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Principles of Economics, Ninth Edition N. Gregory Mankiw

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V. Andreea CHIRITESCU

Eastern Illinois University

N. Gregory Mankiw Principles Of Economics Ninth Edition

Chapter 17

Oligopoly

Only a few sellers

Offer similar or identical products

Interdependent

Game theory

How people behave in strategic situations

Choose among alternative courses of action

Must consider how others might respond to the action he takes

Markets with Only a Few Sellers, Part 1

A small group of sellers, oligopolists

Tension between cooperation and self-interest

Best off cooperating, acting like a monopolist

Produce a small quantity of output

Charge P >MC

Each firm cares only about its own profit

Powerful incentives not to cooperate

Markets with Only a Few Sellers, Part 2

Duopoly

Oligopoly with only two members

Decide what quantity to sell

Price is determined on the market by the demand

Table 1 The Demand Schedule for Water

Quantity	Price	Total Revenue (and total profit)
0 gallons	$120	$0
10	110	1,100
20	100	2,000
30	90	2,700
40	80	3,200
50	70	3,500
60	60	3,600
70	50	3,500
80	40	3,200
90	30	2,700
100	20	2,000
110	10	1,100
120	0	0

Markets with Only a Few Sellers, Part 3

For a perfectly competitive firm

Price = marginal cost

Quantity is efficient

For a monopoly

Price > marginal cost

Quantity is lower than the efficient quantity

Markets with Only a Few Sellers, Part 4

A duopoly can:

Collude and form a cartel, act as a monopoly and agree on:

Total level of production

Quantity produced by each member

Don’t collude, act in self-interest

Difficult to agree; Antitrust laws

Higher quantity; lower price; lower profit

Not competitive allocation

Nash equilibrium

Markets with Only a Few Sellers, Part 5

Collusion

Agreement among firms in a market

Quantities to produce or

Prices to charge

Cartel

Group of firms acting in unison

Equilibrium for an Oligopoly, Part 1

Nash equilibrium

Economic actors interacting with one another

Each choose their best strategy

Given the strategies that all the other actors have chosen

Equilibrium for an Oligopoly, Part 2

Oligopolists

Better off cooperating and reaching the monopoly outcome

They pursue their own self-interest

Do not end up reaching the monopoly outcome and maximizing their joint profit

Each is tempted to raise production and capture a larger share of the market

Total production rises and price falls

Equilibrium for an Oligopoly, Part 3

When firms in an oligopoly individually choose production to maximize profit

Produce a quantity of output

Greater than the level produced by monopoly

Less than the level produced by competition

The price is

Less than the monopoly price

Greater than the competitive price (MC)

Markets with Only a Few Sellers, Part 6

If oligopolists form a cartel

Maximize total profit

Produce monopoly quantity

Charge monopoly price

Difficult to reach and enforce an agreement as the size of the group increases

Markets with Only a Few Sellers, Part 7

If oligopolists do not form a cartel, each firm has to take into account:

The output effect

Because P > MC, selling one more unit increases profit

The price effect

Increasing production increases total amount sold

Decrease in price and lower the profit

Markets with Only a Few Sellers, Part 8

The size of an oligopoly affects the market outcome

As the number of sellers in an oligopoly grows larger

Oligopolistic market looks more like a competitive market

Price approaches marginal cost

Quantity produced approaches socially efficient level

ASK THE EXPERTS

Nash Equilibrium

The Economics of Cooperation, Part 1

The prisoners’ dilemma

Particular “game” between two captured prisoners

Illustrates why cooperation is difficult to maintain even when it is mutually beneficial

