Chapter 16

Oligopoly

Ratna K. Shrestha

Duopoly in Computer CPUs

In CPU market, Intel Corporation and AMD Inc. are two major players.Each of them must take the Price and Output of the other into consideration while making its own Pricing and Output decisions. Why?

Overview

Monopoly & Perfect Competition Markets with only a Few Sellers--Oligopoly Game Theory and The Economics of Cooperation Public Policy Towards Oligopolies

Four Types of Market Structure

Monopoly

Oligopoly

Monopolistic

Competition

Perfect Competitio

n

• Tap water

• Cable TV

• Tennis balls

• Crude oil

•Hockey Skates

• Novels, CD

• Movies

•Toothpaste

• Wheat

• Milk

Number of Firms?

Type of Products?

Many firms

One firm Few

firms Differentiated products

Identical products

Imperfect Competition

Monopolistic Competition

Many firms selling products that are similar but not identical.

e.g. Movies, Soap, Toothpaste, Pizza. Oligopoly

Only a few sellers, each offering a similar or identical product.

e.g. Hockey skates (Bauer and CCM), Crude Oil (OPEC), Automobiles, Steel, Petrochemicals.

Markets with only a Few Sellers

Oligopoly:

Because of the few sellers, the actions of any one seller in the market can have a large impact on the profits of all the other sellers.

Few sellers offering similar product Interdependence among firms in industry. Best off by co-operating and acting like a monopolist. But such explicit cooperation may not be possible due

to antitrust laws or due to temptation for cheating.

A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

Demand Schedule for Water (MC = 0)

Quantity Price Total Revenue0 $120 $ 0

10 110 1,10020 100 2,00030 90 2,70040 80 3,20050 70 3,50060 60 3,60070 50 3,50080 40 3,20090 30 2,700

100 20 2,000110 10 1,100120 0 0

Price and Quantity Supplied

The price of water in a perfectly competitive market would be driven to where MC = 0:

P = MC = $0; Q = 120 gallons The price and quantity in a monopoly market would

be where total profit is maximized:P = $60; Q = 60 gallons

Oligopoly Q = ??

Competition, Monopolies, and Cartels

Collusion/Cartel The two firms may agree on the quantity to

produce and the price to charge. The two firms may join together and act in

unison, in effect as a monopolist. Examples: OPEC, NCAA.

Although oligopolists would like to form cartels and earn monopoly profits, Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

Equilibrium for an Oligopoly

A Nash equilibrium is a situation in which economic agents interacting with one another each chooses his/her best strategy given the strategies that all the others have chosen. So Nash equilibrium is a non-cooperative equilibrium concept. Each player is acting on its own given the strategy of its rivals. In Nash equilibrium concept all the players make their decisions at the same time (unless stated otherwise).

Firm 2’s ReactionCurve

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Cournot Duopoly Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100

Firm 1’s ReactionCurve

x

x

Firm 1’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 2 will produce.

Nash Eqlbm

Non-Collusive Oligopoly

Oligopolies pursuing their own self-interest, but acting independently.

Production is greater than the monopoly quantity but less than the competitive industry quantity.

Market prices are lower than monopoly but greater than competitive price (marginal cost.)

Total profits are less than the monopoly profit.

Size of Oligopoly & Market Outcome

When the number of sellers increase, it has two effects: The output effect: Because P > MC, selling more at

the going price raises profits. The price effect: Raising production lowers the price

and the profit per unit on all units sold. As the number of sellers grows, 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. The profits then tends to be smaller.

Case Study:OPEC and World’s Oil Market

Like any Cartel, OPEC tries to raise price through coordinated reduction in production.For example during 2008, OPEC was able to co-ordinate the cut in production of crude oil and hence charge higher price. As a result the price of gasoline topped closed to $1.50/L. However such coordination may not last or be successful all the time. The problem is each member is tempted to cheat by increasing production and capturing a larger share of the market. OPEC was most successful as a cartel between 1973-1985.

Game Theory

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.

Prisoners’ Dilemma: illustrates the difficulty in maintaining co-operation. Often people (firms) fail to co-operate with one another even when co-operation would make them better off.

The Prisoners’ Dilemma Story: A detective interrogating two accused of crime in two different cells..

Prisoners’ DilemmaP

riso

ner

A

Confess Don’t Confess

Confess

Don’tConfess

Prisoner B

-5, -5 -1, -10

-2, -2-10, -1

Oligopolies and Prisoners’ Dilemma

In the previous prisoner’s dilemma game, each fears that if he doesn’t confess, the other will confess and get away with –1 (while he/she will be punished with - $10. As a result, each of them will Confess with the equilibrium outcome of (Confess, Confess).

Self-interest makes it difficult for both of them to maintain cooperation even though that is best for both of them.

Oligopolies and Prisoners’ Dilemma

Prisoners’ Dilemma illustrates the problem oligopolistic firms face.

Self-interest makes it difficult for the oligopoly to maintain the co-operative outcome, with low production, high prices and so high profits.

