17 Oligopoly

Question 1 An oligopoly is a market in which: Answer: there are only a few sellers, each offering a product similar or identical to the products offered by other firms in the market.

Oligopoly Oligopoly Game theory Only a few sellers Offer similar or identical products Interdependent Game theory How people behave in strategic situations Choose among alternative courses of action Must consider how others might respond to the action he takes

Markets with Only a Few Sellers A small group of sellers Tension between cooperation and self-interest Is best off cooperating Acting like a monopolist Produce a small quantity of output Charge P >MC Each - cares only about its own profit Powerful incentives not to cooperate

Markets with Only a Few Sellers A duopoly example Duopoly Oligopoly with only two members Decide quantity to sell Price – determined on the market By demand

Question 2 One key difference between an oligopoly market and a perfectly competitive market is that oligopolistic firms: Answer: can affect the profit of others firms in the market by choices they make whereas firms in perfectly competitive markets do not affect each other by choice they make.

Markets with Only a Few Sellers Competition, monopolies, and cartels Perfectly competitive firm Price = marginal cost Quantity = efficient Monopoly Price > marginal cost Quantity < efficient quantity

Markets with Only a Few Sellers Competition, monopolies, and cartels Duopoly Collude and form a cartel Act as a monopoly Total level of production Quantity produced by each member Don’t collude – self-interest Difficult to agree; Antitrust laws Higher quantity; lower price; lower profit Not competitive allocation Nash equilibrium

Markets with Only a Few Sellers Collusion Agreement among firms in a market Quantities to produce or Prices to charge Cartel Group of firms acting in unison

Question 3 If, in a particular market, firms sell identical products, then the market is A. perfectly competitive. B. monopolistically competitive. C. an oligopoly. Answer: C. Only

Question 4 A market structure in which there are many firms selling products that are similar but not identical is known as: Answer: oligopoly.

Question 5 The equilibrium quantity in markets characterized by oligopoly is: Answer: higher than in monopoly markets and lower than in perfectly competitive markets.

Markets with Only a Few Sellers The equilibrium for an oligopoly Nash equilibrium Economic actors interacting with one another Each choose their best strategy Given the strategies that all the other actors have chosen

Question 6 Consider a market that is initially perfectly competitive with many firms selling an identical product. Over time, however, suppose the merging of firms results in the market being served by only three or four firms selling this same product. As a result, we would expect: Answer: a decrease in market output and an increase in the price of the product.

Markets with Only a Few Sellers How the size of an oligopoly affects the market outcome More sellers Form a cartel - Maximize profit Produce monopoly quantity Charge monopoly price Difficult to reach & enforce an agreement

Markets with Only a Few Sellers How the size of an oligopoly affects the market outcome More sellers Do not form a cartel – Each firm: The output effect P > MC Sell one more unit: Increase profit The price effect Increase production: increase total amount sold Decrease in price: Lower profit

Markets with Only a Few Sellers How the size of an oligopoly affects the market outcome As the number of sellers in an oligopoly grows larger Oligopolistic market - looks more like a competitive market Price - approaches marginal cost Quantity produced – approaches socially efficient level

The Economics of Cooperation The prisoners’ dilemma Particular “game” between two captured prisoners Illustrates why cooperation is difficult to maintain even when it is mutually beneficial Dominant strategy Strategy that is best for a player in a game Regardless of the strategies chosen by the other players

The prisoners’ dilemma 1 The prisoners’ dilemma Bonnie’s decision Confess Remain silent Clyde’s Decision Remain silent Clyde gets 8 years Bonnie gets 8 years Clyde goes free Bonnie gets 20 years Bonnie goes free Clyde gets 20 years Clyde gets 1 year Bonnie gets 1 year In this game between two criminals suspected of committing a crime, the sentence that each receives depends both on his or her decision whether to confess or remain silent and on the decision made by the other

Question 7 The prisoners’ dilemma is an important game to study because Answer: it identifies the fundamental difficulty in maintaining cooperative agreements.

The Economics of Cooperation Oligopolies as a prisoners’ dilemma Game oligopolists play In trying to reach the monopoly outcome Similar to the game that the two prisoners play in the prisoners’ dilemma Firms are self-interest And do not cooperate Even though cooperation (cartel) would increase profits Each firm has incentive to cheat

Figure 17-1 Katie and Taylor are roommates. On a particular day, their lawn needs to be mowed. Each person has to decide whether to take part in mowing the lawn. At the end of the day, either the lawn will be mowed (if one or both roommates take part in mowing), or it will remain un-mowed (if neither roommate mows). With happiness measured on a scale of 1 (very unhappy) to 10 (very happy), the possible outcomes are as follows:

Question 8 and 9  Refer to Figure 17-1. The dominant strategy for Taylor is to  Answer: refrain from mowing, and there is no dominant strategy for Katie.  Refer to Figure 17-1. If this game is played only once, then which of the following outcomes is the most likely one? Answer: Katie mows and Taylor does not mow.

The Economics of Cooperation Other examples of prisoners’ dilemma Arms races After World War II, United States and the Soviet Union Engaged in a prolonged competition over military power Strategies Build new weapons Disarm Dominant strategy: Arm

Decision of the United States (U.S.) 3 An arms-race game Decision of the United States (U.S.) Arm Disarm Decision of the Soviet Union (USSR) USSR at risk U.S. at risk USSR safe and powerful U.S. at risk and weak U.S. safe and powerful USSR at risk and weak USSR safe U.S. safe In this game between two countries, the safety and power of each country depend on both its decision whether to arm and the decision made by the other country

The Economics of Cooperation Other examples of prisoners’ dilemma Common resources Two companies – own a common pool of oil Strategies Each company drills one well Each company drills a second well Get more oil Dominant strategy Each company drills two wells Lower profit

Question 10 In a game, a dominant strategy is: Answer: the best strategy for a player to follow, regardless of the strategies followed by other players.

