Ch. 18 - Oligopoly
Chapter Overview
This chapter discusses the concept of oligopoly, a market structure characterized by a small number of firms that have significant control over market prices. The chapter explores various aspects of oligopoly, including collusion, competition, and the impact of antitrust laws.
Chapter Objectives (1 of 2)
Describe the characteristics of an oligopoly.
Explain how production decisions are made in a duopoly market.
Explain how collusion impacts production decisions in an oligopolistic market.
Identify the Nash equilibrium, given a payoff matrix.
Determine if a game represented by a payoff matrix is an example of the prisoners' dilemma.
Chapter Objectives (2 of 2)
Identify the dominant strategy, if present, for each player, given a payoff matrix.
Given a scenario, determine which antitrust law is violated.
Given an example of a business practice, identify it as resale price maintenance, predatory pricing, or tying.
18-1 Markets with Only a Few Sellers
Oligopoly Characteristics
Oligopoly: A market structure in which only a few sellers offer similar or identical products.
Game Theory: The study of how people behave in strategic situations where the outcome depends on the choices of multiple agents.
A Duopoly Example
Duopoly: An oligopoly with only two members. For example:
Jack and Jill's Water Wells:
Both own wells that produce drinking water.
The marginal cost of water is zero, leading to total revenue equaling total profit.
Demand Schedule for Water
Table 1 - Demand Schedule
Quantity | Price | Total Revenue (and Total Profit) |
|---|---|---|
0 gallons | $120 | $0 |
10 | $110 | $1,100 |
20 | $100 | $2,000 |
30 | $90 | $2,700 |
40 | $80 | $3,200 |
50 | $70 | $3,500 |
60 | $60 | $3,600 |
70 | $50 | $3,500 |
80 | $40 | $3,200 |
90 | $30 | $2,700 |
100 | $20 | $2,000 |
110 | $10 | $1,100 |
120 | $0 | $0 |
/
Market Comparison
Perfect Competition:
Price equals marginal cost resulting in an equilibrium quantity of 120 gallons.
Monopoly Market:
Price is greater than marginal cost, with profit maximized at a quantity of 60 gallons and price of $60 per gallon.
Quantity produced is lower than the efficient quantity.
Collusion and Cartels
Collusion: An agreement among firms in a market regarding quantities to produce or prices to charge.
Cartel: A group of firms that act together to maximize total profit, producing at a monopoly quantity and charging a monopoly price.
Example: Jack and Jill's Cartel
If they form a cartel, they can agree to split the market. For instance, if each produces 30 gallons, they would charge $60 a gallon, earning a profit of $1,800 each.
Active Learning 1: Collusion in Smallville
Situation: Each gas station agrees to sell $Q = 2,200$ at $P = $7, each earning a profit of $13,200.
If Casey’s gas station cheats and sells $Q = 3,000$, we analyze the consequences for market price and profits.
Outcomes:
Scenario if Casey's cheats:
If both gas stations cheat and sell $Q = 3,000$,
New Total Market Quantity $= 6,000$
Price becomes $5$, each firm's profit reduces to $12,000.
The Equilibrium for an Oligopoly
Market Dynamics
Oligopolists face difficulty forming cartels due to potential squabbling over profit division.
Antitrust laws often deter explicit agreements to prevent monopolistic behavior.
Without binding agreements, total quantity produced by oligopolists typically exceeds monopoly quantity, resulting in lower prices and profits.
Active Learning 2: Duopoly Equilibrium in Smallville
If firms sell at $Q = 3,000$, $P = $5$, should either firm increase quantity to 3,800?
Scenario Analysis:
If Casey’s increases $Q$ to 3,800: Market $Q = 6,800$, Price falls to $4$.
Casey’s profit decreases to $11,400, indicating a lack of incentive to increase production.
Nash Equilibrium
Definition
Nash Equilibrium: A situation wherein economic actors choose strategies that are optimal given the strategies chosen by others. For example, if both Jack and Jill produce 40 gallons, the price would be $40, resulting in each earning a profit of $1,600.
Individual Oligopoly Outcome
In a typical oligopoly, firms produce quantities greater than that of monopolies but less than perfect competition. Prices are usually set between monopoly and competitive levels.
Market Size and Outcomes
Market Dynamics
As the number of firms in an oligopoly increases, the market behaves more like perfect competition.
Price approaches marginal cost, promoting a socially efficient output level.
Positive and negative effects on profits and pricing are established through increased quantity.
The Prisoners' Dilemma
Definition
Prisoners' Dilemma: A game theory scenario that illustrates why cooperation is challenging despite mutual benefits.
