Lecture Notes: Econ 203 Introductory Microeconomics
Lecture/Chapter 17: Oligopoly
M. Cary Leahey
Manhattan College
Fall 2012
Goals
• We now look at oligopoly, another form of imperfectly competition.
• We examine issues of cooperation among these kinds of firms.
• The use of game theory will help us understand why these kinds of
firms find it difficult to cooperate
• We look at the policy record, namely antitrust policy to deal with
these kinds of firms.
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Measuring market concentration
• To figure study the importance of possible oligopolies in particular
industries, we examine concentration ratios.
• The concentration ratio is the percentage of the market’s (or
industry’s) total output supplied by the four largest firms.
• A larger concentration ratio means less competition.
• Oligopoly is a market structure with a high concentration ratio.
• High concentration ratios cover a wide variety of industries, ranging
from autos (79%), to cigarettes (89%), to video game consoles
(100%).
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Oligopoly
• Oligopoly is a market structure with only a few sells offer similar or
identical products.
• The small size of the firms in the markets means that each firm
needs to consider how its competitors will react to his decisions
regarding price and quantity. So the oligopolist must think
strategically.
• Game theory is the study of strategic behavior and hence is
entwined with the study of oligopoly.
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Example: cell phone duopoly in smalltown
P
Q
$0
140
 Smalltown has 140 residents
 The “good”:
cell phone service with unlimited anytime minutes and
free phone
5
130
10
120
 Smalltown’s demand schedule
15
110
 Two firms: T-Mobile, Verizon
20
100
(duopoly: an oligopoly with two firms)
25
90
 Each firm’s costs: FC = $0, MC = $10
30
80
35
70
40
60
45
50
Example: cell phone duopoly in smalltown
P
Q
Revenue
Cost
Profit
$0
140
5
130
650
1,300
–650
10
120
1,200
1,200
0
15
110
1,650
1,100
550
20
100
2,000
1,000
1,000
25
90
2,250
900
1,350
30
80
2,400
800
1,600
35
70
2,450
700
1,750
40
60
2,400
600
1,800
45
50
2,250
500
1,750
$0 $1,400 –1,400
Competitive
outcome:
P = MC = $10
Q = 120
Profit = $0
Monopoly
outcome:
P = $40
Q = 60
Profit = $1,800
Example: cell phone duopoly in smalltown
• One possible duopoly outcome: collusion
• Collusion: an agreement among firms in a market about quantities
to produce or prices to charge
• T-Mobile and Verizon could agree to each produce half of the
monopoly output:
– For each firm: Q = 30, P = $40, profits = $900
• Cartel: a group of firms acting in unison,
e.g., T-Mobile and Verizon in the outcome with collusion
Collusion versus self-interest
• Both firms in the duopoly example would be better off to stick to an
agreement, such as splitting the monopoly
• However, each firm has an incentives to renege on the agreement.
• So it is difficult for firms to form cartels and honor their agreements.
• It is impressive that the “oil cartel” has held up so well, in part
because Saudi Arabia is the swing producer and implicit “enforcer.”
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Equilibrium for a oligopoly
• A situation is which the economic participants (firms) interact with
one another, choosing their best strategy given the strategies of
others is called a Nash equilibrium.
• In the duopoly example, the Nash equilibrium is when each firm
produces Q = 40:
•
Given Verizon’s output of 40, T-Mobile’s best move is also to
produce 40.
•
Given that T-Mobile produces 40, Verizon’s best move is stay at 40
and not to cheat on the implicit agreement.
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Comparison of market outcomes
• When firms in a oligopoly individually choose production (do not
collude) to maximize profit, then
• Oligopoly output is higher than monopoly output but less than
competitive output.
• Oligopoly price is lower than monopoly price but higher than
competitive price.
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Output decision involves both quantity and price effects
• Changing output has two effects on a firms profit (like the monopoly
case).
• The output effect: P > MC, increase output increases profit.
• Price effect: Raising output increased quantity sold at at the “cost” of
lower prices and reduced profit on all units sold.
• If output effect > price effect, output is increased
• If output effect < price effects, output is decreased.
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Game theory
• Game theory is useful in understanding oligopoly behavior as well
as other situations in which players interact and behave
strategically. Some terms.
• Dominant strategy: a strategy that is best for for a player in a game
regardless of the strategies chosen by others.
• Prisoner’s dilemma is a game between two captured criminals that
illustrates why cooperation is difficult even when it is mutually
beneficial.
