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What is Oligopoly?
y The distinguishing features of oligopoly are
Natural or legal barriers that prevent entry of new firms
g p y
A small number of firms compete
What is Oligopoly?
y Barriers to Entry
y Either natural or legal
barriers to entry can
create oligopoly.
y This figure shows two
g
oligopoly situations.
y In part (a), there is a
natural duopoly—a
t l d l
market with two
firms.
What is Oligopoly?
What is Oligopoly?
y In part (b), there is a
natural oligopoly
market with three
firms.
y A legal oligopoly
might arise even
where the demand
and costs leave room
for a larger number of
firms.
What is Oligopoly?
y Small Number of Firms
y Because an oligopoly market has a small number of
firms, the firms are interdependent and face a
temptation to cooperate.
y Interdependence: With a small number of firms, each
Interdependence: With a small number of firms each
firm’s profit depends on every firm’s actions.
y Cartel: A cartel and is an illegal group of firms acting
together to limit output, raise price, and increase profit.
y Firms in oligopoly face the temptation to form a cartel,
but aside from being illegal cartels often break down
but aside from being illegal, cartels often break down.
What is Oligopoly?
y Examples of Oligopoly
y This figure shows some
examples of oligopoly.
l f li l
An HHI that exceeds
1800 is generally regarded
8 i ll d d
as an oligopoly.
An HHI below 1800 is
generally regarded as
monopolistic
competition.
ii
Two Traditional Oligopoly Models
y The Kinked Demand Curve Model
y In the kinked demand curve model of oligopoly, 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.
will follow
Two Traditional Oligopoly Models
y This figure shows the
kinked demand curve
model.
y The demand curve that
a firm believes it faces
has a kink at the
current price and
quantity.
Two Traditional Oligopoly Models
y Above the kink, demand
is relatively elastic
because all other firm s
because all other firm’s
prices remain
unchanged.
y Below the kink, demand
is relatively inelastic
because all other firm s
because all other firm’s
prices change in line with
the price of the firm
shown in the figure.
shown in the figure
Two Traditional Oligopoly Models
y The kink in the
demand curve means
that the MR curve is
discontinuous at the
current quantity—
t tit
shown by that gap AB
in the figure.
Two Traditional Oligopoly Models
y Fluctuations in MC that
remain within the
discontinuous portion of
p
the MR curve leave the
profit‐maximizing
quantity and price
unchanged.
h d
y For example, if costs
increased so that the MC
curve shifted upward
from MC0 to MC1, the
profit‐ maximizing price
and quantity would not
change.
Two Traditional Oligopoly Models
y The beliefs that generate
the kinked demand
y
curve are not always
correct and firms can
figure out this fact.
y If MC increases enough,
all firms raise their
prices and the kink
vanishes.
vanishes
y A firm that bases its
actions on wrong beliefs
doesn’t maximize profit
doesn t maximize profit.
Two Traditional Oligopoly Models
y Dominant Firm Oligopoly
y In a dominant firm oligopoly, there is one large firm that
g p y g
has a significant cost advantage over many other, smaller
competing firms.
y The large firm operates as a monopoly, setting its price
The large firm operates as a monopoly setting its price
and output to maximize its profit.
y The small firms act as perfect competitors, taking as
p p , g
given the market price set by the dominant firm.
Two Traditional Oligopoly Models
y This figure shows a dominant firm industry. On the left
are 10 small firms and on the right is one large firm.
ll f d h h l f
The market demand curve is D, and the supply curve S10 is the
supply curve of the 10 small firms.
supply curve of the 10 small firms
Two Traditional Oligopoly Models
p 5 p q y
y At a price of $1.50, the 10 small firms produce the quantity
demanded. At this price, the large firm would sell nothing.
But at a price of $1.00, the 10 small firms supply only half the
market, leaving the rest to the large firm.
k t l i th t t th l fi
Two Traditional Oligopoly Models
g p
y The demand curve for the large firm’s output is the curve
XD on the right.
