1. © 2007 Thomson South-Western, all rights reserved N. G R E G O R Y M A N K I W PowerPoint ® Slides by Ron Cronovich 16 P R I N C I P L E S O F F O U R T H E D I T I O N Oligopoly

2. 1 CHAPTER 16 OLIGOPOLY Oligopoly: to collude or compete?  Oligopolies – created by barriers to entry.  Market power created if sellers collude.  Oligopoly equilibrium without collusion.  Game Theory: how agents interact when outcomes depend on the actions of each.  How does collusion exist, when prohibited by anti-trust law? Tacit collusion, and incentives for participants to renege for individual gain.  Anti-trust laws to promote competition.

3. 2 CHAPTER 16 OLIGOPOLY Measuring Market Concentration  Concentration ratio: the percentage of the market’s total output supplied by its four largest firms.  The higher the concentration ratio, the less competition.  This chapter focuses on oligopoly, a market structure with high concentration ratios.

4. Concentration Ratios in Selected U.S. Industries IndustryConcentration ratio Greeting cards88% Tennis balls100% Credit cards99% Batteries94% Soft drinks93% Beer85% Breakfast cereal92% Cigarettes89% Book publishers42% Furniture stores8% Truck transportation8% Florists2%

5. 4 CHAPTER 16 OLIGOPOLY PQ $0140 5130 10120 15110 20100 2590 3080 3570 4060 4550 EXAMPLE: Cell Phone Duopoly in Smalltown  Smalltown has 140 residents  The “good”: cell phone service with unlimited anytime minutes and free phone  Smalltown’s demand schedule  Two firms: Cingular, Verizon (duopoly: an oligopoly with two firms)  Each firm’s costs: FC = $0, MC = $10

6. 5 CHAPTER 16 OLIGOPOLY 5045 6040 7035 8030 9025 10020 11015 12010 1305 140$0 QP 1,750 1,800 1,750 1,600 1,350 1,000 550 0 –650 –1,400 Profit 500 600 700 800 900 1,000 1,100 1,200 1,300 $1,400 Cost 2,250 2,400 2,450 2,400 2,250 2,000 1,650 1,200 650 $0 Revenue EXAMPLE: Cell Phone Duopoly in Smalltown Competitive outcome: P = MC = $10 Q = 120 Profit = $0 Competitive outcome: P = MC = $10 Q = 120 Profit = $0 Monopoly outcome: P = $40 Q = 60 Profit = $1,800 Monopoly outcome: P = $40 Q = 60 Profit = $1,800

7. 6 CHAPTER 16 OLIGOPOLY One Possible Duopoly Outcome: Collusion  Collusion: an agreement among firms in a market about quantities to produce or prices to charge  Cingular and Verizon could agree to each produce half of the monopoly output: For each firm: Q = 30, P = $40, profits = $900

8. A C T I V E L E A R N I N G 1 : Collusion vs. self-interest Duopoly outcome with collusion: Each firm agrees to produce Q = 30, earns profit = $900. If Cingular reneges on the agreement and produces Q = 40, what happens to the market price? Cingular’s profits? Is it in Cingular’s interest to renege on the agreement? If both firms renege and produce Q = 40, determine each firm’s profits. 7 PQ $0140 5130 10120 15110 20100 2590 3080 3570 4060 4550

9. A C T I V E L E A R N I N G 1 : Answers If both firms stick to agreement, each firm’s profit = $900 If Cingular reneges on agreement and produces Q = 40: Market quantity = 70, P = $35 Cingular’s profit = 40 x ($35 – 10) = $1000 Cingular’s profits are higher if it reneges. Verizon will conclude the same, so both firms renege, each produces Q = 40: Market quantity = 80, P = $30 Each firm’s profit = 40 x ($30 – 10) = $800 PQ $0140 5130 10120 15110 20100 2590 3080 3570 4060 4550

10. 9 CHAPTER 16 OLIGOPOLY Collusion vs. Self-Interest  Both firms would be better off if both stick to the cartel agreement.  But each firm has incentive to renege on the agreement.  Lesson: Oligopolies have strong incentives to find ways to reach an “agreement” and not to renege. How can this be done under current law?

