1. Chapter 16 OligopolyOligopoly © 2002 by Nelson, a division of Thomson Canada Limited

2. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 2 See what market structures lie between monopoly and competition. Examine what outcomes are possible when a market is an oligopoly.. Learn about the prisoners’ dilemma and how it applies to oligopoly and other issues.. Consider how competition laws try to foster competition in oligopolistic markets. See what market structures lie between monopoly and competition. Examine what outcomes are possible when a market is an oligopoly.. Learn about the prisoners’ dilemma and how it applies to oligopoly and other issues.. Consider how competition laws try to foster competition in oligopolistic markets. In this chapter you will…

3. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 3 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. 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. 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. 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. BETWEEN MONOPOLY AND PERFECT COMPETITION

4. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 4 Tap water Cable TV Monopoly (Chapter 15) Novels Movies Monopolistic Competition (Chapter 17) Tennis balls Crude oil Oligopoly (Chapter 16) Number of Firms? Perfect Wheat Milk Competition (Chapter 14) Type of Products? Identical products Differentiated products One firm Few firms Many firms Figure 16-1: The Four Types of Market Structure

5. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 5 Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. 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 Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. 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 MARKETS WITH ONLY A FEW SELLERS

6. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 6 A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. A town with two residents - Jack and Jill - own wells that produce water safe for drinking. Each Saturday, Jack and Jill decide how many litres of water to pump, bring the water to town, and sell it for whatever price the market will bear. The marginal cost of water is zero. A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. A town with two residents - Jack and Jill - own wells that produce water safe for drinking. Each Saturday, Jack and Jill decide how many litres of water to pump, bring the water to town, and sell it for whatever price the market will bear. The marginal cost of water is zero. A Duopoly Example

7. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 7 00120 110010110 200020100 27003090 32004080 35005070 360060 35007050 32008040 27009030 200010020 110011010 $0$1200 Total revenue (and total profit)PriceQuantity (in litres) Table 16-1: The Demand Curve for Water

8. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 8 Price and Quantity Supplied –The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 litres –The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 litres Price and Quantity Supplied –The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 litres –The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 litres A Duopoly Example

9. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 9 Price and Quantity Supplied –The socially efficient quantity of water is 120 litres, but a monopolist would produce only 60 litres of water. –So what outcome then could be expected from duopolists? 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. Price and Quantity Supplied –The socially efficient quantity of water is 120 litres, but a monopolist would produce only 60 litres of water. –So what outcome then could be expected from duopolists? 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. Competition, Monopolies, and Cartels

10. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 10 Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Competition laws prohibit explicit agreements among oligopolists as a matter of public policy. Lets examine what would happen if Jack and Jill decide separately how much water to produce. At first, one would expect Jack and Jill to reach the monopoly outcome on their own, for this outcome maximizes their joint outcome. In the absence of a binding agreement, the monopoly outcome is unlikely… Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Competition laws prohibit explicit agreements among oligopolists as a matter of public policy. Lets examine what would happen if Jack and Jill decide separately how much water to produce. At first, one would expect Jack and Jill to reach the monopoly outcome on their own, for this outcome maximizes their joint outcome. In the absence of a binding agreement, the monopoly outcome is unlikely… The Equilibrium for an Oligopoly

11. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 11 Why? Jack expects Jill to produce 30 L (half the monopoly quantity). Jack could produce 30 L, for a total of 60 L and the price would be $60. The profit would be $1800 (30 L x $60/L). OR… Jack could produce 40 L, for a total of 70 L and the price would be $50. His profit would be $2000 (40 L x $50/L). The profit in the market would fall from $3600 to $3500 but Jack’s profit would be higher ($2000 vs. $1800). Of course, Jill might reason the same way and produce 40 L. Total sales would be 80 L, with a price of $40 and a profit of $3200. Why? Jack expects Jill to produce 30 L (half the monopoly quantity). Jack could produce 30 L, for a total of 60 L and the price would be $60. The profit would be $1800 (30 L x $60/L). OR… Jack could produce 40 L, for a total of 70 L and the price would be $50. His profit would be $2000 (40 L x $50/L). The profit in the market would fall from $3600 to $3500 but Jack’s profit would be higher ($2000 vs. $1800). Of course, Jill might reason the same way and produce 40 L. Total sales would be 80 L, with a price of $40 and a profit of $3200. The Equilibrium for an Oligopoly

12. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 12 By pursuing their own self-interest, duopolists produce more than the monopoly quantity, charge a price lower than the monopoly price, and earn a profit lower than the monopoly profit. The logic of self-interest increases the duopoly’s output above the monopoly level, it does not lead to the competitive equilibrium. If Jack increases his production from 40 L to 50 L while Jill maintains her production at 40 L, then the total production is 90 L and the price is $30/L. Jack’s profit will be $1500 (50 L x $30). He is better off if he leaves production at 40 L. Jack and Jill’s outcome of 40 L is an equilibrium… a Nash Equilibrium. By pursuing their own self-interest, duopolists produce more than the monopoly quantity, charge a price lower than the monopoly price, and earn a profit lower than the monopoly profit. The logic of self-interest increases the duopoly’s output above the monopoly level, it does not lead to the competitive equilibrium. If Jack increases his production from 40 L to 50 L while Jill maintains her production at 40 L, then the total production is 90 L and the price is $30/L. Jack’s profit will be $1500 (50 L x $30). He is better off if he leaves production at 40 L. Jack and Jill’s outcome of 40 L is an equilibrium… a Nash Equilibrium. The Equilibrium for an Oligopoly

13. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 13 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. When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by a monopoly and less than the level produced by competition. 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. When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by a monopoly and less than the level produced by competition. The Equilibrium for an Oligopoly

14. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 14 The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost). 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 the competitive price (which equals marginal cost). Total profits are less than the monopoly profit. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost). 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 the competitive price (which equals marginal cost). Total profits are less than the monopoly profit. The Equilibrium for an Oligopoly

15. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 15 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. 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. How the Size of an Oligopoly Affects the Market Outcome

16. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 16 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. 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. How the Size of an Oligopoly Affects the Market Outcome

17. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 17 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. 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. GAME THEORY AND THE ECONOMICS OF COOPERATION

18. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 18 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. 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. GAME THEORY AND THE ECONOMICS OF COOPERATION

19. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 19 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. 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. GAME THEORY AND THE ECONOMICS OF COOPERATION

20. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 20 The prisoners’ dilemma is about two criminals who have been captured by the police, Bonnie and Clyde. The police have enough evidence to convict both of a minor crime. They lack however enough hard evidence of convicting them of a more serious crime. The police question Bonnie and Clyde in separate rooms. They are offered each a deal. The prisoners’ dilemma is about two criminals who have been captured by the police, Bonnie and Clyde. The police have enough evidence to convict both of a minor crime. They lack however enough hard evidence of convicting them of a more serious crime. The police question Bonnie and Clyde in separate rooms. They are offered each a deal. The Prisoners’ Dilemma

21. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 21 Bonnie’s Decision Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Clyde gets 20 years Bonnie goes free Clyde gets 1 years Bonnie gets 1 year Clyde goes free Bonnie gets 20 years Confess Remain silent Confess Remain silent Figure 16-2: The Prisoners’ Dilemma

22. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 22 The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. Confessing is the best strategy for Bonnie and for Clyde. In the end, both confess and spend eight years in jail. From their standpoint, it is not a good outcome. By remaining silent they would have spent one year in jail. By pursuing their self-interest, they reach an outcome that is worse for each other. The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. Confessing is the best strategy for Bonnie and for Clyde. In the end, both confess and spend eight years in jail. From their standpoint, it is not a good outcome. By remaining silent they would have spent one year in jail. By pursuing their self-interest, they reach an outcome that is worse for each other. The Prisoners’ Dilemma

23. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 23 Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player. The Prisoners’ Dilemma

24. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 24 Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. Oligopolies as a Prisoners’ Dilemma

25. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 25 Iraq's decision Iran’s decision Iran gets $40 billion Iraq gets $40 billion High Production Low Production High Production Low Production Iran gets $30 billion Iraq gets $60 billion Iran gets $60 billion Iraq gets $30 billion Iran gets $50 billion Iraq gets $50 billion Figure 16-3: The Oligopoly Game

26. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 26 Arms races Advertising Common resources Arms races Advertising Common resources Other Examples of the Prisoners’ Dilemma

27. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 27 Decision of the US Decision of the USSR USSR at risk US at risk Arm Disarm Arm Disarm USSR at risk and weak US safe and powerful USSR safe and powerful US at risk and weak USSR safe US safe Figure 16-4: The Arm’s-Race Game

28. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 28 Labatt’s decision Molson’s decision Molson gets $3 billion profit Labatt’s gets $3 billion profit Advertise Don’t advertise Advertise Don’t advertise Molson gets $5 billion profit Labatt’s gets $2 billion profit Molson gets $4 billion profit Labatt’s gets $4 billion profit Molson gets $2 billion profit Labatt’s gets $5 billion profit Figure 16-5: An Advertising Game

29. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 29 Petro-Canada’s Decision Esso’s Decision Esso gets $4 billion profit Petro-Canada gets $4 billion profit Drill Two Wells Drill One Well Drill Two Wells Drill One Well Esso gets $3 billion profit Petro-Canada gets $6 billion profit Esso gets $6 billion profit Petro-Canada gets $3 billion profit Esso gets $5 billion profit Petro-Canada gets $5 billion profit Figure 16-6: A Common-Resources Game

30. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 30 Even when cooperation is in the best interest of both players it is difficult to maintain. Is lack of cooperation bad from society’s standpoint? It depends! In some cases, the noncooperative equilibrium is bad for society AND the players. (e.g., the arms race game) In other cases, lack of cooperation is desirable from the standpoint of society as a whole. (e.g., the monopoly outcome is good for the oligopolists but bad for consumers.) Even when cooperation is in the best interest of both players it is difficult to maintain. Is lack of cooperation bad from society’s standpoint? It depends! In some cases, the noncooperative equilibrium is bad for society AND the players. (e.g., the arms race game) In other cases, lack of cooperation is desirable from the standpoint of society as a whole. (e.g., the monopoly outcome is good for the oligopolists but bad for consumers.) The Prisoners’ Dilemma and the Welfare of Society

31. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 31 Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain. Why People Sometimes Cooperate

32. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 32 Jack’s decision Jill’s decision Jill gets $1600 profit Jack gets $1600 profit Sell 40 L Sell 30 L Sell 40 L Sell 30 L Jill gets $1500 profit Jack gets $2000 profit Jill gets $2000 profit Jack gets $1500 profit Jill gets $1800 profit Jack gets $1800 profit Figure 16-7: Jack and Jill’s Oligopoly Game

33. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 33 Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high. PUBLIC POLICIES TOWARD OLIGOPOLIES

34. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 34 Competition laws make it illegal to restrain trade or attempt to monopolize a market. Restraint of Trade and the Competition Act

35. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 35 Competition policies sometimes may not allow business practices that have potentially positive effects: –Resale price maintenance –Predatory pricing –Tying Competition policies sometimes may not allow business practices that have potentially positive effects: –Resale price maintenance –Predatory pricing –Tying Controversies Over Competition Policy

36. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 36 Resale Price Maintenance (or fair trade) –occurs when suppliers (like wholesalers) require retailers to charge a specific amount Predatory Pricing –occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market Tying –when a firm offers two (or more) of its products together at a single price, rather than separately Resale Price Maintenance (or fair trade) –occurs when suppliers (like wholesalers) require retailers to charge a specific amount Predatory Pricing –occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market Tying –when a firm offers two (or more) of its products together at a single price, rather than separately Controversies Over Competition Policy

37. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 37 SummarySummary Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome.

38. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 38 SummarySummary 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. 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.

39. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 39 SummarySummary Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.

40. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16: Page 40 The End