Econ 120
Oligopoly! Chapter 14 Market Structures: Part III
Definitions and Characteristics ● Oligopoly = Industry with only a few number
of producers ● Oligopolist = Firm in an Oligopoly
○ This is the most common market.
● Firms have market power. ● There are “moderate” barriers to entry. ● Could be differentiated or standardized ● There is imperfect competition:
○ Firms compete but still have market power.
● They are modeled using game theory.
A few firms run the industry
Examples ● Beer: Anheuser-Busch Inbev (43%) and Miller Coors (25%) ● Search Engines: Google (63%) vs. Bing & Yahoo (combined 34%) ● Smartphones: Apple (44%) & Samsung (29%) ● Toothpaste: Colgate (48%), Crest (29%), and Sensodyne (22%) ● Tennis Balls: Wilson, Penn, Dunlop, Spalding ● Soda: Pepsi and Coke ● Breakfast Cereal: Kelloggs, General Mills, Post, Quaker (85%)
Note: Does not need to be a few big firm. It could be two people both selling handmade clothes in a rural village.
Many major industries are Oligopolies
There are moderate barriers to entry. Barriers to Entry:
1. Increasing Returns to Scale 2. Control of Scarce Resources 3. Government Barriers to Entry
a. Patents & Copyrights
4. Network Externalities 5. Technological Superiority
Barriers to Entry inhibit the market from having many firms. But the barriers to entry aren’t so strong that only one firm can exist.
Increasing Returns to Scale Suppose a firm has increasing returns to scale -- but eventually decreasing returns to scale.
Suppose if they charge the price at the bottom of the LRATC curve, they’ll be willing to supply ½ Of the quantity demanded at that price.
We might end up with 2 firms supplying half Of the industry output at around that price.
One firm won’t drive the other firm out of the market, because they can’t lower prices anymore. If they try to supply more, their costs go up-- and so they’d need a higher price.
Increasing Returns to Scale Grocery Stores
Having a large grocery store is much cheaper than a small grocery store.
...but there reaches a point where increasing your grocery store size increases your cost.
Moderate Barriers to Entry ● Some firms are technological superior to other firms. Other firms can’t
compete. ○ It’s similar to monopoly, but now a couple firms are superior to all other firms.
● Network Externalities ○ No obvious examples.
■ Fashionable clothes might not be cool if no one is wearing them, but also not cool if everyone is wearing them.
■ Social Media and dating sights are more valuable as more people use them, but they Might reach a point where they lose valuae because too many people are on them, and part of their value was a sense of exclusivity and unique-ness.
● Facebook’s great! All my friends are on it. ● Ugh, my relatives joined Facebook-- I’m switching to Instagram.
Oligopoly ● Control of scarce resources or inputs
○ While DeBeers has historically been a Monopolist because they had most of the World’s diamonds, they’re now arguably More Of an Oligopolist.
● Government Barriers ○ Two companies have patents on similar
Products. ■ To get a patent, your product must be unique. ■ But you could possibly patent a “similar” product and compete.
● Two similar night-time flu medicines
Oligopoly Behavior ● For this problem: Let’s ignore costs
– just look at revenue. ● Revenue is maximized when the price is $6. ● If they were maximizing revenue, a monopoly
would charge $6 for their product.
○ Demand above is elastic; Demand below is inelastic
Price Qd Total Revenue
8 40
7 50
6 60
5 70
4 80
Suppose there are two firms. ● Industry revenue is still maximized at $6. ● But this might not happen… why? ● Suppose we start off with a price of $6.
○ each selling 30 units.
○ Each firm has revenue of $180.
● Why not charge $5 and sell 35 units each?
○ Each firm would only make $175.
○ Quantity Effect: $25 each or $50 total. Price Effect: -$30 each or -$60 total.
○ So selling 70 units at $5 is worse. The Price Effect is greater than the Quantity Effect.
Price Qd Total Revenue
8 40
7 50
6 60
5 70
4 80
But what if one firm operates unilaterally? ● What happens if one firm decides to produce 40
units while the other makes 30?
○ Price gets driven down to $5.
■ One firm gets $200, the other gets $150.
■ Before they each got $180.
■ For firm that produced more: Quantity Effect was 10(5) = 50. Price Effect was 30(-1) = -30
■ For firm that didn’t produce more: QE = 0. Price Effect was 30(-1) = -30
■ Firms will have an incentive to charge less and sell more than a monopoly, since the price effect is partially borne by other firms.
