Economic Analysis
for Business
Session XIII: Oligopoly
Instructor
Sandeep Basnyat
9841892281
Sandeep_basnyat@yahoo.com
Introduction:
Between Monopoly and Competition
Two extremes structures of Markets
◦ Competitive markets: many firms, identical products
◦ Monopoly: one firm
In between these extremes: Imperfect competition
◦ Oligopoly: only a few sellers offer similar or identical
products.
◦ Monopolistic competition: many firms sell similar
but not identical products.
Imperfect competition includes industries in which firms have
competitors but do not face so much competition that they are
price takers.
MARKETS WITH ONLY A FEW
SELLERS
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
A Duopoly: An Example
A duopoly is an oligopoly with only two
members. It is the simplest type of oligopoly.
 Book Example:

◦
◦
◦
◦
Jack and Jill own wells that produce water
Pump as much water as they want without cost.
That is, the marginal cost (MC) = 0
Decide how many gallons of water to pump,
bring the water to town, and sell it for whatever
price the market will bear.
The Demand Schedule for Water

What if in Perfect Competition?
 P = MC = $0
 Q = 120 gallons
 The price of water would reflect the
cost of producing it.
 Efficient quantity of water would be
produced and consumed.

What if in Monopoly?

Total profit is maximized at a quantity of 60
gallons and a price of $60 a gallon.
We know, P > MC
Result would be inefficient, for the quantity of
water produced and consumed would fall
(120-60 = 60)


What outcome then could be
expected from duopolists?
Duopoly
• One possible duopoly outcome: Collusion
• Collusion: an agreement among firms in a market
about quantities to produce or prices to charge
• Cartel: a group of firms acting in unison, e.g., Jack and
Jill in the outcome with collusion
• Once a cartel is formed, the market is in effect served by
a monopoly.
• Thus, the duopolists may agree on a monopoly outcome:
P = $60 and Q = 60 gallons
• P > MC and the Result would be inefficient, for the
quantity of water produced and consumed would fall
(120-60 = 60)
Duopoly

If Jack and Jill agreed to split the market
equally, each would produce 30 gallons, the
price would be $60 a gallon, and each would
get a profit of $1,800.
Big question: Does this happen always?
Non-collusive (Cooperative) Oligopoly
If Jack and Jill decide separately how much
water to produce, tension arises among the
duopolists.
 In the absence of a binding agreement,
however, the monopoly outcome is unlikely.
 A non-collusive oligopoly: a market of few
suppliers who do not agree on price or
quantity

Competition, Monopolies and Cartels

Jack may think:

“Even if Jill produce 30 gallons, I produce 40
gallons, and a total of 70 gallons of water
would be sold at a price of $50 a gallon. My
profit would be $2,000.
Even though total profit in the market would
fall, my profit would be higher, because I

would have a larger share of the market.”
Jill may also think the same !
 Each bring 40 gallons to town.
 Total sales would be 80 gallons, and the price
would fall to $40.

If the Duopolists
individually pursue their
own self-interest then:
• Duopoly Q > Monopoly Q
• Duopoly P < Monopoly P
• Duopoly Total profit <
Monopoly Total profit.
THE EQUILIBRIUM FOR AN OLIGOPOLY

What would Jack decide next?
Producing additional gallon or reducing
production of gallon?
“Right now, my profit is $1,600. Suppose I
increase my production to 50 gallons., a total of
90 gallons of water would be sold, and the price
would be $30 a gallon.
 Then my profit would be only $1,500.
 Rather than increasing production, and driving
down the price, I am better off keeping my
production at 40 gallons.”

• If Jill also thinks the same, both will produce 40 gallons.
• Total production will be altogether 80 gallons and the price would be $40 a gallon
• Both would retain $1600 as a revenue
Non collusive (cooperative) Oligopoly

The noncooperative oligopoly equilibrium
◦ bad for oligopoly firms:
prevents them from achieving monopoly profits
◦ good for society:
Q gets closer to the socially efficient output
P gets closer to MC
Nash Equilibrium
The outcome in which Jack and Jill each produce 40 gallons is
called a Nash equilibrium (named after economic theorist John
Nash).
Nash equilibrium: A situation is a situation in which economic
actors interacting with one another each choose their best
strategy given the strategies the others have chosen.
 In this case, given that Jill is producing 40 gallons, the best
strategy for Jack is to produce 40 gallons. Similarly, given that
Jack is producing 40 gallons, the best strategy for Jill is to
produce 40 gallons.
 Once they reach this Nash equilibrium, neither Jack nor Jill has
an incentive to make a different decision.

Price Fixing: Good or Bad?
Resale price maintenance (Maximum
retail price)
 Predatory Pricing
 Tying or Bundling


Public Policy: Promote competition
The Size of the Oligopoly

As the number of firms in the market increases,
◦ the price effect becomes smaller
◦ the oligopoly looks more and more like a
competitive market
◦ P approaches MC
◦ the market quantity approaches the socially
efficient quantity
Game Theory
Game theory: the study of how people
behave in strategic situations
 Dominant strategy: a strategy that is
best for a player in a game regardless of the
strategies chosen by the other players
 Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial

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 and your partner gets 20 yrs.
◦ 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.
• What would be Bonnie decide? Confess? Or Remain silent?
• What would be Clyde decide? Confess? Or Remain silent?
Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
both confess
Confess
Clyde’s
decision
Bonnie’s decision
Confess
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
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 selfinterest takes over and leads them to confess.
 Note: When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.

Other Examples of the Prisoners’ Dilemma

Organization of Petroleum Exporting Countries

Arms race between military superpowers

Common resources

Ad wars..etc.
Is cooperation possible?
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.
Thank you