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C H A P T E R

Oligopoly

Microeconomics P R I N C I P L E S O F

N. Gregory Mankiw

Premium PowerPoint Slides

by Ron Cronovich

17

In this chapter,

look for the answers to these questions:

 What outcomes are possible under oligopoly?

 Why is it difficult for oligopoly firms to cooperate?

 How are antitrust laws used to foster

competition?

1

OLIGOPOLY 2

Measuring Market Concentration

 Concentration ratio: the percentage of the

market’s total output supplied by its four largest

firms.

 The higher the concentration ratio,

the less competition.

 This chapter focuses on oligopoly,

a market structure with high concentration ratios.

Concentration Ratios in Selected U.S. Industries

Industry Concentration ratio

Video game consoles 100%

Tennis balls 100%

Credit cards 99%

Batteries 94%

Soft drinks 93%

Web search engines 92%

Breakfast cereal 92%

Cigarettes 89%

Greeting cards 88%

Beer 85%

Cell phone service 82%

Autos 79%

OLIGOPOLY 4

Oligopoly

 Oligopoly: a market structure in which only a

few sellers offer similar or identical products.

 Strategic behavior in oligopoly:

A firm’s decisions about P or Q can affect other

firms and cause them to react. The firm will

consider these reactions when making decisions.

 Game theory: the study of how people behave

in strategic situations.

OLIGOPOLY 5

P Q

$0 140

5 130

10 120

15 110

20 100

25 90

30 80

35 70

40 60

45 50

EXAMPLE: Cell Phone Duopoly in Smalltown

 Smalltown has 140 residents

 The “good”:

cell phone service with unlimited

anytime minutes and free phone

 Smalltown’s demand schedule

 Two firms: T-Mobile, Verizon

(duopoly: an oligopoly with two firms)

 Each firm’s costs: FC = $0, MC = $10

OLIGOPOLY 6

5045

6040

7035

8030

9025

10020

11015

12010

1305

140$0

QP

1,750

1,800

1,750

1,600

1,350

1,000

550

0

–650

–1,400

Profit

500

600

700

800

900

1,000

1,100

1,200

1,300

$1,400

Cost

2,250

2,400

2,450

2,400

2,250

2,000

1,650

1,200

650

$0

Revenue

EXAMPLE: Cell Phone Duopoly in Smalltown

Competitive

outcome:

P = MC = $10

Q = 120

Profit = $0

Monopoly

outcome:

P = $40

Q = 60

Profit = $1,800

OLIGOPOLY 7

EXAMPLE: Cell Phone Duopoly in Smalltown

 One possible duopoly outcome: collusion

 Collusion: an agreement among firms in a

market about quantities to produce or prices to

charge

 T-Mobile and Verizon could agree to each produce

half of the monopoly output:

 For each firm: Q = 30, P = $40, profits = $900

 Cartel: a group of firms acting in unison,

e.g., T-Mobile and Verizon in the outcome with

collusion

A C T I V E L E A R N I N G 1

Collusion vs. self-interest

8

Duopoly outcome with collusion:

Each firm agrees to produce Q = 30,

earns profit = $900.

If T-Mobile reneges on the agreement and

produces Q = 40, what happens to the

market price? T-Mobile’s profits?

Is it in T-Mobile’s interest to renege on the

agreement?

If both firms renege and produce Q = 40,

determine each firm’s profits.

P Q

$0 140

5 130

10 120

15 110

20 100

25 90

30 80

35 70

40 60

45 50

If both firms stick to agreement,

each firm’s profit = $900

If T-Mobile reneges on agreement and

produces Q = 40:

Market quantity = 70, P = $35

T-Mobile’s profit = 40 x ($35 – 10) = $1000

T-Mobile’s profits are higher if it reneges.

Verizon will conclude the same, so

both firms renege, each produces Q = 40:

Market quantity = 80, P = $30

Each firm’s profit = 40 x ($30 – 10) = $800

A C T I V E L E A R N I N G 1

Answers

9

P Q

$0 140

5 130

10 120

15 110

20 100

25 90

30 80

35 70

40 60

45 50

OLIGOPOLY 10

Collusion vs. Self-Interest

 Both firms would be better off if both stick to the

cartel agreement.

