1In this chapter, look for the answers to these questions: In this chapter, look for the answers to these questions:What market structures lie between perfect competition and monopoly, and what are their characteristics?What outcomes are possible under oligopoly?Why is it difficult for oligopoly firms to cooperate?
2Introduction: Between Monopoly and Competition Two extremesCompetitive markets: many firms, identical productsMonopoly: one firmIn between these extremesOligopoly: only a few sellers offer similar or identical products.Monopolistic competition: many firms sell similar but not identical products.
3WHAT IS OLIGOPOLY? Small Number of Firms In contrast to monopolistic competition and perfect competition, an oligopoly consists of a small number of firms.Each firm has a large market shareThe firms are interdependentThe firms have an incentive to collude
4WHAT IS OLIGOPOLY? Interdependence When a small number of firms compete in a market, they are interdependent in the sense that the profit earned by each firm depends on the firms own actions and on the actions of the other firms.Before making a decision, each firm must consider how the other firms will react to its decision and influence its profit.
5WHAT IS OLIGOPOLY? Temptation to Collude When a small number of firms share a market, they can increase their profit by forming a cartel and acting like a monopoly.A cartel is a group of firms acting together to limit output, raise price, and increase economic profit.Cartels are illegal but they do operate in some markets.Despite the temptation to collude, cartels tend to collapse.
6WHAT IS OLIGOPOLY? Barriers to Entry Either natural or legal barriers to entry can create an oligopoly.Natural barriers arise from the combination of the demand for a product and economies of scale in producing it.If the demand for a product limits to a small number the firms that can earn an economic profit, there is a natural oligopoly.
7Measuring Market Concentration Measuring Market ConcentrationConcentration 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.
8Measuring Market Concentration Industry Concentration ratioVideo game consoles 100%Tennis balls %Credit cards 99%Batteries %Soft drinks %Web search engines 92%Breakfast cereal 92%Cigarettes %Greeting cards 88%Cell phone service 82%
9EXAMPLE: Cell Phone Duopoly in Smalltown PQ$0140513010120151102010025903080357040604550Smalltown has 140 residentsThe “good”: cell phone service with unlimited anytime minutes and free phoneSmalltown’s demand scheduleTwo firms: Cingular, Verizon (duopoly: an oligopoly with two firms)Each firm’s costs: FC = $0, MC = $10
11EXAMPLE: Cell Phone Duopoly in Smalltown One possible duopoly outcome: collusionCollusion: an agreement among firms in a market about quantities to produce or prices to chargeCingular and Verizon could agree to each produce half of the monopoly output:For each firm: Q = 30, P = $40, profits = $900Cartel: a group of firms acting in unison, e.g., Cingular and Verizon in the outcome with collusion
12A C T I V E L E A R N I N G 1: Collusion vs. self-interest PQ$0140513010120151102010025903080357040604550Duopoly outcome with collusion: Each firm agrees to produce Q = 30, earns profit = $900.If Cingular reneges on the agreement and produces Q = 40, what happens to the market price? Cingular’s profits?Is it in Cingular’s interest to renege on the agreement?If both firms renege and produce Q = 40, determine each firm’s profits.
13A C T I V E L E A R N I N G 1: Answers PQ$0140513010120151102010025903080357040604550If both firms stick to agreement,each firm’s profit = $900If Cingular reneges on agreement and produces Q = 40:Market quantity = 70, P = $35Cingular’s profit = 40 x ($35 – 10) = $1000Cingular’s profits are higher if it reneges.Verizon will conclude the same, so both firms renege, each produces Q = 40:Market quantity = 80, P = $30Each firm’s profit = 40 x ($30 – 10) = $800
14Collusion vs. Self-Interest Collusion vs. Self-InterestBoth 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.
15A C T I V E L E A R N I N G 2: The oligopoly equilibrium PQ$0140513010120151102010025903080357040604550If each firm produces Q = 40,market quantity = 80P = $30each firm’s profit = $800Is it in Cingular’s interest to increase its output further, to Q = 50?Is it in Verizon’s interest to increase its output to Q = 50?
16A C T I V E L E A R N I N G 2: Answers PQ$0140513010120151102010025903080357040604550If each firm produces Q = 40, then each firm’s profit = $800.If Cingular increases output to Q = 50:Market quantity = 90, P = $25Cingular’s profit = 50 x ($25 – 10) = $750Cingular’s profits are higher at Q = 40 than at Q = 50.The same is true for Verizon.
17The 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 chosenOur duopoly example has a Nash equilibrium in which each firm produces Q = 40.Given that Verizon produces Q = 40, Cingular’s best move is to produce Q = 40.Given that Cingular produces Q = 40, Verizon’s best move is to produce Q = 40.
