Oligopoly

1
Lecture 18
2
Oligopoly

• Introduction
• have discussed three market structures so far
• price taking (perfectly competitive) markets
• open-market price searchers (monopolistic
  competition)
• closed-market price searchers (monopoly)

3
Oligopoly

• for each market structure we assumed that firms
  decisions were independent (did not take into
  account what others were doing)
• price takers
• output decision of any individual firm did not
  effect total output so no interest in what others
  are doing
• monopoly
• since only one firm in market, no competitors to
  be concerned about
• monopolistic competition
• explicitly assumed that each firm acts
  independently

4
Oligopoly

• when a price searching market exists and there
  are a few firms (but more than one), expect
  actions to be interdependent
• example of two gas stations in a small town

5
Oligopoly

• Definition
• an oligopoly exists when there are relatively few
  (but more than one) price searchers in a market
  who take into account each others expected
  reactions when determining the best price and
  output
• oligopoly literally means few sellers

6
Price and Output

• Equilibrium price and quantity depends on how
  firms react to one another
• Firms cooperate the case of collusion
• collusion is an agreement among sellers to
  restrict competition in some way
• a cartel is a group of colluding firms
• examples OPEC, International Bauxite
  Association
• if all firms band together and act like a single
  monopolist, all can benefit
• want to restrict output and raise price

7
Price and Output

• Firms cooperate the case of collusion
• instability of cartel
• although each firm is better off when they
  collude, they can earn even higher profits if
  they cheat (ie. compete) and others do not
• let other firms bear the burden of keeping price
  up by restricting their output
• free ride on other firms

8
Incentive for Cartel Members to Cheat

• The industry demand (Di) and marginal revenue
  (MRi) show that the oligopolists would
  maximize joint profit at output Qi, where MRi
  MC . . .

price Pi would deliver the largest profit for
the industry as a whole.

• The demand curve facing each firm (df) (under
  the assumption that no other firms cheat)
  would be much more elastic than industry demand
  (Di).

• Given the greater elasticity of its demand
  curve, an individual firm would maximize its
  profit by expanding output to qf where MRf MC .
  . .

and cutting its price to Pf
(from Pi).

• Thus, individual oligopolists could gain by
  secretly shaving price and cheating on the
  collusive agreement.

Pi
Pf
qf
Qi
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Gains from Cheating on Cartel Price
Industry
Firm
P
P
sum of MC
MC
ATC
Pc
Pc
P2
P1
(before cartel)
d1
DAR
MR
Qc
qc
Q
q1
Q
q2

• The industry demand (D) and marginal revenue
  (MR) show that the oligopolists would maximize
  joint profit at the monopoly output Qc where
  industry MR MC.

• Assuming equal outputs, firm produces qc and
  makes an economic profit at the
• cartel price. Total output is number of firms,
  n, times qc.

• The demand curve facing each firm (d2) (under
  the assumption that other firms dont cheat
  and charge Pc), would be more elastic than the
  original demand (d1).

• Although each firm is better off when they
  collude, they can earn even higher profit if
  they cheat and equate MC with the MR from their
  own demand, mr2.

10
Price and Output

• instability of cartel
• since each firm has incentive to cheat, cartels
  often fall apart
• cheating problem is exacerbated by the fact that
  competition can occur on many margins
• competition from new firms
• if cartel firms are making economic profits,
  incentive for new firms to enter the market
• if let new firms into cartel, profit for each
  member diminishes
• if exclude new entrants, they will cut price and
  take business away from cartel

11
Price and Output

• to be successful, a cartel must
• get agreement on production levels
• prevent cheating by cartel members
• restrict entry of new competitors

12
Price and Output

• factors increasing probability of successful
  collusion
• few sellers
• easier to reach agreement
• easier to monitor production and prevent cheating
• stable demand
• easier to determine if cheating is occurring by
  looking at changes in own sales
• similar costs
• if have different costs, more difficult ot reach
  agreement on price and output
• for a given P and Q, if have different costs get
  different levels of profit

13
Price and Output

• factors increasing probability of successful
  collusion
• homogeneous product
• fewer variables to agree on
• limits margins onwhich to compete
• sealed-bid auctions
• bidding to specifications makes product
  homogeneous
• easy to detect cheaters since all bids are
  revealed
• no antitrust enforcement

14
Price and Output

• factors increasing probability of successful
  collusion
• government regulations help enforce cartel
• government established cartels
• example government permitted six New England
  states to form a milk cartel (Northeast
  Interstate Dairy Compact -- NIDC). In 1999
  legislation allowed dairy farmers in Northeastern
  states surrounding NIDC to join NIDC, 7 in 16
  Southern states to form a new regional cartel.
  Soy milk became more popular.
• entry restrictions
• licensing
• enforce minimum prices
• price regulation

15
Price and Output

• Firms do not cooperate, but take into account
  expected reactions when deciding optimal price
  and quantity strategy
• hard to precisely model price and output
  decisions since need to model how firms react to
  one another and strategic behavior by firms
• game theory
• attempts to model decisions by mapping out all
  possible strategies and determining equilibrium
  set of strategies

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Game Theory

• Nash equilibrium
• neither player can do better, given what the
  other is doing
• Im doing the best I can given what you are
  doing
• Youre doing the best you can given what I am
  doing.
• Dominant strategy
• one that is optimal no matter what an opponent
  does
• Im doing the best I can no matter what you
  do.
• Youre doing the best you can no matter what I
  do.
• special case of Nash equilibrium

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Prisoners Dilemma
You study, no grade change Others
study, no grade change
You some effort, big grade
increase Others no effort, modest
grade reduction
You no effort, big grade
decrease Others study, slight
grade increase
You no effort, same grade Others no
effort same grade
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Prisoners Dilemma

• What is the
• Dominant strategy
• Nash equilibrium

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Game Theory

• can get more than one set of equilibrium
  strategies or no equilibrium and thus no unique
  answer
• examples
• battle of the sexes
• constantly changing strategies

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The Battle of the Sexes
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The Battle of the Sexes

• Two Nash Equilibria
• What are they?
• No dominant strategy
• The optimal decision of a player depends on what
  the other player does

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Constantly Changing Strategies
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Constantly Changing Strategies

• Observations
• No Nash equilibrium
• Best strategy keeps changing

Player B
1
2
1
0, 0
0, -1
Player A
2
-1, 0
1, -3
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Repeated Games

• Oligopolistic firms play a repeated game.
• must choose price and output each day
• With each repetition of the Prisoners Dilemma,
  firms can develop reputations about their
  behavior and study the behavior of their
  competitors.

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Pricing Problem
Firm 2
Low Price
High Price
Low Price
Firm 1
High Price
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Pricing Problem

• Non-repeated game
• Strategy is Low1, Low2
• Repeated game
• Tit-for-tat strategy is the most profitable

Firm 2
Low Price
High Price
Low Price
Firm 1
High Price
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Repeated Games

• Conclusion
• With repeated game
• The Prisoners Dilemma can have a cooperative
  outcome with tit-for-tat strategy

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Repeated Games

• Conclusion
• This is most likely to occur in a market with
• Few firms
• Stable demand
• Stable cost
• Cooperation is difficult at best since these
  factors may change in the long-run.

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Price and Output

• In general expect outcome to lie somewhere
  between cooperative (collusive) solution and
  competitive (price taking) solution

P
MC
Pcollusion
Range of
oligopoly prices
Pcomp.
DAR
MR
Q
Qcoll.
Qcomp.
Range of
oligopoly quantities
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EndLecture 18