 But each firm has incentive to renege on the

agreement.

 Lesson:

It is difficult for oligopoly firms to form cartels and

honor their agreements.

If each firm produces Q = 40,

market quantity = 80

P = $30

each firm’s profit = $800

Is it in T-Mobile’s interest to increase its

output further, to Q = 50?

Is it in Verizon’s interest to increase its

output to Q = 50?

A C T I V E L E A R N I N G 2

The oligopoly equilibrium

11

P Q

$0 140

5 130

10 120

15 110

20 100

25 90

30 80

35 70

40 60

45 50

If each firm produces Q = 40,

then each firm’s profit = $800.

If T-Mobile increases output to Q = 50:

Market quantity = 90, P = $25

T-Mobile’s profit = 50 x ($25 – 10) = $750

T-Mobile’s profits are higher at Q = 40

than at Q = 50.

The same is true for Verizon.

A C T I V E L E A R N I N G 2

Answers

12

P Q

$0 140

5 130

10 120

15 110

20 100

25 90

30 80

35 70

40 60

45 50

OLIGOPOLY 13

The Equilibrium for an Oligopoly

 Nash equilibrium: a situation in which

economic participants interacting with one another

each choose their best strategy given the strategies

that all the others have chosen

 Our duopoly example has a Nash equilibrium

in which each firm produces Q = 40.

 Given that Verizon produces Q = 40,

T-Mobile’s best move is to produce Q = 40.

 Given that T-Mobile produces Q = 40,

Verizon’s best move is to produce Q = 40.

OLIGOPOLY 14

A Comparison of Market Outcomes

When firms in an oligopoly individually choose

production to maximize profit,

 oligopoly Q is greater than monopoly Q

but smaller than competitive Q.

 oligopoly P is greater than competitive P

but less than monopoly P.

OLIGOPOLY 15

The Output & Price Effects

 Increasing output has two effects on a firm’s profits:

 Output effect:

If P > MC, selling more output raises profits.

 Price effect:

Raising production increases market quantity,

which reduces market price and reduces profit

on all units sold.

 If output effect > price effect,

the firm increases production.

 If price effect > output effect,

the firm reduces production.

OLIGOPOLY 16

The Size of the Oligopoly

 As the number of firms in the market increases,

 the price effect becomes smaller

 the oligopoly looks more and more like a

competitive market

 P approaches MC

 the market quantity approaches the socially

efficient quantity

Another benefit of international trade:

Trade increases the number of firms competing,

increases Q, brings P closer to marginal cost

OLIGOPOLY 17

Game Theory

 Game theory helps us understand oligopoly and

other situations where “players” interact and

behave strategically.

 Dominant strategy: a strategy that is best

for a player in a game regardless of the

strategies chosen by the other players

 Prisoners’ dilemma: a “game” between

two captured criminals that illustrates

why cooperation is difficult even when it is

mutually beneficial

OLIGOPOLY 18

Prisoners’ Dilemma Example

 The police have caught Bonnie and Clyde,

two suspected bank robbers, but only have

enough evidence to imprison each for 1 year.

 The police question each in separate rooms,

offer each the following deal:

 If you confess and implicate your partner,

you go free.

 If you do not confess but your partner implicates

you, you get 20 years in prison.

 If you both confess, each gets 8 years in prison.

OLIGOPOLY 19

Prisoners’ Dilemma Example

Confess Remain silent

Confess

Remain

silent

Bonnie’s decision

Clyde’s

decision

Bonnie gets

8 years

Clyde

gets 8 years

Bonnie gets

20 years

Bonnie gets

1 year

Bonnie goes

free

Clyde

goes free

Clyde

gets 1 year Clyde

gets 20 years

Confessing is the dominant strategy for both players.

Nash equilibrium:

both confess

OLIGOPOLY 20

Prisoners’ Dilemma Example

 Outcome: Bonnie and Clyde both confess,

each gets 8 years in prison.

