Understanding Oligopoly

Oligopoly

• Possible outcomes include cooperation to maximize joint profits or competition driven by self-interest.
• Cooperation can be hard to maintain because firms face incentives to deviate for individual gain.
• Antitrust laws promote competition by preventing anticompetitive behavior.

Measuring Market Concentration

• Concentration ratio represents the percentage of total output supplied by the largest firms in a market.
• A high ratio indicates less competition.
• Focus is on market structures with high concentration ratios.
• Examples of industries with high concentration ratios: video game consoles and tennis balls, both at 100%.
• Other industries include credit cards (99%), batteries and soft drinks (94%), web search engines and breakfast cereal (92%), cigarettes (89%), greeting cards (88%), beer (85%), cell phone service (82%), and autos (79%).

Defining Oligopoly

• Market structure in which only a few sellers offer similar or identical products.
• Strategic behavior occurs because a firm's decisions about price or quantity can affect other firms, causing them to react.
• Game theory studies how people behave in strategic situations.

Cell Phone Duopoly in Smalltown Example

• Smalltown has 140 residents.
• The "good" is cell phone service with unlimited minutes and a free phone.
• The demand schedule exists within Smalltown.
• There are two firms: AT&T and Verizon, which constitute a duopoly.
• Each firm has fixed costs of $0 and marginal costs of $10.
• Competitive outcome: Price equals marginal cost at $10, quantity is 120, and profit is $0.
• Monopoly outcome: Price is $40, quantity is 60, and profit is $1,800.

Collusion and Cartels

• Duopolies may lead to collusion.
• Collusion involves firms agreeing on quantities to produce or prices to charge.
• AT&T and Verizon could agree to produce half of the monopoly output.
• If they split the monopoly output, each firm's quantity would be 30, price would be $40, and profits would be $900.
• A cartel is a group of firms acting in unison.

Collusion vs. Self-Interest

• In a collusion, each firm agrees to produce a quantity of 30 and each firm earns a profit of $900.
• If AT&T reneges and produces a quantity of 40, the market quantity becomes 70, the price becomes $35, and AT&T's profit increases to $1000.
• If both firms renege and produce a quantity of 40, the market quantity becomes 80, the price becomes $30, and each firm's profit decreases to $800.
• Firms are better off sticking to the cartel agreement; however, each firm has an incentive to renege on the agreement, making it difficult for oligopolies to form cartels and honor agreements.

Oligopoly Equilibrium

• With both firms producing a quantity of 40, the market quantity is 80, the price is $30, and each firm's profit is $800.
• If AT&T increases output to a quantity of 50, the market quantity rises to 90, the price decreases to $25, and AT&T's profit falls to $750.
• AT&T's profits are higher at a quantity of 40 than at a quantity of 50, and the same holds true for Verizon.
• Nash equilibrium is achieved when economic actors interacting with one another choose their best strategy, given the strategies that all the other actors have chosen.
• In a duopoly, each firm produces a quantity of 40, with each firm's best move being to produce a quantity of 40 given that the other firm also produces the same amount.
• In an oligopoly, firms individually maximize profit and produce a greater quantity than a monopoly, but less than a competitive market.
• Consequently, the price is less than a monopoly price but greater than the competitive price (equal to marginal cost).

Output and Price Effects

• Increasing output involves two effects on a firm's profits.
• Output effect: If price is greater than marginal cost, increasing output raises profits.
• Price effect: Raising output increases market quantity, which reduces price and reduces profit on all units sold.

Size of the Oligopoly

• As the number of sellers in an oligopoly increases: the price effect becomes smaller; the oligopoly looks more and more like a competitive market; price approaches marginal cost; and the market quantity approaches the socially efficient quantity.

Nash Equilibrium

• In strategic settings, each party chooses what to do, realizing that others are solving the same problem, which helps understand behaviors like military conflicts and price settings.

The Prisoners' Dilemma

• The prisoners' dilemma involves a game between two captured prisoners.
• It shows why cooperation is difficult to maintain even when it is mutually beneficial.
• Dominant strategy is a strategy that is best regardless of the strategies chosen by other players.

Prisoners' Dilemma Example: Bonnie and Clyde

• Bonnie and Clyde are caught and questioned separately.
• If both confess, they each get 8 years in prison. If neither confesses, they each get 1 year.
• If one confesses and implicates the other, the confessor goes free, and the other gets 20 years.
• Confessing is the dominant strategy for both.
• The Nash equilibrium is for both to confess, resulting in 8 years each.
• Both would have been better off if they had remained silent.

Oligopolies as a Prisoners' Dilemma

• Oligopolies form a cartel to reach the monopoly outcome, but become players in a prisoners' dilemma.
• AT&T and Verizon are duopolists in Smalltown.
• The cartel outcome maximizes profits, with each firm agreeing to serve a quantity of 30 customers.