Examples:– International arms race– Beer Advertising– Management of Common Resources– Cheating in Cartel.

Prisoner’s Dilemma: Arms Race

USA

Arm Disarm

US

SR

Dis

arm

Arm Risk, Risk

Risk, Safe

Safe, Risk

Safe, Safe

Prisoner’s Dilemma: Beer Advertising

LabattAdvertise Don’t

Mo

lsen

Do

n’t

Ad

vert

ise

3, 3

2, 5

5, 2

4, 4

even though (Don’t, Don’t) is the best for both of them,they end up with (Advertise, Advertise).

Dominant Strategy

Dominant Strategy: The best strategy for a player to follow regardless of the strategies pursued by other players.

In the game that follows,

If B chooses Advertise, A also chooses Advertise (10 vs. 6)

If B chooses Don’t Advertise, A again chooses Advertise (15 vs. 10).

No matter what B does, A’s best choice is Advertise!

Dominant Strategy in Advertising Game

Fir

m A

AdvertiseDon’t

Advertise

Advertise

Don’tAdvertise

Firm B

10, 5 15, 0

10, 26, 8

Public Policy Toward Oligopolies

Firms in oligopolies have a strong incentive to collude in order to:– reduce production– raise prices and in turn raise profits

At the same time they have strong incentives to drive others out of business so that they can capture the entire market.

From the standpoint of society, co-operation among oligopolists is undesirable because– it leads to production that is too low and– prices that are too high

Then What should government do to protect the consumers?

Public Policy Toward Oligopolies

Competition Act: Makes it illegal to restrain trade or attempt to

monopolize a market. Consists of:

– criminal provisions– civil provisions

Competition Act

Criminal provisions may include:– Price Fixing, Rigging Bids – Resale Price maintenance– Price Discrimination– Predatory Pricing: Charge low price with the

intention of driving competitors out of the market. Civil provisions include mergers which may not be in

the public interest.

Price Fixing and Bid Rigging The basic intent of this section of the law is to

prevent the formation of cartels and is a part of criminal code.

Commonly prosecuted practices are: – Price-fixing: In the US, price fixing can be

prosecuted as a criminal felony offense under Sherman Antitrust Act. In Canada, it is an indictable criminal offence under section 45 of the Competition Act.

– Bid-rigging: An collusion between two or more competitors, in which one party of a group of bidders (usually for government construction contracts) will be designated to win the bid at a much lower price/bid.

In 1999, Vitamin producers agree to pay US$1 billion to settle U.S. Justice Department investigation of price fixing. The three top makers (Roche, BASF, Rhone-Poulec) accounting for 60% of market met to fix prices for a decade. Bulk vitamin A sold for $11.59/lb in 1990 and $19.84/lb in 1998.

Notaries association in Quebec was fined $25,000 for conspiracy to fix prices of real estate services.

Five snow removal companies in Quebec were fined $1 million for conspiring to share market.

Price Fixing and Bid Rigging

Bid-Rigging in Govt. Contracts

On the news: Ottawa, February 17, 2009 – Criminal charges have been laid against 14 individuals and 7 companies accused of rigging bids to obtain Government of Canada contracts for information technology services, the Competition Bureau announced today. The Bureau found evidence indicating that several IT services companies in the National Capital Region secretly coordinated their bids in an illegal scheme to defraud the government by winning and dividing contracts, while blocking out honest competitors

Resale Price Maintenance (RPM)

If a supplier tries to ensure that retailers sell the product at a particular price then supplier is engaged in RPM.

Prosecution for RPM occurs more often than prosecution for other pricing-related areas of competition policy. From 1986-2004, there have been 3 to 4 cases every year on average.

On October 10, 2002, Stroh Brewery Company (Quebec) Ltd. pleaded guilty in the Federal Court and was sentenced to pay $250,000 for requiring retailers to sell at the price specified by Stroh in order to be eligible for volume discounts.

Predatory Pricing: Cases In 1987, several QB driving schools colluded to fix the

price of driving school services and held almost 94% of Sherbrooke market.

Shortly after the agreement, many of them broke off. The major players threatened these renegade

competitors and also punished them with predatory pricing.

Similarly, Hoffman-Loroche (a pharmaceutical company) was successfully prosecuted for giving away certain drugs in an effort to drive the producers of generic drugs out of the market.

The Competition Bureau investigated a case against Air Canada in 2001 accusing it of predatory pricing to hurt rivals WestJet and CanJet.

Other Interesting Games

Location Game Battle of Sexes

1. Beach Location Game– Two competitors selling soft drinks for the same

price.– Beach 200 yards long and Sunbathers are spread

evenly along the beach.– Customers will buy from the closest vendor.

Beach Location Game

Where will the competitors locate (i.e. where is the Nash equilibrium)?

Similar location game is played by gas stations, car dealers, etc…

Ocean

0 B Beach A 200 yards

C

The Battle of the Sexes

Jim

Wrestling Opera

Wrestling

Opera

Joan

2,1 0,0

1,20,0

What is the Nash Eqlbm. of this game?