Principles of Microeconomics: Oligopoly

Measuring Market Concentration and Definitions of Oligopoly

Concentration Ratio: This is defined as the percentage of a market's total output supplied by its four largest firms. * The degree of competition in a market is inversely related to its concentration ratio: the higher the concentration ratio, the less competition exists within that industry. * This chapter focuses specifically on Oligopoly, which is characterized by a market structure with high concentration ratios.
Concentration Ratios in Selected U.S. Industries (from provided data): * Video game consoles: $100\%$ * Tennis balls: $100\%$ * Credit cards: $99\%$ * Batteries: $94\%$ * Soft drinks: $93\%$ * Web search engines: $92\%$ * Breakfast cereal: $92\%$ * Cigarettes: $89\%$ * Greeting cards: $88\%$ * Beer: $85\%$ * Cell phone service: $82\%$ * Autos: $79\%$
Definition of Oligopoly: A market structure in which only a few sellers offer products that are similar or identical.
Strategic Behavior: In an oligopoly, a firm's decisions regarding Price ( $P$ ) or Quantity ( $Q$ ) can directly affect other firms and cause them to react. A firm must consider these potential reactions when making its own decisions.
Game Theory: The study of how individuals or firms behave in strategic situations.

Example: Cell Phone Duopoly in Smalltown

Scenario Background: * Market: Smalltown has $140$ residents. * The Product: Cell phone service including unlimited anytime minutes and a free phone. * Firms: Two companies, T-Mobile and Verizon, forming a Duopoly (an oligopoly with only two firms). * Costs: Fixed Costs ( $FC$ ) = $\$0$ ; Marginal Cost ( $MC$ ) = $\$10$ .
Smalltown's Demand Schedule: * $P = \$45$ , $Q = 50$ , Revenue = $\$2,250$ , Cost = $\$500$ , Profit = $\$1,750$ * $P = \$40$ , $Q = 60$ , Revenue = $\$2,400$ , Cost = $\$600$ , Profit = $\$1,800$ * $P = \$35$ , $Q = 70$ , Revenue = $\$2,450$ , Cost = $\$700$ , Profit = $\$1,750$ * $P = \$30$ , $Q = 80$ , Revenue = $\$2,400$ , Cost = $\$800$ , Profit = $\$1,600$ * $P = \$25$ , $Q = 90$ , Revenue = $\$2,250$ , Cost = $\$900$ , Profit = $\$1,350$ * $P = \$20$ , $Q = 100$ , Revenue = $\$2,000$ , Cost = $\$1,000$ , Profit = $\$1,000$ * $P = \$15$ , $Q = 110$ , Revenue = $\$1,650$ , Cost = $\$1,100$ , Profit = $\$550$ * $P = \$10$ , $Q = 120$ , Revenue = $\$1,200$ , Cost = $\$1,200$ , Profit = $\$0$ * $P = \$5$ , $Q = 130$ , Revenue = $\$650$ , Cost = $\$1,300$ , Profit = $-\$650$ * $P = \$0$ , $Q = 140$ , Revenue = $\$0$ , Cost = $\$1,400$ , Profit = $-\$1,400$
Comparative Market Outcomes: * Competitive Outcome: Occurs where $P = MC$ . In this scenario, $P = \$10$ , $Q = 120$ , and Profit = $\$0$ . * Monopoly Outcome: Occurs where profit is maximized. In this scenario, $P = \$40$ , $Q = 60$ , and Total Profit = $\$1,800$ .

Collusion, Cartels, and the Incentive to Renege

Collusion: An agreement among firms in a market concerning the quantities to produce or prices to charge.
Cartel: A group of firms acting in unison (e.g., T-Mobile and Verizon agreeing to act like a single monopolist).
Collusion Scenario: * T-Mobile and Verizon agree to split the monopoly output ( $Q = 60$ ) equally. * Each firm produces $Q = 30$ , charges $P = \$40$ , and earns a profit of $\$900$ .
Self-Interest and Reneging (Active Learning 1): * If T-Mobile reneges on the agreement and increases its production to $Q = 40$ while Verizon stays at $Q = 30$ : * Total Market Quantity ( $Q$ ) = $70$ . * Market Price ( $P$ ) drops to $\$35$ . * T-Mobile's Profit = $40 \times (\$35 - \$10) = \$1,000$ . * Conclusion: T-Mobile's profit is higher ( $\$1,000$ vs. $\$900$ ) if it reneges. * However, if both firms conclude the same thing and both renege by producing $Q = 40$ : * Total Market Quantity ( $Q$ ) = $80$ . * Market Price ( $P$ ) drops to $\$30$ . * Each firm's Profit = $40 \times (\$30 - \$10) = \$800$ .
Lesson: Even though both firms are better off sticking to the agreement, individual incentive leads to reneging, making it difficult for oligopolies to maintain cartels.