Dominant Strategy: The strategy that is most beneficial to a player irrespective of competitors’ strategies.
Application in Oligopolies
Oligopolists struggle to maintain high profits due to self-interest driving them to cheat rather than cooperate.
Repeated Dilemmas and Cooperation
In repeated scenarios, cooperation may emerge, allowing cartels to maintain arrangements despite incentives to defect.
Public Policy toward Oligopolies
Government Roles
Governments can guide oligopolistic firms toward competition through policies that improve market outcomes, moving allocation closer to social optima.
Antitrust Laws
Sherman Antitrust Act (1890): Criminalizes collusive agreements.
Clayton Act (1914): Strengthens existing laws to prevent collusion and mergers.
Controversial Business Practices
Resale Price Maintenance: Enforces a fixed retail price, argued to prevent competition.
Predatory Pricing: Involves setting excessively low prices to eliminate competition, seen as non-profitable long-term.
Bundling: Involves selling two goods together at a single price to increase market power.
Conclusion
Firms in oligopolies aim to act like monopolies but are driven by self-interest towards competitive behaviors. Policy interventions can help regulate oligopolistic actions, though the legality of certain practices may vary due to their implications on market competition.
Chapter Overview
This chapter delves into the intricacies of oligopoly, a prevalent market structure defined by the presence of a small number of interdependent firms. These firms possess significant individual control over market prices due to their limited number, leading to complex strategic interactions. The discussion spans various facets of oligopolistic behavior, including the dynamics of collusion, the nature of competition among a few sellers, and the regulatory influence of antitrust laws designed to maintain market fairness.
Chapter Objectives (1 of 2)
Describe the characteristics of an oligopoly. Understand the key features that distinguish an oligopoly from perfect competition and monopoly.
Explain how production decisions are made in a duopoly market. Analyze the strategic choices firms make regarding output levels when there are only two major players.
Explain how collusion impacts production decisions in an oligopolistic market. Evaluate the incentives and challenges firms face when attempting to cooperate to maximize joint profits.
Identify the Nash equilibrium, given a payoff matrix. Learn to pinpoint stable strategy outcomes where no player can improve their situation by unilaterally changing their strategy.
Determine if a game represented by a payoff matrix is an example of the prisoners' dilemma. Recognize the specific conditions under which a strategic interaction resembles the classical prisoners' dilemma scenario.
Chapter Objectives (2 of 2)
Identify the dominant strategy, if present, for each player, given a payoff matrix. Discover how to find a strategy that is optimal for a player regardless of the choices made by opponents.
Given a scenario, determine which antitrust law is violated. Apply knowledge of key antitrust legislation to real-world business practices.
Given an example of a business practice, identify it as resale price maintenance, predatory pricing, or tying. Distinguish between specific controversial business strategies and their potential implications.
18-1 Markets with Only a Few Sellers
Oligopoly Characteristics
Oligopoly: A market structure characterized by a few dominant sellers who offer similar or identical products. This small number of firms implies that each firm's actions significantly affect the others and the overall market outcome, leading to strategic interdependence. Decisions about price, quantity, advertising, and product development are made with a keen eye on competitors' likely responses.
Game Theory: The analytical framework used to study strategic situations where the outcome for each participant depends on the choices of all participants. In oligopolies, firms engage in strategic decision-making, considering how their rivals will react to their moves. Game theory helps economists understand phenomena like collusion, price wars, and advertising battles.
A Duopoly Example
Duopoly: The simplest form of an oligopoly, consisting of only two members. It provides a foundational model for understanding more complex oligopolistic interactions.
Jack and Jill's Water Wells:
Jack and Jill are the sole providers of drinking water, each owning a well. This simplified scenario allows for a clear illustration of duopoly dynamics.
The marginal cost (MC) of pumping water from their wells is assumed to be zero. This assumption simplifies profit calculations, as total revenue becomes equal to total profit (since total cost is only fixed cost, and marginal cost is zero for variable production). Profit maximization then focuses solely on maximizing total revenue.
Demand Schedule for Water
Table 1 - Demand Schedule
Quantity (Gallons) (Q) | Price (P) (per gallon) | Total Revenue (TR) | Marginal Revenue (MR) |
|---|---|---|---|
0 | 120 | 0 | \text{--} |
10 | 110 | 1100 | 110 |
20 | 100 | 2000 | 90 |
30 | 90 | 2700 | 70 |
40 | 80 | 3200 | 50 |
50 | 70 | 3500 | 30 |
60 | 60 | 3600 | 10 |
70 | 50 | 3500 | -10 |
80 | 40 | 3200 | -30 |
90 | 30 | 2700 | -50 |
100 | 20 | 2000 | -70 |
110 | 10 | 1100 | -90 |
120 | 0 | 0 | -110 |
Market Comparison
Perfect Competition: In a perfectly competitive market, firms are price takers, and entry/exit ensures that price equals marginal cost (P = MC). Given a marginal cost of zero, the equilibrium price would be 0, and the equilibrium quantity would be 120 gallons. This outcome is considered socially efficient as it maximizes total surplus.
