Oligopoly

 Oligopoly: a market structure in which only a few sellers

offer similar or identical products. More specifically,
Oligopoly is a market structure in which
 Natural or legal barriers prevent the entry of new firms.
 A small number of firms compete.

 Strategic behavior in oligopoly:

A firm’s decisions about P or Q can affect other firms and
cause them to react. The firm will consider these
reactions when making decisions.
 Game theory: the study of how people behave in
strategic situations.
 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 duopoly—
a market with two
firms.
 What Is Oligopoly?
Small Number of Firms
Because an oligopoly market has only a few
firms, they are interdependent and face a
temptation to cooperate.
Interdependence: With a small number of
firms, each firm’s profit depends on every firm’s
actions.
Temptation to Cooperate: Firms in oligopoly
face the temptation to form a cartel.
A cartel is a group of firms acting together to
limit output, raise price, and increase profit.
Cartels are illegal.
 Measuring Market Concentration
 Concentration ratio: the percentage of the
market’s total output supplied by its four largest
firms.
 The higher the concentration ratio,
the less competition.
 This chapter focuses on oligopoly,
a market structure with high concentration ratios.
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q  Smalltown has 140 residents
$0 140
 The “good”:
5 130
cell phone service with unlimited
10 120 anytime minutes and free phone
15 110
20 100  Smalltown’s demand schedule
25 90  Two firms: T-Mobile, Verizon
30 80 (duopoly: an oligopoly with two firms)
35 70  Each firm’s costs: FC = $0, MC = $10
40 60
45 50
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q Revenue Cost Profit Competitive
Competitive
$0 140 $0 $1,400 –1,400 outcome:
outcome:
P
P == MC
MC == $10
$10
5 130 650 1,300 –650
QQ == 120
120
10 120 1,200 1,200 0
Profit
Profit == $0
$0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350
Monopoly
Monopoly
30 80 2,400 800 1,600 outcome:
outcome:
35 70 2,450 700 1,750 PP == $40
$40
40 60 2,400 600 1,800 Q
Q == 6060
45 50 2,250 500 1,750 Profit
Profit == $1,800
$1,800
OLIGOPOLY 6
EXAMPLE: Cell Phone Duopoly in Smalltown
 One possible duopoly outcome: collusion
 Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
 T-Mobile and Verizon could agree to each produce
half of the monopoly output:
 For each firm: Q = 30, P = $40, profits = $900
 Cartel: a group of firms acting in unison,
e.g., T-Mobile and Verizon in the outcome with
collusion
 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 and are
undertaken in secret.
Firms in a collusive agreement operate a
cartel.
 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.
ACTIVE LEARNING 1
Collusion vs. self-interest
P Q Duopoly outcome with collusion:
$0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = $900.
10 120 If T-Mobile reneges on the agreement and
15 110 produces Q = 40, what happens to the
20 100 market price? T-Mobile’s profits?
25 90 Is it in T-Mobile’s interest to renege on the
30 80 agreement?
35 70 If both firms renege and produce Q = 40,
40 60 determine each firm’s profits.
45 50 10
ACTIVE LEARNING 1
Answers
P Q If both firms stick to agreement,
each firm’s profit = $900
$0 140
5 130 If T-Mobile reneges on agreement and
produces Q = 40:
10 120
Market quantity = 70, P = $35
15 110
T-Mobile’s profit = 40 x ($35 – 10) = $1000
20 100
25 90
T-Mobile’s profits are higher if it reneges.
30 80 Verizon will conclude the same, so
35 70 both firms renege, each produces Q = 40:
Market quantity = 80, P = $30
40 60
Each firm’s profit = 40 x ($30 – 10) = $800
45 50 11
 Collusion vs. Self-Interest
 Both firms would be better off if both stick to the
cartel agreement.
 But each firm has incentive to renege on the
agreement.
 Lesson:
It is difficult for oligopoly firms to form cartels and
honor their agreements.
 The Equilibrium for an Oligopoly
 Nash equilibrium: a situation in which
economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
 Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
 Given that Verizon produces Q = 40,
T-Mobile’s best move is to produce Q = 40.
 Given that T-Mobile produces Q = 40,
Verizon’s best move is to produce Q = 40.
A Comparison of Market Outcomes
When firms in an oligopoly individually choose
production to maximize profit,
 oligopoly Q is greater than monopoly Q
but smaller than competitive Q.
 oligopoly P is greater than competitive P
but less than monopoly P.
 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.
All games have four common features:
Rules
Strategies
Payoffs
Outcome
 Game Theory
 Game theory helps us understand oligopoly and
other situations where “players” interact and
behave strategically.
 Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
 Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial
 Prisoners’ Dilemma Example
 The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
 The police question each in separate rooms,
offer each the following deal:
 If you confess and implicate your partner,
you go free.
 If you do not confess but your partner implicates
you, you get 20 years in prison.
 If you both confess, each gets 8 years in prison.
 Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess Remain silent
Bonnie gets Bonnie gets

