chapter 16 oligopolyoligopoly © 2002 by nelson, a division of thomson canada limited

Chapter 16Chapter 16Chapter 16Chapter 16

OligopolyOligopolyOligopolyOligopoly

©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited©© 2002 by Nelson, a division of Thomson Canada Limited 2002 by Nelson, a division of Thomson Canada Limited

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 16:

• 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.

• 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.

In this chapter you will…In this chapter you will…


• 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.

• 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.

BETWEEN MONOPOLY AND BETWEEN MONOPOLY AND PERFECT COMPETITIONPERFECT COMPETITION


• Tap water• Cable TV

Monopoly(Chapter 15)

• Novels• Movies

MonopolisticCompetition(Chapter 17)

• Tennis balls• Crude oil

Oligopoly(Chapter 16)

Number of Firms?

Perfect

• Wheat• Milk

Competition(Chapter 14)

Type of Products?

Identicalproducts

Differentiatedproducts

Onefirm

Fewfirms

Manyfirms

Figure 16-1: The Four Types of Market Figure 16-1: The Four Types of Market Structure Structure


• 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

• 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

MARKETS WITH ONLY A FEW MARKETS WITH ONLY A FEW SELLERSSELLERS


• 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.

• 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.

A Duopoly ExampleA Duopoly Example


00120

110010110

200020100

27003090

32004080

35005070

36006060

35007050

32008040

27009030

200010020

110011010

$0$1200

Total revenue (and total profit)PriceQuantity (in litres)

Table 16-1: The Demand Curve for Water Table 16-1: The Demand Curve for Water


• 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

• 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

A Duopoly ExampleA Duopoly Example


• 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.

• 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.

Competition, Monopolies, and Competition, Monopolies, and CartelsCartels


• 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…

• 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…

The Equilibrium for an OligopolyThe Equilibrium for an Oligopoly


• 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.

• 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.

• 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.



• 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.

• 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.

• 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.



• 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 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 How the Size of an Oligopoly Affects the Market OutcomeAffects 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.

• 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.

How the Size of an Oligopoly How the Size of an Oligopoly Affects the Market OutcomeAffects the Market Outcome


• 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 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 GAME THEORY AND THE ECONOMICS OF COOPERATIONECONOMICS OF COOPERATION


• 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.

• 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.



• 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 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 is about two criminals who have been captured by the police, Bonnie 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 Bonnie and Clyde in separate rooms.

• They are offered each a deal.

• The prisoners’ dilemma is about two criminals who have been captured by the police, Bonnie 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 Bonnie and Clyde in separate rooms.

• They are offered each a deal.

The Prisoners’ DilemmaThe Prisoners’ Dilemma


Bonnie’s DecisionBonnie’s Decision

Clyde’s Decision

Clyde’s Decision

Clyde gets 8 years

Bonnie gets 8 years

Clyde gets 20 years

Bonnie goes free

Clyde gets 1 years

Bonnie gets 1 year

Clyde goes free

Bonnie gets 20 years

Confess

Remain silent

Confess Remain silent

Figure 16-2: The Prisoners’ Dilemma Figure 16-2: The Prisoners’ Dilemma


• 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 Bonnie 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.

• 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 Bonnie 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.



• Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

• Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.



• Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

• Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

Oligopolies as a Prisoners’ Oligopolies as a Prisoners’ DilemmaDilemma


Iraq's decisionIraq's decision

Iran’s decision

Iran’s decision

Iran gets $40 billion

Iraq gets $40 billion

High Production

Low Production

High Production Low Production







Figure 16-3: The Oligopoly Game Figure 16-3: The Oligopoly Game


• Arms races• Advertising• Common resources

• Arms races• Advertising• Common resources

Other Examples of the Prisoners’ Other Examples of the Prisoners’ Dilemma Dilemma


Decision of the USDecision of the US

Decision of the USSR

Decision of the USSR

USSR at risk

US at risk

Arm

Disarm

Arm Disarm

USSR at risk and weak

US safe and powerful

USSR safe and powerful

US at risk and weak

USSR safe

US safe

Figure 16-4: The Arm’s-Race Game Figure 16-4: The Arm’s-Race Game


Labatt’s decisionLabatt’s decision

Molson’s decision

Molson’s decision

Molson gets $3 billion profit

Labatt’s gets $3 billion profitAdvertise

Don’t advertise

Advertise Don’t advertise


Labatt’s gets $2 billion profit





Figure 16-5: An Advertising Game Figure 16-5: An Advertising Game


Petro-Canada’s DecisionPetro-Canada’s Decision

Esso’s Decision

Esso’s Decision

Esso gets $4 billion profit

Petro-Canada gets $4 billion profitDrill Two

Wells

Drill One Well

Drill Two Wells Drill One Well


Petro-Canada gets $6 billion profit





Figure 16-6: A Common-Resources GameFigure 16-6: A Common-Resources Game


• 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.)

• 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.)

The Prisoners’ Dilemma and the The Prisoners’ Dilemma and the Welfare of SocietyWelfare of Society


• Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

• Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

Why People Sometimes CooperateWhy People Sometimes Cooperate


Jack’s decisionJack’s decision

Jill’s decision

Jill’s decision

Jill gets $1600 profit

Jack gets $1600 profitSell 40 L

Sell 30 L

Sell 40 L Sell 30 L


Jack gets $2000 profit





Figure 16-7: Jack and Jill’s Oligopoly GameFigure 16-7: Jack and Jill’s Oligopoly Game


• 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.

• 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.

PUBLIC POLICIES TOWARD PUBLIC POLICIES TOWARD OLIGOPOLIESOLIGOPOLIES


• Competition laws make it illegal to restrain trade or attempt to monopolize a market.

• Competition laws make it illegal to restrain trade or attempt to monopolize a market.

Restraint of Trade and the Restraint of Trade and the Competition ActCompetition Act


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

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

Controversies Over Competition Controversies Over Competition PolicyPolicy


• 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

• 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

Controversies Over Competition Controversies Over Competition PolicyPolicy


SummarySummary

• 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.

• 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.


SummarySummary

• 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.

• 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.


SummarySummary

• Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.

• Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition.


The EndThe End

chapter 16 oligopolyoligopoly © 2002 by nelson, a division of thomson canada limited

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