Cartels, Oligopolies, and

Monopolistic Competition

Ka-fu Wong
University of Hong
Kong

1
Imperfect Competition

Monopoly = "single seller"

Oligopoly = "few sellers“

An oligopoly is a market that is
dominated by a small number
of firms.

Monopolistic competition:
Monopolistic competition is a
market with a large number of
firms selling similar but not
identical products.
2
Monopoly = “single seller”

Towngas (The Hong Kong and China Gas

Company Limited) supplies cooking fuel to
households in Hong Kong

An electronic payment system using a contactless

smartcard.

The sole supplier of electricity in Kowloon and

New Territories.

The sole supplier of electricity on Hong Kong Island.

3
Oligopoly = “few sellers”

Four mobile
service providers
in Hong Kong

4
Monopolistic competition:

Convenience stores

Pawn shops

Restaurants
5
Studying Oligopoly Behavior
o Is complicated- because it’s not a single firm considering
its costs and pricing (like competitive firms and
monopolies)
o The profits of a large firm depend heavily on the actions
taken by other large firms.
o Strategic Decision-Making = decision making in
situations that are interactive.
o Poker, Chess

6
Games and Strategic Behavior
• We’ll introduce Game Theory as a way of predicting
outcomes in strategic situations like oligopolies.

• We will touch the surface of game theory and will leave

the more complicated discussion in more advanced
courses.

7
Example 1. Should the prisoners confess?

8
Example 1. Should the prisoners confess?
• Two prisoners, X and Y, are held in separate cells for a
serious crime that they did, in fact, commit.
• The prosecutor, however, has only enough hard
evidence to convict them of a minor offense, for which
the penalty is, say, a year in jail.
• Each prisoner is told that if one confesses while the
other remains silent, the confessor will go free while the
other spends 20 years in prison.
• If both confess, they will get an intermediate sentence,
say five years.

9
Example 1. Should the prisoners confess?
• It is often convenient to summarize the elements of a
game in the form of a payoff matrix.
• Three elements:
1. Players (2 prisoners)
2. Strategies (confess, remain silent)
3. Payoffs (jail sentences)

10
 Example 1. Should the prisoners confess?
Prisoner Y
Confess Remain Silent

5 years 0 years for X

Confess for each 20 years for Y

Prisoner X

Remain 20 years for X 1 year

Silent 0 years for Y for each

The two prisoners are not allowed to communicate with one another.
If the prisoners are rational and narrowly self-interested, what will they do?
11
 Example 1. Should the prisoners confess?
Prisoner Y
Confess Remain Silent
Their dominant strategy is to
5 years 0 years for X confess.
Confess for each 20 years for Y
No matter what Y does, X gets a
Prisoner X lighter sentence by speaking out.
1. If Y too confesses, X gets five
Remain 20 years for X 1 year years instead of 20.
Silent 0 years for Y for each
2. And if Y remains silent, X goes
free instead of spending a year
in jail.
Dominant Strategy: One that yields a higher
payoff than the other strategies no matter what The payoffs are perfectly
the other players in a game choose. symmetric, so Y also does better
to confess, no matter what X
Dominated Strategy: One that yields a lower
does.
payoff than the other strategies no matter what
the other players in a game choose.
12
Example 1. Should the prisoners confess?
• The difficulty is that when each behaves in a self-
interested way, both do worse than if each had shown
restraint.
• Thus, when both confess, they get five years, instead of
the one year they could have gotten by remaining silent.
• And hence the name of this game, prisoner's
dilemma.

13
Example 2. Why do people shout at cocktail
parties?

14
Example 2.
Why do people shout at cocktail parties?
• Whenever large numbers of people gather for
conversation in a closed space, the ambient noise level
rises sharply.

• After attending such gatherings, people often complain

of sore throats and hoarse voices from having to speak
so loudly to be heard.

15
Example 2.
Why do people shout at cocktail parties?
• If everyone instead restrained and spoke at a normal
voice level at cocktail parties, they would avoid these
symptoms.

• And because the overall noise level would be lower, they

would hear just as well as when they all shout at one
another.

So why shout?

