Chapter 15
Oligopoly and
Game Theory
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline




Cartels
The Prisoner’s Dilemma
Oligopolies
When Are Cartels and Oligopolies Most
Successful?
 Government Policy toward Cartels and
Oligopolies
 Business Strategy and Changing the Game
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Introduction
 An oligopoly is an industry that is dominated
by a small number of firms.
 A cartel is an oligopoly that tries to act together
to reduce supply, raise prices, and increase
profits.
 Even when an oligopoly is not able to collude,
prices are likely to be higher than in a
competitive market.
 Game theory is used to model decisions in
situations where the players interact.
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Definition
Oligopoly:
a market that is dominated by a small
number of firms.
Cartel:
a group of suppliers who try to act as if
they were a monopoly.
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Definition
Strategic decision making:
decision making in situations that are
interactive.
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Self-Check
An oligopoly is a market that is:
a. Dominated by one firm.
b. Dominated by cartels.
c. Dominated by a few firms.
Answer: c – an oligopoly is a market that is
dominated by a few firms.
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Cartels
 The Organization of Petroleum Exporting
Countries (OPEC) is a cartel of oil-exporting
countries.
 Between 1970 and 1974 OPEC cut back on
their production of oil.
 The price of oil shot up from $7 per barrel to
almost $38 a barrel.
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Cartels
The Price of Oil 1960 – 2012
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Cartels
Price
Price
Competitive Market
(constant cost)
As if controlled
by a monopolist
Profit shared by
members of cartel
PM
PC
MC = AC
Supply
D
QC
Quantity
D
MR
QM
QC
Quantity
A cartel tries to move a market from “Competitive”
toward “As If Controlled By a Monopolist”.
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Self-Check
Cartels try to increase their profits by:
a. Reducing costs.
b. Reducing quantity.
c. Increasing quantity.
Answer: b – cartels try to increase profits by
reducing quantity and therefore increasing price.
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Cartels
 Cartels tend to collapse and lose their power
for three reasons:
1. Cheating by the cartel members.
2. New entrants and demand response.
3. Government prosecution and regulation.
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The Incentive to Cheat
 If a cartel succeeds, each
member makes high profits.
 These profits create an
incentive to cheat
 When everyone reduces
production and price rises,
some members will then
cheat by producing more.
REUTERS/CORBIS
Venezuelan President Hugo Chavez
hugs Saudi Crown Prince Abdullah
bin Abdul Aziz Al Saud during
an OPEC summit in 2000.
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The Incentive to Cheat
Price
Price
Monopoly
Four-Firm Cartel
Other members
Revenue
lost
Revenue
lost
Revenue
gained
PO
PO
P1
Revenue
gained
P1
D
QO
Q1
Quantity
D
QO
Q1
Quantity
 Monopoly ↑ quantity: it bears all of the loss due to the lower price.
 Cartel member ↑ quantity: losses are shared with the other members.
 Conclusion: A member of a cartel has a greater incentive to cheat.
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Self-Check
One of the ways cartels lose their market power
is through:
a. Competing with each other for customers.
b. Going bankrupt.
c. Members cheating on the agreement.
Answer: c – a member of a cartel can increase
profits even further by cheating and producing
more than they had originally agreed on.
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Prisoner’s Dilemma
 A cartel cheating is one version of a game called
the prisoner’s dilemma.
 It suggests that cooperation is difficult to
maintain.
 Political scientist Elinor Ostrom showed that
members of communities with repeated
interaction generally find rules or norms that limit
the prisoner’s dilemma.
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Definition
Prisoner’s dilemma:
a situation where the pursuit of individual
interest leads to a group outcome that is
in the interest of no one;
the negative counterpart to the invisible
hand.
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Prisoner’s Dilemma
A Payoff Table
In this game, Cheat is a better strategy for each player no
matter what the other player’s strategy.
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Definition
Dominant strategy:
a strategy that has a higher payoff than
any other strategy no matter what the
other player does.
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Self-Check
A game where pursuing one’s own interest leads
to an outcome that is in no one’s interest is
called the:
a. Oligopoly outcome.
b. Dominant strategy.
c. Prisoner’s dilemma.
