Oligopoly CHAPTER 13B

Oligopoly IRL In some markets there are only two firms. Computer chips are an example. The chips that drive most PCs are made by Intel and Advanced Micro Devices. How does competition between just two chip makers work? Do they operate in the social interest, like the firms in perfect competition? Or do they restrict output to increase profit, like a monopoly?

What Is Oligopoly? The distinguishing features of oligopoly are  Natural or legal barriers that prevent entry of new firms  A small number of firms compete

What is Oligopoly? Barriers to Entry Either natural or legal barriers to entry can create oligopoly. Figure 13.9 shows two oligopoly situations. In part (a), there is a natural duopoly—a market with two firms. A duopoly with collusion acts like a monopoly.

What is Oligopoly? Small Number of Firms Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. Interdependence: With a small number of firms, each firm’s profit depends on every firm’s actions. Each firm engages in strategic behavior based on the others. Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit. Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.

What is Oligopoly? Examples of Oligopoly Figure shows some examples of oligopoly.  Four largest firms  Next four largest firms  Next 12 largest firms An HHI that exceeds 1,000 is usually an oligopoly. An HHI below 1,000 is usually monopolistic competition.

Oligopoly Games Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. The Prisoners’ Dilemma The prisoners’ dilemma game illustrates the concept of Game Theory 

Oligopoly Games Rules In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. Each is held in a separate cell and cannot communicate with each other.

Oligopoly Games Each is told that both are suspected of committing a more serious crime. If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes. If both confess to the more serious crime, each receives 3 years in jail for both crimes. If neither confesses, each receives a 2-year sentence for the minor crime only.

Oligopoly Games Strategies Strategies are all the possible actions of each player. Art and Bob each have two possible actions: 1. Confess to the larger crime. 2. Deny having committed the larger crime. With two players and two actions for each player, there are four possible outcomes: 1. Both confess. 2. Both deny. 3. Art confesses and Bob denies. 4. Bob confesses and Art denies.

Oligopoly Games Payoffs Each prisoner can work out what happens to him—can work out his payoff—in each of the four possible outcomes. We can tabulate these outcomes in a payoff matrix. A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player. The next slide shows the payoff matrix for this prisoners’ dilemma game.

Oligopoly Games

Outcome If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player. If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibrium—first proposed by John Nash. The following slides show how to find the Nash equilibrium.

Bob’s view of the world

Art’s view of the world

Equilibrium

Oligopoly Games An Oligopoly Price-Fixing Game A game like the prisoners’ dilemma is played in duopoly. A duopoly is a market in which there are only two producers that compete. Duopoly captures the essence of oligopoly. Figure on the next slide describes the demand and cost situation in a natural duopoly.

Oligopoly Games Collusion Suppose that the two firms enter into a collusive agreement. A collusive agreement is an agreement between two (or more) firms to restrict output, raise the price, and increase profits. Such agreements are illegal in the United States and are undertaken in secret. Firms in a collusive agreement operate a cartel.

Oligopoly Games The strategies that firms in a cartel can pursue are to  Comply  Cheat Because each firm has two strategies, there are four possible combinations of actions for the firms: 1. Both comply. 2. Both cheat. 3. Trick complies and Gear cheats. 4. Gear complies and Trick cheats.

Payoff Matrix

Oligopoly Games Possible Outcomes  If both comply, each firm makes $2 million a week.  If both cheat, each firm makes zero economic profit.  If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million.  If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million. The next slide shows the payoff matrix for the duopoly game.

Trick’s view of the world

Gear’s view of the world

Equilibrium

Oligopoly Games Dominant Strategy A strategy is dominant if, regardless of what any other players do, the strategy earns a player a larger payoff than any other. Hence, a strategy is dominant if it is always better than any other strategy, for any profile of other players' action. Sometimes a firm does not have a dominant strategy.strategypayoff Nash Equilibrium When both firms have a dominant strategy, this is the Nash Equilibrium.

Oligopoly Games The Disappearing Invisible Hand In all the versions of the prisoners’ dilemma that we’ve examined, the players end up worse off than they would if they were able to cooperate. The pursuit of self-interest does not promote the social interest in these games.

Repeated Games and Sequential Games One possible punishment strategy is a tit-for-tat strategy. A tit-for-tat strategy is one in which one player cooperates this period if the other player cooperated in the previous period but cheats in the current period if the other player cheated in the previous period