The large firm can set the price and receives a marginal
re enue that is less than price along the cur e MR
revenue that is less than price along the curve MR.
Two Traditional Oligopoly Models
g p y g
y The large firm maximizes profit by setting MR = MC. Let’s
suppose that the marginal cost curve is MC in the figure.
The profit‐maximizing quantity for the large firm is 10,000
litres The price charged is $1 00 a litre
litres. The price charged is $1.00 a litre.
Two Traditional Oligopoly Models
p pp y
y The small firms take the price o $1 a litre and supply the rest of
the quantity demanded (20,000 minus 10,000 litres).
Two Traditional Oligopoly Models
g p y y
y A dominant firm oligopoly can arise only if one firm has
lower costs than the others.
In the long run, such an industry might become a monopoly
as the large firm buys up the small firms and cuts costs.
as the large firm buys up the small firms and cuts costs
Two Traditional Oligopoly Models
g y g p y
y In the long run, such an industry might become a monopoly as
the large firm buys up the small firms and cuts costs.
Oligopoly Games
y Game theory is a tool for studying strategic behaviour,
which is behaviour that takes into account the expected
behaviour of others and the mutual recognition of
interdependence.
What Is a Game?
y All games share four features:
Rules
Strategies
St t i
Payoffs
Outcome.
Oligopoly Games
y The Prisoners’ Dilemma
y The prisoners’ dilemma game illustrates the four
features of a game.
features of a game
y The rules describe the setting of the game, the actions
the players may take, and the consequences of those
actions
actions.
y In the prisoners’ dilemma game, two prisoners (Art and
Bob) have been caught committing a petty crime (i.e.
shoplifting).
h lf )
y Each is held in a separate cell and cannot communicate
with each other.
Oligopoly Games
y Each is told that both are suspected of committing a more
serious crime.
y If one of them confesses, he will get a 1‐year sentence for
If f th f h ill t t f
cooperating while his accomplice get a 10‐year sentence for
both crimes.
y If both confess to the more serious crime, each receives 3
years in jail for both crimes.
y If neither confesses, each receives a 2‐year sentence for the
If i h f h i f h
minor crime only.
Oligopoly Games
y In game theory, strategies are all the possible actions of
each player.
A t d B b h h t
Art and Bob each have two possible actions:
ibl ti
Confess to the larger crime
Deny having committed the larger crime.
Because there are two players and two actions for each
player, there are four possible outcomes:
Both confess
Both deny
Art confesses and Bob denies
Bob confesses and Art denies
Oligopoly Games
y Each prisoner can work out what happens to him—can
work out his payoff—in each of the four possible
outcomes.
t
y We can tabulate these outcomes in a payoff matrix.
y 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.
y The next slide shows the payoff matrix for this prisoners’
dilemma game.
Oligopoly Games
y 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.
y If both players are rational and choose their actions in
this way the outcome is an equilibrium called Nash
this way, the outcome is an equilibrium called Nash
equilibrium—first proposed by John Nash.
y The following slides show how to find the Nash
equlibrium.
Bob’s
B b’
view
of the
world
Bob’s
B b’
view
of the
world
Art’s
A ’
view
of the
world
Art’s
A ’
view
of the
world
Equilibrium
Oligopoly Games
y An Oligopoly Price‐Fixing Game
y A game like the prisoners’ dilemma is played in duopoly.
g p p y p y
y A duopoly is a market in which there are only two
producers that compete.
y Duopoly captures the essence of oligopoly.
D l h f li l
y The figure on the next slide describes the demand and
cost situation in a natural duopoly.
Oligopoly Games
y Part (a) shows each firm’s cost curves.
( )
y Part (b) shows the market demand curve.
Oligopoly Games
y This industry is a natural duopoly.
Thi i d t i t l d l
y Two firms can meet the market demand at the least cost.
Oligopoly Games
y How does this market work?
H d thi k t k?
y What is the price and quantity produced in equilibrium?