Monopoly Market: A monopolist, being the sole seller, faces the entire market demand curve. To maximize profit, a monopolist will produce at the quantity where marginal revenue equals marginal cost (MR = MC). With MC = 0, the monopolist will produce where MR = 0. From Table 1, this occurs at a quantity of 60 gallons, leading to a price of 60 dollars per gallon and a total profit of 3600. The quantity produced (60 gallons) is lower than the efficient quantity (120 gallons in perfect competition), and the price is higher.
Collusion and Cartels
Collusion: A formal or informal agreement among firms in a market to reduce competition by jointly deciding on quantities to produce, prices to charge, or market shares to maintain. Collusion is typically illegal under antitrust laws because it mimics monopolistic behavior.
Cartel: A group of firms that enter into explicit agreements to act collectively as if they were a single monopolist. The goal of a cartel is to maximize total industry profit by restricting output to the monopoly quantity and charging the monopoly price. Maintaining a cartel is challenging due to inherent incentives for individual members to cheat on the agreement.
Example: Jack and Jill's Cartel
If Jack and Jill form a cartel, they would analyze the demand schedule (Table 1) and agree to produce the monopoly quantity that maximizes their combined profit. As determined for a monopoly, this total quantity is 60 gallons, which they would sell at 60 dollars per gallon, earning a total profit of 3600. They could then agree to split this market, for instance, by each producing 30 gallons. In this scenario, each would earn a profit of 1,800 (from 30 \text{ gallons} \times 60 \text{ dollars/gallon}).
Active Learning 1: Collusion in Smallville
Situation: Imagine Smallville has two gas stations, Casey's and Jack's. The marginal cost of gasoline is zero (for simplicity, focusing on strategic interaction over profit). If they collude, they agree to each sell Q = 2,200 gallons, for a total market quantity of 4,400 gallons. At this quantity, the market price is P = 7 dollars per gallon (assuming a demand function where P = 16 - 0.002Q_{total}). Each station earns a profit of (2,200 \text{ gallons} \times 7 \text{ dollars/gallon}) = 15,400.
If Casey’s gas station cheats and unilaterally decides to sell Q = 3,000 gallons, while Jack's adheres to the agreement and sells Q = 2,200 gallons, the total market quantity becomes 3,000 + 2,200 = 5,200 gallons. The market price would then fall to P = (16 - 0.002 \times 5,200) = 16 - 10.4 = 5.60 dollars per gallon.
Outcomes:
Scenario if Casey's cheats (Jack cooperates):
Casey's quantity: 3,000 gallons
Casey's profit: (3,000 \text{ gallons} \times 5.60 \text{ dollars/gallon}) = 16,800 dollars (higher than cooperating)
Jack's quantity: 2,200 gallons
Jack's profit: (2,200 \text{ gallons} \times 5.60 \text{ dollars/gallon}) = 12,320 dollars (lower than cooperating)
This illustrates the strong incentive for an individual firm to cheat and gain a larger profit share at the expense of its partner and the overall cartel profit.
Scenario if both gas stations cheat and sell Q = 3,000 gallons:
New Total Market Quantity = 3,000 + 3,000 = 6,000 gallons.
The market price becomes P = (16 - 0.002 \times 6,000) = 16 - 12 = 4 dollars per gallon.
Each firm's profit reduces to (3,000 \text{ gallons} \times 4 \text{ dollars/gallon}) = 12,000 dollars. This profit is lower than the 15,400 they would have earned by cooperating, and even lower than what Casey would have earned by cheating alone. The outcome for both is worse than cooperation, yet the individual incentive to cheat often leads to this suboptimal collective outcome.
The Equilibrium for an Oligopoly
Market Dynamics
Oligopolists face inherent difficulties in forming and maintaining cartels due to the strong individual incentive for each firm to cheat on the agreement and capture a larger market share. Each firm is tempted to increase its production to earn more profit, assuming its rivals will stick to the agreement.
Furthermore, explicit agreements to collude are typically illegal due to stringent antitrust laws. These laws actively deter actions that could lead to monopolistic behavior, driving firms towards a more competitive outcome than if they were allowed to collude freely.
