Transcript Chapter 16 Oligopoly

Chapter 16 Oligopoly
• T1 Between Monopoly and Perfect Competition
• T2 Markets with only a few sellers
• T3 Game theory and the economics of
cooperation
• T4 Public policy toward oligopolies
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T1 Between Monopoly and Perfect Competition
• The cases of perfect competition and monopoly illustrate
some important ideas about how markets work. Most
markets in the economy, however, include elements of both
these cases and therefore, are not completely described by
either of them.
• The typical firm in the economy faces competition and also
has some degree of market power; however, the
competition and market power are not exactly described and
analyzed by the perfect competition and monopoly. In other
words, the typical firm in our economy is imperfectly
competitive.
• There are two types of imperfectly competitive markets.
– An oligopoly is a market with only a few sellers, each
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offering a product similar or identical to the others.
– Examples: the market for hockey skates; the world
market for crude oil.
– Monopolistic competition describes a market structure
in which there are many firms selling products that are
similar but not identical.
– Examples: the markets for novels, movies, CDs and
computer games.
• See Figure 16-1 on page 353, four types of market structure.
T2 Markets with only a few sellers
• Because an oligopolistic market has only a small group of
sellers, a key feature of oligopoly is the tension between
cooperation and self-interest.
– The group of oligopolists is best off cooperating and
acting like a monopolist-producing a small quantity of
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output and charging a price above MC.
– Yet because each oligopolist cares about only its own
profit, there are powerful incentives at work that hinder a
group of firms from maintaining the monopoly outcome.
A duopoly example
• Image a town in which only two residents, Jack and Jill,
own wells that produce water safe for drinking.
• Each Saturday, Jack and Jill decide how many litres of
water to pump, bring the water to town, and sell it for
whatever price the market will bear.
• We assume that Jack and Jill can pump as much water as
they want without cost. That is, the marginal cost of water
equals zero.
• See Table 16-1 on page 354. It shows the town’s demand
schedule for water.
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Competition, monopolies and cartels
• Suppose the market for water is perfectly competitive
Price = MC ( = 0)  Price=0 and Quantity = 120L.
• Suppose the market for water is monopoly
Table 16-1 shows that the total profit is maximized at a
quantity of 60 L and a price of 60 a litre.
This result would be inefficient, for the quantity of water
produced and consumed would fall short of the socially
efficient level of 120 L.
What outcome should we expect from our duopolists?
• If Jack and Jill were to collude  monopoly outcome
– Our two producers would produce a total of 60 L,
which would be sold at a price of $60 a litre.
– Price exceeds marginal cost and the outcome is socially
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inefficient
• Collusion: an agreement among firms in a market about
quantities to produce or prices to charge
• Cartel: a group of firms acting in unison
– A cartel must agree not only on the total level of
production but also on the amount produced by each
member.
• Although oligopolists would like to form cartels and earn
monopoly profits, often that is not possible. Why? Pursuing
own self-interest
• Oligopolists would be better off cooperating and reaching
the monopoly outcome. Yet because they pursue their own
self-interest, they do not end up reaching the monopoly
outcome and maximizing their joint profit.
• Each oligopolist is tempted to raise production and capture a
larger share of the market. As each of them tries to do this,
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total production rises and the price falls.
• At the same time, self-interest does not drive the market all
the way to the competitive outcome. Oligopolists are aware
that increases in the amount they produce reduce the price
of their product..
• In summary, when firms in an oligopoly individually choose
production to maximize profit, they produce a quantity of
output greater than the level produced by monopoly and less
than the level produced by competition. The oligopoly price
is less than the monopoly price but greater than the
competitive price ( which equals marginal cost)
• As the number of sellers in an oligopoly grows larger, an
oligopolistic market looks more and more like a competitive
market. The price approaches marginal cost and the quantity
produced approaches the socially efficient level.
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T3 Game theory and the economics of cooperation
• Game theory: the study of how people behave in strategic
situations. By “ strategic” we mean a situation in which
each person, when deciding what actions to take, must
consider how others might respond to that action.
• Because the number of firms in an oligopolistic market is
small, each firm must act strategically. Each firm knows that
its profit depends not only on how much it produces, but
also on how much the other firm produce. In making its
production decision, each firm in an oligopoly should
consider how its decision might affect the production
decisions of all the other firms.
• Game theory is not necessary for understanding competitive
or monopoly markets. Why?
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• Prisoners’ Dilemma: a particular game between two
captured prisoners that illustrates why cooperation is
difficult to maintain even when it is mutually beneficial
• Three elements of a game: player, strategy and payoff.
• Dominant strategy: a strategy that is best for a player in a
game regardless of the strategies chosen by the other
players.
