1. Oligopoly Chapter 16

2. Imperfect Competition oImperfect competition refers to those market structures that fall between perfect competition and pure monopoly. oImperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers. oTypes of Imperfectly Competitive Markets oOligopoly oOnly a few sellers, each offering a similar or identical product to the others. oMonopolistic Competition oMany firms selling products that are similar but not identical.

3. The Four Types of Market Structure MonopolyOligopolyMonopolistic Competition Perfect Competition Tap water Cable TV Tennis balls Crude oil Novels Movies Wheat Milk Number of Firms? Type of Products? Many firms One firm Few firms Differentiated products Identical products

4. Markets With Only a Few Sellers oBecause of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. oCharacteristics of an Oligopoly Market oFew sellers offering similar or identical products oInterdependent firms oBest off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost

5. A Duopoly Example: Demand Schedule for Water A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

6. A Duopoly Example: Price and Quantity Supplied u The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 gallons u The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 gallons u The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water. u So what outcome then could be expected from duopolists?

7. Competition, Monopolies, and Cartels u The duopolists may agree on a monopoly outcome. u Collusion uThe two firms may agree on the quantity to produce and the price to charge. uOr, the firms may end up not trusting each other. uThey will compete by lowering prices to gain customers. uConsumers benefit from the competition.

8. Cartels u A Cartel is an organization of firms. The purpose is to act together like a monopoly. 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, e.g. legally binding contracts not available to firms.  Incentive to cheat (Examples: OPEC, class curve).

9. Cartels II Cartels are more effective when:  The number of firms is small because of barriers to entry.  Good is homogeneous.  Demand is inelastic.  Firms can avoid antitrust laws. OPEC has all these characteristics  Sometimes it still falls apart.

10. 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).

11. Summary of Equilibrium for an Oligopoly u Possible outcome if oligopoly firms pursue their own self-interests: u Joint output is greater than the monopoly quantity but less than the competitive industry quantity. u Market prices are lower than monopoly price but greater than competitive price. u Total profits are less than the monopoly profit.

12. A Duopoly Example: Demand Schedule for Water

13. How the Size of an Oligopoly Affects the Market Outcome u How increasing the number of sellers affects the price and quantity: u The output effect: Because price is above marginal cost, selling more at the going price raises profits. u The price effect: Raising production lowers the price and the profit per unit on all units sold.

14. How the Size of an Oligopoly Affects the Market Outcome oAs the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. oThe price approaches marginal cost, and the quantity produced approaches the socially efficient level.

15. Public Policy Towards Oligopoly The public benefits if the government sets up laws to encourage competition, not cooperation between firms. Price fixing is illegal.  Phase of the Moon Antitrust case  Tucker

16. 1948 Tucker Torpedo Automobile

17. An illegal phone call In the early 80s, Howard Putman, President of Braniff Airways and Robert Crandall, the President of American Airlines had the following telephone conversation.

18. An illegal phone call 2 Crandall: I think it’s dumb as hell…to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime. Putnam: Do you have a suggestion for me? Crandall: Yes, I have a suggestion for you. Raise your #$%& fares 20%. I’ll raise mine the next morning.

19. An illegal phone call 3 Putnam: Robert, we… Crandall: You’ll make more money, and I will too. Putnam: We can’t talk about pricing! Crandall: Oh, #$%&, Howard. We can talk about any #$%& thing we want to talk about.

20. An illegal phone call 4 This phone call violated the Sherman Antitrust act. At the time, some argued the government was wrong to get involved in a private telephone conversation. (But what if they had been planning a murder?) Cradall didn’t go to jail but he had to sign an agreement with the government that he wouldn’t talk to the competition anymore.

21. Game Theory and the Economics of Cooperation  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.

22. Game Theory and the Economics of Cooperation oBecause the number of firms in an oligopolistic market is small, each firm must act strategically. oEach firm knows that its profit depends not only on how much it produced but also on how much the other firms produce.