Price Qd Total Revenue
8 40
7 50
6 60
5 70
4 80
Even worse… ● Suppose one firm is selling 40 units and the other
is selling 30 units. The price is $5. ● Suppose the firm selling 30 units decides to sell
40 units. ● The price becomes $4.
○ Their TR goes from $150 to $160– so they should do it.
○ The other firms TR goes from $200 to $160.
○ Industry TR dropped from $350 to $320. Firms often have incentive to do things that harm the industry. When everyone acts this way, everyone ends off worse then if no one sought their self-interest in the first place.
Price Qd Total Revenue
8 40
7 50
6 60
5 70
4 80
Firm Behavior: It’s Tricky ● Monopoly: One firm, raises price above MC, selling Q where MC = MR. →
Makes profit, even in the long run. ● Duopoly (industry with two firms): Could end up making zero profit by
competing. ● Complication: Why don’t the firms both just sell at the monopoly price and
split the profits? ● This is where it gets tricky.
○ Firms could compete– prices will generally be lower and quantities will be higher; it depends on how the market works.
○ But firms could cooperate, charge the monopoly price, and split the profits.
Cooperative Behavior ● Collusion: Firms cooperate to raise joint profits ● Cartel: a legal agreement to sell at lower quantities and higher prices.
○ Acts like a giant monopoly
○ Example: OPEC (Organization of Petroleum Exporting Countries)
○ In our previous example, the two firms meet and agree to charge $6.
○ Illegal if in a formal manner; Firms manage to do it anyways
■ No legal documents; even talking about prices with your competitors isn’t okay.
○ Firms have an incentive to cheat. MR = MC for the firm and MR = MC for the industry are different.
Noncooperative Behavior & Game Theory ● Game Theory
○ Study of behavior in situations of interdependence
○ Interdependence: A situation where a firm’s actions significantly affects the profits of other firms.
○ A large field in economics
○ Also popular in computer science, mathematics, political science and engineering
○ Treat firms as if they were playing a game, developing strategies
■ We’ll assume the goal here is to maximize profit
Key Ideas ● Firms develop strategies
○ Best responses to all possible actions of other firms or players
■ “If my opponent does this, I should do this…" ● We visually model games in a number of ways:
○ Payoff Matrix: shows the payoffs of all participants depending on the actions of other all firms.
○ To the right is a payoff matrix for our past example, where each firm is deciding whether to sell 30 or 40 units.
Dominant Strategies ● Notice: Regardless of what the
other firm does, they should sell 40 units.
● If their opponent produces 30, they should make 40.
● If their opponent produces 40, they should produce 40.
● They should always make 40. ● Both firms have the same
payoff structure, each firm produces 40.
Dominant Strategies ● Notice: Regardless of what the
other firm does, they should sell 40 units.
● Dominant Strategy: An action that is a Best Response regardless of what their opponent does.
● *Note: Not all games have a dominant strategy
Prisoner’s Dilemma ● Both firms produce 40. ● Both make Profit of $160. ● But if both firms instead decided to make
30 units, they’d have $180. ● We call this a prisoner’s dilemma. ● Prisoner’s Dilemma: A situation where
each player has an incentive to act in a manner that helps them but hurts their opponent & when they all do this, they all end up worse off then had they not responded to the incentive.
Prisoner’s Dilemma: Meaning behind the Name ● Two Criminals– and the Cops want them to confess. ● Can put each in jail for 5 years as is. ● If one confesses and the other doesn’t, they get a lighter sentence for
confessing – 2 years, but the other one who doesn’t confess gets punished for 20 years.
● If both confess, they each go to jail for 15 years.
● If the other person doesn’t confess, I should.
● If the other person confesses, so should I.
● Regardless of what the other person does, I should confess.
● Confessing is a dominant strategy. ● Both end up confessing. ● But both players end up worse off
as a result. ● This is the prisoner’s dilemma. ● Hypothetical Solution: Get together and agree to not confess– form a “cartel”.
Equilibrium ● When both confess, neither individual has
a reason to not confess. ● Call this a Nash Equilibrium ● Nash Equilibrium (or a noncooperative
equilibrium): situation where each person is maximizing their payoff given the actions of other players, ignoring the effects those actions have on others.
● My preferred Nash Equilibrium definition: A situation where no one has any reason to change their behavior, given the actions of other players.
Two airlines deciding how much to price. ● Charging the Monopoly Price
might be best for everyone…
○ Maximizes profit ● But charging the competitive
price is a dominant strategy.
