1. Unit 4: Imperfect Competition

2. 2 Perfect Competition Pure Monopoly Monopolistic Competition Oligopoly Characteristics of Oligopolies: A Few Large Producers (Less than 10) Identical or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms use Strategic Pricing Examples: OPEC, Cereal Companies, Car Producers

3.  Oligopolies occur when only a few large firms start to control an industry.  High barriers to entry keep others from entering. Types of Barriers to Entry  1. Economies of Scale Ex: The car industry is difficult to enter because only large firms can make cars at the lowest cost  2. High Start-up Costs  3. Ownership of Raw Materials HOW DO OLIGOPOLIES OCCUR?

4. Game Theory An understanding of GAME THEORY helps firms in an OLIGOPOLY MAXIMIZE PROFIT. The study of how people behave in strategic situations

5. Game theory helps predict human behavior THE ICE CREAM MAN SIMULATION 1.You are a ice cream salesmen at the beach. 2.You have identical prices as another salesmen. 3.Beachgoers will purchase from the closest salesmen. 4.People are evenly distributed along the beach. 5.Each morning the two firms pick locations on the beach. Where is the best location?

6. Firm A decides where to goes first.  What is the best strategy for choosing a location each day?  Can you predict the end result each day?  How is this observed in the “real-world”? B Where should you put your firm? A

7. Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the “real-world”? AB Where should you put your firm? *Note to teachers* (delete) Assign one student firm A and another student firm B. Ask firm A to put their ice cream anywhere along the beach. (the best place is right in the middle) Ask firm B to put theirs in the most profitable location. (the best place is right next to firm A) Explain that if firm B puts theirs anywhere other than right next to firm A they will be less profitable Repeat with firm B choosing first. Students learn that game theory explain why fast food restaurants and gas stations are often located near each other

8. Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the “real-world”? AB Where should you put your firm?

9. Why learn about game theory? Oligopolies are interdependent since they compete with only a few other firms. Their pricing and output decisions must be strategic as to avoid economic losses. Game theory helps us analyze their strategies. SIMULATION!

10. Prisoner’s Dilemma I am innocent…

11. Situation Two suspects are arrested by the police. The police have sufficient evidence for a conviction, and have separated both prisoners, visit each of them to offer the same deal. If one testifies for the prosecution against the other (“betrays”) and the other remains silent (“cooperates”), the betrayer goes free and the silent accomplice receives the full twenty-year sentence. If both remain silent, both prisoners are sentenced to only five years in jail for a minor charge. If both betray each other, each receives a nine-year sentence. Each prisoner must choose to betray or to remain silent. Each one is assured that the other would not know about the decision before the end of the investigation. How would you act if you were one of the prisoners?

12. Directions 1.You cannot communicate with your partner in crime. 2.If the you decide to betray your partner-in- crime, you should place your black card on the table. If you decide to remain silent, you should place red card. 3.When everyone has made a decision, then look at the two cards and add (+) or subtract (-) the requisite number of years on your sheet. 4.The winner is who walks away with more life time left at the 10 th round.

13. Number of Turns Your ActionPartner’s Action Amount of Life Left Start----- 100 years 1 2 3 4 5 6 7 8 9 10

14. Confess Remain (Betray) Silent Confess (Betray) Remain Silent 20 yrs / Free 9 yrs / 9 yrs Prisoner’s Dilemma Free / 20 yrs 5 yrs / 5 yrs

16. Reflection Questions 1.If you only played the game once with your partner and both of you are trying to minimize your individual jail sentences, what is more rationally beneficial, remaining silent or testifying against your partner? Why? 2.If you and your partner had been able to communicate, would your decision have changed? If so, why? 3.What was your strategy when you repeatedly played games with the same partner? Who ended up spending a shorter amount of time in jail? Why? 4.Would you have chosen a different strategy if you were to repeatedly play against your partner again? If so, which strategy would you adopt? If not, why not? 5.Did your moral or personal values play a part in your strategy? If so, do you think they put you at an advantage or a disadvantage? Why?

17. Raise Price Remain the Same Raise Price Remain the Same 45526054 50515564 45526054 50515564 54645060  What’s both companies’ dominant strategy?  What will be the final decision? When PS raises price, XBox should… When PS Remains same price, XBox should… When XBox raises price, PS should… When XBox remains same price, PS should…

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24. What did we learn? 1.Oligopolies must use strategic pricing (they have to worry about the other guy) 2.Oligopolies have a tendency to collude to gain profit.  Collusion is the act of cooperating with rivals in order to “rig” a situation. 3.Collusion results in the incentive to cheat. 4.Firms make informed decisions based on their dominant strategies

25. 2007 FRQ #3 Payoff matrix for two competing bus companies

26. 2009 FRQB #3 Payoff matrix for two competing bus companies

27. 27

28. Oligopoly Because firms are interdependent There are 3 types of Oligopolies 1. Price Leadership 2. Colluding Oligopoly 3. Non-Colluding Oligopoly

29. Example: Small Town Gas Stations To maximize profit what will they do? OPEC does this with OIL #1. Price Leadership

30.  Collusion is ILLEGAL.  Firms CANNOT set prices.  Price leadership is a strategy used by firms to coordinate prices without outright collusion General Process: 1.“Dominant firm” initiates a price change 2.Other firms follow the leader #1. Price Leadership

31. Breakdowns in Price Leadership Temporary Price Wars may occur if other firms don’t follow price increases of dominant firm. Each firm tries to undercut each other. Example: Employee Pricing for Ford #1. Price Leadership

32. #2. Colluding Oligopolies Cartel = Colluding Oligopoly Definition: A cartel is a group of producers that create an agreement to fix prices high. 1.Cartels set price and output at an agreed upon level 2.Firms require identical or highly similar demand and costs 3.Cartel must have a way to punish cheaters 4.Together they act as a monopoly

33. Firms in a colluding oligopoly act as a monopoly and share the profit D MC ATC Q P MR #2. Colluding Oligopolies

34. #3. Non-Colluding Oligopolies Kinked Demand Curve Model Not on AP Test anymore, So don’t worry about it.

35. Elastic Inelastic P1P1 Q1Q1 P2P2 Q2Q2 D Q If this firm increases it’s price, other firms will ignore it & keep prices the same P As the only firm with high prices, Qd for this firm will fall a lot PePe QeQe If this firm decreases it’s price, other firms will match it & lower their prices Since all firms have lower prices, Qd for this firm will increase only a little Not on AP Test anymore, So don’t worry about it.

36. D Q Where is Marginal Revenue? P PePe Q MR has a vertical gap at the kink. The result is that MC can move and Qe won’t change. Price is sticky. MC MR Not on AP Test anymore, So don’t worry about it.