In some markets, there are only a few firms compete.

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In some markets, there are only a few firms
compete. For example, computer chips are made by
Intel and Advanced Micro Devices and each firm
must pay close attention to what the other firm
is doing. How does competition between just two
chip makers work? When a market has only a small
number of firms, do they operate in the social
interest, like firms in perfect competition? Or
do they restrict output to increase profit, like
a monopoly? The models of perfect competition and
monopoly dont predict the behavior of the firms
weve just described. To understand how these
markets work, we need the richer models.
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What Is Oligopoly?

• Oligopoly is a market structure in which
• Natural or legal barriers prevent the entry of
  new firms.
• A small number of firms compete.

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What Is Oligopoly?

• Barriers to Entry
• Either natural or legal barriers to entry can
  create oligopoly.
• Figure 15.1 shows two oligopoly situations.
• In part (a), there is a natural duopolya market
  with two firms.

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What Is Oligopoly?

• In part (b), there is a natural oligopoly market
  with three firms.
• A legal oligopoly might arise even where the
  demand and costs leave room for a larger number
  of firms.

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What Is Oligopoly?

• Small Number of Firms
• Because an oligopoly market has a small number of
  firms, the firms are interdependent and face a
  temptation to cooperate.
• Interdependence With a small number of firms,
  each firms profit depends on every firms
  actions.
• Cartel A cartel and is an illegal group of firms
  acting together to limit output, raise price, and
  increase profit.
• Firms in oligopoly face the temptation to form a
  cartel, but aside from being illegal, cartels
  often break down.

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Two Traditional Oligopoly Models

• The Kinked Demand Curve Model
• In the kinked demand curve model of oligopoly,
  each firm believes that if it raises its price,
  its competitors will not follow, but if it lowers
  its price all of its competitors will follow.

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Two Traditional Oligopoly Models

• Figure 15.2 shows the kinked demand curve model.
• The firm believes that the demand for its product
  has a kink at the current price and quantity.

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Two Traditional Oligopoly Models

• Above the kink, demand is relatively elastic
  because all other firms prices remain unchanged.
• Below the kink, demand is relatively inelastic
  because all other firms prices change in line
  with the price of the firm shown in the figure.

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Two Traditional Oligopoly Models

• The kink in the demand curve means that the MR
  curve is discontinuous at the current
  quantityshown by that gap AB in the figure.

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Two Traditional Oligopoly Models

• This slide helps to envisage why the kink in the
  demand curve puts a break in the marginal revenue
  curve.

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Two Traditional Oligopoly Models

• Fluctuations in MC that remain within the
  discontinuous portion of the MR curve leave the
  profit-maximizing quantity and price unchanged.
• For example, if costs increased so that the MC
  curve shifted upward from MC0 to MC1, the
  profit-maximizing price and quantity would not
  change.

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Two Traditional Oligopoly Models

• The beliefs that generate the kinked demand curve
  are not always correct and firms can figure out
  this fact.
• If MC increases enough, all firms raise their
  prices and the kink vanishes.
• A firm that bases its actions on wrong beliefs
  doesnt maximize profit.

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Two Traditional Oligopoly Models

• Dominant Firm Oligopoly
• In a dominant firm oligopoly, there is one large
  firm that has a significant cost advantage over
  many other, smaller competing firms.
• The large firm operates as a monopoly, setting
  its price and output to maximize its profit.
• The small firms act as perfect competitors,
  taking as given the market price set by the
  dominant firm.

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Two Traditional Oligopoly Models

• Figure 15.3 shows10 small firms in part (a). The
  demand curve, D, is the market demand and the
  supply curve S10 is the supply of the 10 small
  firms.

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Two Traditional Oligopoly Models

• At a price of 1.50, the 10 small firms produce
  the quantity demanded. At this price, the large
  firm would sell nothing.

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Two Traditional Oligopoly Models

• But if the price was 1.00, the 10 small firms
  would supply only half the market, leaving the
  rest to the large firm.

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Two Traditional Oligopoly Models

• The demand curve for the large firms output is
  the curve XD on the right.

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Two Traditional Oligopoly Models

• The large firm can set the price and receives a
  marginal revenue that is less than price along
  the curve MR.

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Two Traditional Oligopoly Models

• The large firm maximizes profit by setting MR
  MC. Lets suppose that the marginal cost curve is
  MC in the figure.

