13
Oligopoly and
Strategic Behavior
Duopoly
• Collusion
– Agreement among rivals specifying prices or
quantities
– Firms ask: “What would a monopoly do?” and
then do that action
• Cartel
– Two or more firms acting in unison to form a
joint monopoly
Mutual Interdependence
• Mutual interdependence
– A market situation in which the actions of one
firm have an impact on the price and output of
its competitors
– AT-Phone’s response depends on the actions
of Horizon, and Horizon’s response depends
on the actions of AT-Phone
– Note the difference between interdependence
and independence
Nash Equilibrium
• Nash Equilibrium
– An economic decision maker has nothing to gain by
changing its own strategy without collusion
– Nobody wants to change their strategy given that the
other firm does not change their strategy
– A “stable” outcome where nobody wants to move from
their current position
– Often discussed with game theory, and easier to see
when games are drawn in matrix form
Game Theory
• Game theory
– Branch of mathematics that economists use to
analyze the strategic behavior of decision makers
– Can help us determine what level of cooperation is
most likely among players in a game
• Basic components of a game
– Players
– Strategies
– Payoffs
Strategic Behavior and the
Dominant Strategy
• Prisoner’s dilemma
– Two suspects are interrogated separately
– They each have the option to confess or keep quiet
• Possible outcomes of prisoner’s dilemma
– If both suspects keep quiet, each suspect will serve
only a small time in jail
– If both confess, both will serve 10 years in jail
– If one suspect confesses and the other remains quiet,
the suspect who confesses goes free, while the
suspect who kept quiet serves 25 years in jail
Presenting
The Prisoner’s Dilemma
Players
Strategies
Payoffs
Thelma
Confess
10 years
in jail
Confess
10 years
in jail
Louise
Keep
Quiet
Keep Quiet
25 years
in jail
goes
free
goes
free
25 years
in jail
1 year in
jail
1 year in
jail
Analyzing
The Prisoner’s Dilemma
• Louise
• Thelma
– Best to Confess or Keep Quiet?
– Best for Louise to Confess no
matter what Thelma does!
– Best to Confess or Keep Quiet?
– Best for Thelma to Confess no
matter what Louise does!
Thelma
Confess
10 years
in jail
Confess
10 years
in jail
Louise
Keep
Quiet
Keep Quiet
25 years
in jail
goes
free
goes
free
25 years
in jail
1 year in
jail
1 year in
jail
Analyzing
The Prisoner’s Dilemma
• Louise
• Thelma
– Best to Confess or Keep Quiet?
– Best for Louise to Confess no
matter what Thelma does!
– Best to Confess or Keep Quiet?
– Best for Thelma to Confess no
matter what Louise does!
Thelma
Confess
10 years
in jail
Confess
10 years
in jail
Louise
Keep
Quiet
Keep Quiet
25 years
in jail
goes
free
goes
free
25 years
in jail
1 year in
jail
1 year in
jail
Interesting Result of this
Game
Nash equilibrium
Payoffs that will result
Thelma
Confess
10 years
in jail
Confess
10 years
in jail
Louise
Keep
Quiet
Keep Quiet
25 years
in jail
goes
free
goes
free
25 years
in jail
1 year in
jail
1 year in
jail
Outcome with
the overall
best sum of
payoffs
Game Theory
• Dominant strategy
– A best response for a player to choose no matter
what the other player chooses
– Not all games or players in a game have a dominant
strategy
• Nash equilibrium implications?
– If both players have a dominant strategy, the
intersection of those dominant strategies will be the
Nash equilibrium.
– Neither player will want to unilaterally deviate.