16
Example 2.
Why do people shout at cocktail parties?
The dominant strategy for everyone is to speak more loudly.

But when all follow their dominant strategies, we get a worse outcome
than if everyone had continued speaking normally.

Other Conversation Pairs

Speak normally Speak more loudly
(3,3) (1,4)
Speak normally Second best Best for others
for you and others Worst for you
You and your partner
(4,1) (2,2)
Best for you Third best
Speak more loudly Worst for others for you and others

17
Nash Equilibrium

Nash equilibrium:
a combination of strategies
such that each player's
strategy is the best he/she
can choose given the strategy
chosen by the other player.

John F. Nash Jr.

The Sveriges Riksbank Prize in Economic Sciences in
Memory of Alfred Nobel 1994
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Nash equilibrium in prisoner’s dilemmas
In prisoner's dilemmas, the Nash equilibrium occurs when
each player plays his dominant strategy.
Many games have a Nash equilibrium, even though not
every player has a dominant strategy.
Other Conversation Pairs
Speak normally Speak more loudly
(3,3) (1,4)
Speak normally Second best Best for others
for you and others Worst for you
You and your partner
(4,1) (2,2)
Best for you Third best
Speak more loudly Worst for others for you and others

19
Example 3a.
Should American spend more on
advertising?
• Suppose that United Airlines and American are the only
carriers that serve the Chicago-St. Louis market.
• They are deciding their advertising spending in the next
period.

20
Example 3a.
Should American spend more on
advertising?
If the relevant payoffs are as shown, does United have a
dominant strategy? Does American?

American
Raise ad Leave spending
spending the same
Raise ad $3000 for U $8000 for U
spending $8000 for A $4000 for A
United
Leave $4000 for U $5000 for U
spending $5000 for A $2000 for A
the same
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Example 3a.
Should American spend more on
advertising?
American 's dominant strategy is to raise its ad spending.
United, however, does not have a dominant strategy.

American
Raise ad Leave spending
spending the same
Raise ad $3000 for U $8000 for U
spending $8000 for A $4000 for A
United
Leave $4000 for U $5000 for U
spending $5000 for A $2000 for A
the same
22
Example 3a.
Should American spend more on
advertising?
What is the Nash equilibrium of the game?

Since United can predict that American will follow its dominant
strategy, United's best move is to leave its own ad spending the
same. Thus the Nash equilibrium is American raises ad spending
and United leaves spending the same.
American
Raise ad Leave spending
spending the same
Raise ad $3000 for U $8000 for U
spending $8000 for A $4000 for A
United Leave $4000 for U $5000 for U
spending $5000 for A $2000 for A
the same 23
Example 4.
Should Michael accept Tom's offer?
• Tom and Michael are subjects in an experiment.
• The experimenter begins by giving $100 to Tom, who must then
propose how to divide the money between himself and Michael.
• He can propose any division he chooses, provided the proposed
amounts are integers and he offers Michael at least one dollar.
• Suppose he proposes $X for himself and $(100-X) for Michael.
Michael must then say whether he accepts the proposal.
• If he does, they each get the amounts proposed.
• But if Michael rejects the proposal, each player gets zero, and the
$100 reverts to the experimenter.
• It is common knowledge that Tom and Michael will play this game
only once and that each has the goal of making as much money for
himself as possible.

What should Tom propose?

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Example 4.
Should Michael accept Tom's offer?
• Unlike earlier games, the timing of each player’s decision in this
game is important.
• The payoffs for this game are better represented in a game tree,
rather than a payoff matrix.
$X for Tom
$(100-X) for
Tom proposes Michael
$X for himself,
$(100-X) for Michael accepts
Michael

A B
Michael refuses

$0 for Tom
$0 for Michael
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 Example 4.
Should Michael accept Tom's offer?
• Suppose Tom proposes $99 for himself, $1 for Michael.
$99 for Tom
$1 for Michael

Tom proposes
$99 for himself, Michael accepts
$1 for Michael

A B
Michael refuses

$0 for Tom
$0 for Michael
This is the most advantageous offer Tom can make, and at point B,
Michael's best bet is to accept it.
Michael's problem is that he cannot make a credible threat to refuse
Tom's one-sided offer. 26
Example 5. Should the business owner open
a distant branch?
• The owner of a thriving local business wants to start up
a satellite outlet in a distant city.

