Economic Analysis Economic Analysis for Businessfor Business

Session XIII: OligopolySession XIII: OligopolyInstructorInstructorSandeep BasnyatSandeep Basnyat98418922819841892281Sandeep_basnyat@yahooSandeep_basnyat@yahoo.com.com

Introduction: Introduction: Between Monopoly and CompetitionBetween Monopoly and Competition

Two extremes structures of Markets◦ Competitive markets: many firms, identical

products◦ Monopoly: one firm

In between these extremes: Imperfect competition

◦ Oligopoly: only a few sellers offer similar or identical products.

◦ Monopolistic competition: many firms sell similar but not identical products.

Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

MARKETS WITH ONLY A FEW MARKETS WITH ONLY A FEW SELLERSSELLERSBecause of the few sellers, the key

feature of oligopoly is the tension between cooperation and self-interest

Characteristics of an Oligopoly Market◦ Few sellers offering similar or identical

products◦ Interdependent firms◦ Best off cooperating and acting like a

monopolist by producing a small quantity of output and charging a price above marginal cost

A Duopoly: An ExampleA Duopoly: An ExampleA duopoly is an oligopoly with only two

members. It is the simplest type of oligopoly.

Book Example: ◦Jack and Jill own wells that produce water◦Pump as much water as they want without

cost. ◦That is, the marginal cost (MC) = 0◦Decide how many gallons of water to pump,

bring the water to town, and sell it for whatever price the market will bear.

What if in Perfect Competition? P = MC = $0 Q = 120 gallons The price of water would reflect

the cost of producing it. Efficient quantity of water would

be produced and consumed.What if in Monopoly? Total profit is maximized at a

quantity of 60 gallons and a price of $60 a gallon.

We know, P > MC Result would be inefficient, for the

quantity of water produced and consumed would fall (120-60 = 60)

The Demand Schedule for WaterThe Demand Schedule for Water

What outcome then could be expected from duopolists?

DuopolyDuopoly• One possible duopoly outcome: Collusion

• Collusion: an agreement among firms in a market about quantities to produce or prices to charge

• Cartel: a group of firms acting in unison, e.g., Jack and Jill in the outcome with collusion

• Once a cartel is formed, the market is in effect served by a monopoly.

• Thus, the duopolists may agree on a monopoly outcome: P = $60 and Q = 60 gallons

• P > MC and the Result would be inefficient, for the quantity of water produced and consumed would fall (120-60 = 60)

DuopolDuopolyyIf Jack and Jill agreed to split the market equally, each would produce 30 gallons, the price would be $60 a gallon, and each would get a profit of $1,800.

Big question: Does this happen always?

Non-collusive (Cooperative) Non-collusive (Cooperative) OligopolyOligopolyIf Jack and Jill decide separately how

much water to produce, tension arises among the duopolists.

In the absence of a binding agreement, however, the monopoly outcome is unlikely.

A non-collusive oligopoly: a market of few suppliers who do not agree on price or quantity

Competition, Monopolies and Competition, Monopolies and CartelsCartels

Jack may think:“Even if Jill produce 30 gallons, I

produce 40 gallons, and a total of 70 gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000.

Even though total profit in the market would fall, my profit would be higher, because I would have a

larger share of the market.” Jill may also think the same !Each bring 40 gallons to town. Total sales would be 80 gallons, and

the price would fall to $40.

If the Duopolists individually pursue their own self-interest then:

•Duopoly Q > Monopoly Q•Duopoly P < Monopoly P•Duopoly Total profit < Monopoly Total profit.

THE EQUILIBRIUM FOR AN THE EQUILIBRIUM FOR AN OLIGOPOLYOLIGOPOLY

What would Jack decide next? Producing additional gallon or reducing production of gallon?

“Right now, my profit is $1,600. Suppose I increase my production to 50 gallons., a total of 90 gallons of water would be sold, and the price would be $30 a gallon.

Then my profit would be only $1,500. Rather than increasing production, and

driving down the price, I am better off keeping my production at 40 gallons.”

• If Jill also thinks the same, both will produce 40 gallons.• Total production will be altogether 80 gallons and the price would be $40 a gallon• Both would retain $1600 as a revenue

Non collusive (cooperative) OligopolyNon collusive (cooperative) Oligopoly

The noncooperative oligopoly equilibrium ◦bad for oligopoly firms:

prevents them from achieving monopoly profits

◦good for society: Q gets closer to the socially efficient output P gets closer to MC

Nash EquilibriumNash EquilibriumThe outcome in which Jack and Jill each produce 40

gallons is called a Nash equilibrium (named after economic theorist John Nash).

Nash equilibrium: A situation is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen.

In this case, given that Jill is producing 40 gallons, the best strategy for Jack is to produce 40 gallons. Similarly, given that Jack is producing 40 gallons, the best strategy for Jill is to produce 40 gallons.

Once they reach this Nash equilibrium, neither Jack nor Jill has an incentive to make a different decision.

Price Fixing: Good or Bad?Price Fixing: Good or Bad?Resale price maintenance

(Maximum retail price)Predatory PricingTying or Bundling

Public Policy: Promote competition

The Size of the OligopolyThe Size of the OligopolyAs the number of firms in the market

increases,◦the price effect becomes smaller◦the oligopoly looks more and more like a

competitive market◦P approaches MC◦the market quantity approaches the

socially efficient quantity

Game TheoryGame TheoryGame theory: the study of how

people behave in strategic situationsDominant strategy: a strategy that

is best for a player in a game regardless of the strategies chosen by the other players

Prisoners’ dilemma: a “game” between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial

Prisoners’ Dilemma ExamplePrisoners’ Dilemma ExampleThe police have caught Bonnie and Clyde,

two suspected bank robbers, but only have enough evidence to imprison each for 1 year.

The police question each in separate rooms, offer each the following deal:◦ If you confess and implicate your partner,

you go free and your partner gets 20 yrs.◦ If you do not confess but your partner implicates

you, you get 20 years in prison.◦ If you both confess, each gets 8 years in prison.

• What would be Bonnie decide? Confess? Or Remain silent?

• What would be Clyde decide? Confess? Or Remain silent?

Prisoners’ Dilemma ExamplePrisoners’ Dilemma Example

Confess Remain silent

Confess

Remain silent

Bonnie’s decision

Clyde’s decision

Bonnie gets

8 yearsClyde gets 8 years

Bonnie gets

20 years

Bonnie gets

1 year

Bonnie goes free

Clyde goes free

Clyde gets 1 year

Clyde gets 20 years

Confessing is the dominant strategy for both players.

Nash equilibrium:

both confess

Prisoners’ Dilemma Prisoners’ Dilemma ExampleExampleOutcome: Bonnie and Clyde both confess,

each gets 8 years in prison. Both would have been better off if both

remained silent.But even if Bonnie and Clyde had agreed

before being caught to remain silent, the logic of self-interest takes over and leads them to confess.

Note: When oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners’ dilemma.

Other Examples of the Prisoners’ Other Examples of the Prisoners’ DilemmaDilemma

Organization of Petroleum Exporting Countries

Arms race between military superpowers

Common resources

Ad wars..etc.

Is cooperation possible?Is cooperation possible?When the game is repeated many

times, cooperation may be possible.Strategies which may lead to

cooperation:◦If your rival reneges in one round,

you renege in all subsequent rounds.◦“Tit-for-tat”

Whatever your rival does in one round (whether renege or cooperate), you do in the following round.

Thank youThank you