Mankiw Principles of Economics Chapter 17: Oligopoly Study Guide
Introduction to Oligopolies and Strategic Behavior
An oligopoly is defined as a market structure in which only a few sellers offer products that are either similar or identical to one another. Because there are only a few sellers, the hallmark of an oligopoly is strategic behavior. This means that any individual firm's decisions regarding price () or quantity () can significantly affect the other firms in the market, causing them to react. Consequently, a firm in an oligopoly must consider these potential reactions when making its own economic decisions. Game theory is the formal study of how people or firms behave in such strategic situations.
Markets with Only a Few Sellers
Oligopolists realize the most profit when they cooperate and act collectively like a single monopolist. However, strong incentives for individual gain often hinder a group of firms from maintaining a cooperative outcome. The simplest form of an oligopoly is a duopoly, which is a market served by only two sellers. This model is often used to illustrate the basic tensions between cooperation and self-interest.
In the example of a gasoline duopoly in Smallville, the market features two stations: 7-eleven and Casey’s. The firms face a demand schedule where, for instance, at a price of P = $7, the quantity demanded is gallons, and at P = $6, quantity demanded is gallons. The costs for each firm are assumed to be a marginal cost () of $1 per gallon and fixed costs () of $0. Under perfect competition, the outcome would be where price equals marginal cost (P = MC = $1), resulting in a total quantity of and a profit of $0. Under a monopoly outcome, the price would be set at P = $7 with a total quantity of , generating a total profit of $26,400.
Collusion, Cartels, and the Incentive to Cheat
Collusion occurs when firms in a market reach an agreement regarding the quantities to produce or the prices to charge. When a group of firms acts in unison in this manner, they form a cartel. Once a cartel is established, the market is effectively served by a monopoly. For example, if 7-eleven and Casey’s collude to reach the monopoly outcome, they would each agree to sell gallons at a price of P = $7, earning a profit of $13,200 each ().
However, self-interest often leads to cheating. If Casey’s decides to cheat and increases its production to while 7-eleven sticks to the agreement (), the total market quantity becomes . According to the demand schedule, the market price drops to P = $6. Casey’s profit would then rise to 3,000 \times (6 - 1) = $15,000, which is higher than the cooperative profit. If both stations decide to cheat and increase their production to each, the total quantity is , the price falls to P = $5, and each firm’s profit drops to 3,000 \times (5 - 1) = $12,000. This demonstrates that while both firms are better off cooperating, the individual incentive to cheat makes cartels difficult to maintain.
The Equilibrium for an Oligopoly
A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. In an oligopoly, when firms individually choose their production levels to maximize profit, they produce a total quantity that is greater than the monopoly quantity but less than the competitive quantity. The resulting market price is lower than the monopoly price but higher than the competitive price (where ).
When an oligopolist decides whether to increase production, they weigh two effects on profit. The output effect occurs because P > MC, meaning that selling more units at the current price will raise profits. The price effect occurs because increasing total production lowers the market price, which reduces the profit earned on all units sold. As the number of sellers in an oligopoly increases, the price effect becomes smaller. Eventually, the price approaches marginal cost, the quantity approaches the socially efficient quantity, and the oligopoly begins to look like a competitive market. This transition is one of the primary benefits cited for international trade, as it introduces more competitors into domestic markets.
The Prisoners’ Dilemma and the Economics of Cooperation
The prisoners’ dilemma is a specific "game" that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. In the classic scenario, two suspects, Bonnie and Clyde, are caught by police. The police have enough evidence to imprison each for year but offer a deal to each separately: if one confesses and implicates their partner, they go free while the partner gets years. If both confess, both get years. If both remain silent, both get only year.
A dominant strategy is a strategy that is best for a player regardless of the strategies chosen by other players. In this case, confessing is the dominant strategy for both Bonnie and Clyde. If Clyde confesses, Bonnie is better off confessing ( years vs. ). If Clyde remains silent, Bonnie is still better off confessing (free vs. year). The Nash equilibrium is for both to confess, even though they would be collectively better off if they both remained silent.