Without binding agreements or effective enforcement mechanisms for cooperation, the total quantity produced by oligopolists in equilibrium typically exceeds the monopoly quantity but remains less than the quantity produced under perfect competition. Consequently, market prices are usually set between the monopoly price and the competitive price, and profits are lower than pure monopoly profits, but generally higher than zero economic profits in perfect competition.
Active Learning 2: Duopoly Equilibrium in Smallville
Revisited Scenario: Assume Casey's and Jack's are currently in an equilibrium where each sells Q = 3,000 gallons and the market price is P = 4 dollars (as established when both cheated in Active Learning 1), resulting in a profit of 12,000 each. Should either firm increase its quantity to 3,800 gallons?
Scenario Analysis:
If Casey’s increases its quantity (QC) to 3,800 gallons, while Jack’s maintains its quantity (QJ) at 3,000 gallons:
Market Total Quantity (Q{total}) = QC + Q_J = 3,800 + 3,000 = 6,800 gallons.
The market price would fall to P = (16 - 0.002 \times 6,800) = 16 - 13.6 = 2.4 dollars per gallon.
Casey’s new profit: (3,800 \text{ gallons} \times 2.4 \text{ dollars/gallon}) = 9,120 dollars.
This profit of 9,120 is a decrease from Casey's current profit of 12,000 dollars. This indicates that at the current equilibrium of Q=3,000 each, Casey's has no incentive to unilaterally increase its production to 3,800 gallons, assuming Jack's holds its quantity constant. This analysis helps to identify a Nash equilibrium where neither firm gains by deviating alone.
Nash Equilibrium
Definition
Nash Equilibrium: A concept in game theory where each economic actor chooses the best strategy for themselves, given the strategies chosen by all other actors. In a Nash equilibrium, no player can improve their outcome by unilaterally changing their own strategy, assuming the other players' strategies remain unchanged. It represents a stable state in a non-cooperative game.
For example, if both Jack and Jill (from the water wells example) produce 40 gallons each, the total market quantity is 80 gallons. From Table 1, the price would be 40 dollars per gallon, resulting in total revenue (and profit) of 3,200 for the market, or 1,600 for each producer (40 \text{ gallons} \times 40 \text{ dollars/gallon}). If Jack unilaterally decides to produce more, say 50 gallons (while Jill stays at 40), the total quantity becomes 90 gallons, price drops to 30 dollars, and Jack's profit becomes (50 \text{ gallons} \times 30 \text{ dollars/gallon}) = 1,500, which is less than 1,600. Conversely, if Jack reduces production to 30 gallons, total quantity becomes 70 gallons, price rises to 50 dollars, and Jack's profit is (30 \text{ gallons} \times 50 \text{ dollars/gallon}) = 1,500, also less than 1,600. Thus, 40 gallons each is a Nash equilibrium; neither firm has an incentive to deviate.
Individual Oligopoly Outcome
In a typical oligopoly not engaged in perfect collusion, firms, driven by self-interest, produce quantities individually greater than what they would produce under strict cartel agreement (monopoly quantity) but less than what would be produced in perfect competition. Consequently, the market price in an oligopoly is usually set between the monopoly price and the perfectly competitive price. This outcome reflects the tension between the desire for monopoly profits and the pressure of competition among the few firms.
Market Size and Outcomes
Market Dynamics
As the number of firms in an oligopoly increases, the market tends to behave more and more like a perfectly competitive market. This occurs because the impact of any single firm's output decision on the market price becomes smaller when there are many firms. Each firm has less market power, reducing the incentive to restrict output to keep prices high.
As the number of sellers grows larger, the output effect (increasing output raises profit) dominates the price effect (increasing output lowers price) for individual firms, making them act closer to price takers.
Price approaches marginal cost (P \to MC), and the total quantity produced in the market approaches the socially efficient output level. This leads to reduced profits for individual firms but a more efficient allocation of resources from a societal perspective.
The Prisoners' Dilemma
Definition
Prisoners' Dilemma: A classic game theory scenario that compellingly illustrates why cooperation is difficult to maintain even when it appears to be mutually beneficial for all parties involved. It highlights the conflict between individual rationality and collective rationality, where individually rational choices can lead to a collectively suboptimal outcome.
Dominant Strategy: A strategy that yields the best outcome for a player, regardless of the strategies chosen by the other players. If a player has a dominant strategy, they will choose it no matter what the opponent does, simplifying the analysis of strategic choices.