○ If they charge a high price, I make money by charging a low price.
○ If they charge a low price, I make money by charging a low price.
Advertising ● If Camel and Marlboro don’t advertise
they share the market. ● If they both advertise, the share the market,
but lose a bunch of money on advertising. ● Both not advertising seems ideal. ● But if my opponent doesn’t advertise,
I should advertise – I make more money. ● If my opponent does advertise, I should also advertise. ● Each firm wants to advertise. ● Regardless of what their opponent does, advertising is a best response. ● But both end up worse off as a result. ● Solution: Ban cigarette advertising because of the harmful effects of cigarettes
Examples ● Alcohol Industry agreed to voluntarily not advertise in 1930s and 1940s ● 1990s: Seagrams started advertising and the cartel ended.
● Gangs and Guns? Speculation...
○ If the rival gang isn’t using guns, a gang can dominate the market by using guns.
○ If the rival gang is using guns, a gang can use guns to defend territory.
○ Whatever the other gang is doing, using guns is arguably a best response.
○ When both operate with guns, each gets the same market share as a situation without guns, except more people die in the process.
○ Solution: ?
Dealing with the Prisoner’s Dilemma ● Form a Cartel: Get together and agree to not cheat. Ban cheating. ● Problem: Everyone wants to cheat. ● Literal Prisoner’s Dilemma: Get together and agree to not confess.
○ Problem: It’s in their best interest to confess. ● “Choosing a Quantity” Example: Get together and agree to produce 30 each.
○ Problem: Each player has a reason to not follow through.
Dealing with the Prisoner’s Dilemma ● Repeated Games– games that happen multiple times. ● Players can have different strategies. ● Tit for Tat: Cooperating at first, but cheating whenever the opponent cheats.
○ In the prisoner’s dilemma, each firm has an incentive to cheat, because the game just happens once.
○ Firms can be rewarded for good behavior or punished for bad behavior if the game is one round.
○ Selling 40 instead of 30 seems beneficial, unless the other firm also sells 40 in response – and does so for decades…
○ If my opponent can credibly threaten to punish me in the future, I might behave differently.
○ Cooperating might be a good idea if you know there are also future consequences.
○ This might break down if the game isn’t repeated enough. Results depend upon how you structure your game.
Tacit Collusion ● Tacit Collusion: Limiting quantity and raising prices to jointly increase profits,
but doing so without any formal agreement. ● Price Leadership: One firm (typically the biggest) sets the price (usually
relatively high) and everyone follows.
○ Illegal to agree to raise prices together at the same time.
○ Totally fine to raise prices together at the same time.
Legal Details ● Sherman Antitrust Act of 1890 ● Response to Standard Oil Company forming a “trust”. They wanted a cartel,
but a cartel wasn’t enforceable– so they didn’t work. Groups of companies all put their shares in the hands of a Board of Trustees– forcing them to operate together and act like a Monopoly.
● "Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal." [5]Section 2:"Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony [.
Results of Sherman Antitrust Act ● Practical Results: No formation of monopolies in a manner that’s
anticompetitive or harmful.
○ If a merger is anti-competitive, the Department of Justice can block it.
○ Breakup of Standard Oil in 1911 into what is now called Exxon and Mobil.
○ Firms argue that they have Increasing Returns to Scale. “If we merge, we’ll be much more efficient, and be able to sell at a lower cost.”
○ But consolidation often just leads to higher prices…
● No explicit collusion
○ Large punishments for discussing prices with competitors
Firms do still implicitly collude A LOT, but it’s imperfect and breaks down for a variety of reasons ● In low concentration industries, firms have a greater incentive to cheat; the “price
effect” is small for them, since they are a small share of the industry and selling more doesn’t influence the price.
● Complexity in pricing and products makes cheating easier. When your price system is complex and you are selling thousands of different products, it gets harder to accuse your rivals of cheating.
● Difference in interest: what’s an acceptable collusion isn’t agreed upon, and firms might cheat because they don’t like how the other opponent is behaving.
● Bargaining Power of Buyers: Firms might agree to charge high prices, but if their buyers are particularly influential (i.e Walmart), they might not follow through.
● When collusion ends (i.e firms compete rather than cooperate) firms often end up dropping their prices to increase their profits. When prices drop as a result of collusion ending, we call this a price war.
Product Differentiation ● In Oligopoly, firms often compete by varying their products (or convincing
customers that their products are different). ● It’s an attempt to get more market power. ● Advertising to make their product seem special. ● Changing their designs ● Adding extras