Principles of Microeconomics November 26 th, 2013

Spectrum of Competition Perfect competition and monopoly are the two “extremes”. Most of the time, the competitive structure in real life is “in between”  The number of firms, type of good, barriers to entry, and general structure determine spectrum position Perfect Competition Monopolistic Competition OligopolyMonopoly

Oligopoly Market structure has the following attributes: Sellers offer similar or identical products There are only a few sellers who share market power Strategy and firm interaction form the foundation for oligopolies Game Theory: The study of how people behave in strategic situations

A Duopoly Example Most straightforward example  only two firms exist in the market Two residents in a town own the only wells that supply water For simplicity sake, MC = 0 The following demand schedule represents how much water the town’s residents are willing to purchase:

Demand Schedule Given MC = 0, Total Revenue is also Profit

Demand Schedule Given MC = 0, Total Revenue is also Profit

Profit-Maximizing and Collusion The perfectly competitive level of output is 120 gallons MC = 0  Set Price = $0. The efficient level of output The profit-maximizing level of output is 60 gallons (Profit = $3,600) Inefficient This is the outcome a monopolist would produce If the two residents decided to work together…

Collusion When members of an oligopoly work together to maximize profits through output or price control Cartel: When firms collude and act in unison The best outcome for the two residents is to sell 60 gallons of water in the town and get $1,800 in profits each. However, it is hard to coordinate There are anti-trust laws in place

The Equilibrium of Oligopoly Resident #1 has an incentive to maximize individual profits. An expectation that resident #2 will only bring 30 gallons to the market.  Profits for resident #1 increase if 40 gallons are brought to the market ($1,800 to $2,000) However, resident #2 likely has the same expectation: Overall result: 80 gallons produced with $1,600 of profit for each resident.

The Equilibrium  Residents will not have a desire to produce 50 gallons (profits decrease from $1600 to $1500) This leads to an equilibrium Nash Equilibrium: An economic situation where actors interacting with each other choose the best strategy given the strategies that other actors have chosen

Outcome Due to individual incentives, the profit-maximizing output is not achieved  Sellers move towards the competitive equilibrium but only so far (to sell more output, prices have to decrease). Oligopoly price is less than monopoly but greater than the competitive price

Oligopoly Size  Outcome? As the size of an oligopoly grows, it becomes increasingly difficult to coordinate and make decisions. It is more difficult to form cartels and collude on prices. Anti-trust laws would prohibit this type of action

Firm’s Decision Making Based off of the following: The Output Effect: Because price is above marginal cost, selling one more gallon of water will raise profit The Price Effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold

Oligopoly Growth As the oligopoly grows, each seller has a smaller impact on market prices As the oligopoly grows in size, the magnitude of the price effect falls. If the oligopoly grows large enough, the price effect disappears altogether.

Outcome from Growth As the number of sellers in an oligopoly grows larger  oligopoly looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Game Theory We can use game theory and payoff matrices to analyze strategic decisions/outcomes. Payoff Matrix: Demonstrates how well off economic actors are under different decisions/circumstances. We will compare these outcomes to predict behavior and analyze decisions.

Prisoner’s Dilemma A demonstration of the payoff matrix model Two criminals (Bonnie and Clyde) have been arrested. There is enough evidence to convict both of a minor crime  Both will serve 1 year Evidence implicates the two in a bank robbery The police desire the criminals to spend the maximize amount of time in jail.

Incentives If both criminals refuse to confess to the bank robbery, each will serve only 1 year The police extend an offer to each criminal: Confess/implicate your partner for the bank robbery  If you confess, you won’t have to serve any time and your partner serves 20 years If both criminals confess, the trial can be skipped and each criminal will serve 8 years We can use a payoff matrix to demonstrate the outcomes

The Dilemma Each criminal has an incentive to minimize their sentence

The Dilemma Bonnie’s outcome depends on Clyde’s decision & Clyde’s outcome depends on Bonnie’s decision

The Dilemma The best outcome overall is for both to remain silent  each only serves 1 year Will this outcome occur?

Dominant Strategy Dominant Strategy: A strategy that is best for a player in a game regardless of the strategies chosen by the other players

Dominant Strategy What is the best strategy for Bonnie?

Dominant Strategy What is the best strategy for Bonnie? If Clyde confesses, the best strategy for Bonnie is to confess

Dominant Strategy What is the best strategy for Bonnie? If Clyde remains silent, the best strategy for Bonnie is to confess

Dominant Strategy Regardless of what Clyde does, Bonnie’s best strategy is to confess This is a dominant strategy

Dominant Strategy Clyde faces the same payoffs and has the same dominant strategy

Outcome With the incentives and payoffs in place, both Bonnie and Clyde will choose to confess  Both serve 8 years in prison

Results Even though the best overall outcome is for both Bonnie and Clyde to stay silent, self-interested incentives drive the two to a different outcome If Bonnie and Clyde coordinated their actions, they could minimize the overall time they spend in jail.

Oligopoly Revisit We can revisit our previous example of the well owners Jack and Jill own the only wells in town and decide how much water to supply Total profits are maximized at 3o gallons but each has an incentive to produce 40 gallons instead The following payoff matrix demonstrates the payoffs for each.

Water & Wells and Oligopoly

Results Though the best outcome is for both to produce 30 gallons, there are incentives for both to produce 40 instead This result is in line with the Nash equilibrium analysis we previously established. Once again, the dominant strategy pushes our individuals from the efficient outcome