Application in Oligopolies
The Prisoners' Dilemma perfectly models the challenges faced by oligopolists attempting to collude. Each firm has a dominant strategy to cheat on a cartel agreement (e.g., by producing more than agreed upon) because cheating yields a higher individual payoff, regardless of whether the other firms cooperate or also cheat. However, if all firms act on this individual incentive, the collective outcome (lower prices and profits for all) is worse than if they had all cooperated.
Repeated Dilemmas and Cooperation
While a single-instance Prisoners' Dilemma often leads to defection, cooperation can emerge and be sustained in repeated game scenarios. When the game is played over and over again, firms can develop strategies that reward cooperation and punish defection. For example, a
Key Terms and Definitions
Oligopoly: A market structure characterized by a few dominant sellers who offer similar or identical products. This small number of firms implies that each firm's actions significantly affect the others and the overall market outcome, leading to strategic interdependence. Decisions about price, quantity, advertising, and product development are made with a keen eye on competitors' likely responses.
Game Theory: The analytical framework used to study strategic situations where the outcome for each participant depends on the choices of all participants. In oligopolies, firms engage in strategic decision-making, considering how their rivals will react to their moves. Game theory helps economists understand phenomena like collusion, price wars, and advertising battles.
Duopoly: The simplest form of an oligopoly, consisting of only two members. It provides a foundational model for understanding more complex oligopolistic interactions.
Collusion: A formal or informal agreement among firms in a market to reduce competition by jointly deciding on quantities to produce, prices to charge, or market shares to maintain. Collusion is typically illegal under antitrust laws because it mimics monopolistic behavior.
Cartel: A group of firms that enter into explicit agreements to act collectively as if they were a single monopolist. The goal of a cartel is to maximize total industry profit by restricting output to the monopoly quantity and charging the monopoly price. Maintaining a cartel is challenging due to inherent incentives for individual members to cheat on the agreement.
Nash Equilibrium: A concept in game theory where each economic actor chooses the best strategy for themselves, given the strategies chosen by all other actors. In a Nash equilibrium, no player can improve their outcome by unilaterally changing their own strategy, assuming the other players' strategies remain unchanged. It represents a stable state in a non-cooperative game.
Prisoners' Dilemma: A classic game theory scenario that compellingly illustrates why cooperation is difficult to maintain even when it appears to be mutually beneficial for all parties involved. It highlights the conflict between individual rationality and collective rationality, where individually rational choices can lead to a collectively suboptimal outcome.
Dominant Strategy: A strategy that yields the best outcome for a player, regardless of the strategies chosen by the other players. If a player has a dominant strategy, they will choose it no matter what the opponent does, simplifying the analysis of strategic choices.
Sherman Antitrust Act (1890): Criminalizes collusive agreements.
Clayton Act (1914): Strengthens existing laws to prevent collusion and mergers.
Resale Price Maintenance: Enforces a fixed retail price, argued to prevent competition.
Predatory Pricing: Involves setting excessively low prices to eliminate competition, seen as non-profitable long-term.
Bundling: Involves selling two goods together at a single price to increase market power.
Public Policy toward Oligopolies
Government Roles
Governments play a crucial role in guiding oligopolistic firms toward more competitive behaviors. Through various policies, governments aim to improve market outcomes, pushing the allocation of resources closer to the socially optimal level, which typically involves higher output and lower prices than an unrestricted oligopoly or monopoly. This intervention is often necessary because self-interested oligopolists have an incentive to collude or act in ways that restrict output and raise prices, leading to deadweight loss.
Antitrust Laws
Sherman Antitrust Act (1890): This landmark federal law prohibits certain business activities that federal government regulators deem to be anti-competitive, and requires the federal government to investigate and pursue trusts, monopolies, and cartels. It criminalizes activities such as price-fixing, bid-rigging, and other collusive agreements among competitors. The act aims to prevent the concentration of economic power that could lead to consumer harm.
Clayton Act (1914): Enacted to provide more specific prohibitions than the broad language of the Sherman Act. The Clayton Act strengthens existing laws by prohibiting specific practices such as price discrimination, exclusive dealing, tying agreements, and mergers and acquisitions that substantially lessen competition or tend to create a monopoly. It addresses anti-competitive practices in their incipiency, aiming to prevent them before they manifest significant harm.
Controversial Business Practices
Resale Price Maintenance (Fair Trade Laws): This practice involves a manufacturer requiring retailers to sell their product at a specific minimum price. Proponents argue it can enhance product quality and service, prevent free-riding on retailer efforts, and promote brand image. Critics argue it stifles intra-brand competition and could lead to higher consumer prices by preventing retailers from competing on price. Its legality often depends on whether it significantly harms competition.