11. A C T I V E L E A R N I N G 2 : Equilibrium when firms do not cooperate. When each firm produces Q = 40, market quantity = 80 P = $30 and each firm profit = $800. QUERY: Is it in Cingular’s interest to increase its output further, to Q = 50? Is it in Verizon’s interest to increase its output to Q = 50? 10 PQ $0140 5130 10120 15110 20100 2590 3080 3570 4060 4550

12. A C T I V E L E A R N I N G 2 : Answers If each firm produces Q = 40, then each firm’s profit = $800. If Cingular increases output to Q = 50: Market quantity = 90, P = $25 Cingular’s profit = 50 x ($25 – 10) = $750 Cingular’s profits are higher at Q = 40 than at Q = 50. The same is true for Verizon. This demonstrates that the equilibrium price is above the competitive level ! 11 PQ $0140 5130 10120 15110 20100 2590 3080 3570 4060 4550

13. 12 CHAPTER 16 OLIGOPOLY The Oligopoly Outcome when firms do not collude -- it depends on the market shares held by each firm.  Increasing output has two effects on a firm’s profits -- more is sold, but market price is driven down: output effect: If P > MC, selling more output raises profits. price effect: Reducing the market price reduces profit on all units that I previously sold.  My output decision balances these two offsetting factors on my profitability. Note, I do not care about my competitors.

14. 13 CHAPTER 16 OLIGOPOLY The Number of Firms in the Oligopoly and the Oligopoly Equilibrium (Without Collusion)  As the number of firms in the market increases, each firm has more incentive to lower price closer to the competitive price. the price effect becomes smaller, I.e. my expansion in output has only a small effect on the market price. I gain much more output and profits, since I am a small competitor. the oligopoly looks more and more like a competitive market, with P approaching MC (and the socially efficient quantity).

15. 14 CHAPTER 16 OLIGOPOLY The Equilibrium for this Duopoly  An equilibrium: participants interacting with one another each choose their best strategy given the strategies that all the others have chosen – no one therefore has incentive to change output.  Our duopoly example has a Nash equilibrium in which each firm produces Q = 40. Given that Verizon produces Q = 40, Cingular’s best move is to produce Q = 40. Given that Cingular produces Q = 40, Verizon’s best move is to produce Q = 40.

16. 15 CHAPTER 16 OLIGOPOLY Game Theory  Game theory: the study of how agents behave in strategic situations, when outcomes depend on how each behaves.  A Nash Equilibrium: each agent has chosen her best strategy given the strategy of others (implying no agent would alter her strategy, knowing how the other agent has acted).  Nash’s Contribution: For a broad class of games, there exists at least one Nash equilibrium (there may be multiple equilibria, requiring players to use “mixed strategies”).

17. 16 CHAPTER 16 OLIGOPOLY Prisoners’ Dilemma: illustrating why cooperation is difficult even when it is mutually beneficial.  The police have caught Bonnie and Clyde, two suspected bank robbers, but only have enough evidence to imprison each for 1 year.  The police question each in separate rooms, offer each the following deal: If you confess and implicate your partner, you go free. If you do not confess but your partner implicates you, you get 20 years in prison. If you both confess, each gets 8 years in prison.

18. 17 CHAPTER 16 OLIGOPOLY Prisoners’ Dilemma Example Confess Remain silent Confess Remain silent Bonnie’s decision Clyde’s decision Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde goes free Clyde gets 1 year Clyde gets 20 years Confessing is the dominant strategy for both players. Nash equilibrium: both confess

19. 18 CHAPTER 16 OLIGOPOLY Prisoners’ Dilemma Example  Outcome: Bonnie and Clyde both confess, each gets 8 years in prison.  Both would have been better off if both remained silent.  But even if Bonnie and Clyde had agreed before being caught to remain silent, the logic of self- interest takes over and leads them to confess.  Note: What happens in the game if police has no evidence – hence both freed if both stay silent?

20. 19 CHAPTER 16 OLIGOPOLY The Role of Dominant Strategies  Dominant Strategy: a strategy that is best for a player regardless of the strategies chosen by the other players.  If both players have a single dominant strategy, the game will have a single equilibrium.  What happens when there is not a dominant strategy – I.e. what I do depends on what others do?

21. 20 CHAPTER 16 OLIGOPOLY More Complex Games – with common and conflicting interests.  Coordination games  Games without a single Nash equilibrium in pure strategies: Rock/paper/scissors; poker. (Solved by playing mixed strategies – combining strategies with probability weights.)  Dynamic (repeated) games: signaling intentions, punishing.  Bargaining games: pre-commitment, my hands are tied.

22. 21 CHAPTER 16 OLIGOPOLY Oligopolies as a Prisoners’ Dilemma  When oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners’ dilemma.  Our earlier example: Cingular and Verizon are duopolists in Smalltown. The cartel outcome maximizes profits: Each firm agrees to serve Q = 30 customers.  Here is the “payoff matrix” for this example…

23. 22 CHAPTER 16 OLIGOPOLY Cingular & Verizon in the Prisoners’ Dilemma Q = 30 Q = 40 Q = 30 Q = 40 Cingular Verizon Cingular’s profit = $900 Verizon’s profit = $900 Cingular’s profit = $1000 Cingular’s profit = $800 Cingular’s profit = $750 Verizon’s profit = $750 Verizon’s profit = $800 Verizon’s profit = $1000 Each firm’s dominant strategy: renege on agreement, produce Q = 40.