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Two Traditional Oligopoly Models

• The profit-maximizing quantity for the large firm
  is 10 units. The price charged is 1.00.

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Two Traditional Oligopoly Models

• The small firms take this price and supply the
  rest of the quantity demanded.

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Two Traditional Oligopoly Models

• In the long run, such an industry might become a
  monopoly as the large firm buys up the small
  firms and cuts costs.

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Oligopoly Games

• Game theory is a tool for studying strategic
  behavior, which is behavior that takes into
  account the expected behavior of others and the
  mutual recognition of interdependence.
• The Prisoners Dilemma
• The prisoners dilemma game illustrates the four
  features of a game.
• Rules
• Strategies
• Payoffs
• Outcome

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Oligopoly Games

• Rules
• The rules describe the setting of the game, the
  actions the players may take, and the
  consequences of those actions.
• In the prisoners dilemma game, two prisoners
  (Art and Bob) have been caught committing a petty
  crime.
• Each is held in a separate cell and cannot
  communicate with each other.

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Oligopoly Games

• Each is told that both are suspected of
  committing a more serious crime.
• If one of them confesses, he will get a 1-year
  sentence for cooperating while his accomplice get
  a 10-year sentence for both crimes.
• If both confess to the more serious crime, each
  receives 3 years in jail for both crimes.
• If neither confesses, each receives a 2-year
  sentence for the minor crime only.

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Oligopoly Games

• Strategies
• Strategies are all the possible actions of each
  player.
• Art and Bob each have two possible actions
• 1. Confess to the larger crime.
• 2. Deny having committed the larger crime.
• With two players and two actions for each player,
  there are four possible outcomes
• 1. Both confess.
• 2. Both deny.
• 3. Art confesses and Bob denies.
• 4. Bob confesses and Art denies.

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Oligopoly Games

• Payoffs
• Each prisoner can work out what happens to
  himcan work out his payoffin each of the four
  possible outcomes.
• We can tabulate these outcomes in a payoff
  matrix.
• A payoff matrix is a table that shows the payoffs
  for every possible action by each player for
  every possible action by the other player.
• The next slide shows the payoff matrix for this
  prisoners dilemma game.

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Oligopoly Games
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Oligopoly Games

• Outcome
• If a player makes a rational choice in pursuit of
  his own best interest, he chooses the action that
  is best for him, given any action taken by the
  other player.
• If both players are rational and choose their
  actions in this way, the outcome is an
  equilibrium called Nash equilibriumfirst
  proposed by John Nash.
• Finding the Nash Equilibrium
• The following slides show how to find the Nash
  equilibrium.

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Bobs view of the world
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Bobs view of the world
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Arts view of the world
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Arts view of the world
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Equilibrium
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Oligopoly Games

• An Oligopoly Price-Fixing Game
• A game like the prisoners dilemma is played in
  duopoly.
• A duopoly is a market in which there are only two
  producers that compete.
• Duopoly captures the essence of oligopoly.
• Cost and Demand Conditions
• Figure 15.4 on the next slide describes the cost
  and demand situation in a natural duopoly.

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Oligopoly Games

• Part (a) shows each firms cost curves.
• Part (b) shows the market demand curve.

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Oligopoly Games

• This industry is a natural duopoly.
• Two firms can meet the market demand at the least
  cost.

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Oligopoly Games

• How does this market work?
• What is the price and quantity produced in
  equilibrium?

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Oligopoly Games

• Collusion
• Suppose that the two firms enter into a collusive
  agreement.
• A collusive agreement is an agreement between two
  (or more) firms to restrict output, raise the
  price, and increase profits.
• Such agreements are illegal in the United States
  and are undertaken in secret.
• Firms in a collusive agreement operate a cartel.

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Oligopoly Games

• The strategies that firms in a cartel can pursue
  are to
• Comply
• Cheat
• Because each firm has two strategies, there are
  four possible combinations of actions for the
  firms
• 1. Both comply.
• 2. Both cheat.
• 3. Trick complies and Gear cheats.
• 4. Gear complies and Trick cheats.

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Oligopoly Games

• Colluding to Maximize Profits
• Firms in a cartel act like a monopoly and
  maximum economic profit.

