Lecture Notes, Chapter 13B

Oligopoly

1. Describe the characteristics of an oligopoly.

Answer

There are a small number of firms that act interdependently. They are tempted to form a cartel and
collude to increase profits. They can compete on price only (if they produce identical products) or
compete on price, product quality and marketing (if they produce slightly different products). Natural or
legal barriers prevent the entry of new firms.

2. "Because firms in an oligopoly are so large, they do not need to consider each other's actions." Is the
previous statement correct or incorrect? Explain your answer.

Answer

The statement is most definitely incorrect. Oligopoly is an industry in which only a few firms compete.
Because there are only a few firms, the hallmark of oligopoly is mutual interdependence, that is, one
firm's action will affect the other firms. The fact that in oligopoly each firm's actions affect its rivals is
unlike the case in perfect competition or monopolistic competition, in which there are so many firms that
one firm's actions have no effect on its rivals, or monopoly, in which there is only one firm and hence no
rivals.

3. What is a cartel?

Answer

A cartel is a group of firms acting together to limit output, raise price and increase economic profit.
Cartels are illegal in the United States. Cartels operate in a market structure with oligopolies. If firms can
stick to the cartel agreement, the firms can earn an economic profit. However, cartels tend to break down
because firms are tempted to cheat on their cartel partners and increase their own profit at the expense of
their partners.

4. "If firms in an oligopoly operate as a monopoly, the industry produces the most output and if they
operate as perfect competitors, the industry produces the least output." Is the previous statement correct
or incorrect? Why?

Answer

The statement is incorrect; it reverses the outcomes. If the firms in an oligopoly operate as a monopoly,
the industry produces the LEAST output and if they operate as perfect competitors, the industry
produces the MOST output.
5. The above figure shows the market for the three moving companies in a small nation. If the movers act
as perfect competitors, what is the price per mile and the number of miles per year? If the movers collude
and act as a single monopoly, what is the price per mile and the number of lines per year?

Answer

If the movers compete, production will be where the demand and supply curves intersect, 300 million
miles of moving per year. The price will be 8¢ per mile. If the movers can successfully collude, then
production is at the point where MR = MC, only 200 million miles of moving per year, and the price is 12¢
per mile

6. What three characteristics do all games have in common?

Answer

The all have rules, strategies, and payoffs.

7. What is a Nash equilibrium? Is this equilibrium the best outcome for the players? Give an example.

Answer

John Nash proposed the concept of an equilibrium in a game where each player takes the best possible
action given the action of other players. A Nash equilibrium is not necessarily the best one for the players.
This can be seen in the prisoners' dilemma. Typically the prisoners' dilemma is a game where two
prisoners are given rules and payoffs to encourage them to confess to a crime. The prisoners, acting in
their own self-interest, confess to the crime to minimize their jail time and so confession is the Nash
equilibrium. But if the players can communicate with each other, they can improve their position. If they
can communicate, they both deny the crime and so both wind up doing less time in jail.
8. Does an oligopoly produce the efficient quantity of output or does it create a deadweight loss? Do the
firms want to produce the efficient quantity of output? Explain your answer.

Answer

An oligopoly might or might not operate efficiently. It operates efficiently if the firms cheat on any
agreement and increase output so that it is the same as the perfectly competitive level. In this case, price
equals marginal cost and the outcome is efficient. There is no deadweight loss. From the firms'
perspectives, this outcome is undesirable because the firms make zero economic profit.
If the firms can play repeated games, detecting and punishing overproduction, the oligopoly is more
likely to restrict output to the monopoly level. This outcome is inefficient because marginal cost does not
equal marginal benefit. A deadweight loss is created. From the firms' perspective, this outcome is more
desirable because the firms make an economic profit.

9. Two firms are introducing an improved version of their toothpastes. They must decide whether or not
to advertise their products. The table above gives the payoff matrix in terms of the economic profits they
expect in each case. The payoffs are in terms of millions of dollars.
a. What is the Nash equilibrium for the game?
b. If they could cooperate, what strategy would they prefer? What would be the payoff?

Answer

a. The Nash equilibrium has each firm advertising and hence each firm receiving $100 million in
economic profit because both decided to advertise.
b. If they could cooperate, they would both choose not to advertise. In this case, each would make $140
million in economic profit.

10. Two firms are competing in a duopoly and are trying to decide which price to set. The two prices
under consideration are a high monopoly price and a low competitive level. If both seller A and seller B
chose the monopoly price, each will make $20 million of economic profit. However, if one picks the
monopoly price while the other picks the competitive price, the high-price firm will lose $1 million while
the low-price firm will make $32 million. If both sell at the competitive level, they both make zero
economic profit. Complete the payoff matrix below and determine the Nash equilibrium.
Answer