Unit 10: Oligopoly

Instructor: Nguyen Tai Vuong

School of Economics and Management
Hanoi University of Science and Technology

Objectives
In this unit, look for the answers to these questions:
• What outcomes are possible under oligopoly?
• Why is it difficult for oligopoly firms to cooperate?
• How are antitrust laws used to foster competition?

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Measuring Market Concentration

• Concentration ratio: the percentage of the market’s total output

supplied by largest firms.

𝐶 = ×100 = ∑ 𝑠

• The higher the concentration ratio, the less competition.

• This unit focuses on oligopoly, a market structure with high

concentration ratios.
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Concentration Ratios in Selected U.S. Industries

Industry CR4
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%
Soft drinks 93%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
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 5

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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EXAMPLE: Cell Phone Duopoly in Smalltown
P Q  Smalltown has 140 residents
$0 140
 The “good”:
5 130
cell phone service with unlimited anytime
10 120 minutes and free phone
15 110
20 100
 Smalltown’s demand schedule
25 90  Two firms: T-Mobile, Verizon
30 80 (duopoly: an oligopoly with two firms)
35 70  Each firm’s costs: FC = $0, MC = $10
40 60
45 50
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EXAMPLE: Cell Phone Duopoly in Smalltown

P Q Revenue Cost Profit Competitive
outcome:
$0 140 $0 $1,400 –1,400
P = MC = $10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350 Monopoly
30 80 2,400 800 1,600 outcome:
35 70 2,450 700 1,750 P = $40
40 60 2,400 600 1,800 Q = 60
45 50 2,250 500 1,750 Profit = $1,800
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4
EXAMPLE: Cell Phone Duopoly in Smalltown

• One possible duopoly outcome: collusion

• Collusion: an agreement among firms in a market about
quantities to produce or prices to charge
• T-Mobile and Verizon could agree to each produce half of the
monopoly output:
• For each firm: Q = 30, P = $40, profits = $900
• Cartel: a group of firms acting in unison,
e.g., T-Mobile and Verizon in the outcome with collusion

ACTIVE LEARNING 1
Collusion vs. self-interest
P Q Duopoly outcome with collusion:
$0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = $900.
10 120 If T-Mobile reneges on the agreement and
15 110 produces Q = 40, what happens to the market
20 100 price? T-Mobile’s profits?
25 90 Is it in T-Mobile’s interest to renege on the
30 80 agreement?
35 70
If both firms renege and produce Q = 40,
40 60 determine each firm’s profits.
45 50
10 10

5
Answers

P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50 11

Collusion vs. Self-Interest

• 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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6
ACTIVE LEARNING 2 The oligopoly equilibrium
P Q
$0 140 If each firm produces Q = 40,
5 130 market quantity = 80
10 120
P = $30
each firm’s profit = $800
15 110
20 100 Is it in T-Mobile’s interest to increase its output
25 90 further, to Q = 50?
30 80 Is it in Verizon’s interest to increase its output to
35 70 Q = 50?
40 60
45 50
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Answers

P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
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7
The Equilibrium for an Oligopoly
• Nash equilibrium: a situation in which
economic participants interacting with one another each choose
their best strategy given the strategies that all the others have
chosen

• Our duopoly example has a Nash equilibrium

in which each firm produces Q = 40.
• Given that Verizon produces Q = 40,
T-Mobile’s best move is to produce Q = 40.
• Given that T-Mobile produces Q = 40,
Verizon’s best move is to produce Q = 40.

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A Comparison of Market Outcomes

When firms in an oligopoly individually choose production to

maximize profit,
• oligopoly Q is greater than monopoly Q but smaller than
competitive Q.
• oligopoly P is greater than competitive P but less than
monopoly P.

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8
 The Output & Price Effects
• Increasing output has two effects on a firm’s profits:
• Output effect:
If P > MC, selling more output raises profits.
• Price effect:
Raising production increases market quantity, which reduces
market price and reduces profit on all units sold.
• If output effect > price effect,
the firm increases production.
• If price effect > output effect,
the firm reduces production.

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The Size of the Oligopoly

• As 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

Another benefit of international trade:

Trade increases the number of firms competing, increases
Q, brings P closer to marginal cost
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9
Game Theory

• Game theory helps us understand oligopoly and other situations

where “players” interact and behave strategically.

• Dominant 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

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Prisoners’ Dilemma Example

• 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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10
Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess Remain silent
Bonnie gets Bonnie gets
8 years 20 years
Confess
Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie goes Bonnie gets
Remain free 1 year
silent Clyde Clyde
gets 20 years gets 1 year
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Prisoners’ Dilemma Example

• 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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11
Oligopolies as a Prisoners’ Dilemma
• When oligopolies form a cartel in hopes of reaching the
monopoly outcome, they become players in a prisoners’
dilemma.