18A Comparison of Market Outcomes A Comparison of Market OutcomesWhen firms in an oligopoly individually choose production to maximize profit,Q is greater than monopoly Q but smaller than competitive market QP is greater than competitive market P but less than monopoly P
19The 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.
20The Size of the Oligopoly As the number of firms in the market increases,the price effect becomes smallerthe oligopoly looks more and more like a competitive marketP approaches MCthe market quantity approaches the socially efficient quantityAnother benefit of international trade: Trade increases the number of firms competing, increases Q, keeps P closer to marginal cost
22The Benefits of a Cartel (to Cartel Members) We assume the industry is in long-run competitive equilibrium, producing Q1 and charging P1. There are no profits.A reduction in output to QC through the formation of a cartel raises prices to PC and brings profits of CPCAB.
23The Benefits of Cheating Cartel Agreement The situation for a representative firm of a cartel: in long-run competitive equilibrium, it produces q1 and charges P1, earning zero economic profits.As a consequence of the cartel agreement, it reduces output to qCC and charges PC.Its profits are the area CPCAB.If it cheats on the cartel agreement and others do not, the firm will increase output to qCC and reap profits of FPCDE.
24The Benefits of Cheating on the Cartel Agreement Note: if this firm can cheat on the cartel agreement, so can others. Given the monetary benefits gained by cheating, it is likely that the cartel will exist for only a short time.
25Game TheoryGame theory: the study of how people behave in strategic situationsDominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other playersNash equilibrium: a situation in which economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosenPrisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial
26Prisoners’ 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.
27Prisoners’ Dilemma Example Confessing is the dominant strategy for both players.Nash equilibrium: both confessBonnie’s decisionConfessRemain silentBonnie gets 8 yearsBonnie gets 20 yearsConfessClyde gets 8 yearsClyde goes freeClyde’s decisionBonnie goes freeBonnie gets 1 yearRemain silentClyde gets 20 yearsClyde gets 1 year
28Prisoners’ Dilemma Example Prisoners’ Dilemma ExampleOutcome: 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.
29Oligopolies as a Prisoners’ Dilemma Oligopolies as a Prisoners’ DilemmaWhen oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners’ dilemma.Our earlier example:Cingular 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…
30Cingular & Verizon in the Prisoners’ Dilemma Each firm’s dominant strategy: renege on agreement, produce Q = 40.CingularQ = 30Q = 40Cingular’s profit = $900Cingular’s profit = $1000Q = 30Verizon’s profit = $900Verizon’s profit = $750VerizonCingular’s profit = $750Cingular’s profit = $800Q = 40Verizon’s profit = $1000Verizon’s profit = $800
31A C T I V E L E A R N I N G 3: The “fare wars” game The players: American Airlines and Delta AirlinesThe choice: cut fares by 50% or leave fares alone.If both airlines cut fares, each airline’s profit = $400 millionIf neither airline cuts fares, each airline’s profit = $600 millionIf only one airline cuts its fares, its profit = $800 million the other airline’s profits = $200 millionDraw the payoff matrix, find the Nash equilibrium.
32A C T I V E L E A R N I N G 3: Answers Nash equilibrium: both firms cut faresAmerican AirlinesCut faresDon’t cut fares$400 million$200 millionCut faresDelta Airlines$400 million$800 million$800 million$600 millionDon’t cut fares$200 million$600 million
33Other 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.The first example, “ad wars,” is not mentioned in the textbook.An interesting note: When Congress banned cigarette advertising on television in 1971, cigarette manufacturers’ profits rose. Prior to the ban, cigarette companies were stuck in a Nash equilibrium in which all were spending heavily on TV ads to steal business from each other. The ban, in effect, forced cigarette manufacturers to switch to the cooperative outcome in which none advertises on TV.The next three examples (OPEC on this slide, arms race & common resources on the next slide) are discussed in much more detail in the textbook. Instead of covering these same examples in detail in this PowerPoint, I chose to present different examples, so that students who read the book still have a reason to attend class (and vice versa).However, it’s still useful to mention the book’s examples here, and briefly discuss them if you wish, so they will be familiar to students when students read the chapter.
34Other 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.
35Prisoners’ Dilemma and Society’s Welfare Prisoners’ Dilemma and Society’s WelfareThe noncooperative oligopoly equilibriumbad for oligopoly firms: prevents them from achieving monopoly profitsgood for society: Q is closer to the socially efficient output P is closer to MCIn other prisoners’ dilemmas, the inability to cooperate may reduce social welfare.e.g., arms race, overuse of common resources
36Why People Sometimes Cooperate Why People Sometimes CooperateWhen the game is repeated many times, cooperation may be possible.Strategies which 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.
37Public Policy Toward Oligopolies Public Policy Toward OligopoliesGovernments 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.
38CHAPTER SUMMARYOligopolists 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.
39CHAPTER SUMMARYThe 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.