24. 23 CHAPTER 16 OLIGOPOLY Other Examples of the Prisoners’ Dilemma Ad Wars Two firms spend millions on TV ads to steal business from each other. Each firm’s ad cancels out the effects of the other, and both firms’ profits fall by the cost of the ads. Organization of Petroleum Exporting Countries Member countries try to act like a cartel, agree to limit oil production to boost prices & profits. But agreements sometimes break down when individual countries renege.

25. 24 CHAPTER 16 OLIGOPOLY Why Firms Sometimes Cooperate  When the game is repeated many times, cooperation may be possible.  Strategies which may lead to cooperation: If your rival reneges in one round, you renege in all subsequent rounds. “Tit-for-tat” Whatever your rival does in one round (whether renege or cooperate), you do in the following round.

26. 25 CHAPTER 16 OLIGOPOLY Public Policy Toward Oligopolies: Restraint of Trade and Antitrust Laws  Government policy can improve market outcomes – by promoting competition, preventing collusion, and promoting open entry.  Sherman Antitrust Act (1890): forbids collusion between competitors, and “monopolizing, or attempting to monopolize..”  Clayton Antitrust Act (1914): strengthened rights of individuals damaged by anticompetitive arrangements between firms  Sanctions: injunctions, triple damage fines, fines and criminal charges/jail for executives, break up firms.

27. 26 CHAPTER 16 OLIGOPOLY “Tacit” collusion: how firms can agree without an “agreement”!  Trade associations share information on costs, marketing practices, shares, pricing practices.  Formula pricing: price based on advertised base price, markup for delivery and special features.  “Full cost pricing”: changing prices only when major, visible, and “permanent” cost changes.  Meeting competition clauses: “If any other seller offers a lower price, I will meet it.”  Open price policies; one firm is a price leader (I am meeting the competition and market conditions).

28. 27 CHAPTER 16 OLIGOPOLY What conditions promote tacit agreement?  Small number of firms that are relatively alike; homogeneous product; demand not fluctuate much; actions of firms easily observed, punishment can be severe.  Entry is difficult.  Substantial communicating of information about costs, demand shocks, my inventory: so that my price actions can be seen as a reasonable reaction to market, not as starting a price war.

29. 28 CHAPTER 16 OLIGOPOLY Controversies Over Antitrust Policy  Most people agree that price-fixing agreements among competitors should be illegal.  Many business practices that firms used to harm competitors (or erect entry barriers) can be defended as aggressively competing for business.  Many antitrust cases are filed by competitors, not the government.  Some economists sometimes disagree whether aggressive antitrust enforcement stifles business practices that are not necessarily harmful and have legitimate objectives.

30. 29 CHAPTER 16 OLIGOPOLY Predatory Pricing  Occurs when a firm cuts prices to prevent entry or drive a competitor out of the market, so that it can charge monopoly prices later.  Illegal under antitrust laws, but hard for the courts to determine when a price cut is predatory versus competitive & beneficial to consumers.  Many economists doubt that predatory pricing is a rational strategy: It involves selling at a loss, which is extremely costly for the firm.

31. 30 CHAPTER 16 OLIGOPOLY Significant Recent Anti-trust Litigation  U.S. vs IBM (1969): charges IBM with monopolizing computer market: IBM bundled its machines, software and support; introduced under-priced new machines it could not deliver on time. Justice dropped case as “without merit” in 1982.  AMD vs Intel (2005): Intel with 90% of market has monopolized by pricing chips below costs (predatory).  U.S. vs Microsoft (1998): charges that Microsoft bundles its browser and operating systems. Microsoft found guilty in 1999, and District Judge orders company be split into two parts, but breakup order was reversed by Appeals Court. Government settled case in Nov, 2002.

32. 31 CHAPTER 16 OLIGOPOLY CONCLUSION  Oligopolies can end up looking like monopolies or like competitive markets, depending on the number of firms and how cooperative they are.  The prisoners’ dilemma shows how difficult it is for firms to maintain cooperation, even when doing so is in their best interest.  Policymakers use the antitrust laws to regulate oligopolists’ behavior. The proper scope of these laws is the subject of ongoing controversy.

33. 32 CHAPTER 16 OLIGOPOLY CHAPTER SUMMARY  Oligopolists can maximize profits if they form a cartel and act like a monopolist.  Yet, self-interest leads each oligopolist to a higher quantity and lower price than under the monopoly outcome.  The larger the number of firms, the closer will be the quantity and price to the levels that would prevail under competition.

34. 33 CHAPTER 16 OLIGOPOLY CHAPTER SUMMARY  The prisoners’ dilemma shows that self-interest can prevent people from cooperating, even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many situations.  Policymakers use the antitrust laws to prevent oligopolies from engaging in anticompetitive behavior such as price-fixing. But the application of these laws is sometimes controversial.