Duopoly and the
Prisoner’s Dilemma
AT-Phone
Low
Low
Horizon
High
High
$27,000
$27,000
$30,000
$22,500
$22,500
$30,000
$24,000
$24,000
An outcome that is better
for both players
Nash equilibrium
payoffs that will result
Advertising and the
Prisoner’s Dilemma
Coca-Cola
Advertises
Does Not Advertise
$100 M
$75 M
Advertises
$100 M
$150 M
Pepsico
Does Not
Advertise
$150 M
$75 M
Nash equilibrium
payoffs that will result
$125 M
$125 M
An outcome that is better
for both players
Intuition of Advertising
Prisoner’s Dilemma
• Advertising
– Costly
– Purpose: increase
product demand
– If both firms advertise,
expenses go up, but
demand increases;
each cancels other out
– “Arms race” of
advertising
Cigarette Advertising on TV
• In 1970, Congress enacted a law making
cigarette advertising on TV illegal
– Reasoning: too many ads being seen by
children and teens
– Goal: reduce smoking among all ages
• Unintended consequence
– This actually increased the economic profits
of cigarette makers
– The law ended their prisoner’s dilemma of
advertising
Escaping the Prisoner’s
Dilemma in the Long Run
• The Nash equilibrium in prisoner dilemma
games may give the best short run payoffs
• However,
– Many games are repeated
– This repetition occurs over a longer time span
– Dominant strategies may not consider longrun benefits of cooperation
Escaping the Prisoner’s
Dilemma in the Long Run
• Tit for tat
– A long run strategy designed to create
cooperation among participants
– Strategy: mimic the decision your opponent
made in the previous round.
– Changes the incentives and encourages
cooperation
– Useful because interactions in life occur over
the long run. Relationships between people
and businesses involve mutual trust.
Caution About Game Theory
• Not all games are like the prisoner’s
dilemma
– Not all games have a dominant strategy
– Not all games have a pure strategy like the
Nash equilibrium
• Think about Paper, Rock, Scissors
– Your best response is different, depending on
what your opponent throws. There is no
dominant hand to play.
No Dominant Strategy
Oligopoly Policy:
Antitrust
• Antitrust policy
– Government efforts that attempt to prevent
oligopolies from behaving like monopolies
• Sherman Act of 1890
– “Every person who shall monopolize, or
attempt to monopolize, or combine or
conspire with any other person or persons, to
monopolize any part of the trade or commerce
among the several States, or with foreign
nations, shall be deemed guilty of a felony.”
Oligopoly Policy:
Antitrust
• Clayton Act of 1914 added a few more
items that were considered detrimental
– Price discrimination that lessens competition
– Exclusive dealings that restrict the ability of a buyer to
deal with competitors
– Tying arrangements (similar to bundling)
– Mergers that lessen competition
– Prevents a person from serving as a director on more
than one board in the same industry
Predatory Pricing
• Predatory pricing
– Firms set prices below AVC with the intent
of driving rivals from the market
– Illegal, but difficult to prosecute
– Often difficult to distinguish between
predatory pricing and intense market
competition
• Examples:
– Wal-Mart is often assumed to be a
predator but is never prosecuted
– Microsoft was prosecuted eventually for
tying, but not for predatory pricing
Predatory Pricing Scheme
$
Incumbent
Firm’s
Price
AVC,MC
Competitor
Enters
Competitor
Leaves
Time
Network Externalities
• Network externality
– Occurs when the number of customers who
purchase a good influences the quantity
demanded
– Often is a factor in whether the resulting
market structure is oligopoly
– Classic examples include technologies
such as cell phones and fax machines
• A new technology has to reach “critical mass”
before it is effective for consumers
• How useful would a fax machine be if only 10
people had the machine?
Network Externalities
• Positive network externalities
– Bandwagon effect
– Individual preferences for a good
increase as the number of people
buying the good increases
– Internet, social networks, cell
phones, fax machines,
MMORPGs, video game
consoles, fads, night clubs
Network Externalities
• Negative network externalities
– Snob effect
– Individual preferences for a good
decrease as the number of people buying the good
increases
– Exotic pets and sports cars
– Hipsters
– Services that are prone to “congestion.” Pool,
beach, student union gets “too crowded,” and you
don’t want to go.