• Dominated strategy:a strategy that is worst for a player in
a game regardless of the strategies chosen by the other
players. It also can be eliminated
• Nash Equilibrium: a situation in which economic actors
interacting with one another each choose their best strategy
given the strategies that all the other actors have chosen.
• We can get the Nash Equilibrium by dominant strategy,
dominated strategy or cell by cell inspection.
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• Simultaneous game vs. Sequential game
• See Figure 16-2 on page 360 (Prisoners’ Dilemma)
– (Confess, Confess) is the Nash Equilibrium
– This result is the inferior outcome.
– Dominant strategy
• See Figure 16-3 on page 362 (Crude Oil production game)
– (High Production, High Production) is the Nash
Equilibrium
– This result is the inferior outcome with low profits for
each country.
– Dominant strategy
• See Figure 16-4 on page 363 Arms-race game ( to build
new weapons or to disarm)
– (Arm, Arm) is the Nash Equilibrium
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– This result is the inferior outcome in which both
countries are at risk
– Dominant strategy
• See Figure 16-5 on page 364 Advertising Game
– (Advertise, Advertise) is the Nash Equilibrium
– This result is the inferior outcome with lower profits for
each company
– Dominant strategy
• See Figure 16-6 on page 365 A Common Resources Game
– ( Drill Two Wells, Drill Two Wells) is the Nash
Equilibrium
– This result is the inferior outcome with lower profits for
each company
– Dominant strategy.
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• See Figure 16-7 on page 366 Jack and Jill’s Oligopoly
Game
– ( Sell 40 L, Sell 40 L) is the Nash Equilibrium
– This result is the inferior outcome with lower profits for
each company
– Dominant strategy.
T4 Public policy toward oligopolies
• Restraint of trade and the competition Act
– Freedom to make contracts is an essential part of a
market economy. However, Canadian judges have
refused to enforce agreements that restrain trade among
competitors (reducing quantities and raising prices, or
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price-fixing) to be against the public interest.
– Canada’s Competition Act codifies and reinforces this
policy. See Section 45(1) of the Act.
– The Competition Act contains both civil and criminal
provisions.
• Civil provision:
– such as merger cases are heard by Competition
Tribunal
• Criminal provision:
– such as conspiracies in restraint of trade, bidrigging, price discrimination, resale price
maintenance and predatory pricing
– The Attorney General of Canada
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Controversies over competition policy
• Over time, much controversy has centred on the question
of what kinds of behaviour competition laws should
prohibit. Most commentators agree that price-fixing
agreements among competing firms should be illegal.
• However, the competition laws have been used to
condemn some business practices whose effects are not
obvious. The followings are three examples.
• Ex1 Resale Price Maintenance ( also called fair trade)
• The manufacturer requires the retailers to charge
customers a certain price. Charging any price lower than
the requested price would be treated as the retailers’
violation of contract with the manufacturer.
• Resale price maintenance might seem anticompetitive and
therefore, detrimental to society. Like an agreement among
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members of a cartel, it prevents the retailers
• from competing on price. For this reason, the courts have
often viewed resale price maintenance as a violation of
competition laws.
• Economists defend resale price maintenance on two
grounds. First, they deny that it is aimed at reducing
competition. To the extent that the manufacturer has any
market power, it can exert that power through the wholesale
price rather than through resale price maintenance.
Moreover, a cartel of retailers sells less than a group of
competitive retailers, the manufacturer would be worse off
if its retailers were a cartel. So, the manufacturer has no
incentive to discourage competition among its retailers.
Second, economists believe that resale price maintenance
has a legitimate goal. The manufacturer may want its
retailers to provide customers with a pleasant showroom
and a knowledgeable sales force.
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• Yet without resale price maintenance, some customers
would take advantage of one store’s service to learn about
the product and then buy the product at a discount retailer
that does not provide this service.Resale price
maintenance is one way for the manufacturer to solve this
free-rider problem.
• An important principle: business practices that appear
to reduce competition may in fact have legitimate
purposes.
• Therefore, this principle makes the application of the
competition laws all the more difficult.
• Ex2 Predatory Pricing
• Firms with market power normally use that power to raise
prices above the competitive level. But should
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policymakers ever be concerned that firms with market
• power might charge prices that are too low?
• Imagine that price war among Air Can and other small
airline companies. Air Can’s price cuts may be intended to
drive small companies out of the market; so Air Can may
recapture its monopoly and raise prices again.
• Some economists are skeptical of this argument and believe
that predatory pricing is rarely, and perhaps never, a
profitable business strategy. Why? For a price war to drive
out a rival, prices have to be driven below cost.
• Ex3 Tying (selling products as a bundle)
• The practice of tying is banned under the civil provisions of
the Competition Act because tying allows a firm to extend
its market power to other goods.
• Economists, however, are skeptical of this argument. 17