Oligopoly
CHAPTER
13B
Oligopoly IRL
In some markets there are only two firms. Computer chipsare an example.
The chips that drive most PCs are made by Intel andAdvanced Micro Devices.
How does competition between just two chip makers work?
Do they operate in the social interest, like the firms inperfect competition?
Or do they restrict output to increase profit, like amonopoly?
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
What is Oligopoly?
Barriers to Entry
Either natural or legalbarriers to entry cancreate oligopoly.
Figure 13.9 shows twooligopoly situations.
In part (a), there is anatural duopoly—amarket with two firms.
A duopoly with collusionacts like a monopoly.
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 tocooperate.
Interdependence: With a small number of firms, eachfirm’s profit depends on every firm’s actions. Each firmengages in strategic behavior based on the others.
Cartel: A cartel and is an illegal group of firms actingtogether to limit output, raise price, and increase profit.
Firms in oligopoly face the temptation to form a cartel, butaside from being illegal, cartels often break down.
What is Oligopoly?
Examples of Oligopoly
Figure 13.10 shows someexamples of oligopoly.
Four largest firms
Next four largest firms
Next 12 largest firms
An HHI that exceeds 1,000is usually an oligopoly.
An HHI below 1,000 isusually monopolisticcompetition.
Oligopoly Games
Game theory is a tool for studying strategic behavior,which is behavior that takes into account the expectedbehavior of others and the mutual recognition ofinterdependence.
The Prisoners’ Dilemma
The prisoners’ dilemma game illustrates the concept ofGame Theory
Oligopoly Games
Rules
In the prisoners’ dilemma game, two prisoners (Art andBob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicatewith each other.
Oligopoly Games
Each is told that both are suspected of committing a moreserious crime.
If one of them confesses, he will get a 1-year sentence forcooperating while his accomplice get a 10-year sentence forboth crimes.
If both confess to the more serious crime, each receives 3years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for theminor crime only.
Oligopoly Games
Strategies
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.
With two players and two actions for each player, there arefour possible outcomes:
1. Both confess.
2. Both deny.
3. Art confesses and Bob denies.
4. Bob confesses and Art denies.
Oligopoly Games
Payoffs
Each prisoner can work out what happens to him—can workout his payoff—in each of the four possible outcomes.
We can tabulate these outcomes in a payoff matrix.
A payoff matrix is a table that shows the payoffs for everypossible action by each player for every possible action bythe other player.
The next slide shows the payoff matrix for this prisoners’dilemma game.
Oligopoly Games
Oligopoly Games
Outcome
If a player makes a rational choice in pursuit of his ownbest interest, he chooses the action that is best for him,given any action taken by the other player.
If both players are rational and choose their actions in thisway, the outcome is an equilibrium called Nashequilibrium—first proposed by John Nash.
The following slides show how to find the Nashequilibrium.
Bob’sviewof theworld
Bob’sviewof theworld
Art’sviewof theworld
Art’sviewof theworld
Equilibrium
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 twoproducers that compete.
Duopoly captures the essence of oligopoly.
Figure 13.13 on the next slide describes the demand andcost situation in a natural duopoly.
Oligopoly Games
Collusion
Suppose that the two firms enter into a collusiveagreement.
A collusive agreement is an agreement between two (ormore) firms to restrict output, raise the price, and increaseprofits.
Such agreements are illegal in the United States and areundertaken in secret.
Firms in a collusive agreement operate a cartel.
Oligopoly Games
The strategies that firms in a cartel can pursue are to
Comply
Cheat
Because each firm has two strategies, there are fourpossible combinations of actions for the firms:
1. Both comply.
2. Both cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.
PayoffMatrix
Oligopoly Games
Possible Outcomes
If both comply, each firm makes $2 million a week.
If both cheat, each firm makes zero economic profit.
If Trick complies and Gear cheats, Trick incurs aneconomic loss of $1 million and Gear makes aneconomic profit of $4.5 million.
If Gear complies and Trick cheats, Gear incurs aneconomic loss of $1 million and Trick makes aneconomic profit of $4.5 million.
The next slide shows the payoff matrix for the duopolygame.
Trick’sviewof theworld
Trick’sviewof theworld
Gear’sviewof theworld
Gear’sviewof theworld
Equilibrium
Oligopoly Games
Dominant Strategy
Nash Equilibrium
When both firms have a dominant strategy, this is theNash Equilibrium
.
Oligopoly Games
The Disappearing Invisible Hand
In all the versions of the prisoners’ dilemma that we’veexamined, the players end up worse off than they would ifthey were able to cooperate.
The pursuit of self-interest does not promote thesocial interest in these games.
Repeated Games and Sequential Games
One possible punishment strategy is a tit-for-tat strategy.
A tit-for-tat strategy is one in which one player cooperatesthis period if the other player cooperated in the previousperiod but cheats in the current period if the other playercheated in the previous period