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Example 5. Should the business owner open
a distant branch?
• If the outlet is managed honestly, the owner can pay the manager
$1000 per week and still earn an economic profit of $1000 per week
from the outlet.
• The manager’s best alternative employment pays $500 per week.
• The owner's concern is that she will not be able to monitor the
behavior of the outlet manager, and that this person would
therefore be in a position to embezzle heavily from the business.
• The owner knows that if the distant outlet is managed dishonestly,
the manager can earn $1500 per week, while causing the owner a
financial loss of $500 per week.

If the owner believes that all managers are selfish income-maximizers,

will she open the new outlet?

28
Example 5. Should the business owner open
a distant branch?
First step: Construct the game tree for the distant-outlet game .

$1000 for owner

$1000 for manager
manage honestly
Managerial C
candidate
promises to manage dishonestly
manage Open distant outlet -$500 for owner
honestly $1500 for manager

A B
Don’t open outlet

Owner gets $0
Manager gets $500
for working elsewhere
29
Example 5. Should the business owner open
a distant branch?
To predict how game will play out, work backward from end of the tree.

$1000 for owner

$1000 for manager
manage honestly
Managerial C
candidate
promises to manage dishonestly
manage Open distant outlet -$500 for owner
honestly $1500 for manager

A B
Don’t open outlet

Owner gets $0
Manager gets $500
for working elsewhere
30
 Example 5. Should the business owner open
a distant branch?
If the outlet is opened, the manager must decide at C whether to
manage honestly.
$1000 for owner
$1000 for manager
manage honestly
C
manage dishonestly
Open distant outlet -$500 for owner
$1500 for manager

If his only goal is to make as much money for himself as he can, he will
manage dishonestly (bottom branch at C), since that way he earns $500
more than by managing honestly (top branch at C).
So if the owner opens the new office, she will end up with a financial loss
of $500. 31
Example 5. Should the business owner open
a distant branch?
If instead she had chosen not to open the office (bottom branch at
point B), she would have ended up with a financial return of zero.
Owner gets -$500
Manager gets $1500
Open outlet

Don’t open outlet

Owner gets $0
Manager gets $500
for working elsewhere

And since zero is better than -$500, she will choose not to open the
satellite office.
32
Example 5. Should the business owner open
a distant branch?
Even though opening the outlet and managing it honestly would be
better for both the owner and manager, purely self-interested
persons cannot achieve this outcome.
$1000 for owner
$1000 for manager
manage honestly
Managerial C
candidate
promises to manage dishonestly
manage Open distant outlet -$500 for owner
honestly $1500 for manager

A B
Don’t open outlet

Owner gets $0
Equilibrium: Manager gets $500
for working elsewhere
Owner not open distant outlet
Manger manages dishonestly if hired to mange the distant outlet.
33
A Thought Experiment
• I have just gotten home from a crowded concert and
discover I have lost $1000 in cash. The cash had been
in my coat pocket in a plain envelope with my name and
address written on it.
• Do you know anyone who you feel certain would return
it to me if he or she found it?

34
Resolving Prisoner's Dilemmas and Other
Commitment Problems
• In games like the prisoner's dilemma, the ultimatum
bargaining game, and the satellite office game, players
have trouble arriving at the outcomes they desire
because they are unable to make credible commitments.

35
Resolving Prisoner's Dilemmas and Other
Commitment Problems
• For example, if both players in the prisoner's dilemma
could somehow reach a binding agreement to remain
silent, each would be assured of getting a shorter
sentence.

Hence the logic of the

underworld code of
Omerta, under which the
family of anyone who
provided evidence against
a fellow mob member
would be killed.
36
Example 6. Will the restaurateur pay the
waiter extra to provide good service?
The restaurateur wants his waiter to provide
good service so that customers will enjoy their
meals and come back in the future.

If the waiter provides good service, the owner

can pay him $100 per day.

But if the waiter provides bad service, the most

he can pay the waiter is $60 per day.

The waiter is willing to provide bad service for

$60 per day, and for $30 extra would be willing
to provide good service.

