1. Oligopoly and Game Theory
ETP Economics 101

2. 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.

3. 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.

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

5. 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

6. 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

7. Duopoly Collude and form a cartel Don’t collude – self-interest
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

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

9. 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.

10. 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.

11. 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).

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

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

18. 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

19. 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.

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

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

22. 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

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

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

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

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

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

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

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

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

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

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

33. Where to advertise? No Nash equilibrium in pure strategies 8
Two on-line e-commerce providers planning advertising strategy -- advertise in NBA (basketball) or NHL (hockey) series?
We.com plan to use comparative advertising -- more effective when viewers see advertisements of both competitors;
Competitor.com using unique advertising -- more effective on separate channel.
Draw arrows: no Nash equilibrium in pure strategies:
in some games in strategic form, there may be no Nash equilibrium in pure strategies
No Nash equilibrium in pure strategies 8

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

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

36. Evening News: Prime time for news is 8:0pm; second best is 7:30pm;
since audience is limited, get maximum viewership if two channels schedule at different times.
Question: which station gets 8:0pm? Situation has elements of
coordination -- avoiding same time slot
competition -- getting the 8:0pm slot

37. 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

38. 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.

39. 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

40. 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

41. 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

42. 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

43. 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