Oligopoly Games
y Suppose that the two firms enter into a collusive
agreement.
y A collusive agreement is an agreement between two
(or more) firms to restrict output, raise price, and
increase profits.
increase profits
y Such agreements are illegal in Canada and are
undertaken in secret.
y Firms in a collusive agreement operate a cartel.
Oligopoly Games
The possible strategies are
Comply
Cheat
Because each firm has two strategies, there are four
possible outcomes:
Both comply
Both cheat
Trick complies and Gear cheats
Gear complies and Trick cheats
Oligopoly Games
y The first possible outcome—both comply—earns the
Th fi t ibl t b th l th
maximum economic profit, which is the same as a
monopoly would earn.
Oligopoly Games
y To find that profit, we set marginal cost for the cartel equal
T fi d th t fit t i l t f th t l l
to marginal revenue for the cartel. This figure shows this
outcome.
Oligopoly Games
y The cartel’s marginal cost curve is the horizontal sum of
Th t l’ i l t i th h i t l f
the MC curves of the two firms and the marginal revenue
curve is like that of a monopoly.
Oligopoly Games
y The firm’s maximize economic profit by producing the
Th fi ’ i i i fit b d i th
quantity at which MCI = MR.
Oligopoly Games
y Each firm agrees to produce 2,000 units and each firm
E h fi t d it d h fi
shares the maximum economic profit.
Oligopoly Games
y When each firm produces 2,000 units, the price is
Wh h fi d it th i i
greater than the firm’s marginal cost, so if one firm
increased output, its profit would increase.
Oligopoly Games
y This figure shows what happens when one firm cheats
Thi fi h h t h h fi h t
and increases its output from 2,000 to 3,000 units.
Industry output increases to 5,000 and the price falls.
Oligopoly Games
y For the complier, ATC
F th li ATC now exceeds price.
d i
y For the cheat, price exceeds ATC.
Oligopoly Games
y For the complier incurs an economic loss.
For the complier incurs an economic loss
The cheat earns an increased economic profit.
Oligopoly Games
y Either firm could cheat, so this figure shows two of the
Ei h fi ld h hi fi h f h
possible outcomes.
y Next, let’s see the effects of both firms cheating.
Next, let s see the effects of both firms cheating.
Oligopoly Games
y This figure shows the outcome if both firms cheat and
Thi fi h th t if b th fi h t d
increase their output to 3,000 units.
Oligopoly Games
y Industry output is 6,000 units, the price falls, and both
I d t t t i 6 it th i f ll d b th
firms earn zero economic profit—the same as in perfect
competition.
Oligopoly Games
y You’ve now seen the four possible outcomes:
If both comply, they make $2 million a week each.
If both comply they make $2 million a week each
If both cheat, they earn zero economic profit.
If Trick complies and Gear cheats, Trick incurs a loss of $1
million and Gear makes a profit of $4.5 million.
If Gear complies and Trick cheats, Gear incurs a loss of $1
million and Trick makes a profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly
game.
Payoff
Matrix
Trick’s
view of
th
the
world
Trick’s
view of
th
the
world
Gear’s
view of
th
the
world
Gear’s
view of
th
the
world
Equilibrium
Oligopoly Games
y The Nash equilibrium is where both firms cheat.
y The quantity and price are those of a competitive
market and the firms earn normal profit
market, and the firms earn normal profit.
y Other Oligopoly Games
y Advertising and R&D games are also prisoners
Advertising and R&D games are also prisoners’
dilemmas.
y An R&D Game
y Procter & Gamble and Kimberley Clark play an R&D
game in the market for disposable diapers.
Oligopoly Games
l l
y Here is the payoff matrix for the Pampers versus Huggies game.
What is the outcome?
Wh t i th t ?
Oligopoly Games
y The Disappearing Invisible Hand
y In all the versions of the prisoners’ dilemma that we’ve
p
examined, the players end up worse off than they would
if they were able to cooperate.
y The pursuit of self‐interest
The pursuit of self interest does not promote the social
interest in these games.
