Oligopoly and Game Theory ETP Economics 101

Imperfect Competition  Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly.  Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

Types  Types of Imperfectly Competitive Markets  Monopolistic Competition  Many firms selling products that are similar but not identical.  Oligopoly  Only a few sellers, each offering a similar or identical product to the others.

Key Feature  Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

Characteristics  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

Simple Type: Duopoly  A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.  Duopoly  Oligopoly with only two members  Decide quantity to sell  Price – determined on the market  By demand

 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 7

Collusion and Cartel  The duopolists may agree on a monopoly outcome.  Collusion  An agreement among firms in a market about quantities to produce or prices to charge.  Cartel  A group of firms acting in unison.

Is Cartel Possible?  Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

The Equilibrium for an Oligopoly  A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

The equilibrium for an Oligopoly  When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.  The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

Size of an Oligopoly  How increasing the number of sellers affects the price and quantity:  The output effect: Because price is above marginal cost, selling more at the going price raises profits.  The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.

Size of an Oligopoly  As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.  The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Strategic Action  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.

Game Theory  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.

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 is a particular “ game ” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Copyright©2003 Southwestern/Thomson Learning Bonnie’ s Decision Confess Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Clyde goes free Bonnie goes free Clyde gets 20 years gets 1 yearBonnie Clyde gets 1 year Remain Silent Remain Silent Clyde’s Decision

Dominant Strategy  The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.  Dominant strategies in Prisoners ’ dilemma: _ Clyde: Confess _ Bonnie: Confess

Nash Equilibrium & Best Outcome  Nash Equilibrium (self-interest): _ Clyde: Confess & Bonnie: Confess  Best Outcome (cooperation): _ Clyde: Silent & Bonnie: Silent  Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

Game Example: OPEC  Iraq and Iran: Members of OPEC  Their decisions on oil production.  Decisions: High Production or Low Production

Copyright©2003 Southwestern/Thomson Learning Iraq’s Decision High Production High Production Iraq gets $40 billion Iran gets $40 billion Iraq gets $30 billion Iran gets $60 billion Iraq gets $60 billion Iran gets $30 billion Iraq gets $50 billion Iran gets $50 billion Low Production Low Production Iran’s Decision

Nash Equilibrium  Dominant strategies: _ Iran: High Production _ Iraq: High Production  Nash Equilibrium (self-interest): _ Iran: High Production & Iraq: High Production  Best Outcome (cooperation): _ Iran: low production & Iraq: low production

Game Example: Arm Race  Game Players: USA & Russia  Decisions: Arm or Disarm

Copyright©2003 Southwestern/Thomson Learning Decision of the United States (U.S.) Arm U.S. at risk USSR at risk U.S. at risk and weak USSR safe and powerful U.S. safe and powerful USSR at risk and weak U.S. safe USSR safe Disarm Decision of the Soviet Union (USSR)

Nash Equilibrium  Dominant strategies: _ USA: Arm _ Russia: Arm  Nash Equilibrium (self-interest): _ USA: Arm & Russia: Arm  Best Outcome (cooperation): _ USA: Disarm & Russia: Disarm

Game Example: Advertising  Players: Camel & Marlboro  Decisions: Advertise or Don ’ t advertise

Copyright©2003 Southwestern/Thomson Learning Marlboro’ s Decision Advertise Marlboro gets $3 billion profit Camel gets $3 billion profit Camel gets $5 billion profit Marlboro gets $2 billion profit Camel gets $2 billion profit Marlboro gets $5 billion profit Camel gets $4 billion profit Marlboro gets $4 billion profit Don’t Advertise Don’t Advertise Camel’s Decision

Nash Equilibrium  Dominant strategies: _ Camel: Advertise _ Marlboro: Advertise  Nash Equilibrium (self-interest): _ Camel: Advertise _ Marlboro: Advertise  Best Outcome (cooperation): _ Camel: Don ’ t Advertise _ Marlboro: Don ’ t Advertise

Game Example: Common Resource such as Oil  Players: Texaco & Exxon  Decisions: Drill Two Wells or Drill one Well

Copyright©2003 Southwestern/Thomson Learning Exxon’s Decision Drill Two Wells Drill Two Wells Exxon gets $4 million profit Texaco gets $4 million profit Texaco gets $6 million profit Exxon gets $3 million profit Texaco gets $3 million profit Exxon gets $6 million profit Texaco gets $5 million profit Exxon gets $5 million profit Drill One Well Drill One Well Texaco’s Decision

Nash Equilibrium  Dominant strategies: _ Texaco: Drill Two Wells _ Exxon: Drill Two Wells  Nash Equilibrium (self-interest): _Texaco: Drill Two Wells _ Exxon: Drill Two Wells  Best Outcome (cooperation): _ Texaco: Drill One Well _ Exxon: Drill One Well

Game Example: Where to Advertise?  Players: Competitor.com or We.com  Decisions: NBA and NHL

No Nash equilibrium in pure strategies Where to advertise?

No Nash Equilibrium  Dominant strategies: _ We.com: none _ Competitor.com: none Nash Equilibrium (self-interest): _ We.com: none _ Competitor.com: none

Game Example: Evening News  Players: ATV and TVB  Decisions: 7:30 pm or 8:00 pm

Evening News:

Nash Equilibrium  Dominant strategies: _ ATV: none _ TVB: none Two Nash Equilibria (self-interest): _ ATV: 7:30pm & TVB: 8:00pm or _ ATV: 8:00pm & TVB: 7:30pm

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.

 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 39

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 40

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 41

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 42

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 43