SS 132: Microeconomics SS 132: Microeconomics: Oligopoly Oligopoly

29-Nov-16
SS 132: Microeconomics
Oligopoly
Dr Arshad Ali Bhatti

Fall 2016
In this lecture you will…

• See what market structures lie between
monopoly and competition.
• Examine what outcomes are possible
when a market is an oligopoly..
• Learn about the prisoners’ dilemma and
how it applies to oligopoly and other
issues..
• Consider how competition laws try to
foster competition in oligopolistic
markets.
Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 2
1
29-Nov-16
BETWEEN MONOPOLY AND

PERFECT COMPETITION
• Imperfect competition refers to those market
structures that fall between perfect competition
and pure monopoly.
• Imperfect competition includes industries in
which firms have competitors but do not face so
much competition that they are price takers.
• Types of Imperfectly Competitive Markets
– Oligopoly
• Only a few sellers, each offering a similar or identical
product to the others.
– Monopolistic Competition
• Many firms selling products that are similar but not
identical.
Figure 1: The Four Types of Market

Structure
Number of Firms?
Many
firms
Type of Products?
One Few Differentiated Identical

firm firms products products
Monopolistic Perfect
Monopoly Oligopoly Competition Competition
• Tap water • Tennis balls • Novels • Wheat

• Cable TV • Crude oil • Movies • Milk
2
29-Nov-16
MARKETS WITH ONLY A FEW

SELLERS
• Because of the few sellers, the key feature
of oligopoly is the tension between
cooperation and self-interest.
• Characteristics of an Oligopoly Market
– Few sellers offering similar or identical
products
– Interdependent firms
– Best off cooperating and acting like a
monopolist by producing a small
quantity of output and charging a price
above marginal cost
A Duopoly Example
• A duopoly is an oligopoly with only two
members. It is the simplest type of
oligopoly.
• A town with two residents - Jack and Jill -
own wells that produce water safe for
drinking.
• Each Saturday, Jack and Jill decide how
many litres of water to pump, bring the
water to town, and sell it for whatever
price the market will bear.
• The marginal cost of water is zero.
3
29-Nov-16
Table 1: The Demand Curve for Water
Total revenue (and

Quantity (in litres) Price total profit)
0 $120 $0
10 110 1100
20 100 2000
30 90 2700
40 80 3200
50 70 3500
60 60 3600
70 50 3500
80 40 3200
90 30 2700
100 20 2000
110 10 1100
120 0 0
A Duopoly Example
• Price and Quantity Supplied
– The price of water in a perfectly
competitive market would be driven to
where the marginal cost is zero:
• P = MC = $0
• Q = 120 litres
– The price and quantity in a monopoly
market would be where total profit is
maximized:
• P = $60
• Q = 60 litres
4
29-Nov-16
Competition, Monopolies, and

Cartels
• Price and Quantity Supplied
– The socially efficient quantity of water is 120
litres, but a monopolist would produce only 60
litres of water.
– So what outcome then could be expected from
duopolists?
• The duopolists may agree on a monopoly
outcome.
– Collusion
• An agreement among firms in a market about
quantities to produce or prices to charge.
– Cartel
• A group of firms acting in unison.
The Equilibrium for an Oligopoly

• Although oligopolists would like to form cartels
and earn monopoly profits, often that is not
possible.
• Competition laws prohibit explicit agreements
among oligopolists as a matter of public policy.
• Lets examine what would happen if Jack and Jill
decide separately how much water to produce.
• At first, one would expect Jack and Jill to reach
the monopoly outcome on their own, for this
outcome maximizes their joint outcome.
• In the absence of a binding agreement, the
monopoly outcome is unlikely…
5
29-Nov-16

• Why?
• Jack expects Jill to produce 30 L (half the monopoly
quantity).
• Jack could produce 30 L, for a total of 60 L and the price

would be $60. The profit would be $1800 (30 L x $60/L).
OR…
• Jack could produce 40 L, for a total of 70 L and the price
would be $50. His profit would be $2000 (40 L x $50/L).
• The profit in the market would fall from $3600 to $3500 but
Jack’s profit would be higher ($2000 vs. $1800).
• Of course, Jill might reason the same way and produce 40

L. Total sales would be 80 L, with a price of $40 and a profit
of $3200.

• By pursuing their own self-interest, duopolists produce
more than the monopoly quantity, charge a price lower than
the monopoly price, and earn a profit lower than the
monopoly profit.
• The logic of self-interest increases the duopoly’s output
above the monopoly level, it does not lead to the
competitive equilibrium.
• If Jack increases his production from 40 L to 50 L while Jill
maintains her production at 40 L, then the total production
is 90 L and the price is $30/L.
• Jack’s profit will be $1500 (50 L x $30). He is better off if he
leaves production at 40 L.
• Jack and Jill’s outcome of 40 L is an equilibrium… a Nash
Equilibrium.
6
29-Nov-16

• 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 others
have chosen.
• When firms in an oligopoly individually

choose production to maximize profit,
they produce a quantity of output greater
than the level produced by a monopoly
and less than the level produced by
competition.

