,500. Rather than increasing production, and driving down the price, I am better off keeping my production at 40 gallons.” If Jill also thinks the same, both will produce 40 gallons. Total production will be altogether 80 gallons and the price would be $40 a gallon Both would retain $1600 as a revenue

Non collusive (cooperative) Oligopoly The noncooperative oligopoly equilibrium ◦ bad for oligopoly firms: prevents them from achieving monopoly profits ◦ good for society: Q gets closer to the socially efficient output P gets closer to MC

Nash Equilibrium The outcome in which Jack and Jill each produce 40 gallons is called a Nash equilibrium (named after economic theorist John Nash). Nash equilibrium: A situation is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen. In this case, given that Jill is producing 40 gallons, the best strategy for Jack is to produce 40 gallons. Similarly, given that Jack is producing 40 gallons, the best strategy for Jill is to produce 40 gallons. Once they reach this Nash equilibrium, neither Jack nor Jill has an incentive to make a different decision.

Price Fixing: Good or Bad? Resale price maintenance (Maximum retail price) Predatory Pricing Tying or Bundling Public Policy: Promote competition

The Size of the Oligopoly As the number of firms in the market increases, ◦ the price effect becomes smaller ◦ the oligopoly looks more and more like a competitive market ◦ P approaches MC ◦ the market quantity approaches the socially efficient quantity

Game Theory Game theory: the study of how people behave in strategic situations Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial

Prisoners’ Dilemma Example The police have caught Bonnie and Clyde, two suspected bank robbers, but only have enough evidence to imprison each for 1 year. The police question each in separate rooms, offer each the following deal: ◦ If you confess and implicate your partner, you go free and your partner gets 20 yrs. ◦ If you do not confess but your partner implicates you, you get 20 years in prison. ◦ If you both confess, each gets 8 years in prison. What would be Bonnie decide? Confess? Or Remain silent? What would be Clyde decide? Confess? Or Remain silent?

Prisoners’ Dilemma Example Confess Remain silent Confess Remain silent Bonnie’s decision Clyde’s decision Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde goes free Clyde gets 1 year Clyde gets 20 years Confessing is the dominant strategy for both players. Nash equilibrium: both confess

Prisoners’ Dilemma Example Outcome: Bonnie and Clyde both confess, each gets 8 years in prison. Both would have been better off if both remained silent. But even if Bonnie and Clyde had agreed before being caught to remain silent, the logic of self- interest takes over and leads them to confess. Note: When oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners’ dilemma.

Other Examples of the Prisoners’ Dilemma Organization of Petroleum Exporting Countries Arms race between military superpowers Common resources Ad wars..etc.

Is cooperation possible? When the game is repeated many times, cooperation may be possible. Strategies which may lead to cooperation: ◦ If your rival reneges in one round, you renege in all subsequent rounds. ◦ “Tit-for-tat” Whatever your rival does in one round (whether renege or cooperate), you do in the following round.

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