ECO 103: PRINCIPLES
OF MICROECONOMICS
CHAPTER 17: OLIGOPOLY
DR. SAHAR ARSHAD MAHMOOD
ASSISTANT PROFESSOR
SCHOOL OF ECONOMICS AND SOCIAL
SCIENCES
IBA , K ARACHI
WHAT YOU WILL LEARN
• what outcomes are possible when a market is an oligopoly.
• the prisoners’ dilemma and how it applies to oligopoly and other
issues.
• how the antitrust laws try to foster competition in oligopolistic
markets.
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OLIGOPOLY
• Oligopoly: a market structure in which only a few sellers offer
similar or identical products
• Strategic behavior in oligopoly:
• A firm’s decisions about P or Q can affect other firms and cause
them to react
• The firm will consider these reactions when making decisions
• Game theory: the study of how people behave in strategic situations
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MARKETS WITH ONLY A FEW
SELLERS
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MARKETS WITH ONLY A FEW
SELLERS
Both firms would be better off if both stick to the cartel agreement.
• But each firm has incentive to renege on the agreement.
• Lesson: It is difficult for oligopoly firms to form cartels and honor
their agreements
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MARKETS WITH ONLY A FEW
SELLERS
Suppose they form a cartel
Profit is maximized at 60 gallons > Price $60 so profit is $3600. If they
divide 30 gallons each, their individual profit is $1800
Suppose Jack Deviates
Produces 40 gallons > increase in quantity supplied to 70 gallons >
price rises to $50
Total profit decreases to $3500 with Jack getting 40 x 50 = $2000, Jill
gets 30 * 50 = $1500
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MARKETS WITH ONLY A FEW
SELLERS
Nash equilibrium
• Economic actors interacting with one another, each choose their best
strategy
• Given the strategies that all the other actors have chosen
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MARKETS WITH ONLY A FEW
SELLERS
When firms in an oligopoly individually choose production to
maximize profit
• Produce Q
• Greater than monopoly Q
• Less than competitive Q
• The price is
• Less than the monopoly P
• Greater than the competitive P = MC
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MARKETS WITH ONLY A FEW
SELLERS
Increasing output has two effects on a firm’s profits:
• Output effect:
If P > MC, increasing output raises profits
• Price effect:
Raising output increases market quantity, which reduces price
and reduces profit on all units sold
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MARKETS WITH ONLY A FEW
SELLERS
As the number of sellers in an oligopoly 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
Another benefit of international trade
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JOHN NASH
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THE ECONOMICS OF COOPERATION
The prisoners’ dilemma
• Particular “game” between two captured prisoners
• Illustrates why cooperation is difficult to maintain even when it is
mutually beneficial
Dominant strategy
• Strategy that is best for a player in a game
• Regardless of the strategies chosen by the other players
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THE PRISONERS’ DILEMMA
The 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.
• 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.
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THE PRISONERS’ DILEMMA
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THE PRISONERS’ DILEMMA
Outcome: 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.
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OLIGOPOLIES AS A PRISONERS’
DILEMMA
When oligopolies form a cartel
• In hopes of reaching the monopoly outcome, they become players in
a prisoners’ dilemma.
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OLIGOPOLIES AS A PRISONERS’
DILEMMA
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CLASS EXAMPLE
The players: Delta Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone
• If both airlines cut fares, each airline’s profit = $400 million
• If neither airline cuts fares, each airline’s profit = $600 million
• If only one airline cuts its fares, its profit = $800 million; the other
airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium
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CLASS EXAMPLE
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OTHER EXAMPLES OF THE
PRISONERS’ DILEMMA
Arms race between military superpowers
• Each country would be better off if both disarm, but each has a
dominant strategy of arming.
Common resources
• All would be better off if everyone conserved common resources, but
each person’s dominant strategy is overusing the resources.
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THE PRISONERS’ DILEMMA AND THE
WELFARE OF SOCIETY
Noncooperative oligopoly equilibrium
• May be bad for oligopolists
• Prevents them from achieving monopoly profits
• May be bad for society
• Examples: Arms race game, Common resource game
• May be good for society
• Quantity and price – closer to optimal level
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WHY PEOPLE SOMETIMES
COOPERATE
• When the game is repeated many times, cooperation may be possible
Two strategies 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.
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PUBLIC POLICY TOWARD
OLIGOPOLIES
Governments
• Can sometimes improve market outcomes
Policymakers
• Try to induce firms in an oligopoly to compete rather than cooperate
• Move the allocation of resources closer to the social optimum
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PUBLIC POLICY TOWARD
OLIGOPOLIES
Antitrust laws
• The Sherman Antitrust Act, 1890
• Elevated agreements among oligopolists from an unenforceable
contract to a criminal conspiracy
• The Clayton Act, 1914
• Further strengthened the antitrust laws
• Used to prevent mergers
• Used to prevent oligopolists from colluding
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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 when
using antitrust laws to stifle business practices that are not
necessarily harmful, and may have legitimate objectives.
We consider three such practices…
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CONTROVERSIES OVER ANTITRUST
POLICY-RESALE PRICE
MAINTENANCE
A manufacturer imposes lower limits on the prices retailers can
charge
• Often opposed because it appears to reduce competition at the retail
level
• Yet, any market power the manufacturer has is at the wholesale level
• No gains from restricting competition at the retail level
• Legitimate objective: preventing discount retailers from free-riding
on the services provided by full-service retailers
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CONTROVERSIES OVER ANTITRUST
POLICY-PREDATORY PRICING
A firm cuts prices to prevent entry or drive a competitor out of the
market
• So that it can charge monopoly prices later
Illegal under antitrust laws
• Difficult: when a price cut is predatory and when it is competitive &
beneficial to consumers?
Many economists doubt that predatory pricing is a rational
strategy:
• It involves selling at a loss (costly for the firm)
• It can backfire
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CONTROVERSIES OVER ANTITRUST
POLICY-TYING
A manufacturer bundles two products together and sells them for
one price
Critics
• Tying gives firms more market power by connecting weak products
to strong ones
Others: tying cannot change market power
• Buyers are not willing to pay more for two goods together than for
the goods separately
Firms may use tying for price discrimination
• Sometimes increases economic efficiency
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SUMMARY
• Oligopolists can maximize profits if they form a cartel and act like a
monopolist.
• Yet, 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 people from
cooperating, even when cooperation is in their mutual interest. The logic
of the prisoners’ dilemma applies in many situations.
• Policymakers use the antitrust laws to prevent oligopolies from engaging
in anticompetitive behavior such as price-fixing. But the application of
these laws is sometimes controversial.
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THANK YOU
Dr. Sahar Arshad Mahmood
samahmood@iba.edu.pk
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