Chapter 16 Oligopoly

Objectives 1. Recognize market structures that are between competition and monopoly 2. Know the equilibrium characteristics of oligopoly. 3. Understand the concept of prisoners’ dilemma and how it applies to oligopoly. 4. Learn how anti-trust laws can increase competition in oligopoly markets

The Spectrum of Market Structure

Pure Competition Chapter 14

The Spectrum of Market Structure Pure Competition Chapter 14 Pure Monopoly Chapter 15

The Spectrum of Market Structure Pure Competition Chapter 14 Pure Monopoly Chapter 15

The Spectrum of Market Structure Pure Competition Chapter 14 Pure Monopoly Chapter 15 Imperfect Competition Chapters 16 & 17

Imperfect Competition is... …market structures that fall between perfect competition and pure monopoly. u Characteristic of: – Industries in which the firms have competitors but... do not face so much competition that the firm is a price taker.

Imperfect Competition Two types of imperfectly competitive markets: ¬ Monopolistic Competition Many firms selling products that are similar but not identical (e.g. movies.) ­ Oligopoly Only a few sellers, each offering a similar or identical product to the others (e.g. tennis balls.)

The Four Types of Market Structure MonopolyOligopolyMonopolistic Competition Perfect Competition 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: Oligopoly Because of the few sellers, the actions of any one seller in the market can have a large impact on the profits of all the other sellers.

Markets with only a Few Sellers: Oligopoly u Characteristics of an Oligopoly Market: – Few sellers offering similar product – Interdependent on other firms in industry – Best off by cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost u Duopoly Example...

OLIGOPOLY u Oligopoly is a market structure characterized by 1. A few sellers 2. With a homogeneous or differentiated product 3. Much control overprice (pricemaker) 4. Difficulty in entering and exiting the market.

Lessons From Duopoly Example A duopoly (and oligopoly) market structure may result in: ¬ Collusion : The two firms (industry) agreeing on the quantity to produce and the market price to charge. ­ Cartel : The two firms (industry) joining together and acting in unison. v In effect, the actions may result in the market being served by a monopoly.

A duopoly (and oligopoly) market structure may result in: (cont..) ® Oligopolies pursuing their own self- interest. ¯ Production is greater than the monopoly quantity but less than the competitive industry quantity. ° Market prices are lower than monopoly but greater than competitive price (marginal cost.) ± Total profits are less than the monopoly profit.

How the Size of an Oligopoly Affects the Market Outcome u How increasing the number of sellers affects the price and quantity: u The output effect: Because price is above marginal cost, selling more at the going price raises profits. u The price effect: Raising production lowers the price and the profit per unit on all units sold.

The Equilibrium for an Oligopoly u Nash Equilibrium: n ÷ (n + 1) – where n is the number of firms in the industry. – If n = 3, then the joint output would be 3/4 or 75% of the competitive market u Nash Equilibrium: – the joint output of the oligopoly firms (industry) would be less than the output of the competitive market.

Oligopoly Size and Market Outcome u As the size of an oligopoly increases, production will increase (i.e. the output effect) maintaining price above marginal cost. u As the number of sellers in an oligopoly grows larger, the market is more similar to a competitive market. – Price approaches marginal cost and output is more socially efficient.

The Demand Schedule for Water Table 16-1 Quantity (in gallons) Price Total Revenue (and Total Profit) $ $

A Duopoly Example: Price and Quantity Supplied u The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 gallons u The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 gallons

Quick Quiz! u If the members of an oligopoly could agree on a total quantity to produce, what quantity would they choose? u If oligopolies do not act together, do they produce a total quantity more or less than the previous question?

Game Theory & The Economics of Cooperation u Game Theory: the study of how people behave in strategic situations. – “Strategic” decisions means that each person (firm) in deciding what actions to take, must consider how others (firms) might respond to that action. – In an oligopolistic market the number of firms are small, hence each firm acts strategically.

Game Theory & The Economics of Cooperation u Prisoners’ Dilemma: illustrates the difficulty in maintaining cooperation. – Often people (firms) fail to cooperate with one another even when cooperation would make them better off. u The Prisoners’ Dilemma Story: – Bonnie and Clyde Example (Table 16-2)

The Prisoners’ Dilemma Person #1 Decision Choice # 1Choice # 2 Person # 2 Decision Choice # 2 Choice # 1 Payoff 1,1 Payoff 2,1 Payoff 1,2 Payoff 2,2

The Prisoners’ Dilemma Figure 16-2 Bonnie’s Decision 8 years for each Bonnie goes free Clyde gets 20 yrs Bonnie gets 20 yrs Clyde goes free 1 year for each ConfessRemain Silent Confess Remain Silent Clyde’s Decision

The Prisoners’ Dilemma u Dominant Strategy: The best strategy for a player to follow regardless of the strategies pursued by other players. – Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual. – Self interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly profits.

Oligopolies and Prisoners’ Dilemma u Self interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly profits. u May lead to cartel cheating. u Examples: – Iran and Iraq (Table 16-3) – International arms race (Table 16-4) – Cigarette Advertising (Table 16-5)

An Oligopoly Game Figure 16-2 Iraq’s Decision $40 billion for each Iraq gets $60 billion Iran gets $30 billion Iraq gets $30 billion Iran gets $60 billion $50 billion for each High Production Iran’s Decision High Production Low Production Low Production

An Advertising Game Figure 16-5 Marlboro’s Decision $3 billion profit for each Marlboro gets $2 billion profit Camel gets $5 billion profit $4 billion profit for each Advertise Camel’s Decision Don’t Advertise Don’t Advertise Marlboro gets $5 billion profit Camel gets $2 billion profit

Public Policy Toward Oligopolies u Firms in oligopolies have a strong incentive to collude in order to: – reduce production – raise prices – increase profits “People in the same trade seldom meet together... but the conversation ends in a conspiracy against the public, or in some [diversion] to raise prices.” (Adam Smith, 1776)

Why People Sometimes Cooperate Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

Public Policy Toward Oligopolies From the standpoint of society, cooperation among oligopolists is undesirable because – it leads to production that is too low – prices that are too high

Public Policy Toward Oligopolies u Antitrust Laws: – Sherman Antitrust Act of 1890 – Clayton Act of 1914 u Make it illegal to restrain trade or attempt to monopolize a market.

Controversies over Antitrust Policy u Sometimes the Antitrust Policies may not allow business practices that have potentially positive effects: – Resale Price Maintenance – Predatory pricing – Tying u Examples… –Toys “R” Us –The Movie Industry

Resale Price Maintenance Resale price maintenance (or fair trade) occurs when suppliers (like wholesalers) require the retailers that they sell to, to charge customers a specific amount.

Predatory Pricing Predatory pricing occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market.

Tying Tying refers to when a firm offers two (or more) of its products together at a single price, rather than separately.

Quick Quiz! u What kind of agreement is illegal for businesses to make? u Why are the antitrust laws controversial?

Summary u An oligopoly may end up looking more like a monopoly or a competitive market, depending on how many firms there are. u Oligopolies can attempt to cooperate with each other but are limited by laws. u Antitrust laws are used to regulate the behavior of oligopolies.

Summary u Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. u If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome.

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

Summary u Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.