The owner's problem is that he cannot tell

whether the waiter has provided good service.37
Example 6. Will the restaurateur pay the
waiter extra to provide good service?
Restaurateur
Pay waiter Pay waiter
$100/day $60/day
Provide Second best Best for owner
good service for each Worst for waiter
Waiter
Provide bad Best for waiter Third best
service Worst for owner for each

Each side has a dominant strategy:

Restaurateur- pay $60/day; waiter- provide bad service.

Outcome is lower-right cell and that is inefficient.

Tipping is a solution to this commitment problem.
38
Changing material incentive as a solution to
commitment problem
• The Mafia's code of silence, tips for waiters -- all work
by changing the material incentives facing the relevant
decision makers.
• But it is not always practical to changes material
incentives in precisely the desired ways.

39
Example 7. Tipping
• What if the restaurant is located in a distant city the
diner doesn’t expect to visit again?

Quanjude
Quanjude is a very famous restaurant, specialized in Beijing duck .
40
Example 7. Tipping
• Unlike case of restaurant with local patrons, this waiter has no way
to penalize the diner in the future if he leaves no tip.
Diner
Leave Leave
15% tip no tip
Provide Second best Best for diner
good service for each Worst for waiter
Waiter
Provide bad Best for waiter Third best
service Worst for diner for each

Dominant strategy for the waiter: provide bad service.

Dominant strategy for diner: leave no tip.
Again a worse outcome for each than if waiter had provided good
service and diner had tipped. 41
Moral Sentiments as Commitment Devices
• If commitment problems cannot be solved by altering
the relevant material incentives, it may nonetheless be
possible to solve them by altering people's psychological
incentives.
• For example, feelings of guilt when they cause harm to
others, feelings of sympathy for the interests of their
trading partners, feelings of outrage when they are
treated unjustly, and so on.
• These feelings may lessen the incentive to behave in
opportunistic and mutually destructive ways.

42
Two Standards of Rationality
1. The Self-interest Standard:
– A person is rational if she is efficient in pursuit of her
own interests.
– The self-interest model appears inadequate in
explaining some real-world phenomena.

Return wallets Rescues Bone marrow Blood donation

donation

43
Two Standards of Rationality
2. The Adaptive Rationality Standard:
– A taste can be added to the self-interest model, but
only if people with such taste will not be penalized in
the long run, and acquiring such taste will not lead
to the extinction.

Return wallets Rescues Bone marrow Blood donation

donation
44
The Possibility of Honest Managers
• If the owner believes that the managerial candidate
comes from a society whose members have been
strongly conditioned to behave honestly, will she open
the new office?

45
The Possibility of Honest Managers
• Suppose that the effect of the conditioning is to cause
the managerial candidate to be willing to pay $10,000 to
avoid the guilt he would feel if he managed dishonestly.

46
The Possibility of Honest Managers
Manager manages
honestly.
Owner gets $1000,
manager gets $1000
C
Owner opens Manager manages
satellite office dishonestly.
Owner gets -$500,
Managerial manager gets -$8500
candidate
promises to
manage Owner does not
honestly open satellite office

Owner gets $0,

Manager gets $500 by
working elsewhere
47
Can a taste survive?
• The taste of honesty can help induce better outcome, as
in the distant outlet problem.
– Owners like to hire managers who are honest.
– An honest manager can earn a higher payoff.
• What happen if an honest manager fails to convince the
owner that he is honest?

• A taste for honesty cannot be favored by natural

selection unless others can infer the presence of that
taste.

48
Who are more likely to be honest (i.e. , to
have a taste of honesty)?
• The person is very religious, e.g., Buddhist, Christian,
etc.
• The person listens to classical music.
• The person belongs to some hiking club.
• The person is more educated, e.g., holds higher degree,
such as PhD in Economics.
• The person has gotten a written recommendation from
Mr. Li Ka Shing.

49
Cartels
o Some oligopoly firms are competitive with each other,
some are cooperative with each other. We’ll focus on
the cooperative ones (since all firms would rather not
compete!)
o A Cartel = a group of suppliers that tries to act as if they
were a monopoly.
o The goal of these suppliers? To coordinate in order
to reduce supply, raise prices, and increase profits.