• The oligopoly price is less than the monopoly
price but greater than the competitive price
(which equals marginal cost).
• Summary
– Possible outcome if oligopoly firms pursue
their own self-interests:
• Joint output is greater than the monopoly quantity
but less than the competitive industry quantity.
• Market prices are lower than monopoly price but
greater than the competitive price (which equals
marginal cost).
• Total profits are less than the monopoly profit.
7
29-Nov-16
How the Size of an Oligopoly

Affects the Market Outcome
• How increasing the number of sellers
affects the price and quantity:
– The output effect: Because price is
above marginal cost, selling more at the
going price raises profits.
– The price effect: Raising production will
increase the amount sold, which will
lower the price and the profit per unit on
all units sold.
How the Size of an Oligopoly

Affects the Market Outcome
• As the number of sellers in an
oligopoly grows larger, an
oligopolistic market looks more and
more like a competitive market.
• The price approaches marginal cost,

and the quantity produced
approaches the socially efficient
level.
8
29-Nov-16
GAME THEORY AND THE

ECONOMICS OF COOPERATION
• Game theory is the study of how
people behave in strategic situations.
• Strategic decisions are those in

which each person, in deciding what
actions to take, must consider how
others might respond to that action.
GAME THEORY AND THE

• Because the number of firms in an
oligopolistic market is small, each
firm must act strategically.
• Each firm knows that its profit

depends not only on how much it
produces but also on how much the
other firms produce.
9
29-Nov-16
GAME THEORY AND THE

• The prisoners’ dilemma provides insight
into the difficulty in maintaining
cooperation.
• Often people (firms) fail to cooperate with
one another even when cooperation would
make them better off.
• The prisoners’ dilemma is a particular
“game” between two captured prisoners
that illustrates why cooperation is difficult
to maintain even when it is mutually
beneficial.
The Prisoners’ Dilemma

• The prisoners’ dilemma is about two criminals
who have been captured by the police, Babar and
Clyde.
• The police have enough evidence to convict both
of a minor crime.
• They lack however enough hard evidence of
convicting them of a more serious crime.
• The police question Babar and Clyde in separate
rooms.
• They are each offered a deal.
10
29-Nov-16
Figure 2: The Prisoners’ Dilemma
Babar’s Decision
Confess Remain silent
Babar gets 8 years Babar gets 20 years

Confess
Clyde’s Clyde gets 8 years Clyde goes free

Decision
Babar goes free Babar gets 1 year
Remain
silent
Clyde gets 20 years Clyde gets 1 years

• The dominant strategy is the best strategy for a
player to follow regardless of the strategies
chosen by the other players.
• Confessing is the best strategy for Babar and for
Clyde.
• In the end, both confess and spend eight years in
jail.
• From their standpoint, it is not a good outcome.
By remaining silent they would have spent one
year in jail.
• By pursuing their self-interest, they reach an
outcome that is worse for each other.
11
29-Nov-16

• Cooperation is difficult to maintain,
because cooperation is not in the best
interest of the individual player.
Oligopolies as a Prisoners’
Dilemma
• Self-interest makes it difficult for the
oligopoly to maintain a cooperative
outcome with low production, high prices,
and monopoly profits.
12
29-Nov-16
Figure 3: The Oligopoly Game
Iraq's decision
High Production Low Production
Iraq gets $40 billion Iraq gets $30 billion

High
Production
Iran’s Iran gets $40 billion Iran gets $60 billion

decision
Iraq gets $60 billion Iraq gets $50 billion
Low
Production
Iran gets $30 billion Iran gets $50 billion
Other Examples of the Prisoners’

Dilemma
• Arms races
• Advertising
• Common resources
13
29-Nov-16
Figure 4: The Arm’s-Race Game
Decision of the US
Arm Disarm
US at risk US at risk and weak
Arm
Decision USSR at risk USSR safe and

of the powerful
USSR US safe and powerful US safe
Disarm
USSR at risk and USSR safe

weak
Figure 5: An Advertising Game
Unilever’s decision
Advertise Don’t advertise
Unilever’s gets $3 Unilever’s gets $2

billion profit billion profit
Advertise
P&G gets $3 billion P&G gets $5 billion

P&G’s
profit profit
decision
Unilever’s gets $5 Unilever’s gets $4
Don’t
advertise
P&G gets $2 billion P&G gets $4 billion
profit profit
14
29-Nov-16
Figure 6: A Common-Resources Game
Petro-Canada’s Decision
Drill Two Wells Drill One Well
Petro-Canada gets $4 Petro-Canada gets $3