AT&T & Verizon in the Prisoners' Dilemma

• Each firm's dominant strategy is to renege on the agreement and produce a quantity of 40. Then a firm's profit would equal $800

The Fare Wars Game

• The players are Delta Airlines and United Airlines, competing in the fare wars games.
• The choice is to cut fares by 50% or to leave fares alone
• If both airlines cut fares, each airline's profit is $400 million.
• If neither airline cuts fares, each airline's profit is $600 million.
• If only one airline cuts fares, its profit is $800 million, and the other airline's profits is $200 million.
• The nash equilibrium is that both firms will cut fares

Other Examples of the Prisoners' Dilemma

• In ad wars, two firms spend millions on TV ads to steal business from each other, canceling out the effects of each other's ads.
• The Organization of Petroleum Exporting Countries (OPEC) member countries try to act like a cartel. They agree to limit oil production to boost prices and profits, but agreements sometimes break down when individual countries renege.
• In an arms race between military superpowers, each country would be better off if both disarm but each has a dominant strategy of arming.
• All would be better off if everyone conserved common resources. However, each person's dominant strategy is overusing the resources.

Welfare of Society

• Noncooperative oligopoly equilibrium can be a bad thing for oligopolists, bad for society, and good for society.
• It may be bad in that, noncooperative oligopoly equilibrium prevents them from achieving monopoly profits.
• It may be bad in that, situations may arise like an arms race game or a common resource game.
• It may be good in that, Quantity and price may be closer to optimal levels.

Negative Campaign Ads Example

• If R runs a negative ad attacking D, 3000 fewer people will vote for D, with 1000 voting for R and the rest abstaining.
• If D runs a negative ad attacking R, R loses 3000 votes, D gains 1000, and 2000 abstain.
• The question is whether R and D will stick to an agreement to refrain from running attack ads.
• Each candidate's dominant strategy is to run attack ads. If both candidates are running the Nash equilibrium would be 100 votes for each

Why People Sometimes Cooperate

• Repeated games allow for cooperation.
• Two strategies may lead to cooperation.
• First strategy is that if your rival reneges in one round, you renege in all subsequent rounds.
• Second strategy is a "Tit-for-tat", so whatever your rival does in one round, you do in the following round.

Public Policy Toward Oligopolies

• Governments can improve market outcomes.
• Policymakers try to induce firms in an oligopoly to compete rather than cooperate.
• They move the allocation of resources closer to the social optimum.
• Antitrust laws include the Sherman Antitrust Act of 1890, which elevated agreements among oligopolists from unenforceable contracts to criminal conspiracy.
• The Clayton Act of 1914 further strengthened antitrust laws.
• These laws are used to prevent mergers and oligopolists from colluding.

Controversies Over Antitrust Policy

• Most people agree that price-fixing agreements among competitors should be illegal.
• Some economists are concerned that policymakers go too far using antitrust laws to stifle business practices that are not necessarily harmful, and may have legitimate objectives.

Resale Price Maintenance ("Fair Trade")

• Manufacturers impose lower limits on the prices retailers can charge.
• This is often opposed because it appears to reduce competition at the retail level.
• However, any market power the manufacturer has is at the wholesale level, and there are no gains from restricting competition at the retail level.
• A legitimate objective is preventing discount retailers from free-riding on the services provided by full-service retailers.

Predatory Pricing

• A firm cuts prices to prevent entry or drive a competitor out of the market.
• The firm does so so that it can charge monopoly prices later
• Predatory pricing can be illegal under antitrust laws. However, it can be difficult to decipher when a price cut is predatory and when it is competitive & beneficial to consumers.
• Many economists doubt that predatory pricing is a rational strategy because it involves selling at a loss, which is costly for the firm, and it can backfire.

Tying

• A manufacturer bundles two products together and sells them for one price.
• Its criticized as, tying gives firms more market power by connecting weak products to strong ones.
• Opposers of this criticism are, buyers are not willing to pay more for two goods together than for the goods separately.
• Firms may use tying for price discrimination, which sometimes increases economic efficiency.

Summary Points on Oligopolies

• Oligopolists can maximize profits if they form a cartel and act like a monopolist.
• Self-interest leads each oligopolist to a higher quantity and lower price than under the monopoly outcome.
• The larger the number of firms, the closer will be the quantity and price to the levels that would prevail under competition.
• The prisoners' dilemma shows that self-interest can prevent cooperation, even when it is in mutual interest.
• The logic of the prisoners' dilemma applies in many situations.
• Policymakers use antitrust laws to prevent anticompetitive behavior such as price-fixing.
• The application of these laws is sometimes controversial.