Imperfect Competition Oligopoly

Outline  Types of imperfect competition  Oligopoly and its characteristics  Collusion and cartels  Equilibrium for an oligopoly  Game theory and the economics of cooperation Prisoners’ Dilemma Prisoners’ Dilemma  Public policy toward oligopolies

Imperfect Competition  Based on the number of sellers and product type Monopoly Perfect Competition Imperfect Competition Oligopoly Monopolistic Competition

Oligopoly  Oligopoly is a market structure in which only a few sellers offer similar or identical products  A key feature of oligopoly is the tension between cooperation and self-interest  Duopoly is a limited case of oligopoly with two sellers  Cooperation among oligopolists results in collusion  Collusion is an agreement among firms in a market about quantities to produce or prices to charge

QuantityPrice TR= Total Profit

Oligopoly  Collusion results in a cartel  A cartel is a group of firms acting in unison and the market functions like a monopoly  However, cartels are not easy to form and sustain in the absence of a binding agreement  Self-interest in the form of profit motive translates into cornering the larger share of the market  Where is the equilibrium for an oligopoly?

Oligopoly  Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen  Due to the presence of the Nash equilibrium oligopolists stop short of producing output where P=MC  When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition

Oligopoly  At this equilibrium, the oligopoly price is less than the monopoly price but greater than the competitive price  Impact of the number of sellers on the oligopoly market: The output effect The output effect The price effect The price effect  The larger the number of sellers the smaller the price effect and in such an event oligopoly may approach a competitive market equilibrium

Game theory  Game theory is a study of how people behave in strategic situations  Prisoners’ dilemma is a particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial  The sentence that each prisoner receives depends on his/her decision (whether to confess or to not confess) and on the decision made by the other prisoner

Game theory Prisoner #1 (P.1) Prisoner #2 (P.2) Confess Not Confess Confess P.1 and P.2 get eight years each P.1 gets 20 years P.2 goes free Not Confess P.1 goes free P.2 gets 20 years P.1 and P.2 get one year each P.1’s Decision P.2’s Decision Dominant strategy is to confess and it is the Nash equilibrium.

Application of Prisoner's Dilemma to Oligopoly Jack and Mary High production (40L) Low production (30 L) High production (40 L) J & M get $1600 profit each J gets $1500 profit M gets $2000 profit Low production (30 L) J gets $2000 profit M gets $1500 profit J gets $1800 profit M gets $1800 profit Jack’s (J) Decision Mary’s (M) Decision Dominant strategy is to produce 40 L each. This equilibrium quantity is called the Nash equilibrium.

The Prisoners’ Dilemma and Welfare  Depending on the circumstances, a non- cooperative equilibrium could lead to loss of welfare Overuse of common property resources Overuse of common property resources  However, lack of cooperation is desirable from welfare point of view if the oligopolists would reach a monopoly outcome with cooperation (reduction in total surplus)  Oligopolists can solve prisoner’s dilemma if the game is repeated more than once.

Public Policy Toward Oligopolies  Policy aims to induce firms to compete rather than cooperate  Canada’s Competition Act subjects the following activities to criminal prosecution: Bid-rigging Bid-rigging Price discrimination Price discrimination Resale price maintenance Resale price maintenance Predatory pricing Predatory pricing

Controversies over Competition Policy  Resale price maintenance Does not reduce competition Does not reduce competition One of the mechanisms to solve free-rider problem One of the mechanisms to solve free-rider problem  Predatory pricing Is not a profitable business strategy Is not a profitable business strategy  Tying Is it a form of price discrimination? Is it a form of price discrimination? Efficiency effects of tying are ambiguous Efficiency effects of tying are ambiguous The Microsoft CaseThe Microsoft Case

Priosoner’s Dilemma  