Drill Two
Wells
Esso’s Esso gets $4 billion Esso gets $6 billion
profit profit
Decision
Petro-Canada gets $6 Petro-Canada gets $5
Drill One
Well
Esso gets $3 billion Esso gets $5 billion
profit profit
The Prisoners’ Dilemma and the

Welfare of Society
• Even when cooperation is in the best interest of
both players it is difficult to maintain.
• Is lack of cooperation bad from society’s
standpoint?
• It depends!
• In some cases, the noncooperative equilibrium is
bad for society AND the players. (e.g., the arms
race game)
• In other cases, lack of cooperation is desirable
from the standpoint of society as a whole. (e.g.,
the monopoly outcome is good for the
oligopolists but bad for consumers.)
15
29-Nov-16
Why People Sometimes Cooperate

• Firms that care about future profits will
cooperate in repeated games rather than
cheating in a single game to achieve a
one-time gain.
Figure 7: Jack and Jill’s Oligopoly Game
Jack’s decision
Sell 40 L Sell 30 L
Jack gets $1600 Jack gets $1500 profit

Sell 40 L profit
Jill gets $1600 Jill gets $2000

Jill’s profit profit
decision
Jack gets $2000 profit Jack gets $1800 profit
Sell 30 L
Jill gets $1500 Jill gets $1800
profit profit
16
29-Nov-16
PUBLIC POLICIES TOWARD

OLIGOPOLIES
• Cooperation among oligopolists is
undesirable from the standpoint of society
as a whole because it leads to production
that is too low and prices that are too
high.
Restraint of Trade and the

Competition Act
• Competition laws make it illegal to restrain
trade or attempt to monopolize a market.
17
29-Nov-16
Controversies Over Competition

Policy
• Competition policies sometimes may not
allow business practices that have
potentially positive effects:
– Resale price maintenance
– Predatory pricing
– Tying
Controversies Over Competition

Policy
• Resale Price Maintenance (or fair trade)
– occurs when suppliers (like wholesalers)
require retailers to charge a specific amount
• Predatory Pricing
– occurs when a large firm begins to cut the
price of its product(s) with the intent of driving
its competitor(s) out of the market
• Tying
– when a firm offers two (or more) of its
products together at a single price, rather than
separately
18
29-Nov-16
Summary
• Oligopolists maximize their total profits by
forming a cartel and acting like a
monopolist.
• If oligopolists make decisions about
production levels individually, the result is
a greater quantity and a lower price than
under the monopoly outcome.
Summary
• The prisoners’ dilemma shows that self-
interest can prevent people from
maintaining cooperation, even when
cooperation is in their mutual self-interest.
• The logic of the prisoners’ dilemma
applies in many situations, including
oligopolies.
19
29-Nov-16
Summary
• Policymakers use the antitrust laws to
prevent oligopolies from engaging in
behavior that reduces competition.
The End
20

SS 132: Microeconomics SS 132: Microeconomics: Oligopoly Oligopoly

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

SS 132: Microeconomics SS 132: Microeconomics: Oligopoly Oligopoly

Uploaded by

Copyright:

Available Formats

29-Nov-16

Dr Arshad Ali Bhatti

In this lecture you will…

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 2

BETWEEN MONOPOLY AND

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 3

Figure 1: The Four Types of Market

One Few Differentiated Identical

• Tap water • Tennis balls • Novels • Wheat

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 4

MARKETS WITH ONLY A FEW

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 5

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 6

Table 1: The Demand Curve for Water

Total revenue (and

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 7

Competition, Monopolies, and

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 9

The Equilibrium for an Oligopoly

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 10

The Equilibrium for an Oligopoly

• Jack could produce 30 L, for a total of 60 L and the price

• Of course, Jill might reason the same way and produce 40

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 11

The Equilibrium for an Oligopoly

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 12

The Equilibrium for an Oligopoly

• When firms in an oligopoly individually

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 13

The Equilibrium for an Oligopoly

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 14

How the Size of an Oligopoly

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 15

How the Size of an Oligopoly

• The price approaches marginal cost,

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 16

GAME THEORY AND THE

• Strategic decisions are those in

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 17

GAME THEORY AND THE

• Each firm knows that its profit

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 18

GAME THEORY AND THE

The Prisoners’ Dilemma

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 20

Figure 2: The Prisoners’ Dilemma

Babar gets 8 years Babar gets 20 years

Clyde’s Clyde gets 8 years Clyde goes free

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 21

The Prisoners’ Dilemma

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 22

The Prisoners’ Dilemma

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 23

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 24

Figure 3: The Oligopoly Game

Iraq gets $40 billion Iraq gets $30 billion

Iran’s Iran gets $40 billion Iran gets $60 billion

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 25

Other Examples of the Prisoners’

Dr Arshad Ali Bhatti/ Fall 2016 Chapter 16: Page 26

Figure 4: The Arm’s-Race Game

US at risk US at risk and weak

Decision USSR at risk USSR safe and