 The
spectrum of competition:
Perfect Comp. ------------- Monopoly
Monop. Comp.-- Oligopoly
 Assumptions underlying oligopoly

Few Sellers


Interdependence – each seller must be aware that
their actions will provoke actions by rival firms
Differentiated versus non-differentiated
products (cars or oil

Differentiated products leads to non-price competition
through activities such as advertising, style changes,
quality
 Price



competition vs. non-price competition
Interdependence in pricing means that price wars
may develop and reduce profits
Product differentiation avoids price competition
Advertising is used to increase market share


Informative
Persuasive (self-cancelling)
 Modeling
oligopoly is difficult because
interdependence can lead to different behaviors
 Assumptions


Two producers: Jack and Jill
Zero marginal costs – (for simplicity
revenue=profits
 Outcomes



Competition: Maximum production, zero
price(remember there are no costs) , and no
profits
Monopoly: Reduced Output, highest price,
positive profits
Oligopoly: Let the games begin!
-Jack and Jill collude
with 30 gals each
Profit max = $3,600
split two ways $1,800
-Jack assumes Jill will
stay at 30 gals, increases
production to 40 gals.
price falls to $50, Jack’s
profit rises to $2,000, but
Jill may do the same and
price falls to $40, both
make $1,600
-If Jack tries to increase to
50 gals, price falls to $30
and his profits go to $1,500
Copyright © 2004 South-Western
-At 40 gals. Neither Jack
nor Jill have an incentive
to change production.
-Nash Equilibrium :
choose the best strategy
given the strategies that the
other economic agents have
chosen.
-Note: when firms in a
duopoly act to max. profit
they chose a level of output
less than a competitive firm
but more than a monopolist
would produce.
Copyright © 2004 South-Western
 Duopoly
(cont.)
Collusion – form a cartel and act like a
monopolist – highest economic profit, in most
cases in the US, this is illegal.
 Pursuing own self-interest – actions depend on
what you think the other will do: not react or
react


The incentive to “cheat”:


If you produce more (or charge a lower price and sell
more), assuming MR>MC, your profits will rise, that is, if
the other firm does not do the same thing.
The incentive to “cooperate”

If you produce more (or charge a lower price and sell
more), the other firm will do the same, and your profits
will fall

Raising (or lowering) output produces two effects:
Output effect: because P>MC, the additional output will raise
profits
 Price effect: additional output will lower the price and reduce
profits on all those units that would have been sold at the old
price


Rules for action:



Raise output if OE>PE
Don’t raise output if OE<PE
As the number of firms increases, the PE falls, so output
is increased, many firms produce the competitive or
efficient solution.

Freer trade has resulted in increasing number of firms in the
automobile market, the camera market, and the electronics
markets.
Explicit agreements among firms to fix output
and prices
 Examples are OPEC, Electrical Conspiracy (Econ
USA), Shipping Cartel
 Incentive to cooperate – earn monopoly profits
 Incentive to cheat – increase individual profits if
cheating is not detected or punished.
 Sources of instability in cartels:






Number of Sellers
Cost differences
Potential competition
Recessions
Cheating
 Annual
Oil Market Chronology
 History of Oil Prices
 Game
theory is an attempt to model and
understand behavior given the presence of
interdependence
 Games have the following characteristics:




Rules
Strategies
Payoffs
Outcome
 Two
criminals, Bill and Paul, are caught
red-handed stealing a car, and will
receive 2 year sentences; however, they
become suspects in a previous bank
robbery. The DA’s job is to see if he can
solve the bank robbery.