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Oligopoly Games

• To find that profit, we set marginal cost for the
  cartel equal to marginal revenue for the cartel.

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Oligopoly Games

• The cartels marginal cost curve is the
  horizontal sum of the MC curves of the two firms
  and the marginal revenue curve is like that of a
  monopoly.

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Oligopoly Games

• The firms maximize economic profit by producing
  the quantity at which MCI MR.

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Oligopoly Games

• Each firm agrees to produce 2,000 units and each
  firm shares the maximum economic profit.
• The blue rectangle shows each firms economic
  profit.

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Oligopoly Games

• When each firm produces 2,000 units, the price is
  greater than the firms marginal cost, so if one
  firm increased output, its profit would increase.

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Oligopoly Games

• One Firm Cheats on a Collusive Agreement
• Suppose the cheat increases its output to 3,000
  units. Industry output increases to 5,000 and the
  price falls.

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Oligopoly Games

• For the complier, ATC now exceeds price.
• For the cheat, price exceeds ATC.

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Oligopoly Games

• The complier incurs an economic loss.
• The cheat makes an increased economic profit.

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Oligopoly Games

• Both Firms Cheat
• Suppose that both increase their output to 3,000
  units.

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Oligopoly Games

• Industry output is 6,000 units, the price falls,
  and both firms make zero economic profitthe same
  as in perfect competition.

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Oligopoly Games

• Possible Outcomes
• If both comply, each firm makes 2 million a
  week.
• If both cheat, each firm makes zero economic
  profit.
• If Trick complies and Gear cheats, Trick incurs
  an economic loss of 1 million and Gear makes an
  economic profit of 4.5 million.
• If Gear complies and Trick cheats, Gear incurs
  an economic loss of 1 million and Trick makes
  an economic profit of 4.5 million.
• The next slide shows the payoff matrix for the
  duopoly game.

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Payoff Matrix
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Tricks view of the world
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Tricks view of the world
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Gears view of the world
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Gears view of the world
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Equilibrium
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Oligopoly Games

• Nash Equilibrium in Duopolists Dilemma
• The Nash equilibrium is that both firms cheat.
• The quantity and price are those of a competitive
  market, and the firms make zero economic profit.
• Other Oligopoly Games
• Advertising and RD games are also prisoners
  dilemmas.
• An RD Game
• Procter Gamble and Kimberley Clark play an RD
  game in the market for disposable diapers.

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Oligopoly Games

• The payoff matrix for the Pampers Versus Huggies
  game.

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Oligopoly Games

• The Disappearing Invisible Hand
• In all the versions of the prisoners dilemma
  that weve examined, the players end up worse off
  than they would if they were able to cooperate.
• The pursuit of self-interest does not promote the
  social interest in these games.

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Oligopoly Games

• A Game of Chicken
• In the prisoners dilemma game, the Nash
  equilibrium is a dominant strategy equilibrium,
  by which we mean the best strategy for each
  player is independent of what the other player
  does.
• Not all games have such an equilibrium.
• One that doesnt is the game of chicken.

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Payoff Matrix
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KCs view of the world
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KCs view of the world
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PGs view of the world
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PGs view of the world
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Equilibrium
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Repeated Games and Sequential Games

• A Repeated Duopoly Game
• If a game is played repeatedly, it is possible
  for duopolists to successfully collude and make a
  monopoly profit.
• If the players take turns and move sequentially
  (rather than simultaneously as in the prisoners
  dilemma), many outcomes are possible.
• In a repeated prisoners dilemma duopoly game,
  additional punishment strategies enable the firms
  to comply and achieve a cooperative equilibrium,
  in which the firms make and share the monopoly
  profit.

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Repeated Games and Sequential Games

• One possible punishment strategy is a tit-for-tat
  strategy.
• A tit-for-tat strategy is one in which one player
  cooperates this period if the other player
  cooperated in the previous period but cheats in
  the current period if the other player cheated in
  the previous period.
• A more severe punishment strategy is a trigger
  strategy.
• A trigger strategy is one in which a player
  cooperates if the other player cooperates but
  plays the Nash equilibrium strategy forever
  thereafter if the other player cheats.

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Repeated Games and Sequential Games

• Table 15.5 shows that a tit-for-tat strategy is
  sufficient to produce a cooperative equilibrium
  in a repeated duopoly game.

