Chapter 18

Chapter 18: Oligopoly

Definition of Oligopoly

  • Oligopoly: A market structure where a few sellers offer similar or identical products.

  • Strategic Behaviour: Decisions made by a business regarding price (P) or quantity (Q) that can influence the reactions of other businesses.

  • Game Theory: The study of strategic decision-making among individuals or businesses.

Example: Cell Phone Duopoly in Smalltown

  • Population: 140 residents of Smalltown.

  • Good Provided: Cell phone service with unlimited minutes and free phones.

  • Demand Schedule: Illustrates consumer demand in relation to price.

  • Businesses Involved: Telus and Rogers (a duopoly, which is a specific type of oligopoly).

  • Cost Structure:

    • Fixed Costs (FC): $0

    • Marginal Cost (MC): $10

Competitive vs. Monopoly Outcomes

  • Competitive Outcome:

    • Price (P) = MC = $10

    • Quantity (Q) = 120

    • Profit = $0

  • Monopoly Outcome:

    • Price (P) = $40

    • Quantity (Q) = 60

    • Profit = $1,800

Collusion in Oligopoly

  • Collusion: An agreement among businesses about production quantities or prices.

  • Example Outcome:

    • Colluding to produce half the monopoly output:

      • Each produces Q = 30, P = $40

      • Profits = $900 each

  • Cartel: A group of firms that collude to act together.

Incentives Against Collusion

  • If one business (Telus) breaks the agreement and increases production:

    • Market quantity = 70, Price (P) = $35

    • Telus's profit = $1,000

  • As a result, each firm has an incentive to renege on collusion, typically leading to both firms losing cooperation.

Cooperation vs. Self-Interest in Oligopoly

  • Tension: Cooperation (collusion) versus self-interest.

  • Oligopolists would benefit more from sticking to agreements but are incentivized to act in their self-interest, leading to difficulty in maintaining cartels and limiting monopoly-like behavior.

Nash Equilibrium in Oligopoly

  • Nash Equilibrium: Where each participant's best strategy depends on the actions of others.

  • In the duopoly example, both firms producing Q = 40 is a Nash equilibrium since both firms' optimal strategy depends on the other producing the same.

Comparison of Oligopoly Market Outcomes

  • Production: Oligopoly Q is greater than monopoly Q but less than competitive Q.

  • Price: Oligopoly P is higher than competitive P but lower than monopoly P.

Output and Price Effects in Oligopoly

  • Output Effect: If P > MC, increasing output raises profits.

  • Price Effect: Increasing market quantity can lower market price, which reduces profit on all units sold.

    • Businesses continue to produce based on the comparison of output effect and price effect.

The Size and Nature of Oligopoly

  • Increasing the number of firms:

    • Price effects become smaller, leading to competitive market characteristics

    • Price approaches marginal cost

    • Market quantity approaches socially efficient levels.

Role of Game Theory in Oligopoly

  • Game Theory: Analyzes strategic interactions between firms.

  • Dominant Strategy: Preferred strategy regardless of the opponent's action.

  • Prisoners’ Dilemma: A scenario demonstrating that cooperation can be challenging even when mutually beneficial.

Prisoners' Dilemma Example

  • Bonnie and Clyde: Caught with limited evidence, offered a deal to confess.

    • Outcomes based on choices (Confess or remain silent). Each ends up with prison terms conflicting with a potential better outcome.

  • Dominant Strategy: For both Bonnie and Clyde to confess.

Application of Prisoners’ Dilemma in Oligopolies

  • Oligopolists face a similar dilemma when forming cartels. The mutual best outcome (monopoly profits) undermined by self-interest leads them to produce more than agreed, reducing overall profits.

Other Prisoners' Dilemma Examples

  • Advertising Wars: Companies spend on ads that cancel out effects, resulting in lower profits.

  • OPEC: Member countries attempt to cooperate, but self-interest often leads to individual renunciation.

  • Arms Race: Countries benefit from cooperation (disarm), but each acts in self-interest to arm themselves.

Prisoners’ Dilemma and Social Welfare

  • Non-cooperative Equilibrium: Ensures lower profits for businesses but aligns closer with social efficiency regarding output and pricing.

  • Challenges of Cooperation: In multiple scenarios, inability to cooperate can lead to social welfare declines.

Application: Covid-19 Toilet Paper Shortage

  • Consumer behavior during shortages leads to irrational racing to stores, similar to competitive environments.

  • Nash Equilibrium results in consumers racing to stock up on TP, potentially leading to shortages.

Why Cooperation May Occur

  • In repeated game scenarios:

    • Strategies such as “Tit-for-Tat” promote cooperation.

Public Policy Related to Oligopolies

  • Governments can improve market outcomes by promoting competition and preventing collusion.

  • Antitrust Laws: Regulations aim to stabilize market dynamics by disallowing practices that restrict trade.

Conclusion

  • Oligopolies can behave like monopolies or competitive markets, based on their inter-business relationships and number of competitors.

  • The prisoners' dilemma exemplifies challenges in cooperation within oligopolies, leading to regulatory responses for maintain market efficiency.