Rules:


Each player is held in separate rooms and cannot
communicate.
Each is told that he is suspected of the larger crime
and
if both confess to the bank robbery, they get 5 year
sentences
 if one rats on the other and the other does not confess to
the bank robbery, he gets off, and the other gets a 10 year
sentence


Strategies: Each player has two possible
actions



Confess to the bank robbery
Do not confess to the bank robbery
Payoffs: Two players with two outcomes  four
possible outcomes with the following payoffs




Both confess – each get 5 year sentences
Both deny – each get 2 year sentence
Bill confesses and Paul denies – Bill gets off and Paul
gets 10 years
Paul confesses and Bill denies – Paul gets off and Bill
gets 10 years.
Bill
BILL
Deny
Confess
5 years
P Confess
5 years
A
U
Paul
L
Deny
10 years
10 years
Off
Off
2 years
2 years
Paul – if Bill confesses I should too (5 vs 10), if Bill denies, I should
still confess (off vs 2)
Bill – if Paul confesses I should too (5 vs 10); if Paul doesn’t. I should
still confess (off vs 2)
 Nash
Equilibrium – the player does what is
best for himself after he takes into
account the other players’ actions.
 Dominant solution – the outcome that is
better than all the rest.
 Dominant solution for Paul is to confess
and the same is true for Bill.
 The ‘best’ solution for both is to
cooperate, but the dilemma is that they
can’t so they end up with a second best
solution.
Show a situation where the best situation for
players is to maintain current prices and that
prices remain stable in spite of firms with
different cost structures.
 Asymmetry in price movements:




If firm raises price, no one follows, therefore quantity
demanded is elastic
If firm lowers price, all follow suit so the quantity
demanded is quite inelastic
Marginal revenue curve is discontinuous and
allows for various marginal cost curves.


If the firm raises its
price above P, it faces
an elastic demand
curve, payoff low
If the firm lowers its
price below P, it faces
an inelastic demand
curve, payoff low



Different firms can have
different MCs. As long as
they fall with in the
discontinuous MR, P will
remain stable.
Output Effect < Price
Effect for price
movements with the
discontinuous MR curve.
If MC increases enough,
all firms raise their
prices and the kink
vanishes.
A
large dominant firm with lower costs
that it competitors becomes the price
maker.
 A competitive fringe with many firms that
are price takers or followers.
 The dominant firm’s demand curve is the
total market demand minus the supply of
the competitive fringe.
 The dominant firm sets price and its
quantity based upon residual demand and
this determines the price for competitive
firms and their supply. (Examples OPEC).

The large firm can set the price and receives a
marginal revenue that is less than price along the curve
MR.
Dominant Firm’s
Demand Curve
Residual
Demand

As long as the dominant firm has lower costs, it can act
like a monopolist over the residual demand.
 Barometric
price leadership - firms come
to tacit agreement to allow one firm to
set the price according to cost
considerations. If cost move is justified,
others will follow and validate the price .
If not, or if some firm decides to defect,
the price change will not be validated.
 Rotating price leadership – firms come to
tacit agreement to allow the price leading
firm to rotate among key players in the
industry.
 Monopoly
power is often granted by
government via regulation. Example Ma
Bell (Econ USA).
 Other examples are shipping and the
airline industry (pre-deregulation).
 Justifications for government regulation
include infant industry and natural
monopoly.
 Criticisms include decreased competition,
increased costs due to x-inefficiency and
lobbying, and regulation outlives its
usefulness.
 One
presumption is that as the number of
sellers decreases, market power
increases.
 Concentration Ratios – percentage of
market share controlled by x number of
firms, most commonly a four-firm
concentration ratio
 Four-firm concentration ratio = (Sales by
four largest firms in an industry/Sales by
all firms in the industry) x 100
Primary Copper
Cigarettes
Beer
Breakfast Cereals
Motor Vehicles
Greeting Cards
Small-arms munitions
Household Refrigerators and
Freezers
98,95
93,99
90,90
85,83
84,83
84
84,89
82,82
 Do
not take into account foreign competition
 Fail to account for potential competition.

Contestable markets – firms are able to enter and
exit at low cost. Potential entry acts as a limit
to market power.
GM
Ford
Daimler-Chrysler
Toyota
Honda
Nissan
Mitsubishi
Mazda
Subaru
Suzuki
27
24
16
10
7
4
2
2
1
.3
4 US firms
Control
67%
Japanese Firms
Control
26%
WSJ 4/4/2001 and
Carbaugh page 201
 Vertical
Merger – merging with a firm that
supplies inputs
 Horizontal Merger – merging with a
competitor
 Conglomerate Merger –merging with firms
that are not related
 Successful mergers – Boeing and
McDonnell-Douglas
 Unsuccessful Mergers – AOL Time Warner