Predatory Pricing: This strategy involves a firm setting its prices excessively low, often below its variable costs, with the intent to drive competitors out of the market. Once competitors are eliminated, the firm plans to raise prices to recoup its losses and earn monopoly profits. It is exceedingly difficult to prove in court, as aggressive price competition is generally beneficial for consumers, and predatory pricing requires demonstrating both the intent to eliminate rivals and a reasonable prospect of recouping losses through future monopoly power.
Tying (Bundling): This practice occurs when a seller requires a customer to purchase one product (the tied good) as a condition for buying another product (the tying good). For example, a software company might require users of its popular operating system to also use its web browser. Arguments in favor suggest it can lead to efficient packaging of complementary goods or ensure product quality. Arguments against contend that it can extend market power from one product market to another, thereby reducing competition in the market for the tied good. Its legality is often debated based on its actual anti-competitive effects and the degree of market power held by the tying firm.
Conclusion
Firms in oligopolies inherently aim to act like monopolies (e.g., by restricting output and raising prices for higher profits), but they are often driven by self-interest and the threat of competition (even from a few rivals) toward more competitive behaviors. Public policy, primarily through antitrust laws, is critical in regulating these oligopolistic actions. These interventions help prevent anti-competitive practices, promote market efficiency, and protect consumer welfare. However, the legality and economic effects of certain business practices, such as resale price maintenance, predatory pricing, and tying, often remain subjects of economic and legal debate due to their complex implications on market competition and consumer welfare.
Chapter Overview
This chapter delves into the intricacies of oligopoly, a prevalent market structure defined by the presence of a small number of interdependent firms. These firms possess significant individual control over market prices due to their limited number, leading to complex strategic interactions. The discussion spans various facets of oligopolistic behavior, including the dynamics of collusion, the nature of competition among a few sellers, and the regulatory influence of antitrust laws designed to maintain market fairness.
Chapter Objectives (1 of 2)
Describe the characteristics of an oligopoly. Understand the key features that distinguish an oligopoly from perfect competition and monopoly.
Explain how production decisions are made in a duopoly market. Analyze the strategic choices firms make regarding output levels when there are only two major players.
Explain how collusion impacts production decisions in an oligopolistic market. Evaluate the incentives and challenges firms face when attempting to cooperate to maximize joint profits.
Identify the Nash equilibrium, given a payoff matrix. Learn to pinpoint stable strategy outcomes where no player can improve their situation by unilaterally changing their strategy.
Determine if a game represented by a payoff matrix is an example of the prisoners' dilemma. Recognize the specific conditions under which a strategic interaction resembles the classical prisoners' dilemma scenario.
Chapter Objectives (2 of 2)
Identify the dominant strategy, if present, for each player, given a payoff matrix. Discover how to find a strategy that is optimal for a player regardless of the choices made by opponents.
Given a scenario, determine which antitrust law is violated. Apply knowledge of key antitrust legislation to real-world business practices.
Given an example of a business practice, identify it as resale price maintenance, predatory pricing, or tying. Distinguish between specific controversial business strategies and their potential implications.
18-1 Markets with Only a Few Sellers
Oligopoly Characteristics
Oligopoly: A market structure characterized by a few dominant sellers who offer similar or identical products. This small number of firms implies that each firm's actions significantly affect the others and the overall market outcome, leading to strategic interdependence. Decisions about price, quantity, advertising, and product development are made with a keen eye on competitors' likely responses.
Game Theory: The analytical framework used to study strategic situations where the outcome for each participant depends on the choices of all participants. In oligopolies, firms engage in strategic decision-making, considering how their rivals will react to their moves. Game theory helps economists understand phenomena like collusion, price wars, and advertising battles.
A Duopoly Example
Duopoly: The simplest form of an oligopoly, consisting of only two members. It provides a foundational model for understanding more complex oligopolistic interactions.
Jack and Jill's Water Wells:
Jack and Jill are the sole providers of drinking water, each owning a well. This simplified scenario allows for a clear illustration of duopoly dynamics.
The marginal cost (MC) of pumping water from their wells is assumed to be zero. This assumption simplifies profit calculations, as total revenue becomes equal to total profit (since total cost is only fixed cost, and marginal cost is zero for variable production). Profit maximization then focuses solely on maximizing total revenue.
Demand Schedule for Water
Table 1 - Demand Schedule
Market Comparison
Perfect Competition: In a perfectly competitive market, firms are price takers, and entry/exit ensures that price equals marginal cost (P = MC). Given a marginal cost of zero, the equilibrium price would be 0, and the equilibrium quantity would be 120 gallons. This outcome is considered socially efficient as it maximizes total surplus.