Nash Equilibrium in Oligopoly

Nash Equilibrium Definition: A situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen.
Duopoly Nash Equilibrium: * In the Smalltown example, the Nash equilibrium occurs when each firm produces $Q = 40$ . * Given Verizon produces $40$ , T-Mobile's best strategy is $40$ . (If T-Mobile increased to $50$ , market $Q = 90$ , $P = \$25$ , and profit would fall to $50 \times (\$25 - \$10) = \$750$ ). * Given T-Mobile produces $40$ , Verizon's best strategy is $40$ .
Comparison of Market Outcomes: * Quantity: Q_{monopoly} < Q_{oligopoly} < Q_{competitive} * Price: P_{competitive} < P_{oligopoly} < P_{monopoly}

The Mechanics of Increasing Output

Output Effect: Because P > MC, selling one more unit of output at the going price will raise profit.
Price Effect: Raising production increases the total amount sold, which lowers the price of the product and reduces the profit on all other units sold.
Decision Rule: * If Output Effect > Price Effect, the firm will increase production. * If Price Effect > Output Effect, the firm will reduce production.
The Size of the Oligopoly: * As the number of firms in the market increases, the price effect felt by any single firm becomes smaller. * The oligopoly market begins to look more like a competitive market. * Price ( $P$ ) approaches Marginal Cost ( $MC$ ). * The market quantity approaches the socially efficient quantity. * International Trade Benefit: Trade increases the number of firms competing in a market, which increases $Q$ and brings $P$ closer to $MC$ .\n

Game Theory and the Prisoners' Dilemma

Dominant Strategy: A strategy that is the best for a player in a game regardless of the strategies chosen by the other players.
Prisoners' Dilemma: A "game" between two captured criminals (Bonnie and Clyde) illustrating why cooperation is difficult even when it is mutually beneficial. * The Deal: * If both confess: each gets $8$ years. * If one confesses and the other is silent: the confessor goes free, the silent one gets $20$ years. * If both remain silent: each gets $1$ year (due to limited evidence). * Outcome: For both Bonnie and Clyde, confessing is the dominant strategy. The Nash equilibrium is that both confess, even though remaining silent would result in shorter sentences for both.
Oligopolies as Prisoners' Dilemma: Cartel members are effectively players in a prisoners' dilemma where the "cooperate" move is sticking to the low-output agreement and the "defect" move is overproducing.

Real-World Examples of the Prisoners' Dilemma

Fare Wars (Active Learning 3): * Players: American Airlines and United Airlines. * Choice: Cut fares by $50\%$ or leave fares alone. * Both cut fares: Profit = $\$400$ million each. * Neither cuts fares: Profit = $\$600$ million each. * One cuts, one doesn't: Cutter profit = $\$800$ million; Non-cutter profit = $\$200$ million. * Nash Equilibrium: Both airlines cut fares.
Ad Wars: Two firms spend millions on advertising to steal business. The ads cancel each other out, and both firms' profits fall by the cost of the advertising.
OPEC: Member countries attempt to act as a cartel to limit oil production. Agreements often break down when individual member countries renege to increase their own revenue.
Arms Races: Superpowers are better off disarming, but the dominant strategy is to arm for protection or advantage.
Common Resources: All are better off conserving, but the dominant strategy is to overuse the resource before others do.
Negative Campaign Ads: * If Candidate R runs a negative ad: Candidate D loses $3000$ votes, Candidate R gains $1000$ votes, $2000$ people abstain. * If Candidate D runs a negative ad: Candidate R loses $3000$ votes, Candidate D gains $1000$ votes, $2000$ people abstain. * Nash Equilibrium: Both run negative ads. This has no net effect on the election result (ads cancel out) but has negative social consequences: lower turnout and higher voter apathy.

Why Cooperation Sometimes Happens

Repeated Games: If a game is played multiple times, firms may find ways to cooperate.
Strategies for Cooperation: * Persistent Reneging: If the rival reneges once, you renege in all subsequent rounds. * Tit-for-Tat: You do whatever your rival did in the previous round (cooperate if they cooperated, renege if they reneged).

Public Policy Toward Oligopolies

Role of Policymakers: Because oligopoly production is too low and prices are too high compared to the social optimum, governments use policies to promote competition and prevent cooperation.
Legal Framework: * Sherman Antitrust Act (1890): Forbids collusion between competitors. * Clayton Antitrust Act (1914): Strengthened the rights of individuals damaged by anticompetitive arrangements.
Antitrust Controversies: Economists debate the use of antitrust laws against certain business practices that might have legitimate objectives: 1. Resale Price Maintenance ("Fair Trade"): A manufacturer sets a lower limit on retail prices. While it appears to reduce competition, it can prevent discount retailers from "free-riding" on the services provided by full-service retailers. 2. Predatory Pricing: Cutting prices to drive out competitors to charge monopoly prices later. Economists doubt its rationality as it involves certain losses for the predator and often backfires. 3. Tying: Bundling two products for one price. Critics say it extends market power; defenders say buyers won't pay more for the bundle than the separate goods and that it can be a form of efficient price discrimination.

Summary of Market Dynamics

Oligopolists can maximize collective profits by forming a cartel, but individual self-interest leads them to produce a higher quantity at a lower price than a monopolist would.
As the number of firms in an oligopoly increases, the market quantity and price move toward competitive levels.
The prisoners' dilemma illustrates why self-interest thwarts cooperation.
Antitrust laws are the primary tool to prevent price-fixing, though their application to practices like tying and resale price maintenance remains a subject of debate.