Network Externalities
• Switching costs
– Costs that are incurred by a consumer when he
switches suppliers
– Another advantage to a firm having a large network
– Demand for existing product becomes more
inelastic if costs of switching to a new product are
higher
• Example: cellphone providers
– Early termination fees
– Free in-network calls
– FTC reduced switching costs in 2003 by requiring
phone companies to allow a consumer to take their
old phone number to a new provider
Price Taking
Perfect Competition
1. Many firms
Price Making
Monopolistic
Competition
1. Many firms
Oligopoly
Monopoly
1. Few firms
1. One firm
2. Extremely high
barriers to entry.
The firm has
significant control
over price.
2. Atomistic assumption—firms
are so small that no single
buyer or seller has ANY control
over price
2. Each firm has
some control over
price
2. Medium to high
entry barriers to
entry. The firm has
more control over
price.
3. Firms are so small that no
single buyer or seller has ANY
control over price
3. Product
differentiation
3. Mutual
interdependence
3. The firm IS the
industry
4. Easy entry/exit
4. Long run
economic profit
possible
4. Long run
economic profit
probable
4 Homogeneous output
5. There is perfect information
about product price and quantity
6. Easy entry/exit
5. Output can be
homogenous or
differentiated
More Game Theory in Media
• This link provides further examples of game
theory in media and contains links to video clips
Conclusion
• Oligopoly
– A market structure in which there are a small number
of firms
– Firms interact strategically
– Can be competitive (results closer to monopolistic
competition)
– Can be collusive (results closer to monopoly)
• Antitrust policies
– Restrain excessive market power
– Give incentives to compete instead of collude
– Each industry examined on a case-by-case basis
Summary
• Oligopoly: a small number of firms sell a
differentiated product in a market with significant
barriers to entry. The small number of sellers in
oligopoly leads to mutual interdependence.
– An oligopolist is like a monopolistic competitor in that
it sells differentiated products.
– It is also like a monopolist in that it enjoys significant
barriers to entry.
• Oligopolists have a tendency to collude and to
form cartels in hope of achieving monopolylike
profits.
Summary
• Oligopolistic markets are socially inefficient since
P > MC. The result under oligopoly will fall
somewhere between the competitive and
monopoly outcomes.
• Game theory helps determine when cooperation
among oligopolists is most likely.
– In many cases, cooperation fails to materialize
because decision-makers have dominant strategies
that lead them to be uncooperative.
– This causes firms to compete with price, advertising,
or R & D when they could potentially earn more profit
by curtailing these activities.
Summary
• A dominant strategy ignores the long run
benefits of cooperation and focuses solely on
the short run gains
– Whenever repeated interaction exists, decisionmakers fare better under tit for tat, an approach that
maximizes the long run profit
• Antitrust laws are complex and cases are hard to
prosecute, but they provide firms an incentive to
compete rather than collude
• The presence of significant positive network
externalities causes small firms to be driven out
of business or to merge with larger competitors
Practice What You Know
Which of the following is most likely to
become an oligopoly industry?
A. An industry without entry barriers
B. An industry where economies of scale are
very small
C. An industry with sizeable network effects
D. An industry with hundreds of competitors
Practice What You Know
Which of the following is true about
oligopoly?
A. Oligopolies are illegal in the United States
B. All oligopoly industries will try to collude
C. Oligopoly industries generally have a high
concentration ratio
D. Firms in an oligopoly act independently
from other firms in the oligopoly
Practice What You Know
Why do cartel deals tend not to last?
A. Each firm in the cartel has a dominant
strategy to be uncooperative and defect
from the cartel agreement
B. Cartel profits are lower than competitive
profits
C. Cartels create more competition
D. Firms know that cartels are often illegal
so they break the deal to escape
Practice What You Know
What is an example of a good with a
positive network effect?
A. An online multiplayer game
B. A fast-food burger
C. A dry-cleaning service
D. A cable TV subscription
Practice What You Know
How can a pure strategy Nash equilibrium
be accurately described?
A. It is always the overall best outcome
B. It’s an outcome in which neither player
wants to change strategies
C. It can only be reached by collusion
D. One exists in all games