• Our earlier example:

• T-Mobile and Verizon are duopolists in Smalltown.
• The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.

• Here is the “payoff matrix” for this example…

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T-Mobile & Verizon in the Prisoners’ Dilemma

Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
T-Mobile
Q = 30 Q = 40
T-Mobile’s T-Mobile’s
profit = $900 profit = $1000
Q = 30
Verizon’s Verizon’s
profit = $900 profit = $750
Verizon
T-Mobile’s T-Mobile’s
profit = $750 profit = $800
Q = 40
Verizon’s profit Verizon’s
= $1000 profit = $800
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A C T I V E L E A R N I N G 3 The “fare wars” game

The players: American 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.

25 25

Answers

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Other Examples of the Prisoners’ Dilemma
Ad Wars
Two firms spend millions on TV ads to steal business from each
other. Each firm’s ad
cancels out the effects of the other,
and both firms’ profits fall by the cost of the ads.
Organization of Petroleum Exporting Countries Member countries
try to act like a cartel, agree to
limit oil production to boost prices & profits.
But agreements sometimes break down
when individual countries renege.

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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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Prisoners’ Dilemma and Society’s Welfare
• The noncooperative oligopoly equilibrium
• Bad for oligopoly firms:
prevents them from achieving monopoly profits
• Good for society:
Q is closer to the socially efficient output
P is closer to MC
• In other prisoners’ dilemmas, the inability to cooperate
may reduce social welfare.
• e.g., arms race, overuse of common resources

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Another Example: Negative Campaign Ads

• Election with two candidates, “R” and “D.”

• If R runs a negative ad attacking D,
3000 fewer people will vote for D:
1000 of these people vote for R, the rest abstain.
• If D runs a negative ad attacking R,
R loses 3000 votes, D gains 1000, 2000 abstain.
• R and D agree to refrain from running attack ads. Will each one
stick to the agreement?

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 Another Example: Negative Campaign Ads

Each candidate’s dominant R’s decision

strategy: run attack ads. Do not run attack Run attack ads
ads (cooperate) (defect)

Do not run no votes lost R gains 1000

attack ads or gained votes
(cooperate) no votes D loses
lost or gained 3000 votes
D’s decision
R loses 3000 R loses
Run votes 2000 votes
attack ads D gains D loses
(defect) 1000 votes 2000 votes
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Another Example: Negative Campaign Ads

• Nash eq’m: both candidates run attack ads.
• Effects on election outcome: NONE.
Each side’s ads cancel out the effects of the other side’s ads.
• Effects on society: NEGATIVE.
Lower voter turnout, higher apathy about politics, less voter
scrutiny of elected officials’ actions.

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Why People Sometimes Cooperate

• When the game is repeated many times, cooperation

may be possible.
• These 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

• Recall one of the Ten Principles from Unit 1:

Governments can sometimes
improve market outcomes.

• In oligopolies, production is too low and prices are too high,

relative to the social optimum.

• Role for policymakers:

Promote competition, prevent cooperation to move the oligopoly
outcome closer to the efficient outcome.

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Restraint of Trade and Antitrust Laws
• Sherman Antitrust Act (1890):
Forbids collusion between competitors
• Clayton Antitrust Act (1914):
Strengthened rights of individuals damaged by anticompetitive
arrangements between firms

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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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1. Resale Price Maintenance (“Fair Trade”)

• Occurs when a manufacturer imposes lower limits on the prices

retailers can charge.
• Is often opposed because it appears to reduce competition at
the retail level.
• Yet, any market power the manufacturer has
is at the wholesale level; manufacturers do not gain from
restricting competition at the retail level.
• The practice has a legitimate objective:
preventing discount retailers from free-riding
on the services provided by full-service retailers.

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2. Predatory Pricing
• Occurs when 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, but hard for the courts to determine
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, which is extremely costly for the firm.
• It can backfire.

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3. Tying

• Occurs when a manufacturer bundles two products together and

sells them for one price (e.g., Microsoft including a browser with its
operating system)
• Critics argue that tying gives firms more market power by
connecting weak products to strong ones.
• Others counter that 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,
which is not illegal, and which sometimes
increases economic efficiency.

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CONCLUSION

• Oligopolies can end up looking like monopolies or like competitive

markets, depending on the number of firms and how cooperative
they are.
• The prisoners’ dilemma shows how difficult it is for firms to
maintain cooperation, even when doing so is in their best
interest.
• Policymakers use the antitrust laws to regulate oligopolists’
behavior. The proper scope of these laws is the subject of
ongoing controversy.

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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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