Monopoly Market: A monopolist, being the sole seller, faces the entire market demand curve. To maximize profit, a monopolist will produce at the quantity where marginal revenue equals marginal cost (MR = MC). With MC = 0, the monopolist will produce where MR = 0. From Table 1, this occurs at a quantity of 60 gallons, leading to a price of 60 dollars per gallon and a total profit of 3600. The quantity produced (60 gallons) is lower than the efficient quantity (120 gallons in perfect competition), and the price is higher.
Collusion and Cartels
Collusion: A formal or informal agreement among firms in a market to reduce competition by jointly deciding on quantities to produce, prices to charge, or market shares to maintain. Collusion is typically illegal under antitrust laws because it mimics monopolistic behavior.
Cartel: A group of firms that enter into explicit agreements to act collectively as if they were a single monopolist. The goal of a cartel is to maximize total industry profit by restricting output to the monopoly quantity and charging the monopoly price. Maintaining a cartel is challenging due to inherent incentives for individual members to cheat on the agreement.
Example: Jack and Jill's Cartel
If Jack and Jill form a cartel, they would analyze the demand schedule (Table 1) and agree to produce the monopoly quantity that maximizes their combined profit. As determined for a monopoly, this total quantity is 60 gallons, which they would sell at 60 dollars per gallon, earning a total profit of 3600. They could then agree to split this market, for instance, by each producing 30 gallons. In this scenario, each would earn a profit of 1,800 (from 30 \text{ gallons} \times 60 \text{ dollars/gallon}).
Active Learning 1: Collusion in Smallville
Situation: Imagine Smallville has two gas stations, Casey's and Jack's. The marginal cost of gasoline is zero (for simplicity, focusing on strategic interaction over profit). If they collude, they agree to each sell Q = 2,200 gallons, for a total market quantity of 4,400 gallons. At this quantity, the market price is P = 7 dollars per gallon (assuming a demand function where P = 16 - 0.002Q_{\text{total}}). Each station earns a profit of (2,200 \text{ gallons} \times 7 \text{ dollars/gallon}) = 15,400 dollars.
If Casey’s gas station cheats and unilaterally decides to sell Q = 3,000 gallons, while Jack's adheres to the agreement and sells Q = 2,200 gallons, the total market quantity becomes 3,000 + 2,200 = 5,200 gallons. The market price would then fall to P = (16 - 0.002 \times 5,200) = 16 - 10.4 = 5.60 dollars per gallon.
Outcomes:
Scenario if Casey's cheats (Jack cooperates):
Casey's quantity: 3,000 gallons
Casey's profit: (3,000 \text{ gallons} \times 5.60 \text{ dollars/gallon}) = 16,800 dollars (higher than cooperating)
Jack's quantity: 2,200 gallons
Jack's profit: (2,200 \text{ gallons} \times 5.60 \text{ dollars/gallon}) = 12,320 dollars (lower than cooperating)
This illustrates the strong incentive for an individual firm to cheat and gain a larger profit share at the expense of its partner and the overall cartel profit.
Scenario if both gas stations cheat and sell Q = 3,000 gallons:
New Total Market Quantity = 3,000 + 3,000 = 6,000 gallons.
The market price becomes P = (16 - 0.002 \times 6,000) = 16 - 12 = 4 dollars per gallon.
Each firm's profit reduces to (3,000 \text{ gallons} \times 4 \text{ dollars/gallon}) = 12,000 dollars. This profit is lower than the 15,400 they would have earned by cooperating, and even lower than what Casey would have earned by cheating alone. The outcome for both is worse than cooperation, yet the individual incentive to cheat often leads to this suboptimal collective outcome.
The Equilibrium for an Oligopoly
Market Dynamics
Oligopolists face inherent difficulties in forming and maintaining cartels due to the strong individual incentive for each firm to cheat on the agreement and capture a larger market share. Each firm is tempted to increase its production to earn more profit, assuming its rivals will stick to the agreement.
Furthermore, explicit agreements to collude are typically illegal due to stringent antitrust laws. These laws actively deter actions that could lead to monopolistic behavior, driving firms towards a more competitive outcome than if they were allowed to collude freely.
Without binding agreements or effective enforcement mechanisms for cooperation, the total quantity produced by oligopolists in equilibrium typically exceeds the monopoly quantity but remains less than the quantity produced under perfect competition. Consequently, market prices are usually set between the monopoly price and the competitive price, and profits are lower than pure monopoly profits, but generally higher than zero economic profits in perfect competition.
Active Learning 2: Duopoly Equilibrium in Smallville
Revisited Scenario: Assume Casey's and Jack's are currently in an equilibrium where each sells Q = 3,000 gallons and the market price is P = 4 dollars (as established when both cheated in Active Learning 1), resulting in a profit of 12,000 each. Should either firm increase its quantity to 3,800 gallons?
