OLIGOPOLY Oligopoly is a market with few sellers selling similar or identical products. “Few” means more than one, but not so many that each firm doesn’t have a substantial influence over market price.

OLIGOPOLY Price Quantity (P) (Q) The market demand for a product is given on the left. The technology for producing the product has zero fixed cost and constant marginal cost of $1. Then ATC=AVC=MC=1 for any firm regardless of size. We will consider three ways of organizing production (perfect competition, monopoly, and oligopoly), and examine the economic

OLIGOPOLY Price Quantity (P) (Q) efficiency of each.

PERFECT COMPETITION Price Quantity (P) (Q) Each perfectly competitive firm will produce where Ppc=MC=1, so that a total of Qpc=9 units will be produced. This is the socially optimal level of output. Each firm will have zero economic profit since ATC=MC=P, and (P-ATC) x Q = 0.

MONOPOLY P Q TR MR The monopolist will produce where P>MR=MC=1, which occurs at Qm=5 units of output. Monopoly price will be Pm=5, and monopoly profits will be (Pm-ATC) x Qm = (5-1)x5 =20.

MONOPOLY P Q TR MR $ Q ATC=MC D MR Ppc=1 Pm=5 Qm= 5 Qpc=9 DEADWEIGHT LOSS The perfectly competitive industry is efficient in allocating resources, while the

MONOPOLY P Q TR MR $ Q ATC=MC D MR Ppc=1 Pm=5 Qm= 5 Qpc=9 DEADWEIGHT LOSS monopoly allocates too few resources producing a deadweight loss of

MONOPOLY P Q TR MR $ Q ATC=MC D MR Ppc=1 Pm=5 Qm= 5 Qpc=9 DEADWEIGHT LOSS (1/2) x (Qpc-Qm) x (Pm-Ppc) =(1/2)(9-5)(4-1)=8.

DUOPOLY P Q TR MR The special case of oligopoly, where there are only two firms, is called duopoly. Assume that the two firms are identical. Then they can maximize their combined profits by together producing the monopoly output of 5 and charging the monopoly price

DUOPOLY P Q TR MR of 5. If each of the duopolists produce 2.5 units of output, they will each have a profit of (P-ATC) x Q = (5-1) x 2.5=10. Then their combined profit will be the same as a monopolist’s profit. When firms enter into an agreement about their production levels

DUOPOLY and price to charge, this is called collusion, and the group of firms in the agreement is a cartel. Then a cartel may allocate resources in the same way as a monopoly. However there are often strong incentives for duopolists (oligopolists) to jointly produce a larger output than a monopolist. When duopoly firm A sees its competitor, firm B, producing 2.5 units of output, A can increase its profit by producing more than 2.5 units.

DUOPOLY Q B Q A Q P TR A MR A TC A PROFIT If B continues to produce and sell 2.5 units, A can increase profits to 10.5 by selling 3.5 units of output. Price will fall to 4 so that B’s profit will now be (P-ATC)xQ=(4-1)x2.5=7.5, a decrease of 2.5. Therefore, when A increases its sales, B’s profit is affected. Similarly, if B changes

DUOPOLY the quantity that it sells, A’s profit will change. Therefore the two firms are interdependent. When each firm believes that the other will produce and sell 2.5 units, each has the incentive to produce and sell 3.5 units to increase their profit. However, when each firm produces 3.5 units, total output is 7 and market price is 3. Then each firm’s profit is (P-ATC)xQ=(3-1)X3.5=7. Each firm does worse than when they each produce 2.5.

DUOPOLY Firm A Firm B The table at the left summarizes the results of the two duopolists’ actions. A’s profits for each output pair is given in the upper right of each cell; B’s profit for each output pair is in the lower left of each cell. When B sells 2.5 and A sells 3.5, A’s profit is 10.5 and B’s profit is 7.5.

GAME THEORY Since the duopolists’ actions affect each other, they must develop strategies for deciding how much output to produce. Strategic decision making can be conveniently analyzed using game theory. An elementary game is known as the prisoners’ dilemma.

PRISONERS’ DILEMMA Butch Remain Silent Confess Remain Sundance Silent Confess 5 years 0 years 5 years 20 years 20 years 10 years 0 years 10 years Each prisoner will get a 5 year sentence if they both remain silent. However, each has an incentive to confess and have their sentence reduced to 0 years. But if both confess, they will

PRISONERS’ DILEMMA Butch Remain Silent Confess Remain Sundance Silent Confess 5 years 0 years 5 years 20 years 20 years 10 years 0 years 10 years both be worse off than if they both remain silent. The actions of each will have not only an effect on themselves, but also on the other. The results of their actions are interdependent. If Butch

PRISONERS’ DILEMMA Butch Remain Silent Confess Remain Sundance Silent Confess 5 years 0 years 5 years 20 years 20 years 10 years 0 years 10 years confesses and Sundance remains silent, Sundance’s sentence will increase from 5 to 20 years.

DUOPOLY Firm A Firm B The duopolists’ game is similar to the prisoners’ dilemma. Each has an incentive to choose an action that is not jointly optimal. The actions of each duopolist has an effect on the profits of the other.

OPEC Founded in 1960, the Organization of Petroleum Exporting Countries (OPEC) is a cartel of 11 countries that collectively produce about 75% of the world’s oil. Periodically, the cartel assigns production quotas to each of its members to limit production in order to increase price and profits of its members. The cartel has no legal means of enforcing the production quotas. They are simply accepted by mutual consent. When price is high,

OPEC each country has an incentive to increase its production to increase its own profits. But when a number of countries increase production, price will fall and so will the OPEC members’ profits. In fact the history of OPEC has seen output quotas raise petroleum (and gasoline) prices, only to have some members eventually cheat on the agreement. Saudi Arabia (which is an OPEC member) has attempted to penalize the cheaters by flooding the

OPEC world market with oil, and driving down world price and the profits of oil producers. The idea that Saudi Arabia is attempting to convey is that countries who cheat will be “punished” with low prices and profits when they do not follow their production quotas. Repeatedly playing this game OPEC members should eventually learn that the best strategy to play is to adhere to their production quotas.