1. Introduction to Oligopoly
Econ: 64
Module
Introduction to Oligopoly
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

2. What you will learn in this Module:
Why oligopolists have an incentive to act in ways that reduce their combined profit.
Why oligopolies can benefit from collusion.
The purpose of this module is to develop the oligopoly market structure. Many of the high-profile industries in the U.S. are oligopolies and all share a common characteristic: mutual interdependence. Firms often find that it could be mutually beneficial to collude or not compete as vigorously as possible because competition drives down profits for the industry.

3. I. Understanding Oligopoly
“Few” producers
Remember HHI
Page
Interdependence- Actions of one firm have an impact on another firm and vice versa
Module 57 describes oligopoly as a market structure with a few large producers. There is no universal definition of how many producers must exist before we call the market an oligopoly, so we use measures like the HHI to quantify the market concentration.
An additional key characteristic of oligopoly is that the firms are interdependent and engage in strategic behavior.
Interdependence simply means that the actions of one firm (Honda, for example) have an impact on another large firm (Toyota) and vice versa. If Honda would choose to advertise during the Super Bowl, Toyota would be affected and must decide whether to respond or do nothing.

4. II. Collusion and Competition
Oligopoly firms can increase their profits by colluding to restrict output or raise price.
Maintaining collusive agreements is difficult because there is an incentive to cheat
Collusion is illegal
Oligopoly firms can collude to restrict output and raise price to increase profits (i.e. behave like a monopoly).
It is difficult to maintain the collusive agreement, especially as the number of firms involved increases. Each firm has an incentive to cheat by producing a little more (and it is more difficult to get caught the more firms there are) so firms are likely to cheat. And if all firms cheat, the collusive (or cartel) profits disappear.
And, it should be clearly noted that explicitly agreeing to collude on the basis of price and/or output is illegal and people can, and do, get fined and/or imprisoned for doing so.

5. Price versus Quantity Competition
Bertrand
Price competition- undercut prices of competititon
Competitive outcome
Cournot
Quantity competition
Economic profits
Strategies between duopolists have been studied by economist for many years.
Joseph Bertrand ( ) showed that when firms are selling an identical product, oligopolists will repeatedly lower price to undercut the competition. This process ends at the perfectly competitive outcome where P=MC.
Augustin Cournot ( ) focused on quantity competition, rather than price competition. Again assuming a homogenous product, duopoly firms choose output to maximize profit, given the output of the rival firm. There exists an equilibrium level of output that allows each firm to earn profits that are below monopoly-level profits, but are above normal profits.

6. Oligopoly is a market structure that is characterized by a ______ number of ______ firms that produce ______ products.
large; relatively small, independent; identical
Small; independent; identical or differentiated
Large; relatively small, independent; differentiated
Small; independent; differentiated
Small; interdependent; identical or differentiated
Answer: E

7. An extreme case of oligopoly in which firms collude to raise joint profits is known as a:
Duopoly
Cartel
Dominant producer
Price war
Price leadership
Answer: B

8. Margaret Ray and David Anderson
Econ: 65
Module
Game Theory
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

9. What you will learn in this Module:
How oligopoly can be analyzed using game theory.
The concept of the prisoners’ dilemma.
How repeated interactions among oligopolists can result in collusion in the absence of any formal agreement.
The purpose of this module is to show how game theory is used to model the decisions made by oligopolists. The module also describes a situation known as the prisoners’ dilemma and strategies through which the firms can escape the outcome predicted by the dilemma.

10. I. Game Theory
Game Theory: study of how interdependent decision makers make choices.
When two firms are close rivals, the choices of each affect the outcomes for each.
When two firms are close rivals, the choices of each affect the outcomes for each. In other words, they are mutually interdependent. For example, if a retailer like Target lowers the price of a Nintendo Wii, it expects to steal customers from a store like Best Buy. And this prompts Best Buy to match the lower price on the Wii and maybe even offer something else to entice customers away from Target.
These strategies and mutually interdependent outcomes can be studied with game theory.
One simple definition of game theory.

11. II. Non-Cooperative Games
Each player competes to maximize individual payoffs and ignores the effects of his/her action on the payoffs received by the rival.
Oligopoly Video
Game Theory Practice
Golden Balls
When two firms are close rivals, the choices of each affect the outcomes for each. In other words, they are mutually interdependent. For example, if a retailer like Target lowers the price of a Nintendo Wii, it expects to steal customers from a store like Best Buy. And this prompts Best Buy to match the lower price on the Wii and maybe even offer something else to entice customers away from Target.
These strategies and mutually interdependent outcomes can be studied with game theory.
One simple definition of game theory.