Scenario Analysis:
If Casey’s increases its quantity (QC) to 3,800 gallons, while Jack’s maintains its quantity (QJ) at 3,000 gallons:
Market Total Quantity (Q{\text{total}}) = QC + Q_J = 3,800 + 3,000 = 6,800 gallons.
The market price would fall to P = (16 - 0.002 \times 6,800) = 16 - 13.6 = 2.4 dollars per gallon.
Casey’s new profit: (3,800 \text{ gallons} \times 2.4 \text{ dollars/gallon}) = 9,120 dollars.
This profit of 9,120 is a decrease from Casey's current profit of 12,000 dollars. This indicates that at the current equilibrium of Q=3,000 each, Casey's has no incentive to unilaterally increase its production to 3,800 gallons, assuming Jack's holds its quantity constant. This analysis helps to identify a Nash equilibrium where neither firm gains by deviating alone.
Nash Equilibrium
Definition
Nash Equilibrium: A concept in game theory where each economic actor chooses the best strategy for themselves, given the strategies chosen by all other actors. In a Nash equilibrium, no player can improve their outcome by unilaterally changing their own strategy, assuming the other players' strategies remain unchanged. It represents a stable state in a non-cooperative game.
For example, if both Jack and Jill (from the water wells example) produce 40 gallons each, the total market quantity is 80 gallons. From Table 1, the price would be 40 dollars per gallon, resulting in total revenue (and profit) of 3,200 for the market, or 1,600 for each producer (40 \text{ gallons} \times 40 \text{ dollars/gallon}). If Jack unilaterally decides to produce more, say 50 gallons (while Jill stays at 40), the total quantity becomes 90 gallons, price drops to 30 dollars, and Jack's profit becomes (50 \text{ gallons} \times 30 \text{ dollars/gallon}) = 1,500, which is less than 1,600. Conversely, if Jack reduces production to 30 gallons, total quantity becomes 70 gallons, price rises to 50 dollars, and Jack's profit is (30 \text{ gallons} \times 50 \text{ dollars/gallon}) = 1,500, also less than 1,600. Thus, 40 gallons each is a Nash equilibrium; neither firm has an incentive to deviate.
Individual Oligopoly Outcome
In a typical oligopoly not engaged in perfect collusion, firms, driven by self-interest, produce quantities individually greater than what they would produce under strict cartel agreement (monopoly quantity) but less than what would be produced in perfect competition. Consequently, the market price in an oligopoly is usually set between the monopoly price and the perfectly competitive price. This outcome reflects the tension between the desire for monopoly profits and the pressure of competition among the few firms.
Market Size and Outcomes
Market Dynamics
As the number of firms in an oligopoly increases, the market tends to behave more and more like a perfectly competitive market. This occurs because the impact of any single firm's output decision on the market price becomes smaller when there are many firms. Each firm has less market power, reducing the incentive to restrict output to keep prices high.
As the number of sellers grows larger, the output effect (increasing output raises profit) dominates the price effect (increasing output lowers price) for individual firms, making them act closer to price takers.
Price approaches marginal cost (P \to MC), and the total quantity produced in the market approaches the socially efficient output level. This leads to reduced profits for individual firms but a more efficient allocation of resources from a societal perspective.
The Prisoners' Dilemma
Definition
Prisoners' Dilemma: A classic game theory scenario that compellingly illustrates why cooperation is difficult to maintain even when it appears to be mutually beneficial for all parties involved. It highlights the conflict between individual rationality and collective rationality, where individually rational choices can lead to a collectively suboptimal outcome.
Dominant Strategy: A strategy that yields the best outcome for a player, regardless of the strategies chosen by the other players. If a player has a dominant strategy, they will choose it no matter what the opponent does, simplifying the analysis of strategic choices.
Application in Oligopolies
The Prisoners' Dilemma perfectly models the challenges faced by oligopolists attempting to collude. Each firm has a dominant strategy to cheat on a cartel agreement (e.g., by producing more than agreed upon) because cheating yields a higher individual payoff, regardless of whether the other firms cooperate or also cheat. However, if all firms act on this individual incentive, the collective outcome (lower prices and profits for all) is worse than if they had all cooperated.
Repeated Dilemmas and Cooperation
While a single-instance Prisoners' Dilemma often leads to defection, cooperation can emerge and be sustained in repeated game scenarios. When the game is played over and over again, firms can develop strategies that reward cooperation and punish defection. For example, a ____________________________________________________________________________________________________________