 Both would have been better off if both remained

silent.

 But even if Bonnie and Clyde had agreed before

being caught to remain silent, the logic of self-

interest takes over and leads them to confess.

OLIGOPOLY 21

Oligopolies as a Prisoners’ Dilemma

 When oligopolies form a cartel in hopes

of reaching the monopoly outcome,

they become players in a prisoners’ dilemma.

 Our earlier example:

 T-Mobile and Verizon are duopolists in

Smalltown.

 The cartel outcome maximizes profits:

Each firm agrees to serve Q = 30 customers.

 Here is the “payoff matrix” for this example…

OLIGOPOLY 22

T-Mobile & Verizon in the Prisoners’ Dilemma

Q = 30 Q = 40

Q = 30

Q = 40

T-Mobile

Verizon

T-Mobile’s

profit = $900

Verizon’s

profit = $900

T-Mobile’s

profit = $1000

T-Mobile’s

profit = $800

T-Mobile’s

profit = $750

Verizon’s

profit = $750

Verizon’s

profit = $800 Verizon’s profit

= $1000

Each firm’s dominant strategy: renege on agreement,

produce Q = 40.

The players: American Airlines and United Airlines

The choice: cut fares by 50% or leave fares alone

 If both airlines cut fares,

each airline’s profit = $400 million

 If neither airline cuts fares,

each airline’s profit = $600 million

 If only one airline cuts its fares,

its profit = $800 million

the other airline’s profits = $200 million

Draw the payoff matrix, find the Nash equilibrium.

A C T I V E L E A R N I N G 3

The “fare wars” game

23

A C T I V E L E A R N I N G 3

Answers

24

Nash equilibrium:

both firms cut fares

Cut fares Don’t cut fares

Cut fares

Don’t cut

fares

American Airlines

United

Airlines $600 million

$600 million

$200 million

$800 million

$800 million

$200 million

$400 million

$400 million

OLIGOPOLY 25

Other Examples of the Prisoners’ Dilemma

Ad Wars

Two firms spend millions on TV ads to steal

business from each other. Each firm’s ad

cancels out the effects of the other,

and both firms’ profits fall by the cost of the ads.

Organization of Petroleum Exporting Countries

Member countries try to act like a cartel, agree to

limit oil production to boost prices & profits.

But agreements sometimes break down

when individual countries renege.

OLIGOPOLY 26

Other Examples of the Prisoners’ Dilemma

Arms race between military superpowers

Each country would be better off if both disarm,

but each has a dominant strategy of arming.

Common resources

All would be better off if everyone conserved

common resources, but each person’s dominant

strategy is overusing the resources.

OLIGOPOLY 27

Prisoners’ Dilemma and Society’s Welfare

 The noncooperative oligopoly equilibrium

 Bad for oligopoly firms:

prevents them from achieving monopoly profits

 Good for society:

Q is closer to the socially efficient output

P is closer to MC

 In other prisoners’ dilemmas, the inability to

cooperate may reduce social welfare.

 e.g., arms race, overuse of common resources

OLIGOPOLY 28

Another Example: Negative Campaign Ads

 Election with two candidates, “R” and “D.”

 If R runs a negative ad attacking D,

3000 fewer people will vote for D:

1000 of these people vote for R, the rest abstain.

 If D runs a negative ad attacking R,

R loses 3000 votes, D gains 1000, 2000 abstain.

 R and D agree to refrain from running attack ads.

Will each one stick to the agreement?

OLIGOPOLY 29

Another Example: Negative Campaign Ads

Do not run attack

ads (cooperate)

R’s decision

D’s decision

no votes lost

or gained

no votes

lost or gained

R gains 1000

votes

R loses

2000 votes

R loses 3000

votes

D loses

3000 votes

D loses

2000 votes D gains

1000 votes

Each candidate’s

dominant strategy:

run attack ads. Run attack ads

(defect)

Do not run

attack ads

(cooperate)

Run

attack ads

(defect)

OLIGOPOLY 30

Another Example: Negative Campaign Ads

 Nash eq’m: both candidates run attack ads.

