Market Structures:Oligopoly

Imperfect Competition
The spectrum of competition:
Perfect Comp. ------------- Monopoly
Monop. Comp.-- Oligopoly
Assumptions underlying oligopoly
Few Sellers
Interdependence each seller must be aware that their actions
will provoke actions by rival firms
Differentiated versus non-differentiated products (cars
or oil
Differentiated products leads to non-price competition through
activities such as advertising, style changes, quality

Oligopoly
Price competition vs. non-price competition
Interdependence in pricing means that price
wars may develop and reduce profits
Product differentiation avoids price competition
Advertising is used to increase market share
Informative
Persuasive (self-cancelling)
Modeling oligopoly is difficult because
interdependence can lead to different
behaviors

Duopoly Example
Assumptions
Two producers: Jack and Jill
Zero marginal costs (for simplicity revenue=profits
Outcomes
Competition: Maximum production, zero
price(remember there are no costs) , and no profits
Monopoly: Reduced Output, highest price, positive
profits
Oligopoly: Let the games begin!

Duopoly (cont.)
Collusion form a cartel and act like a monopolist
highest economic profit, in most cases in the US, this is
illegal.
Pursuing own self-interest actions depend on what
you think the other will do: not react or react
The incentive to cheat:
If you produce more (or charge a lower price and sell more),
assuming MR>MC, your profits will rise, that is, if the other firm
does not do the same thing.
The incentive to cooperate
If you produce more (or charge a lower price and sell more), the
other firm will do the same, and your profits will fall
Oligopolists Supply Decision
Raising (or lowering) output produces two effects:
Output effect: because P>MC, the additional output will raise
profits
Price effect: additional output will lower the price and reduce
profits on all those units that would have been sold at the old price
Rules for action:
Raise output if OE>PE
Dont raise output if OE<PE
As the number of firms increases, the PE falls, so output is
increased, many firms produce the competitive or efficient
solution.
Freer trade has resulted in increasing number of firms in the
automobile market, the camera market, and the electronics
markets.
Cartels
Explicit agreements among firms to fix output and prices
Examples are OPEC, Electrical Conspiracy (Econ USA),
Shipping Cartel
Incentive to cooperate earn monopoly profits
Incentive to cheat increase individual profits if cheating
is not detected or punished.
Sources of instability in cartels:
Number of Sellers
Cost differences
Potential competition
Recessions
Cheating
Game Theory
Game theory is an attempt to model and
understand behavior given the presence of
interdependence
Games have the following characteristics:
Rules
Strategies
Payoffs
Outcome

The Prisoners Dilemma
Two criminals, Bill and Paul, are caught red-
handed stealing a car, and will receive 2 year
sentences; however, they become suspects in a
previous bank robbery. The DAs job is to see if
he can solve the bank robbery.
Rules:
Each player is held in separate rooms and cannot
communicate.
Each is told that he is suspected of the larger crime and
if both confess to the bank robbery, they get 5 year sentences
if one rats on the other and the other does not confess to the bank
robbery, he gets off, and the other gets a 10 year sentence
Strategies: Each player has two possible actions
Confess to the bank robbery
Do not confess to the bank robbery
Payoffs: Two players with two outcomes four
possible outcomes with the following payoffs
Both confess each get 5 year sentences
Both deny each get 2 year sentence
Bill confesses and Paul denies Bill gets off and Paul gets 10
years
Paul confesses and Bill denies Paul gets off and Bill gets 10
years.

Nash Equilibrium the player does what is best
for himself after he takes into account the other
players actions.
Dominant solution the outcome that is better
than all the rest.
Dominant solution for Paul is to confess and the
same is true for Bill.
The best solution for both is to cooperate, but the
dilemma is that they cant so they end up with a
second best solution.

Kinked Demand Curve Model
Show a situation where the best situation for players is to
maintain current prices and that prices remain stable in
spite of firms with different cost structures.
Asymmetry in price movements:
If firm raises price, no one follows, therefore quantity demanded is
elastic
If firm lowers price, all follow suit so the quantity demanded is
quite inelastic
Marginal revenue curve is discontinuous and allows for
various marginal cost curves.
Kinked Demand Curve
If the firm raises its
price above P, it faces
an elastic demand curve,
payoff low
If the firm lowers its
price below P, it faces
an inelastic demand
curve, payoff low
Kinked Demand Curve
Different firms can have
different MCs. As long as
they fall with in the
discontinuous MR, P will
remain stable.
Output Effect < Price
Effect for price
movements with the
discontinuous MR curve.
If MC increases enough,
all firms raise their prices
and the kink vanishes.


Dominant Firm Price Leadership
A large dominant firm with lower costs that it
competitors becomes the price maker.
A competitive fringe with many firms that are
price takers or followers.
The dominant firms demand curve is the total
market demand minus the supply of the
competitive fringe.
The dominant firm sets price and its quantity
based upon residual demand and this determines
the price for competitive firms and their supply.
(Examples OPEC).
Dominant Firm
The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.
Residual
Demand
Dominant Firms
Demand Curve
Dominant Firm
As long as the dominant firm has lower costs, it can act like
a monopolist over the residual demand.

Cartels and Government
Monopoly power is often granted by government
via regulation. Example Ma Bell (Econ USA).
Other examples are shipping and the airline
industry (pre-deregulation).
Justifications for government regulation include
infant industry and natural monopoly.
Criticisms include decreased competition,
increased costs due to x-inefficiency and lobbying,
and regulation outlives its usefulness.