12. B. Terms to Know
Payoff matrix- is a diagram showing how the payoffs to each player in a game depend on the actions of both.
Dominant strategy- is an action that is a player’s best action regardless of what the other player does.
Nash equilibrium- occurs when the game ends, and each player is happy with the outcome, given the choice made by the rival.
The payoff matrix is a diagram showing how the payoffs to each player in a game depend on the actions of both.
A dominant strategy is an action that is a player’s best action regardless of what the other player does.
A Nash equilibrium occurs when the game ends, and each player is happy with the outcome, given the choice made by the rival.

13. C. Prisoner’s Dilemma
The payoff matrix below summarizes the strategies and outcomes. The payoffs are measured as years in prison, so smaller numbers are preferred.
Each player has an incentive to choose an action that benefits his/herself at the other player’s expense.
Both players are then worse off than if they had acted cooperatively.
Confession is the dominant strategy when the game is played simultaneously and they cannot talk (collude). No matter what Crook #2 does, it’s always better for Crook #1 to confess. The same is true of Crook #2’s thinking. This is the Nash equilibrium.
Characteristic of the prisoner’s dilemma is that players pursue their dominant strategy and the game comes to Nash equilibrium. However, the outcome is an undesirable one and could have been avoided through some kind of cooperative agreement (collusion).
Crook 2
Confess
Silent
Crook 1
#1: 5 years
#2: 5 years
#1: 1 year
#2: 20 years
#1: 20 years
#2: 1 year
#1: 2 years
#2: 2 years

14. D. Repeated Interaction and Tacit Collusion
Strategic Behavior: taking account of the effects of an action today on the future actions of other players in the game.
Repeated interaction can lead to strategic behavior
Tit for tat strategy
Tacit Collusion- cooperation among producers, without a formal agreement, to limit production and raise prices so as to raise profits.
Strategic Behavior: taking account of the effects of an action today on the future actions of other players in the game.
One renowned strategy in game theory is one called “tit for tat”. The strategy is very simple.
The firm begins by cooperating today. Then every day from this point forward, the firm will do today, whatever the other firm did yesterday.
Tacit Collusion: cooperation among producers, without a formal agreement, to limit production and raise prices so as to raise profits.

15. Margaret Ray and David Anderson
Econ: 66
Module
Oligopoly in Practice
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson

16. What you will learn in this Module:
The legal constraints of antitrust policy.
The factors that limit tacit collusion.
The causes and effects of price wars, product differentiation, price leadership, and nonprice competition.
The importance of oligopoly in the real world.
The purpose of this module is to explore the legal framework designed to prevent collusive behavior. The module also discusses the characteristics of oligopolies that make tacit collusion less likely in practice.

17. I. Antitrust Legislation
Laws including the Sherman Act and the Clayton Act make cartels, collusion, and certain anti- competitive business practices illegal
Prevents Overt Collusion
Explicit cartel collusion on a large scale is uncommon today because of legislation such as the Sherman Antitrust Act of Modern economies such as the United States and the European Union have made it difficult to form monopolies or for oligopolies to act like monopolies.

18. II. Factors Limiting Tacit Collusion (gentleman’s agreement)
There are some industry characteristics that make such tacit collusion less likely in the real world.
1) Tacit collusion requires that the participants “get it”. They understand that if everyone keeps the price high, all firms benefit. But if there are many firms, someone might not understand this mechanism for higher profits. And more firms means it’s easier to cheat on the tacit agreement without being detected. A large number of firms also means that it is easier for firms to enter the industry. In other words, it’s not a very concentrated oligopoly to begin with.
2) The tacit agreement just can’t keep up when there are a variety of products and related services.
3) Do the firms share common interests and agree upon how the market should be shared? Do they operate in the same regions of the country or world? Do they have similar agreements with their labor unions and suppliers? Is one firm more established, while the other is a relatively new entrant? If firms have quite diverse characteristics and interests, it will be more difficult to establish and maintain tacit agreements.
4) Producers usually sell their products to a retailer, who in turn sells the product to the consumer. For example, the breakfast cereal industry, an oligopoly of just a few firms (General Mills, General Foods), sells to large grocery chains like Kroger, Safeway, and Wal-Mart. These huge retailers (the grocery stores) compete in a very competitive environment for shoppers, and they have a lot of buying power due to their size. Because of these two factors, if General Mills and General Foods tried to tacitly agree to keep cereal prices high, it is unlikely to succeed
Large numbers
The more firms in the industry, the less likely tacit collusion will be successful
Complex products and pricing schemes
It is easier to tacitly agree to keep a price high if the product is simple and there are few ways price can be set.
Differences in interests
If firms have diverse characteristics and interests, it will be more difficult to establish and maintain tacit agreements.
Bargaining powers of buyers
If the buyers of a product have bargaining power, or they operate in a competitive retail environment, tacit agreements to keep prices high are unlikely to succeed.
Sca