The Economics of Cooperation The prisoners’ dilemma and the welfare of society Dominant strategy Noncooperative equilibrium May be bad for society and the players Arms race game Common resource game May be good for society Quantity and price – closer to optimal level

Table 17-1 Consider a small town that has two grocery stores from which residents can choose to buy a gallon of milk. The store owners each must make a decision to set a high milk price or a low milk price. The payoff table, showing profit per week, is provided. The profit in each cell is shown as (Store 1, Store 2).

Question 11 Refer to Table 17-1. If grocery store 2 sets a low price, what price should grocery store 1 set? And what will grocery store 1’s payoff equal? Answer: Low Price, $500

The Economics of Cooperation Why people sometimes cooperate Game of repeated prisoners’ dilemma Repeat the game Agree on penalties if one cheats Both have incentive to cooperate

The prisoners’ dilemma tournament Repeated prisoners’ dilemma Encourage cooperation Penalty for not cooperating Better strategy Return to cooperative outcome after a period of noncooperation Best strategy: tit-for-tat Player - start by cooperating Then do whatever the other player did last time Starts out friendly Penalizes unfriendly players Forgives them if warranted

Question 12 Which of the following statements is (are) true of the prisoners’ dilemma? A. Rational self-interest leads neither party to confess. B. Cooperation between the prisoners is difficult to maintain. C. Cooperation between the prisoners is individually rational. Answer: B Only

Public Policy Toward Oligopolies Restraint of trade and the antitrust laws Common law: antitrust laws The Sherman Antitrust Act, 1890 Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy The Clayton Act, 1914 Further strengthened the antitrust laws Used to prevent mergers Used to prevent oligopolists from colluding

An illegal phone call Robert Crandall - president of American Airlines Howard Putnam - president of Braniff Airways CRANDALL: I think it’s dumb as hell . . . to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime. PUTNAM: Do you have a suggestion for me? CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent. I’ll raise mine the next morning. PUTNAM: Robert, we . . . CRANDALL: You’ll make more money, and I will, too. PUTNAM: We can’t talk about pricing! CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we want to talk about.

Public Policy Toward Oligopolies Controversies over antitrust policies Resale price maintenance (fair trade) Require retailers to charge customers a given price Might seem anticompetitive Prevents the retailers from competing on price Defenders: Not aimed at reducing competition Legitimate goal Some retailers offer service

Public Policy Toward Oligopolies Controversies over antitrust policies Predatory pricing Charge prices that are too low Anticompetitive Price cuts may be intended to drive other firms out of the market Skeptics Predatory pricing – not a profitable strategy Price war - to drive out a rival Prices - driven below cost

Public Policy Toward Oligopolies Controversies over antitrust policies Tying Offer two goods together at a single price Expand market power Skeptics Cannot increase market power by binding two goods together Form of price discrimination Tying may increase profit

FRQ 1 Describe the source of tension between cooperation and self-interest in a market characterized by oligopoly. Use an example of an actual cartel arrangement to demonstrate why this tension creates instability in cartels.

FRQ 1 Answer The source of the tension exists because total profits are maximized when oligopolists cooperate on price and quantity by operating as a monopolist. However, individual profits can be gained by individuals cheating on their cooperative agreement. This is why cooperative agreements among members of a cartel are inherently unstable. This is evident in the problem OPEC experiences in enforcing the cooperative agreement on production and price of crude oil.

FRQ 2 Ford and General Motors are considering expanding into the Vietnamese automobile market. Given the payoffs in the box, answer the following questions. A. Does GM have a dominant strategy? Explain. B. Does Ford have a dominant strategy? Explain. C. If both GM and Ford only play this game one time, what will be each of their payoffs?

FRQ 2 Answer A. Yes, the dominant strategy for GM is to expand. Expansion is better for GM regardless of what Ford does. B. Yes, the dominant strategy for Ford is to expand. Expansion is better for Ford regardless of what GM does. C. They will each follow their dominant strategy and wind up with two each.

U.S. government’s suit against the Microsoft Corporation, 1998 The Microsoft case U.S. government’s suit against the Microsoft Corporation, 1998 Central issue: tying Should Microsoft be allowed to integrate its Internet browser into its Windows operating system The government’s claim: Microsoft was bundling - to expand market power into the market of Internet browsers Would deter other software companies from entering the market and offering new products

The Microsoft case Microsoft responded New features into old products - natural part of technological progress Cars - include CD players, air conditioners Cameras - built-in flashes Operating systems - added many features to Windows Previously stand-alone products Computers - more reliable and easier to use Integration of Internet technology, The next natural next step

The Microsoft case Disagreement The government Microsoft Extent of Microsoft’s market power The government More than 80% of new personal computers Use a Microsoft operating system Substantial monopoly power Microsoft Software market is always changing Competitors: Apple Mac & Linux operating systems Low price – limited market power

The Microsoft case November 1999 ruling June 2000 2001, appeals court Microsoft - great monopoly power Illegally abused that power June 2000 Microsoft – to be broken up into two companies Operating system & Applications software 2001, appeals court Overturned the breakup order September 2001 Justice Department - wanted to settle the case quickly

Private antitrust suits Suits brought by the European Union The Microsoft case Settlement: November 2002 Microsoft – some restrictions Government – browser would remain part of the Windows operating system Private antitrust suits Suits brought by the European Union Alleging a variety of anticompetitive behaviors