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Lecture 18

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Lecture 18

Uploaded by

Charity Kwok
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© © All Rights Reserved
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Oligopoly

This Chapter

• The last market structure we will learn is oligopoly.


• Monopolistic competition is closer to the case of perfect competition, while oligopoly is
closer to the case of monopoly.
• One of the implication of “a large number of firms” is that “no one firm’s actions
directly affect the actions of others”. What about “a small number of firms”?
• It turns out that if the number of firms is small, one firm’s actions will directly affect the
actions of others – so-called “strategic interactions”
• The study of oligopoly markets involve lots of such interactions – with an analytical
framework called “game theory”
What Is Oligopoly?

Oligopoly is a market structure in which


• Natural or legal barriers prevent the entry of new firms.
• A small number of firms compete.
What Is Oligopoly?

Barriers to Entry
Either natural or legal barriers to
entry can create oligopoly.
In part (a), there is a natural
duopoly—a market with two firms.
In part (b), there is a natural
oligopoly market with three firms.

A legal oligopoly might arise even


where the demand and costs leave
room for a larger number of firms.
What Is Oligopoly?

Small Number of Firms


Because an oligopoly market has only a few firms, they are interdependent and face a
temptation to cooperate.
Interdependence: With a small number of firms, each firm’s profit depends on every
firm’s actions.
Temptation to Cooperate: Firms in oligopoly face the temptation to form a cartel.
• A cartel is a group of firms acting together to limit output, raise price, and increase profit.
Cartels are illegal.
We use the framework of game theory to analyze the interactions among firms in an
oligopoly market.
What Is Oligopoly?
Examples of oligopoly competition
Oligopoly Games

What Is a Game?
Game theory is a tool for studying strategic behavior, which is behavior that takes
into account the expected behavior of others and the mutual recognition of
interdependence.
All games have four common features:
• Rules
• Strategies
• Payoffs
• Outcome
Oligopoly Games

The Prisoners’ Dilemma


In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught
committing a petty crime.
Oligopoly Games

Rules
The rules describe the setting of the game, the actions the players may take, and the
consequences of those actions.
• Each is held in a separate cell and cannot communicate with the other.
• Each is told that both are suspected of committing a more serious crime.
• If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice
will get a 10-year sentence for both crimes.
• If both confess to the more serious crime, each receives a 3-year sentence for both crimes.
• If neither confesses, each receives a 2-year sentence for the minor crime only.
Oligopoly Games

Strategies
Strategies are all the possible actions of each player.
Art and Bob each have two possible actions:
1. Confess to the larger crime.
2. Deny having committed the larger crime.
Oligopoly Games

Outcomes
With two players and two actions for each player, there are four possible outcomes:
1. Both confess.
2. Both deny.
3. Art confesses, and Bob denies.
4. Bob confesses, and Art denies.
Oligopoly Games

Payoffs
Each prisoner can work out what happens
to him—can work out his payoff—in each
of the four possible outcomes.
We can tabulate these outcomes in a
payoff matrix that shows the payoffs for
every possible action by each player for
every possible action by the other player.
Which outcome is the best for both?
Oligopoly Games

Outcome
If a player makes a rational choice in
pursuit of his own best interest, he
chooses the action that is best for him,
given any action taken by the other
player.
If both players are rational and choose
their actions in this way, the outcome is
an equilibrium called a Nash
equilibrium—first proposed by John
Nash.
Oligopoly Games

Bob’s view of the world


Oligopoly Games

Bob’s view of the world


Oligopoly Games

Art’s view of the world


Oligopoly Games

Art’s view of the world


Oligopoly Games

Equilibrium
Oligopoly Games

The Dilemma
The dilemma arises as each prisoner contemplates the consequences of his decision
and puts himself in the place of his accomplice.
Each knows that it would be best if both denied.
But each also knows that if he denies it is in the best interest of the other to confess.
The dilemma leads to the equilibrium of the game.
Oligopoly Games