 Effects on election outcome: NONE.

Each side’s ads cancel out the effects of the

other side’s ads.

 Effects on society: NEGATIVE.

Lower voter turnout, higher apathy about politics,

less voter scrutiny of elected officials’ actions.

OLIGOPOLY 31

Why People Sometimes Cooperate

 When the game is repeated many times,

cooperation may be possible.

 These strategies may lead to cooperation:

 If your rival reneges in one round,

you renege in all subsequent rounds.

 “Tit-for-tat”

Whatever your rival does in one round

(whether renege or cooperate),

you do in the following round.

OLIGOPOLY 32

Public Policy Toward Oligopolies

 Recall one of the Ten Principles from Chap.1:

Governments can sometimes

improve market outcomes.

 In oligopolies, production is too low and prices

are too high, relative to the social optimum.

 Role for policymakers:

Promote competition, prevent cooperation

to move the oligopoly outcome closer to

the efficient outcome.

OLIGOPOLY 33

Restraint of Trade and Antitrust Laws

 Sherman Antitrust Act (1890):

Forbids collusion between competitors

 Clayton Antitrust Act (1914):

Strengthened rights of individuals damaged by

anticompetitive arrangements between firms

OLIGOPOLY 34

Controversies Over Antitrust Policy

 Most people agree that price-fixing agreements

among competitors should be illegal.

 Some economists are concerned that

policymakers go too far when using antitrust laws

to stifle business practices that are not

necessarily harmful, and may have legitimate

objectives.

 We consider three such practices…

OLIGOPOLY 35

1. Resale Price Maintenance (“Fair Trade”)

 Occurs when a manufacturer imposes lower limits

on the prices retailers can charge.

 Is often opposed because it appears to reduce

competition at the retail level.

 Yet, any market power the manufacturer has

is at the wholesale level; manufacturers do not

gain from restricting competition at the retail level.

 The practice has a legitimate objective:

preventing discount retailers from free-riding

on the services provided by full-service retailers.

OLIGOPOLY 36

2. Predatory Pricing  Occurs when a firm cuts prices to prevent entry

or drive a competitor out of the market,

so that it can charge monopoly prices later.

 Illegal under antitrust laws, but hard for the courts

to determine when a price cut is predatory and

when it is competitive & beneficial to consumers.

 Many economists doubt that predatory pricing is a

rational strategy:

 It involves selling at a loss, which is extremely

costly for the firm.

 It can backfire.

OLIGOPOLY 37

3. Tying

 Occurs when a manufacturer bundles two products

together and sells them for one price (e.g., Microsoft

including a browser with its operating system)

 Critics argue that tying gives firms more market

power by connecting weak products to strong ones.

 Others counter that tying cannot change market

power: Buyers are not willing to pay more for two

goods together than for the goods separately.

 Firms may use tying for price discrimination,

which is not illegal, and which sometimes

increases economic efficiency.

OLIGOPOLY 38

CONCLUSION

 Oligopolies can end up looking like monopolies

or like competitive markets, depending on the

number of firms and how cooperative they are.

 The prisoners’ dilemma shows how difficult it is

for firms to maintain cooperation, even when

doing so is in their best interest.

 Policymakers use the antitrust laws to regulate

oligopolists’ behavior. The proper scope of these

laws is the subject of ongoing controversy.

CHAPTER SUMMARY

 Oligopolists can maximize profits if they form a

cartel and act like a monopolist.

 Yet, self-interest leads each oligopolist to a higher

quantity and lower price than under the monopoly

outcome.

 The larger the number of firms, the closer will be

the quantity and price to the levels that would

prevail under competition.

39

CHAPTER SUMMARY

 The prisoners’ dilemma shows that self-interest

can prevent people from cooperating, even when

cooperation is in their mutual interest. The logic of

the prisoners’ dilemma applies in many situations.

 Policymakers use the antitrust laws to prevent

oligopolies from engaging in anticompetitive

behavior such as price-fixing. But the application

of these laws is sometimes controversial.

40