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Prisoners’ dilemma example
 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
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Prisoners’ dilemma example
Confessing is the dominant strategy for both players.
Nash equilibrium: both confess
Bonnie’s decision
Confess
Confess
Clyde’s
decision
Remain silent
Bonnie gets
8 years
Clyde
gets 8 years
Bonnie goes
free
Remain
silent Clyde
gets 20 years
Bonnie gets
20 years
Clyde
goes free
Bonnie gets
1 year
Clyde
gets 1 year
Prisoners’ dilemma example
• The outcome is usually that both confess and get 8 years in prison.
• Both would have been better off not confessing and getting only 1 –
year sentences.
• But even if they had agreed before hand not to confess, the logic of
self-interest takes over and leads them to confess.
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Oligopoly behavior as prisoners’ dilemma
• When oligopolies form a cartel in hope of sharing the monopoly
outcome, they became stuck in a prisoners’ dilemma.
• In our earlier example of the cell phone duopoly, the two firms
decided to split the monopoly outcome of Q = 30.
• The next slide shows the payoff matrix.
• Other examples of prisoners’ dilemma in oligopoly behavior:
•
Airline fare wars
•
Ad wars
•
OPEC
•
Arms races
•
Common resources
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The prisoners’ dilemma: payoff matrix
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
T-Mobile
Q = 30
Q = 30
Verizon
Q = 40
T-Mobile’s
profit = $900
Verizon’s
profit = $900
T-Mobile’s
profit = $750
Verizon’s
profit = $1000
Q = 40
T-Mobile’s
profit = $1000
Verizon’s
profit = $750
T-Mobile’s
profit = $800
Verizon’s
profit = $800
Prisoners’ dilemma and societal welfare
• The noncooperative (non-cartel) oligopoly equilibrium:
•
Bad for oligopoly firms as they cannot split the monopoly profits.
•
Good for societal and Q is closer to socially efficient output and P
is closer to MC
• But in other prisoners'’ dilemma example, such as the arms race,
the inability to cooperate may reduce societal welfare.
• Cooperation is possible after learning and being repeatedly
“burned.”
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Public policy toward oligopolies
• With output too low and price too high in an oligopolistic equilibrium
relative to the societal optimum, there is a role for public policy.
• Public policy can promote competition and prevent cooperation to
bring the market outcome closer to the desired societal outcome.
• Restraint of trade and anti-trust laws (Sherman Antitrust Act of 1890
and the Clayton Antitrust Act of 1914) are the best known historical
examples with T Roosevelt the famed “trust-buster.”
• Most agree than price-fixing agreements should be illegal.
• But there is concern that anti-trust enforcement goes “too far” and
may stifle “legitimate” business practices.
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Antitrust policy and resale price maintenance
• At first blush retail price maintenance, allowing imposing lower
limits on prices retailers can charge appears to reduce competition
at he retail level. For example warranties only honored at
“authorized” retailers that agree to sell below an authorized price.
• But market power at the wholesale level by manufacturers does not
necessarily spillover to benefit at the retail level.
• This practice has a legitimate business end in restricting free
loading, in which discount firms “free ride” off of the expenses
incurred in servicing customers at full-service retailers.
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Predatory pricing and bundling/typing
• Predatory pricing occur when a firm sells at below cost to prevent
entry or drive a competitor out of business and hen charge
monopoly prices later.
• While this is illegal, it is hard to tell, when a price cut is predatory or
rather beneficial to customers. It is in the short-run.
• Some skepticism about the virtues of predatory pricing as it is costly
in the short-run and can backfire.
• Bundling or tying develops when a manufacturing sells a number of
products in a bundle.
• Critics worry that it gives firms market power by connecting weak
products with stronger ones. Others counter that consumer will not
pay more more two products together or bought separately.
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Summary and conclusion
• Oligopolies can end up looking like monopolies or like perfect
competitors depending on the number of firms and how cooperative
the behavior is.
• Prisoners’ dilemma show how hard cooperation is, when when it is
in all participants best interest.
• Public policy can employ antitrust laws to increase competition and
prevent predatory pricing. The scope of those actions is
controversial.
• Oligopolies maximize profit if they cooperate and form a cartel and
split the monopoly profits.
• However, self interest leads to an output of greater output and lower
price, close to the societal desired outcome. The more firms and the
less cooperation leads to a more competitive outcome.
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