23. Playing the Game We will consider a 2x2 game  There are 2 players or firms  Each player has a choice of 2 strategies  Games can be expanded to NxN case

24. 2x2 Game Player 1 Strategy AStrategy B Strategy A Strategy B Player 2 Payoff for Player 2 Payoff for Player 1 Payoff for Player 2 “Payoff” indicates the result that the player receives if the outcome ends up being in that box.

25. Important Concepts in Game Theory Dominant Strategy-Best strategy a player can pick regardless of what the other player does. Nash Equilibrium-An outcome where neither player has an incentive to change strategy, given the other player’s strategy.

26. Important Concepts in Game Theory II Prisoner’s Dilemma: A game where there is a Nash equilibrium, but both players would be better off at the same time with a different outcome or square.

27. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free Does either player have a dominate strategy? First, let’s look at the game from Clyde’s point of view.

28. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free Clyde’s dominant strategy is to confess.

29. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free What about Bonnie? Does she have a dominate strategy?

30. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free Bonnie’s dominant strategy is to confess.

31. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free The Confess, Confess box is a Nash equilibrium.

32. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free The Confess, Confess box is a Nash equilibrium.

33. The Prisoners’ Dilemma Bonnie’s Decision ConfessRemain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free Both players would have been better off if they had kept their mouths shut, but they didn’t trust each other. The police benefited from this lack of trust.

34. Another Game Circuit City Low PriceHigh Price Low Price High Price Good Guys Good Guys gets $45 million Circuit City gets $45 million Circuit City gets $40 million Circuit City gets $50 million Circuit City gets $65 million Good Guys gets $40 million Good Guys gets $50 million Good Guys gets $65 million

35. Oligopolies as a Prisoners’ Dilemma Circuit City Low PriceHigh Price Low Price High Price Good Guys Good Guys gets $45 million Circuit City gets $45 million Circuit City gets $40 million Circuit City gets $50 million Circuit City gets $65 million Good Guys gets $40 million Good Guys gets $50 million Good Guys gets $65 million It’s the same as with Bonnie and Clyde. Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. The consumer benefits from the competition and lack of trust between firms.

36. Not all games are the same A player doesn’t necessarily have a dominant strategy. There can be 0, 1, or more than 1 Nash equilibrium in a game. A game may or may not be a Prisoner’s Dilemma game.

37. Let’s Do Another One Mazda Advertise a lotDon’t Advertise as Much Advertise a lot Don’t advertise as much Honda Honda gets $100 million Mazda gets $60 million Mazda gets $30 million Mazda gets $40 million Mazda gets $90 million Honda gets $70 million Honda gets $180 million Honda gets $140 million

38. From Honda’s Viewpoint Mazda Advertise a lotDon’t Advertise as Much Advertise a lot Don’t advertise as much Honda Honda gets $100 million Mazda gets $60 million Mazda gets $30 million Mazda gets $40 million Mazda gets $90 million Honda gets $70 million Honda gets $180 million Honda gets $140 million No dominant strategy for Honda

39. From Mazda’s Viewpoint Mazda Advertise a lotDon’t Advertise as Much Advertise a lot Don’t advertise as much Honda Honda gets $100 million Mazda gets $60 million Mazda gets $30 million Mazda gets $40 million Mazda gets $90 million Honda gets $70 million Honda gets $180 million Honda gets $140 million Mazda’s Dominant Strategy is to Advertise a lot.

40. End Game Mazda Advertise a lotDon’t Advertise as Much Advertise a lot Don’t advertise as much Honda Honda gets $100 million Mazda gets $60 million Mazda gets $30 million Mazda gets $40 million Mazda gets $90 million Honda gets $70 million Honda gets $180 million Honda gets $140 million The Nash equilibrium is where both firms advertise. (It doesn’t always have to be in the upper left-hand corner). This game is not a prisoner’s dilemma.