Objectives © Pearson Education, 2005 Oligopoly LUBS1940: Topic 7

Objectives © Pearson Education, 2005 After studying this topic, you will able to:  Define and identify oligopoly  Explain two traditional oligopoly models  Use game theory to explain how price and output are determined in oligopoly  Use game theory to explain other strategic decisions

© Pearson Education, 2005 What is Oligopoly? The distinguishing features of oligopoly are:  Natural or legal barriers that prevent entry of new firms  A small number of firms compete

© Pearson Education, 2005 What is Oligopoly? Barriers to Entry Either natural or legal barriers to entry can create oligopoly. Figure 13.8 shows two oligopoly situations. In part (a), there is a natural duopoly  a market with two firms.

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What is Oligopoly? Small Number of Firms Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. Interdependence With a small number of firms, each firm’s profit depends on every other firm’s actions. Temptation to Cooperate When a small number of firms share the market, they can increase their profits 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 profit. Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.

© Pearson Education, 2005 Two Traditional Oligopoly Models Two traditional models of oligopoly are:  The kinked demand curve model  The dominant firm model The Kinked Demand Curve Model In the kinked demand curve model, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.

© Pearson Education, 2005 Two Traditional Oligopoly Models The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact. If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesn’t maximize profit.

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Two Traditional Oligopoly Models Dominant Firm Oligopoly In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. The large firm operates as a monopoly, setting its price and output to maximize its profit. The small firms act as perfect competitors, taking as given the market price set by the dominant firm.

© Pearson Education, 2005 Two Traditional Oligopoly Models In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.

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Oligopoly Games Game theory is a tool for studying strategic behaviour  behaviour that takes into account the expected behaviour of others and the recognition of mutual interdependence. What Is a Game? All games share four features: 1.Rules 2.Strategies 3.Payoffs 4.Outcome

© Pearson Education, 2005 Oligopoly Games The Prisoners’ Dilemma The prisoners’ dilemma game illustrates the four features of a game. In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. Rules Each prisoner is held in a separate room and cannot communicate with the other prisoner.

© Pearson Education, 2005 Oligopoly Games Strategies In game theory, 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.

© Pearson Education, 2005 Oligopoly Games Payoffs Because there are 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.

© Pearson Education, 2005 Oligopoly Games Outcome The choices of both prisoners determine the outcome. If each 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. If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibrium  first proposed by John Nash.

Bob’s view of the world

Art’s view of the world

Equilibrium

© Pearson Education, 2005 Oligopoly Games An Oligopoly Price-fixing Game A game like the prisoners’ dilemma is played in duopoly. A duopoly is a market in which there are only two producers that compete. Duopoly captures the essence of oligopoly. Figure on the next slide describes the demand and cost situation in a natural duopoly.

© Pearson Education, 2005 Oligopoly Games How does this market work? What is the price and quantity produced in equilibrium?

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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 price and increase profits. Such agreements are illegal in the European Union and are undertaken in secret. Firms in a collusive agreement operate a cartel.

© Pearson Education, 2005 Oligopoly Games The possible strategies are: 1.Comply 2.Cheat Because each firm has two strategies, there are four possible outcomes: 1.Both comply 2.Both cheat 3.Trick complies and Gear cheats 4.Gear complies and Trick cheats

© Pearson Education, 2005 Oligopoly Games Colluding to Maximize profits The first possible outcome  both comply  earns the maximum economic profit, which is the same as a monopoly would earn. To find that profit, we set marginal cost for the cartel equal to marginal revenue for the cartel. Figure shows this outcome.

© Pearson Education, 2005 Oligopoly Games When each firm produces 2,000 units, the price is greater than the firm’s marginal cost, so if one firm increased output, its profit would increase.

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Oligopoly Games One Firm Cheats On a Collusive Agreement Either firm could cheat, so this figure shows two of the possible outcomes.

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Oligopoly Games Both Firms Cheat The figure shows the outcome if both firms cheat and increase their output to 3,000 units.

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Oligopoly Games The Payoff Matrix You’ve now seen the four possible outcomes: 1.If both comply, they make £2 million a week each. 2.If both cheat, they make zero economic profit. 3.If Trick complies and Gear cheats, Trick incurs an economic loss of £1 million and Gear makes an economic profit of £4.5 million. 4.If Gear complies and Trick cheats, Gear incurs an economic loss of £1 million and Trick makes an economic profit of £4.5 million. The next slide shows the payoff matrix.

Payoff Matrix

Trick’s view of the world

Gear’s view of the world

Equilibrium

© Pearson Education, 2005 Oligopoly Games The Nash equilibrium is where both firms cheat. The quantity and price are those of a competitive market and the firms make normal profit. Other Oligopoly Games Advertising and R & D games are also prisoners’ dilemmas. See Box 13.1 for a prisoners’ dilemma in soap powder.

© Pearson Education, 2005 Oligopoly Games The Disappearing Invisible Hand In all the versions of the prisoners’ dilemma that we’ve examined, the players end up worse off than they would if they were able to cooperate. The pursuit of self-interest does not promote the social interest in these games.

© Pearson Education, 2005 Oligopoly Games A Game of Chicken In the prisoners’ dilemma game, the Nash equilibrium is a dominant strategy equilibrium, by which we mean the best strategy for each player is independent of what the other player does. Not all games have such an equilibrium. One that doesn’t is the game of “chicken”.

Payoff Matrix

KC’s view of the world

P&G’s view of the world

Equilibrium

© Pearson Education, 2005 Repeated Games and Sequential Games A Repeated Duopoly Game If a game is played repeatedly, it is possible for duopolists to successfully collude and make a monopoly profit. If the players take turns and move sequentially (rather than simultaneously as in the prisoners’ dilemma), many outcomes are possible.

© Pearson Education, 2005 Repeated Games and Sequential Games In a repeated prisoners’ dilemma duopoly game, additional punishment strategies enable the firms to comply and achieve a cooperative equilibrium, in which the firms make and share the monopoly profit.

© Pearson Education, 2005 Repeated Games and Sequential Games One possible punishment strategy is a tit-for-tat strategy, in which one player cooperates this period if the other player cooperated in the previous period but cheats in the current period if the other player cheated in the previous period. A more severe punishment strategy is a trigger strategy in which a player cooperates if the other player cooperates but plays the Nash equilibrium strategy forever thereafter if the other player cheats.

© Pearson Education, 2005 Repeated Games and Sequential Games Table 13.4 shows that a tit-for-tat strategy is sufficient to produce a cooperative equilibrium in a repeated duopoly game. Price wars might result from a tit-for-tat strategy where there is an additional complication  uncertainty about changes in demand. A fall in demand might lower the price and bring forth a round of tit-for-tat punishment.

© Pearson Education, 2005 Repeated Games and Sequential Games A Sequential Entry Game in a Contestable Market In a contestable market  a market in which firms can enter and leave so easily that firms in the market face competition from potential entrants  firms play a sequential entry game.

© Pearson Education, 2005 Repeated Games and Sequential Games Figure shows the game tree for a sequential entry game in a contestable market.

© Pearson Education, 2005 Repeated Games and Sequential Games In the first stage, Agile decides whether to set the monopoly price or the competitive price.

© Pearson Education, 2005 Repeated Games and Sequential Games In the second stage, Wanabe decides whether to enter or stay out.

© Pearson Education, 2005 Repeated Games and Sequential Games In the equilibrium of this entry game, Agile sets a competitive price and makes a normal profit to keep Wanabe out. A less costly strategy is limit pricing, which sets the price at the highest level that is consistent with keeping the potential entrant out.