1. © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney Prepared by: Fernando & Yvonn Quijano

2. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 2 of 25 The law catches up with a colluding oligopolist. What you will learn in this chapter: ➤ The meaning of oligopoly, and why it occurs ➤ How our understanding of oligopoly can be enhanced by using game theory, especially the concept of the prisoners’ dilemma ➤ How repeated interactions among oligopolists can help them achieve tacit collusion ➤ How oligopoly works in practice, under the legal constraints of antitrust policy ➤ How prices and profits are determined in monopolistic competition in the short run and the long run ➤ Why oligopolists and monopolistically competitive firms differentiate their products ➤ The economic significance of advertising and brand names

3. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 3 of 25 Oligopoly An oligopoly is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist. When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.

4. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 4 of 25 Oligopoly An oligopoly consisting of only two firms is a duopoly. Each firm is known as a duopolist. Understanding Oligopoly Sellers engage in collusion when they cooperate to raise each others’ profits. A cartel is an agreement by several producers that increases their combined profits by telling each one how much to produce.

5. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 5 of 25 Oligopoly When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. Understanding Oligopoly

6. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 6 of 25 Oligopoly The reward received by a player in a game, such as the profit earned by an oligopolist, is that player’s payoff. A payoff matrix shows how the payoff to each of the participants in a two- player game depends on the actions of both. Such a matrix helps us analyze interdependence. The Prisoners’ Dilemma

7. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 7 of 25 Oligopoly The Prisoners’ Dilemma

8. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 8 of 25 Oligopoly The Prisoners’ Dilemma Prisoners’ dilemma is a game based on two premises: (1) Each player has an incentive to choose an action that benefits him or herself at the other player’s expense. (2) When both players act in this way, both are worse off than if they had chosen different actions.

9. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 9 of 25 Oligopoly The Prisoners’ Dilemma

10. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 10 of 25 Oligopoly The Prisoners’ Dilemma An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players.

11. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 11 of 25 Oligopoly Overcoming the Prisoners’ Dilemma: Repeated Interaction and Tacit Collusion A firm engages in strategic behavior when it attempts to influence the future behavior of other firms. A strategy of tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period.

12. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 12 of 25 Oligopoly Overcoming the Prisoners’ Dilemma: Repeated Interaction and Tacit Collusion

13. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 13 of 25 Oligopoly Overcoming the Prisoners’ Dilemma: Repeated Interaction and Tacit Collusion When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusion.

14. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 14 of 25 economics in action The Rise and Fall and Rise of OPEC

15. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 15 of 25 Oligopoly in Practice The Legal Framework Antitrust policy refers to the efforts of the government to prevent oligopolistic industries from becoming or behaving like monopolies.

16. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 16 of 25 Oligopoly in Practice Tacit Collusion and Price Wars Large Numbers Complex Products and Pricing Schemes Differences in Interests Bargaining Power of Buyers A price war occurs when tacit collusion breaks down and prices collapse.

17. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 17 of 25 Monopolistic Competition Monopolistic competition is a market structure in which there are many competing producers in an industry, each producer sells a differentiated product, and there is free entry into and exit from the industry in the long run. Large Numbers Differentiated Products Free Entry Into and Exit From the Industry in the Long Run

18. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 18 of 25 Monopolistic Competition Monopolistic Competition in the Short Run

19. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 19 of 25 Monopolistic Competition Monopolistic Competition in the Long Run

20. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 20 of 25 Monopolistic Competition Monopolistic Competition in the Long Run In the long run, a monopolistically competitive industry ends up in zero- profit equilibrium: each firm makes zero profit at its profit-maximizing quantity.

21. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 21 of 25 Monopolistic Competition Monopolistic Competition in the Long Run

22. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 22 of 25 Product Differentiation Firms engage in product differentiation when they try to convince buyers that their product is different from the products of other firms in the industry. ■ differentiation by style or type ■differentiation by location ■differentiation by quality There are three important forms of product differentiation:

23. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 23 of 25 Product Differentiation Advertising is worthwhile only in industries in which firms have at least some market power. Given that advertising “works,” it’s not hard to see why firms with market power would spend money on it. The big question about advertising is why it works. A related question is whether advertising is, from society’s point of view, a waste of resources. Controversies about Product Differentiation The Role of Advertising

24. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 24 of 25 Product Differentiation Brand Names A brand name is a name owned by a particular firm that distinguishes its products from those of other firms.

25. chapter © 2007 Worth Publishers Essentials of Economics Krugman Wells Olney 25 of 25 Oligopoly Oligopolist Imperfect competition Duopoly Duopolist Collusion Cartel Interdependence Game theory Payoff Payoff matrix Prisoners’ dilemma Dominant strategy Nash equilibrium Noncooperative equilibrium Strategic behavior Tit for tat Tacit collusion Antitrust policy Price war Monopolistic competition Zero-profit equilibrium Product differentiation Brand name K E Y T E R M S