A Bad Outcome
For the prisoners, the equilibrium of the game is not the best outcome.
If neither confesses, each gets a 2-year sentence.
Can this better outcome be achieved?
No, because each prisoner can figure out that there is a best strategy for each of them.
Each knows that it is not in his best interest to deny.
Oligopoly Games

An Oligopoly Price-Fixing Game


A game like the prisoners’ dilemma is often played in duopoly.
A duopoly is a market in which there are only two producers that compete.
Duopoly captures the essence of oligopoly.
• The analytical framework can be easily extended to the case of three firms.
The figure on the next slide describes the cost and demand situation in a natural
duopoly in which two firms, Trick and Gear, compete.
Oligopoly Games
Part (a) shows each firm’s cost curves.
Part (b) shows the market demand curve.
Oligopoly Games
This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.
Oligopoly Games
How does this market work?
What is the price and quantity produced in equilibrium?
Oligopoly Games

Collusion
Suppose that the two firms enter into a collusive agreement.
A collusive agreement is an agreement between two (or more) firms to restrict output,
raise the price, and increase profits.
Such agreements are illegal in the United States and are undertaken in secret.
Firms in a collusive agreement operate a cartel.
Oligopoly Games

The strategies that firms in a cartel can pursue are to


• Comply
• Cheat
Because each firm has two strategies, there are four possible combinations of actions
for the firms:
1. Both comply.
2. Both cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.
Oligopoly Games
Colluding to Maximize Profits
Firms in a cartel act like a monopoly and maximize economic profit.
Oligopoly Games
To find that profit, set the cartel's marginal cost equal to its marginal revenue.
Oligopoly Games
The cartel’s marginal cost curve is the horizontal sum of the MC curves of the two
firms. The marginal revenue curve is like that of a monopoly.
Oligopoly Games
The firms maximize economic profit by producing the quantity at which 𝑀𝐶𝐼 = 𝑀𝑅.
Oligopoly Games
Each firm agrees to produce 2,000 units and to share the economic profit.
The blue rectangle shows each firm’s economic profit.
Oligopoly Games
When each firm produces 2,000 units, the price is greater than the firm’s marginal cost,
so if one firm increased output, its profit would increase.
Oligopoly Games
One Firm Cheats on a Collusive Agreement
Suppose the cheat increases its output to 3,000 units. Industry output increases to
5,000 and the price falls.
Oligopoly Games
For the complier, ATC now exceeds the price.
For the cheat, the price exceeds ATC.
Oligopoly Games
The complier incurs an economic loss.
The cheat increases its economic profit.
Oligopoly Games
Both Firms Cheat
Suppose that both increase their output to 3,000 units.
Oligopoly Games
Industry output is 6,000 units, the price falls.
Both firms make zero economic profit—the same as in perfect competition.
Oligopoly Games

The Payoff Matrix


• If both comply, each firm makes $2 million a week.
• If both cheat, each firm makes zero economic profit.
• If Trick complies and Gear cheats, Trick incurs a loss of $1 million and Gear makes a
profit of $4.5 million.
• If Gear complies and Trick cheats, Gear incurs a loss of $1 million and Trick makes a
profit of $4.5 million.
Oligopoly Games

Payoff Matrix
Oligopoly Games

Equilibrium
Oligopoly Games

Nash Equilibrium in the Duopolists’ Dilemma


The Nash equilibrium is that both firms cheat.
The quantity and price are those of a competitive market, and firms make zero
economic profit.

Firms may also engage in advertising and research and development (R&D) games.
These games are also prisoners’ dilemmas.
Oligopoly Games

For example, an R&D Game in the


Market for Tissues
• Anti-Viral Kleenex and Puffs Plus
Lotion weren’t developed because
Kimberly-Clark (Kleenex) and P&G
(Puffs) were thinking about helping you
cope with a miserable cold.
• These tissues and other innovations in
the quality of facial tissues are the
product of a costly R&D game.
Oligopoly Games

The payoff matrix is shown below.


What is the equilibrium?

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