Oligopoly Games
y A Game of Chicken
y In the prisoners’ dilemma game, the Nash equilibrium is
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.
the other player does
y Not all games have such an equilibrium.
y One that doesn’t is the game of “chicken.”
One that doesn t is the game of chicken.
Oligopoly Games
y A Game of Chicken
A G f Chi k
y Two dudes – Vinny and Hank – are trying to impress the
same girl…Debbie.
y She challenges them to play “chicken” – this requires
them to drive their cars toward each other at high speeds
with the loser being the player that swerves first.
i h h l b i h l h fi
y The possible outcomes to the game are:
y Vinny and Hank both “chicken out” and Debbie goes out with
someone else.
y One of them “chickens out” the winner getting the date.
O f h “ h k ” h h d
y Both are “brave” and dead…and Debbie is sad.
Oligopoly Games
Hank s strategies
Hank’s strategies
Chicken “Brave”
0
70
Chicken
Payoff 0 -10
Matrix Vinny’s
y
strategies
-10 -311
“Brave”
70 -311
Oligopoly Games
Hank s strategies
Hank’s strategies
Chicken
0
Chicken
Vinny’s 0
view of Vinny’s
y
the strategies
-10
world “Brave”
70
Oligopoly Games
Hank s strategies
Hank’s strategies
“Brave”
70
Chicken
Vinny’s -10
view of Vinny’s
y
the strategies
-311
world “Brave”
-311
Oligopoly Games
Hank s strategies
Hank’s strategies
Chicken “Brave”
0
70
Chicken
Hank’s 0 -10
view of Vinny’s
y
the strategies
world
Oligopoly Games
Hank s strategies
Hank’s strategies
Chicken “Brave”
Hank’s
view of Vinny’s
y
the strategies
-10 -311
world “Brave”
70 -311
Oligopoly Games
Hank s strategies
Hank’s strategies
Chicken “Brave”
0
70
Chicken
0 -10
Vinny’s
y
strategies
-10 -311
“Brave”
70 -311
Two Nash Equilibriums
Repeated Games and Sequential Games
y A Repeated Duopoly Game
y If a game is played repeatedly, it is possible for
d
duopolists
li t to successfully collude and earn a monopoly
t f ll ll d d l
profit.
y If the players take turns and move sequentially (rather
p y q y(
than simultaneously as in the prisoner’s dilemma), many
outcomes are possible.
y In a repeated prisoners’ dilemma duopoly game,
I d i ’ dil d l
additional punishment strategies enable the firms to
py p q
comply and achieve a cooperative equilibrium, in
which the firms make and share the monopoly profit.
Repeated Games and Sequential Games
y 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.
y 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
b l h h lb
forever thereafter if the other player cheats.
Repeated Games and Sequential Games
y Price wars might result from a tit‐for‐tat strategy where
there is an additional complication—uncertainty about
changes in demand.
y A fall in demand might lower the price and bring forth a
round of tit for tat punishment
round of tit‐for‐tat punishment.
Repeated Games and Sequential Games
y A Sequential Entry Game in a Contestable Market
y In a contestable market—a market in which firms can
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.
i l
Repeated Games and Sequential Games
y This figure shows the game tree for a sequential entry
game in a contestable market.
Repeated Games and Sequential Games
y In the first stage, Agile decides whether to set the
I h fi A il d id h h h
monopoly price or the competitive price.
Repeated Games and Sequential Games
y In the second stage, Wanabe decides whether to enter or
stay out.
Repeated Games and Sequential Games
y In the equilibrium of this entry game, Agile sets a
competitive price and earns a normal profit (50) to keep
Wanabe out.
Repeated Games and Sequential Games
y In the equilibrium of this entry game, Agile sets a
competitive price and earns a normal profit to keep
Wanabe out.
out
y A less costly strategy is limit pricing, which sets the
price at the highest level that is consistent with keeping
the potential entrant out.