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Oligopoly is a market structure featuring a small number of Sellers that together account for a large fraction of market sales. Oligopoly

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Features of oligopoly Fewness of sellers Seller interdependence ( each firm must consider its rivals’ reactions in response to its decisions about prices, output, and advertising). Entry is hard: economies of scale, huge capital investment may be the barriers to enter.

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Examples Airlines industry Petroleum refining Automobile industry Long distance road transportation by bus. Many of there routes have buses operated by limited numbers of operators. Mobile telephony. Internet service providers

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Measures of seller concentration The concentration ratio is the percentage of total market sales accounted for by an absolute number of the largest firms in the market. The four-firm concentration ratio (CR 4 ) measures the percent of total market sales accounted for by the top four firms in the market. The eight-firm concentration ratio (CR 8 ) measures the percent of total market sales accounted for by the top eight firms in the market.

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Concentration Ratios: Very Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers

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Concentration Ratios: Less Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers

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Oligopoly Games –Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. –The Prisoners’ Dilemma –The prisoners’ dilemma game illustrates the four features of a game. Rules Strategies Payoffs Outcome

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Oligopoly Games –Rules –The rules describe the setting of the game, the actions the players may take, and the consequences of those actions. –In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. –Each is held in a separate cell and cannot communicate with each other.

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Oligopoly Games –Each is told that both are suspected of committing a more serious crime. –If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice get a 10-year sentence for both crimes. –If both confess to the more serious crime, each receives 3 years in jail for both crimes. –If neither confesses, each receives a 2-year sentence for the minor crime only.

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Oligopoly Games –Strategies –Strategies are all the possible actions of each player. –Art and Bob each have two possible actions: –1. Confess to the larger crime. –2. Deny having committed the larger crime. –With two players and two actions for each player, there are four possible outcomes: –1. Both confess. –2. Both deny. –3. Art confesses and Bob denies. –4. Bob confesses and Art denies.

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Oligopoly Games –Payoffs –Each prisoner can work out what happens to him— can work out his payoff—in each of the four possible outcomes. –We can tabulate these outcomes in a payoff matrix. –A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player. –The next slide shows the payoff matrix for this prisoners’ dilemma game.

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Oligopoly Games

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–Outcome –If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player. –A list of strategies, one for each player, is a Nash equilibrium if each player’s strategy maximizes his (or her) payoff given the strategies selected by the other players—first proposed by John Nash.

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Outcomes and Payoffs The firm’s action, together with the actions of its rivals, determine its payoff In the standard “business” game, the payoff can be in the form of profit, market share, ratings points, In war games, the payoff might be measured in enemy killed or territory seized.

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The payoff matrix for a running shoe duopoly High Price Low Price High Price $10 million, $10 million $12 million, $5 million Low Price $5 million, $12 million $7 million, $7 million REEBOK NIKE Notice that “low price” is the dominant strategy

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McDonalds and KFC are rivals in the market for home-delivered Burger. Each rival seeks to gain an advantage through advertising (product differentiation). Advertising rivalry

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The payoff matrix for a Burger duopoly Low Advertising High Advertising Low Advertising $400, $400 $500, $150 High Advertising $150, $500 $300, $300 KFC McDonalds Notice that “high advertising” is the dominant strategy

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Oligopoly Games –Collusion –Suppose that the two firms enter into a collusive agreement. –A collusive agreement is an agreement between two (or more) firms to restrict output, raise the price, and increase profits. –Such agreements are illegal in the United States and are undertaken in secret. –Firms in a collusive agreement operate a cartel.

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Oligopoly Games –The strategies that firms in a cartel can pursue are to Comply Cheat –Because each firm has two strategies, there are four possible combinations of actions for the firms: –1. Both comply. –2. Both cheat. –3. Trick complies and Gear cheats. –4. Gear complies and Trick cheats.

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Oligopoly Games –Possible Outcomes If both comply, each firm makes $2 million a week. If both cheat, each firm makes zero economic profit. If Trick complies and Gear cheats, Trick incurs an economic loss of $1 million and Gear makes an economic profit of $4.5 million. If Gear complies and Trick cheats, Gear incurs an economic loss of $1 million and Trick makes an economic profit of $4.5 million.

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Payoff Matrix

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