50
OPEC Cartel
o OPEC (the Organization of Petroleum Exporting
Countries) limits production for each member nation- to
raise oil prices and profits- a cartel.

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The Price of Oil, 1960-2005

52
 Cartels and Profit Maximization
A Cartel Tries to Move a Market from “Competition” towards “As if Controlled
by a Monopolist”
Competition As if Controlled by a Monopolist
P P

Profit
Pm

Pc S Pc MC = AC

D MR D
Q Q
Qc Qm Qc 53
Cartels and Cheating
o Reality? Few cartels effectively control the market price,
and most tend to collapse over time.
o Reasons why cartels collapse:
1. Cheating by cartel members.
2. New entrants and demand response.
3. Government prosecution.

54
Cartels and Cheating
o Every country in OPEC can earn more by cheating than
by keeping to their allotment.
o So, everyone cheats, and the cartel collapses!

Don’t let me down:

Venezuelan President Hugo Chavez
and Saudi Crown Prince Abdullah bin
Abdul Aziz Al Saud at an OPEC
summit

55
Cheating on the OPEC Cartel
o Cheating is also profitable when other members do not
keep their promise to reduce production.
o A single cartel member does not have significant
monopoly power.
o So reducing production does not raise the world price
enough to make up for its lost sales.

56
 The Incentive to Cheat
Should I expand output?
Price
Initial price = P0
Initial quantity = Q0
Initial output by you = Q0/4

P0
Assumption: four-firm cartel

MC=AC

MR Demand

Q0 Quantity
57
 The Incentive to Cheat
Should I expand output?
Price
Initial price = P0 At the original quantity,
Initial quantity = Q0 Total profit of the four firms together is maximized:
Initial output by you = Q0/4 TR(Q0)-TC(Q0)
Profit of the individual firms is TR(Q0)/4-TC(Q0)/4

No incentive to expand by Q = (Q1-Q0) if the gain in

revenue is to be equally shared by all and the loss in
P0 revenue is equally shared by all.

P1

MC=AC

Demand

Q0 Quantity
Q1
58
 The Incentive to Cheat
Should I expand output?
Price
Initial price = P0 If I expand by Q = (Q1-Q0), ….
Initial quantity = Q0
Initial output by you = Q0/4 If I cheat, ….
the gain in revenue will not be equally shared by all
and the loss in revenue is equally shared by all.

(P1-P0)*Q0/4
P0

P1

MC=AC

P1*(Q1-Q0)
Demand

Q0 Quantity
Q1
59
The Cheating Dilemma
o A payoff matrix can show us the incentive to cheat:
o Example: assume the world oil market is dominated
by two large countries, Saudi Arabia and Russia.
o Each country has two choices or strategies:
o Cooperate by reducing output and acting like a
monopolist.
o Cheat and expand production.

60
The Cheating Dilemma

Russia’s Strategies
Cooperate Cheat
Saudi Arabia’s Cooperate ($400, $400) ($200, $500)
Strategies Cheat ($500, $200) ($300, $300)

o If both countries cooperate, they each earn $400.

o If one cheats while the other doesn’t, the cheater earns
$500 and the non-cheater earns $200.
o If they both cheat, they each earn $300.

61
The Cheating Dilemma
Russia’s Strategies
Cooperate Cheat
Saudi Arabia’s Cooperate ($400, $400) ($200, $500)
Strategies Cheat ($500, $200) ($300, $300)

o The dominant strategy for Saudi Arabia? Cheat.

o If Russia cooperates? Best to cheat.
o Cheating pays $500 while cooperating pays $400.
o If Russia cheats? Also best to cheat.
o Cheating pays $300 while cooperating pays $200.

62
The Cheating Dilemma
Russia’s Strategies
Cooperate Cheat
Saudi Arabia’s Cooperate ($400, $400) ($200, $500)
Strategies Cheat ($500, $200) ($300, $300)

o The dominant strategy for Russia? You decide…

o If Saudi Arabia cooperates? Cheat.
o Cheating pays $500 while cooperating pays $400.
o If Saudi Arabia cheats? Cheat.
o Cheating pays $300 while cooperating pays $200.
o No matter what the other player does, each player is better
off cheating.