Answer: c – this is called the prisoner’s
dilemma.
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Collusion
 When only a handful of firms can realistically bid
on a contract, it becomes profitable to collude.
 Firms can agree to take turns being the “low”
bidder.
 Collusive outcomes may evolve even without
explicit agreement.
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Definition
Tacit collusion:
when firms limit competition with one
another but they do so without explicit
agreement or communication.
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Oligopolies
 Oligopolies are markets dominated by a small
number of firms.
 A firm in an oligopoly has some influence over
price and therefore has an incentive to reduce
output and increase price.
 Price in an oligopoly is likely to be below
monopoly levels but above competitive levels.
 The more firms in an industry, the closer price
will be to competitive levels.
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Oligopolies
Price
Four firm oligopoly:
 Firm 4 ↓Q → ↑ price to P1 → Profit
 Other firms ↑P → ↑ their profits
Profit increase
other firms.
Profit increase firm 4
P1
P0
MC = AC
Demand
Q1 Q0
Quantity
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Self-Check
Oligopoly prices tend to be:
a. Lower than monopoly but higher than
competitive prices.
b. Lower than monopoly or competitive prices.
c. Higher than monopoly but lower than
competitive prices.
Answer: a – oligopoly prices tend to be lower
than monopoly but higher than competitive prices.
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Definition
Barriers to entry:
factors that increase the cost to new firms
of entering an industry.
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Oligopolies
 Cartels and oligopolies tend to be most
successful when there are barriers to entry.
 Important barriers to entry include:
1.
2.
3.
4.
Control over a key resource or input.
Economies of scale.
Network effects.
Government barriers.
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Government Policy
 Most cartels have been illegal in the United
States since the Sherman Antitrust Act of 1890.
 Antitrust laws are used to prosecute cartels,
block mergers, and break up very large firms.
 Sometimes governments reduce competition and
create barriers to entry by supporting cartels.
 For example, the U.S. government raises the
price of milk through subsidies and quotas.
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Government Policy
 Government-enforced monopolies and cartels
are a serious problem facing poor nations.
 Government-supported cartels usually mean
higher prices, lower-quality service, and less
innovation.
 People spend their energies trying to get
monopoly or cartel privileges from governments.
 Government becomes more corrupt.
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Business Strategy
Price Matching
 Suppose competing firms offer to match lower
prices and give customers 10% of the difference.
 If one sets price at $1000 and the other at $800,
customers can buy from the higher-priced firm at
$800 – (10% x 800) = $780.
 A firm has no incentive to drop price, because its
competitor will get all the customers.
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Business Strategy
Lowe’s and Home Depot face the Prisoner’s Dilemma.
The price matching game.
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Business Strategy
Loyalty Plans
 Loyalty plans reward regular customers with
special treatment or a better price.
 Once customers are locked in, firms don’t have to
compete as much.
 If a firm raises price, its customers will remain
loyal; if it lowers price, other firms’ customers will
also remain loyal.
 Loyalty increases monopoly power and results in
higher prices.
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Business Strategy
Innovation
 Pursuit of market power can lead to innovation
and product differentiation.
 One reason firms innovate is to produce a
product with fewer substitutes.
 Fewer substitutes mean more inelastic demand,
leading to higher prices and profits.
 Firms also compete by differentiating their
products with different styles or features.
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Self-Check
Loyalty plans lead to:
a. Higher prices.
b. Lower prices.
c. More competition.
Answer: a – by encouraging lock-in, loyalty plans
lead to monopoly power and thus higher prices.
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Takeaway
 An oligopoly is a market dominated by a small
number of firm.
 Oligopolies form when there are significant
barriers to entry.
 Prices in an oligopoly tend to be below
monopoly prices but above competitive prices.
 A cartel is an oligopoly that maximizes profits by
limiting competition and producing the monopoly
quantity.
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Takeaway
 Most cartels are not stable; either members
cheat or new competitors enter the market.
 Governments break up some cartels, but enforce
many others.
 Game theory is the study of strategic interaction.
 The prisoner’s dilemma game explains why
cheating is common in cartels.
 Firms can reduce competitive pressures through
price matching, loyalty programs, and innovation.
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