Oligopolies face a similar dilemma. While reaching a monopoly outcome is jointly rational, the logic of self-interest often leads them to a noncooperative outcome with lower profits. Other real-world examples of the prisoners’ dilemma include ad wars (where competing ads cancel each other out but costs remain), the Organization of Petroleum Exporting Countries (OPEC) (where members have incentives to exceed production quotas), arms races between superpowers, and the overuse of common resources.
Societal Welfare and Cooperation over Time
A noncooperative oligopoly equilibrium can be detrimental to the firms because it prevents them from reaching monopoly profits. However, it can be beneficial for society because the resulting higher quantities and lower prices are closer to the socially optimal levels. Conversely, in games like the arms race or common resource depletion, the lack of cooperation is bad for society.
Cooperation sometimes occurs when a game is repeated many times. Two strategies that may sustain cooperation in repeated games are the "grim trigger" strategy (if a rival reneges once, you renege in all subsequent rounds) and the "tit-for-tat" strategy (whatever your rival did in the previous round, you do in the current round).
Case Studies and Active Learning in Strategic Interaction
In a scenario involving commercial fishing on Lake Michigan, two companies, "The Joy of Fishing" and "The Singing Fish," must choose between a small and large catch. If both catch a small quantity, each earns $300 million (the colluding outcome). However, if one catches a large quantity and the other small, the large catcher earns $400 million while the other earns $150 million. If both catch a large quantity, each earns $250 million. The Nash equilibrium is for both to catch a large quantity, resulting in less total profit than the cooperative outcome.
In political campaigns, candidates "R" and "D" face a similar choice regarding negative ads. If both refrain from attack ads, no votes are lost. If both run attack ads, their effects cancel out, but society suffers from lower voter turnout and increased apathy. Each candidate's dominant strategy is to run attack ads, leading to a Nash equilibrium that is socially negative but strategically inescapable for the individual candidates.
A third example involves the airline fare wars between American Airlines and Braniff Airways. If neither cuts fares, both earn $600 million. If both cut fares by , each earns $400 million. If only one cuts fares, they earn $800 million while the competitor earns $200 million. Here, the Nash equilibrium is for both firms to cut fares, as each firm attempts to maximize its own profit regardless of the other's choice.
Public Policy and Antitrust Laws
To foster competition, governments use antitrust laws to prevent oligopolies from acting like monopolies. The Sherman Antitrust Act of 1890 turned agreements among oligopolists into criminal conspiracies. The Clayton Act of 1914 further strengthened these protections. These laws are used to block mergers that create excessive market power and to prevent price-fixing agreements.
There are several controversial business practices that antitrust regulators monitor, though economists debate their actual impact on competition:
Resale Price Maintenance: This occurs when a manufacturer requires retailers to charge a specific minimum price. While critics say it reduces retail competition, supporters argue it prevents discount retailers from free-riding on the services provided by full-service retailers.
Predatory Pricing: This involves a firm cutting prices below cost to drive competitors out of the market and then raising prices once a monopoly is established. Economists debate its effectiveness because the predator often loses more money than the prey.
Bundling: This is the practice of selling two or more products together for a single price. While some see it as a way to extend market power, others view it as a tool for price discrimination that can actually increase economic efficiency.
Expert Perspectives on Digital Economy and Market Power
The IGM Economic Experts Panel has provided insights on market power in the modern digital economy. They suggest that if a few firms hold a large market share, it is strong evidence of substantial market power. Regarding Google, experts noted that its dominance arose from economies of scale and quality algorithms, yet some argue its operating practices could negatively affect social welfare in the long run. There is also ongoing debate about whether technology giants warrant new regulations or fundamental changes in antitrust policy, including the potential divestment of companies like WhatsApp and Instagram from Facebook (Meta).