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Repeated Games and Sequential Games

• Price wars might result from a tit-for-tat
  strategy where there is an additional
  complicationuncertainty about changes in demand.
• A fall in demand might lower the price and bring
  forth a round of tit-for-tat punishment.

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Repeated Games and Sequential Games

• A Sequential Entry Game in a Contestable Market
• In a contestable marketa market in which firms
  can enter and leave so easily that firms in the
  market face competition from potential
  entrantsfirms play a sequential entry game.

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Repeated Games and Sequential Games

• Figure 15.8 shows the game tree for a sequential
  entry game in a contestable market.

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Repeated Games and Sequential Games

• In the first stage, Agile decides whether to set
  the monopoly price or the competitive price.

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Repeated Games and Sequential Games

• In the second stage, Wanabe decides whether to
  enter or stay out.

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Repeated Games and Sequential Games

• In the equilibrium of this entry game,
• Agile sets a competitive price and makes zero
  economic profit to keep Wanabe out.
• A less costly strategy is limit pricing, which
  sets the price at the highest level that is
  consistent with keeping the potential entrant out.

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Antitrust Law

• Antitrust law provides an alternative way in
  which the government may influence the
  marketplace.
• The Antitrust Laws
• The first antitrust law, the Sherman Act, was
  passed in 1890. It outlawed any combination,
  trust, or conspiracy that restricts interstate
  trade, and prohibited the attempt to
  monopolize.

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Antitrust Law
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Antitrust Law

• A wave of merger activities at the beginning of
  the twentieth century produced a stronger
  antitrust law, the Clayton Act, and created the
  Federal Trade Commission.
• The Clayton Act was passed in 1914.
• The Clayton Act made illegal specific business
  practices such as price discrimination,
  interlocking directorships, and acquisition of a
  competitors shares if the practices
  substantially lessen competition or create
  monopoly.

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Antitrust Law

• Table 15.7 (next slide) summarizes the Clayton
  Act and its amendments, the Robinson-Patman Act
  passed in 1936 and the Cellar-Kefauver Act passed
  in 1950.
• The Federal Trade Commission, formed in 1914,
  looks for cases of unfair methods of competition
  and unfair or deceptive business practices.

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Antitrust Law
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Antitrust Law

• Price Fixing Always Illegal
• Price fixing is always a violation of the
  antitrust law.
• If the Justice Department can prove the existence
  of price fixing, there is no defense.

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Antitrust Law

• Three Antitrust Policy Debates
• But some practices are more controversial and
  generate debate. Three of them are
• Resale price maintenance
• Tying arrangements
• Predatory pricing

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Antitrust Law

• Resale Price Maintenance
• Most manufacturers sell their product to the
  final consumer through a wholesale and retail
  distribution chain.
• Resale price maintenance occurs when a
  manufacturer agrees with a distributor on the
  price at which the product will be resold.
• Resale price maintenance is inefficient if it
  promotes monopoly pricing.
• But resale price maintenance can be efficient if
  it provides retailers with an incentive to
  provide an efficient level of retail service in
  selling a product.

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Antitrust Law

• Tying Arrangements
• A tying arrangement is an agreement to sell one
  product only if the buyer agrees to buy another
  different product as well.
• Some people argue that by tying, a firm can make
  a larger profit.
• Where buyers have a differing willingness to pay
  for the separate items, a firm can price
  discriminate and take a larger amount of the
  consumer surplus by tying.

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Antitrust Law

• Predatory Pricing
• Predatory pricing is setting a low price to drive
  competitors out of business with the intention of
  then setting the monopoly price.
• Economists are skeptical that predatory pricing
  actually occurs.
• A high, certain, and immediate loss is a poor
  exchange for a temporary, uncertain, and future
  gain.
• No case of predatory pricing has been
  definitively found.

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Antitrust Law

• Merger Rules
• The Federal Trade Commission (FTC) uses
  guidelines to determine which mergers to examine
  and possibly block.
• The Herfindahl-Hirschman index (HHI) is one of
  those guidelines (explained in Chapter 9).
• If the original HHI is between 1,000 and 1,800,
  any merger that raises the HHI by 100 or more is
  challenged.
• If the original HHI is greater than 1,800, any
  merger that raises the HHI by more than 50 is
  challenged.