19. III. Product Differentiation and Tacit Collusion
Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry (either by making them different or just convincing buyers that they are). If firms can convince buyers, they can charge a higher price.
A price leader is a firm that sets a price and the rival firms follow it. By following the leader, a tacit agreement is created.
Non-Price competition occurs when firms compete without lowering prices; non-price competition.
For example: Offer a warranty or better service than their rivals, offer longer hours, a charge card with rewards program, personal shoppers, or amenities like a café in the store.
Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry (either by making them different or just convincing buyers that they are). If firms can convince buyers, they can charge a higher price.
A price leader is a firm that sets a price and the rival firms follow it. By following the leader, a tacit agreement is created.
Non-Price competition occurs when firms compete without lowering prices; non-price competition. For example:
Offer a warranty or better service than their rivals, offer longer hours, a charge card with rewards program, personal shoppers, or amenities like a café in the store.

20. How Important is Oligopoly?
Prevalence in the “real world”
Difficulty of modeling oligopoly firm behavior
Oligopoly is more common in the real world than perfect competition and monopoly and it is also more difficult to study. After all, the oil industry behaves differently than the breakfast cereal industry.
But, economists use the benchmarks of perfect competition and monopoly to gauge the behavior of oligopolists and the outcomes. Are firms able to tacitly raise prices? If so, the market will share more characteristics with monopoly (high profits, deadweight loss) than with perfect competition.

21. Introduction to Monopolistic Competition
Econ: 67
Module
Introduction to Monopolistic Competition
KRUGMAN'S
MICROECONOMICS for AP*

22. What you will learn in this Module:
How prices and profits are determined in monopolistic competition, both in the short run and in the long run.
How monopolistic competition can lead to inefficiency and excess capacity.
The purpose of this module is to introduce the monopolistic competition market structure. The short-run and long-run outcomes are presented and compared to the efficiencies found in perfect competition.

23. I. Monopolistic Competition
Characteristics in common with perfect comp.:
Many firms exist in the market, but not as many as perfect competition.
There are no barriers to entry or exit.
Characteristics in common with monopoly:
The product is differentiated.
Each firm has some ability to set the price of their product.
Ex. Local restaurants, clothing stores
This market structure shares characteristics with both perfect competition and monopoly.
Unlike oligopoly, there is little opportunity for tacit collusion as there are too many firms in the industry for it to be successful. The only real opportunity for strategic behavior is to advertise to consumers the message that their differentiated product is better than the similar, but different, rival products.
A good example of monopolistic competition is the local market for restaurants, retail groceries or clothing stores.

24. II. Monopolistic Competition in the Short Run
In the short run, monopolistic competitors set price and quantity in the same way a monopoly does.
Monopolistic competitors can earn a profit in the short run.
Because firms have a differentiated product, the demand for their product is downward sloping.
The firm maximizes profit the same way all of the other firms do: by finding Q* where MR=MC. The price P* is found by going vertically to the demand curve. The rectangle of profit is found by locating ATC at the output Q*.
The firm here is earning positive economic profit because P*>ATC.

25. Monopolistic Competition in the Short Run
ATC
C. Monopolistic competitors can also earn a loss in the short run.
However positive profits are not guaranteed. If demand is too weak, or if costs are too high, losses could be incurred in the short run.
The firm here is incurring economic losses because P*<ATC.

26. III. Monopolistic competition in the Long Run
Entry and exit occur in response to short- run profits or losses causing demand to shift
In the long run, Monopolistic competitors earn a normal profit
What happens to a profit-making firm when other entrepreneurs see that economic profits are being made?
-Short-run profits attract entry into the market.
-Demand and marginal revenue for existing firms’ products declines (shifts to the left), as there are more similar products available to the same number of consumers.
-A weaker demand causes prices to fall. Lower prices cause economic profits to fall (the profit rectangle is getting smaller).
-Entry stops when normal profits are made (firms are breaking even).
What happens to a firm when losses are being incurred?
-Short-run losses prompt exit from the market.
-Demand and marginal revenue for remaining firms’ products rises (shifts to the right), as there are fewer similar products available to the same number of consumers.
-A stronger demand causes prices to rise.
-Higher prices cause economic losses to fall (the rectangle of losses is getting smaller).
What does this mean?
The only way for firms to break even (earn a normal profit) is for P*=ATC so there is no profit or loss rectangle.
Since price comes from the demand curve, the only way for P*=ATC is for the demand curve to touch ATC at the output Q*, where MR=MC.
In our graph, the only place where this happens is where the downward-sloping demand curve is just tangent to the U-shaped ATC curve at the output Q*.
Because there are only normal profits being made, firms will neither enter nor exit this market and long-run equilibrium is achieved.

