Natural or legal barriers prevent new firms from entering.
A small number of firms compete.
Examples include markets for computer chips (Intel, AMD), batteries (Duracell, Energizer), and airplanes (Boeing, Airbus).
Barriers to Entry
Natural barriers can lead to a natural duopoly (two firms) or natural oligopoly (three firms).
Legal barriers can also create an oligopoly even if demand and costs could support more firms.
Small Number of Firms
Interdependence: Each firm's profit depends on the actions of other firms.
Temptation to Cooperate: Firms may be tempted to form a cartel, which is illegal.
Cartel: A group of firms that limit output, raise prices, and increase profit.
Oligopoly Games & Game Theory
Game Theory: Tool for studying strategic behavior, considering expected behavior of others and mutual interdependence.
Games consist of:
Rules
Strategies
Payoffs
Outcome
The Prisoner's Dilemma
Two prisoners (Art and Bob) caught committing a petty crime, suspected of a more serious crime.
Rules:
Each is in a separate cell and cannot communicate.
Confessing results in a 1-year sentence, accomplice gets 10 years.
If both confess, each gets 3 years.
If neither confesses, each gets 2 years for the minor crime.
Strategies:
Each has two possible actions: confess or deny.
Possible Outcomes:
Both confess.
Both deny.
Art confesses, Bob denies.
Bob confesses, Art denies.
Payoff Matrix: Shows payoffs for every possible action by each player.
Outcome: Rational choice leads each player to choose the action that is best for them, given the other player's action.
Nash Equilibrium: An equilibrium where each player chooses their best strategy given the strategies chosen by the other players (proposed by John Nash).
Dilemma: Best outcome for both is to deny, but the dominant strategy is to confess, leading to a suboptimal outcome.
Finding the Nash Equilibrium
Each player considers the consequences of their decision and the potential actions of the other player.
Equilibrium is reached when both players confess, resulting in a 3-year sentence each.
The Duopolists’ Dilemma
Similar to the prisoners’ dilemma, but played by two firms in a duopoly.
Duopoly: Market with only two competing producers.
Cost and Demand Conditions: Consider two firms, Trick and Gear, in a natural duopoly.
Collusion
Collusive Agreement: Firms agree to restrict output, raise prices, and increase profits (illegal in the U.S.).
Strategies:
Comply
Cheat
Colluding to Maximize Profits
Firms in a cartel act like a monopoly.
Economic profit is maximized where marginal cost (MC) equals marginal revenue (MR).
Each firm agrees to produce a certain quantity and share the economic profit.
If one firm increases output (cheats), its profit would increase because price is greater than marginal cost.
One Firm Cheats
If one firm cheats and increases output, industry output increases and the price falls.
The complier incurs an economic loss, while the cheat increases its economic profit.
Both Firms Cheat
If both firms increase output, industry output increases further, the price falls, and both firms make zero economic profit, similar to perfect competition.
Payoff Matrix
Illustrates the economic profits or losses for each firm based on their decisions to comply or cheat.
Payoff examples:
Both comply: Each makes 2 million per week.
Both cheat: Each makes zero economic profit.
One complies, one cheats: Complier loses 1 million, cheater makes 4.5 million.
Nash Equilibrium in the Duopolists’ Dilemma
The Nash equilibrium is that both firms cheat, leading to a competitive market outcome with zero economic profit.
Other Oligopoly Games
Include advertising and research and development (R&D) games, which are also prisoners’ dilemmas.
Example: R&D Game in the Market for Tissues (Kleenex vs. Puffs).
Payoff matrix shows potential profits based on whether each firm invests in R&D.
Game of Chicken
Arises when R&D creates a new technology that cannot be patented.
Both firms can benefit from either firm's R&D.
Equilibrium is for one firm to do the R&D, but it's uncertain which firm will do it.
Repeated Games and Sequential Games
Repeated Duopoly Game: Successful collusion and monopoly profit are possible if the game is played repeatedly.
Punishment Strategies:
Tit-for-Tat: Cooperate if the other player cooperated in the previous period, cheat if they cheated.
Trigger Strategy: Cooperate if the other player cooperates, but play the Nash equilibrium strategy forever if they cheat.
Games and Price Wars
Price wars might result from a tit-for-tat strategy combined with uncertainty about changes in demand.
Falling demand might trigger a round of tit-for-tat punishment.
Sequential Entry Game in a Contestable Market
Contestable Market: Firms can enter and leave easily, facing competition from potential entrants.
Game Tree: Illustrates the sequence of decisions and payoffs.
In the first stage, the existing firm (Agile) decides whether to set the monopoly price or the competitive price.
In the second stage, the potential entrant (Wanabe) decides whether to enter or stay out.
Equilibrium: Agile sets a competitive price to keep Wanabe out, making zero economic profit.
Limit Pricing: Setting the price at the highest level that is consistent with keeping the potential entrant out.
Antitrust Law
Regulates oligopolies, preventing them from becoming monopolies or behaving like monopolies.
The Antitrust Laws
Sherman Act (1890): Outlawed combinations, trusts, or conspiracies that restrict interstate trade, and prohibited attempts to monopolize.
Clayton Act (1914): Made illegal specific business practices that substantially lessen competition or create a monopoly.
Federal Trade Commission (FTC): Formed in 1914 to look for cases of unfair methods of competition and unfair or deceptive business practices.
The Clayton Act and Its Amendments
Robinson-Patman Act (1936)
Celler-Kefauver Act (1950)
Prohibit practices only if they substantially lessen competition or create a monopoly, including:
Price discrimination
Tying arrangements
Requirements contracts
Exclusive dealing
Territorial confinement
Acquiring a competitor's shares or assets
Becoming a director of a competing firm
Price Fixing
Always a violation of antitrust law; no defense if the Justice Department proves its existence.
Antitrust Policy Debates
Resale Price Maintenance: A manufacturer agrees with a distributor on the resale price.
Can be inefficient if it promotes monopoly pricing.
Can be efficient if it provides retailers with an incentive to provide an efficient level of retail service.
Tying Arrangements: Selling one product only if the buyer agrees to buy another different product as well.
Can allow a firm to price discriminate and take a larger amount of consumer surplus.
Predatory Pricing: Setting a low price to drive competitors out of business with the intention of then setting the monopoly price.
Economists are skeptical that predatory pricing actually occurs.
No case of predatory pricing has been definitively found.
Mergers and Acquisitions
The Federal Trade Commission (FTC) uses guidelines to determine which mergers to examine and possibly block.
Herfindahl-Hirschman Index (HHI): Used as a guideline.
If the original HHI is between 1,000 and 1,800, any merger that raises the HHI by 100 or more is challenged.
If the original HHI is greater than 1,800, any merger that raises the HHI by more than 50 is challenged.