1. Microeconomics 1000
Lecture 13 Oligopoly

2. BETWEEN MONOPOLY AND PERFECT COMPETITION
Many markets are not monopolies, but the number of firms is relatively small, and so firms have some market power.
In other markets, the products are differentiated, with each firm producing different varieties of the same product.
These markets are often referred to as oligopoly and monopolistic competition, respectively.

3. BETWEEN MONOPOLY AND PERFECT COMPETITION
Types of Imperfectly Competitive Markets
Oligopoly
Only a few sellers, each offering a similar or identical product to the others.
Monopolistic Competition
Many firms selling products that are similar but not identical.

4. Figure 1 Four Types of Market Structure
Number of Firms?
One
firm
Few
firms
Many
firms
Type of Products?
Differentiated
products
Identical
products •
Novels
Movies
Monopolistic
Competition
(Chapter 17)
Perfect •
Wheat
Milk
Competition
(Chapter 14)
Football matches
Rail connection
Monopoly
(Chapter 15) •
Car tires
Crude oil
Oligopoly
(Chapter 16)
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5. MARKETS WITH ONLY A FEW SELLERS
Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.
Firms are best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost; but cooperation is difficult to sustain
A classical illustration is the prisoners’ dilemma
Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

6. The Prisoners’ Dilemma
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.

7. Figure 2 The Prisoners’ Dilemma
B’ s Decision
Confess
Remain Silent
B gets 8 years
C gets 8 years
B gets 20 years
C goes free
Confess
C’s
Decision
B goes free
C gets 20 years
gets 1 year B
C gets 1 year
Remain
Silent
Copyright©2003 Southwestern/Thomson Learning

8. The Prisoners’ Dilemma
The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.
Confess
Cooperation (Remain Silent) is difficult to maintain, because cooperation is not in the best interest of the individual player.

9. 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.

10. The Equilibrium in a game
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.

11. Oligopoly as a game In oligopoly, a firm’s profit is
But price p depends on total output
Thus, the optimal strategy for a firm depends on what its competitors are doing, and vice versa
There is strategic interaction

12. A Duopoly Example
A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.
Suppose for simplicity that the two firms are symmetric (same unit cost, homogeneous product)
Consider the “cooperative” outcome: both firms agree to produce a half of the monopoly quantity, so that the price equals the monopoly price

13. Price and output effects
Recall that an increase in output has two opposite effects on the firm’s profit:
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.

14. Why cooperation is difficult to sustain

15. Why cooperation is difficult to sustain

16. Example Suppose the demand function is
and the unit cost is c = 50. Then, the monopoly price is 150 and the monopoly output is 100. The monopoly profit (gross of the fixed cost) is
(150 – 50) x 100 =1000
To see why this is the profit maximising solution, observe that a one percent increase (decrease) in quantity causes a one percent decrease (increase) in the price-cost margin
For example, with q = 101, profit would be
(149 – 50) x 101 = 9999 < 10000

17. Example (cont’d) Now suppose there are two symmetric oligopolists
Start from the monopoly solution, assuming that monopoly output is split evenly among the two firms, and consider the incentive to increase output by one unit (i.e., from 50 to 51):
Initial profit: (150 – 50) x 50 = 5000
Profit after change: (149 – 50) x 51 = 5049
(The other firm’s profit falls to 4950)

18. Oligopoly equilibrium
Because each firm has a unilateral incentive to increase output, in the resulting equilibrium total output will be greater than under monopoly
It follows that the price will be lower than under monopoly
The deadweight loss will be lower than under monopoly
But the profit will also be lower than under monopoly

19. 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.

20. Figure 3 Industry profit as a function of total output
Monopoly quantity
Monopoly
profit
Oligopoly equilibrium
somewhere here
Quantity
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21. Figure 4 Monopoly v. Oligopoly equilibrium
Price
Marginal
revenue
Demand
Oligopoly equilibrium
somewhere here
Quantity sold
Monopoly
price
Profit
Marginal cost
Quantity
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22. Oligopoly equilibrium
Where exactly the oligopoly equilibrium will lie depends of the fine details of the strategic interaction among the firms
For example, while it is a matter of indifference to imagine to think of a monopolist as choosing the quantity or the price, under oligopoly it does make a difference
If firms set price, we have the so called Bertrand equilibrium
If firms set quantities, we have the Cournot equilibrium
In general, competition in the Bertrand model is more intense than in the Cournot model

23. Figure 5 How the monopoly equilibrium is implemented
Price
Demand
Quantity sold
Monopoly
price
Marginal cost
Quantity
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24. Equilibrium for an Oligopoly
Summary
Possible outcome if oligopoly firms pursue their own self-interests:
Joint output is greater than the monopoly quantity but less than the competitive industry quantity.
Market prices are lower than monopoly price but greater than competitive price.
Total profits are less than the monopoly profit.

25. Competition, Monopolies, and Cartels
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.

26. Competition, Monopolies, and Cartels
Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible.
However, firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.
Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.
They also prohibit “facilitating practices”, such as information exchange

27. How the Size of an Oligopoly Affects the Market Outcome
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.

28. How the Size of an Oligopoly Affects the Market Outcome
As the number of sellers in an oligopoly grows larger, the incentive to increase output becomes stronger and stronger.
The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

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

30. Summary
Oligopolists would maximise their total profits by forming a cartel and acting like a monopolist.
However, if oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome.
Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.