Oligopoly Chapter Overview

• Key Questions:

  • What outcomes are possible under oligopoly?

  • Why is it difficult for oligopoly firms to cooperate?

  • How can we use game theory to analyze the economics of cooperation?

  • How are antitrust laws used to foster competition?

Review of Market Structures

• Concentration Ratio:

  • Measures a market’s domination by a small number of firms.

  • Defined as the percentage of total output in the market supplied by the four largest firms.

  • Most industries have a concentration ratio of less than 50%.

  • Some industries with greater than 90% concentration include:

  • Aircraft manufacturing

  • Tobacco

  • Passenger car rentals

  • Express delivery services

• Four Types of Market Structure:

  • Monopoly: One firm (e.g., tap water, cable TV).

  • Oligopoly: Few firms (e.g., tennis balls, cigarettes).

  • Monopolistic Competition: Many firms, differentiated products (e.g., novels, movies).

  • Perfect Competition: Many firms, identical products (e.g., wheat, milk).

Oligopoly

• Definition:

  • Market structure characterized by a small number of sellers offering similar or identical products.

• Strategic Behavior in Oligopoly:

  • A firm’s decisions regarding price (P) or quantity (Q) can significantly impact other firms and elicit reactions.

  • Firms must consider other firms' reactions during decision-making.

• Game Theory:

  • Study of strategic interactions where individuals or firms make decisions that take into account the actions of others.

Markets with Few Sellers

• Oligopolists:

  • Maximize profit when cooperating (acting as a monopoly).

  • Strong incentives prevent maintenance of cooperative outcomes.

• Duopoly:

  • A specific oligopoly with only two sellers.

Example 1: Gas Station Duopoly in Smallville

• Situation:

  • Smallville has two gas stations: 7-Eleven and Casey’s (a duopoly).

• Demand Schedule for Gasoline:

  • Price (P) and quantity demanded (Q) given in a table:

  • For instance, at $0, Q = 10,000 gallons; at $7, Q = 2,800 gallons.

• Cost Analysis:

  • Each firm’s marginal cost (MC) = $1, fixed cost (FC) = $0.

  • Competitive outcome:

  • Price (P) = MC = $1, Q = 9,200, Profit = $0.

  • Monopoly outcome:

  • Price (P) = $7, Q = 4,400, Profit = $26,400.

Collusion

• Definition:

  • Agreement among firms in a market regarding production quantities or pricing.

• Cartel:

  • Group of firms acting together as a monopoly.

Active Learning 1: Collusion in Smallville

• Scenario: Each gas station agrees to sell Q = 2,200 at P = $7 with profit = $13,200 each.

• If Casey’s cheats on agreement (sells Q = 3,000):

  • Calculate new market price and Casey’s profit.

• If both cheat (Q = 3,000 each):

  • Calculate profits under cheating scenario.

Active Learning 1: Answers

• If both stick to agreement: Each earns $13,200.

• If Casey’s cheats:

  • Market quantity = 5,200; Price (P) = $6; Casey’s profit = $15,000.

• Yes, it is in Casey’s interest to cheat, as it yields higher profit.

• If both cheat:

  • Market quantity = 6,000; Price (P) = $5; Profit = $12,000 each.

Collusion vs. Self-Interest

• Observation:

  • Both firms benefit from collusion but are incentivized to cheat due to self-interest.

• Lesson:

  • Forming and maintaining cartels is difficult for oligopoly firms.

Active Learning 2: Duopoly Equilibrium in Smallville

• Scenario:

  • Firms sell Q = 3,000 at P = $5, profit = $12,000 each.

• Decision on quantity increase to 3,800:

  • Calculate price and profit outcomes for both firms.

Active Learning 2: Answers

• If Casey’s increases Q to 3,800:

  • Market Q = 6,800; P = $4; Casey’s profit = $11,400.

• Lower profit at Q = 3,800 than at Q = 3,000, so firms should not increase quantity.

The Equilibrium for an Oligopoly

• Nash Equilibrium:

  • A situation where all economic actors choose their best strategy given the choices of others.

• In an oligopoly:

  • Firms produce a quantity greater than monopoly output but less than competitive output.

  • Price is more than the competitive price but less than monopoly price.

Output & Price Effects

• Effects on profit from increasing output:

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

  • Price Effect: Raising total quantity sold decreases price, ultimately reducing profits on all units sold.

Size of an Oligopoly

• As the number of sellers increases:

  • Price effect diminishes.

  • Market resembles more competitive scenarios.

  • Price approaches marginal cost.

  • Market quantity approaches socially efficient quantity.

Market Share and Market Power

• Market Share Statement:

  • A few firms holding a large market share indicates substantial market power.

The Economics of Cooperation

• The Prisoners’ Dilemma:

  • Game illustrating difficulty in cooperation when mutually beneficial.

• Dominant Strategy: A strategy that is optimal for a player regardless of opponents’ strategies.

Example 2: The Prisoners’ Dilemma

• Scenario: Bonnie and Clyde are suspected robbers, presented with confession options:

  • Confessing leads to varying prison time depending on the choices made with regards to each other's confessions.

Outcome Analysis of the Game**

• Dominant Strategy:

  • Both confess; Nash equilibrium exists in mutual confession.

  • Remark: Each would be better off remaining silent but self-interest prevails.

Oligopolies as a Prisoners’ Dilemma

• Oligopolies forming cartels resemble the prisoners’ dilemma.

• While aiming for monopoly profits, they face incentives to cheat due to self-interest.

Example 3: Casey’s and 7-Eleven: Prisoners’ Dilemma

• Profit comparisons between collusion Q = 2,200 and cheating Q = 3,000 demonstrate firms' dominant strategy is to cheat.

Other Examples of the Prisoners’ Dilemma

• Advertising Wars: Firms spending heavily on ads in efforts to outcompete, often canceling each other out.

• OPEC Behavior: Attempts at cooperative production limits often undermined by members cheating.

• Arms Race: Shared best interests for disarmament countered by a dominant strategy of arming.

• Common Resource Overuse: Incentive to overuse shared resources rather than conserve.

Welfare of Society

• Noncooperative-Oligopoly Equilibrium:

  • Negatively impacts oligopolists’ ability to achieve monopoly profits but may benefit society by approaching optimal pricing levels.

Active Learning Example: Go Fish on Lake Michigan

• Comparative outcomes of two fishing companies demonstrate colluding and Nash equilibrium scenarios.

Example of Negative Campaign Ads

• Election dynamics wherein both candidates suffer from their ads' cancels out appetite, affecting societal engagement.