27. Comparing Monopolistic Competition with Perfect Competition
Economic profit = 0 (normal profit), so ATC=P in both due to entry and exit
MR = MC in both (profit maximization rule)
In perfect competition, ATC = P = MR = MC
In monopolistic competition ATC = P > MR = MC
Perfect competition achieves productive efficiency by producing at the minimum ATC
Monopolistic competition results in excess capacity
Recall what we learned when studying perfect competition.
The long-run level of output is where P=MR=MC=ATC.
Economic profits are zero; a normal profit is earned.
In monopolistic competition, we have learned that:
The long-run level of output is where P=ATC>MR=MC.
So while profits are zero in both market structures, the clear difference is that in monopolistic competition P>MC.
A more subtle difference exists in exactly where on the ATC curve is P=ATC.
In perfect competition, P=ATC at the minimum of the ATC curve. The level of output being produced is the one that corresponds to the lowest ATC.
In monopolistic competition, P=ATC on the downward sloping range of the ATC curve. This level of output is smaller than the one that minimizes ATC. Economists call this excess capacity.
So we can add another difference, referred to as excess capacity, between the two market structures.
In monopolistic competition, firms do not produce the level of output at which ATC is minimized.
By extension, the entire industry does not produce these products at the lowest possible cost.

28. IV. Is Monopolistic Competition efficient?
No, P > MC so there is DWL
BUT, variety (differentiated products) provides a benefit to consumers.
In the Monopoly module, we saw that deadweight loss exists when output stops prior to the point where P=MC. In fact, anytime price is not equal to marginal cost, efficiency can be improved.
In monopolistic competition, P>MC so deadweight loss exists, and inefficiency exists. Because there is more competition for consumers, the wedge between price and marginal cost is lower in this market structure than it was in monopoly, so the degree of DWL is smaller in monopolistic competition.
Can we live with some DWL?
Probably. After all, the reason why P>MC is because firms have differentiated products that allows them some degree of pricing power similar to, but not as significant as, a monopolist.
This DWL might be called the “price of variety”. The monopolistically competitive restaurant industry is much preferred (though inefficient) to the perfectly competitive version where all menus are the same.

29. Product Differentiation and Advertising
Econ: 68
Module
Product Differentiation and Advertising
KRUGMAN'S
MICROECONOMICS for AP*

30. What you will learn in this Module:
How and why oligopolists and monopolistic competitors differentiate their products.
The economic significance of advertising and brand names.
The purpose of this module is to broadly cover how firms differentiate their products so that higher prices can be charged to consumers. The module also looks at the economics of advertising and branding of products.

31. I. Product Differentiation
Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry.
Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry (either by making them different or just convincing buyers that they are). If firms can convince buyers, they can charge a higher price.
In monopolistic competition, firms engage in product differentiation because it allows the firms some degree of pricing (market) power.
In oligopolies, firms differentiate their products as a form of nonprice competition to take market share from close rivals.
How is this done?
Differentiation can be real (a truck with four-wheel drive is different from a truck without) or perceived (bleach is bleach, no matter what Proctor and Gamble tries to tell you).
The point is that it does not matter. If a consumer believes your firm’s product is better, your firm can charge a higher price and reap higher profits.

32. II. Differentiation by Style or Type
As long as consumers have different tastes, producers will be able to increase profits by differentiating their products to suit those tastes.
A pepperoni pizza with deep-dish crust is different from the same pizza on thin crust, or with a crust stuffed with cheese.
If a consumer really wants the crust stuffed with cheese, then he/she believes this is an imperfect substitute for a regular pepperoni pizza with a regular crust. This allows the seller to charge a higher price for the stuffed crust.

33. III. Differentiation by Location
Many monopolistically competitive firms differentiate their product by location – particularly in service industries
The grocery store and gas station closest to your house is usually your preferred store and gas station. Because of its location, near your house, it is different and better than stores and gas stations across town. And because shopping closer to home saves you money (and time), you are probably willing to pay a little bit more for the convenience of this location.

34. IV. Differentiation by Quality
Even if quality differences are mostly perceived, consumers are often willing to pay a higher price for a product they perceive to be of higher quality.
A Mercedes sedan and a Kia sedan will both get you to the prom or to the mall, but one is generally agreed to have a higher quality.
Because most consumers agree that a Mercedes sedan has superior quality to a Kia sedan, prices are higher for the Mercedes.
Even if quality differences are mostly perceived, consumers are often willing to pay a higher price for a product they perceive to be of higher quality.

35. V. Is Product Differentiation Efficient?
Product differentiation can increase product variety and advertising can provide useful information, both of which can benefit consumers.
Product differentiation can be a waste of resources and advertising can mislead consumers, both of which can be an inefficient use of resources.
The formula for household chlorine bleach is NaClO, sodium hypochlorite. This is the key bleaching ingredient in every single brand that one can find at the grocery store.
The leading brand, Clorox, has about 65% of the market share for household bleach, and spends millions of dollars to maintain this dominance.
Economists wonder if advertising dollars are the best use of economic resources.