63
New Entrants and Demand Response
Break Down Cartels
o Cheating is not the only reason for cartels to fail.
o The high prices of a cartel attract new entrants.
o Supply will increase and push down the price.
o Consumers will favor the new firms with lower prices.
o More substitutes will be available in the long run.

64
How to Sustain a Cartel
o Possess access to natural resources that are difficult to
duplicate
o can avoid this problem of new entrants.
o E.g. Oil, diamonds, nutmeg

65
How to Sustain a Cartel
o Control access to some key input that can’t be easily
duplicated
o E.g. the NBA buyer’s cartel uses a salary cap is
enforced by kicking out teams that don’t comply.
o No substitutes exist for the NBA league.
o Who wins and who loses under this structure?

66
Government Prosecution and Regulation
o Most cartels are illegal in the United States since the
Sherman Antitrust Act of 1890.
o Antitrust Laws give the government the power to
regulate or prohibit business practices that may be anti-
competitive.
o empowers the government to prosecute and punish
collusive behavior.

o Anti-monopoly law in mainland China

o Competition law in Hong Kong.

67
Government-Supported Cartels
o Surprisingly, governments do not always prosecute
cartels, and often they support cartels.
o In the U.S.: many cartels are supported by the
government, including milk.
o In many poor nations, governments regularly enrich
themselves through cartels.
o The most successful cartels operate with the explicit
support of (and enforcement by) the government.

68
Summary: Successful Cartels
o Cartels are more likely to be stable and successful if they
can prevent new entrants through:
o Control of natural resources or
o Control of access to some key input that can’t be
easily duplicated
o Weak enforcement of antitrust laws (or lack of laws)
o Achieving government support

69
Oligopolies
o Cartels may be tough to keep together… BUT oligopoly
can still maintain prices (and profits) that are higher
than competitive firms.

70
The Incentive and Ability to Raise Price in
Oligopoly
o A firm in oligopoly who reduces quantity by the amount Q0–Q1
increases the market price to P1 (which is greater than MC.)
o The increase in price increases the profits of the firm that cuts
output (the green area), as well as increasing the profits of the
other firms in the industry.

71
Oligopoly Pricing
o Can we be more specific? Economists have developed
many models of oligopolistic pricing.
o A lot depends on factors specific to the industry; We
leave further discussion for intermediate and advanced
microeconomics studies.

72
Monopolistic Competition
o Monopolistic Competition is a market structure that’s a
little like monopoly and a little like competition.
Specifically:
o many competitors
o products are similar but not identical
o downward-sloping demand curve
o each firm earns zero profit

73
 Monopolistic Competition and
Profit Maximization
Same profit maximizing rule as competitive and monopoly firms: produce where MR = MC

But…. This profit

will attract new
entrants.

74
Zero Profit in the Long Run
o If firms are earning economic profits, new firms will
want to enter the industry.
o This will reduce the demand curve facing each individual
producer.
o In the long run, each supplier will earn normal profits,
and price will equal ATC.

75
Monopolistic Competition and
Profit Maximization
Firms will continue to enter ,
reducing the demand facing the
firm.
The process will stop only when
typical firms earns zero profit

76
 Monopolistic Competition and
Profit Maximization

• Firms in both industries produce where P = AC and earn zero profits.

• However, firms under monopolistic competition charge prices above marginal
cost, they produce a smaller quantity, and Q* is not at minimum average cost.
77
The Economics of Advertising
o Oligopolies and Monopolistically Competitive Firms
advertise….
o Is advertising good or bad? It’s Complicated.
o (There are different types of advertising)

78
Types of Advertising
o “Informative” Advertising:
o price, quality and availability information

79
Types of Advertising

“If they’re spending

so much $$$ on
advertising for this
product, they must
expect it to be
profitable and
around a long time.
Must be good.”

80
Types of Advertising
o Advertising as Part of the Product:
o Even if NO information is given, does “Branding” make
the product more enjoyable?
o Tasters enjoy the cola more if it’s labeled as “Coke”…

81