Confess 8 years 20 years

Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie Bonnie gets
Remain goes free
silent Clyde 1 year
Clyde
gets 20 years gets 1 year

OLIGOPOLY 18
 Prisoners’ Dilemma Example
 Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.
 Both would have been better off if both remained
silent.
 But even if Bonnie and Clyde had agreed before
being caught to remain silent, the logic of self-
interest takes over and leads them to confess.
 Oligopolies as a Prisoners’ Dilemma
 When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
 Our earlier example:
 T-Mobile and Verizon are duopolists in
Smalltown.
 The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
 Here is the “payoff matrix” for this example…
T-Mobile & Verizon in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
T-Mobile
Q = 30 Q = 40
T-Mobile’s T-Mobile’s
profit = $900 profit = $1000
Q = 30
Verizon’s Verizon’s
profit = $900 profit = $750
Verizon
T-Mobile’s T-Mobile’s
profit = $750 profit = $800
Q = 40
Verizon’s Verizon’s
profit = $1000 profit = $800
ACTIVE LEARNING 3
The “fare wars” game
The players: American Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone
 If both airlines cut fares,
each airline’s profit = $400 million
 If neither airline cuts fares,
each airline’s profit = $600 million
 If only one airline cuts its fares,
its profit = $800 million
the other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium.
22
ACTIVE LEARNING 3
Answers
Nash equilibrium:
American Airlines
both firms cut fares
Cut fares Don’t cut fares
$400 million $200 million

Cut fares

United $400 million $800 million

Airlines
$800 million $600 million
Don’t cut
fares
$200 million $600 million
23
 Oligopoly Games
Each firm agrees to produce 2,000 units and to share
the economic profit.
The blue rectangle shows each firm’s economic profit.
 Oligopoly Games
When each firm produces 2,000 units, the price is
greater than the firm’s marginal cost, so if one firm
increased output, its profit would increase.
 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.
 The Benefits of Being Members of a Cartel

We assume the
industry is in long-run
equilibrium, producing
Q1, and charging P1.
There are no profits. A
reduction in output to
QC through the
formation of a cartel
raises price to PC and
brings profits of CPCAB
 Problems with Cartels
 High profits will provide an incentive for firms
from outside the industry to join the industry.
 After the cartel agreement is made, cartel
members have an incentive to cheat on the
agreement.
 If a firm cheats on the cartel agreements and
other firms do not, then the cheating firm can
increase its profits. Of course if all firms cheat,
the cartel members are back where they started
at: no cartel agreements and at the original price.
Benefits of Cheating in a Cartel Agreement
 The Kinked Demand Curve Theory
 The key behavioral assumption is that if a single
firm lowers price, other firms will do likewise, but
if a single firm raises price, other firms will not
follow suit.
 1. 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.
 2. The Figure below shows the kinked demand
curve model.
 The Kinked Demand Curve Theory

OLIGOPOLY 32
 The Kinked Demand Curve Theory
 a) The demand curve that a firm believes it faces has a kink at the
current price and quantity. Above the kink, demand is relatively elastic
because all other firm’s prices remain unchanged; and below the kink,
demand is relatively inelastic because all other firm’s prices change in
line with the price of the firm shown in the figure.
 b) The kink in the demand curve means that the MR curve is
discontinuous at the current quantity. Fluctuations in MC that remain
within the discontinuous portion of the MR curve leave the profit-
maximizing quantity and price unchanged.
 3. 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 doesn’t maximize profit.

OLIGOPOLY 33