Dominant strategy

Strategy that is best for a player in a game

Regardless of the strategies chosen by the other players

Figure 1 The Prisoners’ Dilemma

The Economics of Cooperation, Part 2

The prisoners’ dilemma

Because each pursues his or her own interests

The two prisoners together reach an outcome that is worse for each of them

Cooperation between the two prisoners is difficult to maintain

Because cooperation is individually irrational

The Economics of Cooperation, Part 3

Game oligopolists play

In trying to reach the monopoly outcome

Similar to the game that the two prisoners play in the prisoners’ dilemma

Firms are self-interested

And do not cooperate

Even though cooperation (cartel) would increase profits

Each firm has incentive to cheat

Figure 2 Jack and Jill’s Oligopoly Game

OPEC and the World Oil Market, Part 1

Organization of Petroleum Exporting Countries (OPEC) is a cartel

Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela

By 1973: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon

Control about 80 percent of the world’s oil reserves

OPEC and the World Oil Market, Part 2

OPEC

Tries to raise the price of its product

Coordinated reduction in quantity produced

Tries to set production levels for each of the member countries

Problem

The countries want to maintain a high price of oil

OPEC and the World Oil Market, Part 3

Problem

Each member of the cartel

Tempted to increase its production

Get a larger share of the total profit

Cheat on agreement

OPEC – successful at maintaining cooperation and high prices

From 1973 to 1985: increase in price

OPEC and the World Oil Market, Part 4

Mid-1980s — member countries began arguing about production levels

OPEC — ineffective at maintaining cooperation

Decrease in price

Recent years: less successful at reaching and enforcing agreements

Fluctuations in oil prices

Driven by supply and demand

The Economics of Cooperation, Part 4

Arms races

After World War II, United States and the Soviet Union

Engaged in a prolonged competition over military power

Strategies

Build new weapons

Disarm

Dominant strategy: Arm

Figure 3 An Arms-Race Game

The Economics of Cooperation, Part 5

Common resources

Two companies own a common pool of oil

Strategies

Each company drills one well

Each company drills a second well and get more oil

Dominant strategy

Each company drills two wells: lower profit

Figure 4 A Common-Resources Game

Welfare of Society

Dominant strategy

Noncooperative equilibrium may be bad for society and the players

Examples: Arms race game, Common resource game

Noncooperative equilibrium may be good for society

Oligopolists trying to obtain monopoly profits

Quantity and price – closer to optimal level

Why People Sometimes Cooperate

Game of repeated prisoners’ dilemma

Repeat the game

Agree on penalties if one cheats

Both have incentive to cooperate

As long as the players care enough about future profits, they will choose to forgo the one-time gain from defection

The Prisoners’ Dilemma Tournament, Part 1

Repeated prisoners’ dilemma

The score at the end of the game is the total number of years in jail

Encourage cooperation

Penalty for not cooperating

Better strategy

Return to cooperative outcome after a period of noncooperation

The Prisoners’ Dilemma Tournament, Part 2

Repeated prisoners’ dilemma

Best strategy: tit-for-tat

Player starts by cooperating, then do whatever the other player did last time

Starts out friendly

Penalizes unfriendly players

Forgives them if warranted

Public Policy Toward Oligopolies, Part 1

Governments

Can sometimes improve market outcomes

Policymakers

Try to induce firms in an oligopoly to compete rather than cooperate

Move the allocation of resources closer to the social optimum

Public Policy Toward Oligopolies, Part 2

Antitrust laws

The Sherman Antitrust Act, 1890

Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy

The Clayton Act, 1914

Further strengthened the antitrust laws

Used to prevent mergers

Used to prevent oligopolists from colluding

An Illegal Phone Call, Part 1

Robert Crandall — president of American Airlines

Howard Putnam — president of Braniff Airways

Crandall: I think it’s dumb as hell . . . to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime.

Putnam: Do you have a suggestion for me?

Crandall: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent. I’ll raise mine the next morning.

An Illegal Phone Call, Part 2

Putnam: Robert, we . . .

Crandall: You’ll make more money, and I will, too.

Putnam: We can’t talk about pricing!

Crandall: Oh @#$%, Howard. We can talk about any &*#@ thing we want to talk about.

The Sherman Antitrust Act

Prohibits competing executives from even talking about fixing prices

Public Policy Toward Oligopolies, Part 3

Controversies over antitrust policies

Used to condemn some business practices whose effects are not obvious

Resale price maintenance

Predatory pricing

Tying

Public Policy Toward Oligopolies, Part 4

Resale price maintenance (fair trade)

Require retailers to charge customers a given price

Might seem anticompetitive

Prevents the retailers from competing on price

Defenders:

Not aimed at reducing competition

Legitimate goal: some retailers offer service

Public Policy Toward Oligopolies, Part 5

Predatory pricing

Charge prices that are too low

Anticompetitive

Price cuts may be intended to drive other firms out of the market

Skeptics

Predatory pricing — not a profitable strategy

Price war — to drive out a rival’ prices are driven below cost

Public Policy Toward Oligopolies, Part 6

Tying

Offer two goods together at a single price

Expand market power

Skeptics

Cannot increase market power by binding two goods together

Form of price discrimination

Tying may increase profit

The Microsoft Case, Part 1

U.S. government’s suit against the Microsoft Corporation, 1998

Central issue: tying

Should Microsoft be allowed to integrate its Internet browser into its Windows operating system

Bundling to expand market power into the market of Internet browsers

Would deter other software companies from entering the market and offering new products

The Microsoft Case, Part 2

Microsoft responded

New features into old products - natural part of technological progress

Cars — include CD players, air conditioners

Cameras — built-in flashes

Operating systems — added many features to Windows

Previously stand-alone products

Computers - more reliable and easier to use

Integration of Internet technology

The next natural next step

The Microsoft Case, Part 3

Disagreement

Extent of Microsoft’s market power

The government

More than 80% of new personal computers

Used a Microsoft operating system

Substantial monopoly power

“Me? A monopolist? Now just wait a minute . . .”

The Microsoft Case, Part 4

Microsoft

Software market is always changing

Competitors: Apple Mac & Linux operating systems

Low price – limited market power

November 1999 ruling

Microsoft — great monopoly power

Illegally abused that power

The Microsoft Case, Part 5

June 2000

Microsoft – to be broken up into two companies

Operating system & Applications software

2001, appeals court

Overturned the breakup order

September 2001

Justice Department — wanted to settle the case quickly

The Microsoft Case, Part 6

Settlement: November 2002

Microsoft – some restrictions

Government – browser would remain part of the Windows operating system

Private antitrust suits

Suits brought by the European Union

Alleging a variety of anticompetitive behaviors