Transcript The Prisoners` Dilemma

Monopoly and Oligopoly
Obid A. Khakimov
[email protected]
What you will learn in this chapter:
The significance of monopoly, where a single monopolist
is the only producer of a good
How a monopolist determines its profit-maximizing output
and price
The difference between monopoly and perfect competition,
and the effects of that difference on society’s welfare
What price discrimination is, and why it is so prevalent
when producers have market power
The meaning of oligopoly, and why it occurs
Why oligopolists have an incentive to act in ways that reduce
their combined profit, and why they can benefit from
collusion
How our understanding of oligopoly can be enhanced by using
game theory, especially the concept of the prisoners’
dilemma
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Types of Market Structure
In order to develop principles and make predictions
about markets and how producers will behave in
them, economists have developed four principal
models of market structure:
perfect competition
monopoly
oligopoly
monopolistic competition
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Types of Market
Structure
This system of market structures is based on two dimensions:
The number of producers in the market (one, few, or many)
Whether the goods offered are identical or differentiated .
Differentiated goods are goods that are different but considered
somewhat substitutable by consumers (think Coke versus Pepsi).
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The Meaning of Monopoly
Our First Departure from Perfect Competition…
A monopolist is a firm that is the only producer of a
good that has no close substitutes. An industry
controlled by a monopolist is known as a monopoly.
e.g. De Beers
The ability of a monopolist to raise its price above
the competitive level by reducing output is known as
market power.
What do monopolists do with this market power?
Let’s take a look at the following graph…
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Why Do Monopolies Exist?
A monopolist has market power and as a result will
charge higher prices and produce less output than a
competitive industry. This generates profit for the
monopolist in the short run and long run.
Profits will not persist in the long run unless there is a
barrier to entry. This can take the form of
control of natural resources or inputs,
economies of scale,
technological superiority, or
legal restrictions imposed by governments,
including patents and copyrights.
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How a Monopolist Maximizes Profit
The price-taking firm’s optimal output rule is to
produce the output level at which the marginal cost
of the last unit produced is equal to the market
price.
A monopolist, in contrast, is the sole supplier of its
good. So its demand curve is simply the market
demand curve, which is downward sloping.
This downward slope creates a “wedge” between
the price of the good and the marginal revenue of
the good—the change in revenue generated by
producing one more unit.
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Comparing the Demand Curves of a Perfectly
Competitive Firm and a Monopolist
An individual perfectly competitive firm cannot affect the market
price of the good  it faces a horizontal demand curve DC , as
shown in panel (a). A monopolist, on the other hand, can affect
the price (sole supplier in the industry)  its demand curve is the
market demand curve, DM, as shown in panel (b). To sell more
output it must lower the price; by reducing output it raises the
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price.
How a Monopolist Maximizes Profit
An increase in production by a monopolist has two
opposing effects on revenue:
A quantity effect. One more unit is sold,
increasing total revenue by the price at which the
unit is sold.
A price effect. In order to sell the last unit, the
monopolist must cut the market price on all units
sold. This decreases total revenue.
The quantity effect and the price effect are
illustrated by the two shaded areas in panel (a) of
the following figure based on the numbers on the
table accompanying it.
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The Monopolist’s Profit- Maximizing
Output and Price
To maximize profit, the monopolist compares
marginal cost with marginal revenue.
If marginal revenue exceeds marginal cost, De
Beers increases profit by producing more; if
marginal revenue is less than marginal cost, De
Beers increases profit by producing less. So the
monopolist maximizes its profit by using the
optimal output rule:
At the monopolist’s profit-maximizing quantity of
output,
MR = MC
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Monopoly versus Perfect Competition
P = MC at the perfectly competitive firm’s profit-
maximizing quantity of output
P > MR = MC at the monopolist’s profit-maximizing
quantity of output
Compared with a competitive industry, a monopolist
does the following:
 Produces a smaller quantity: QM < QC
 Charges a higher price: PM > PC
 Earns a profit
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Monopoly and Public Policy
By reducing output and raising price above
marginal cost, a monopolist captures some of the
consumer surplus as profit and causes deadweight
loss. To avoid deadweight loss, government policy
attempts to prevent monopoly behavior.
When monopolies are “created” rather than
natural, governments should act to prevent them
from forming and break up existing ones.
The government policies used to prevent or
eliminate monopolies are known as antitrust policy.
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Price Discrimination
Up to this point we have considered only the case
of a single-price monopolist, one who charges
all consumers the same price. As the term
suggests, not all monopolists do this.
In fact, many if not most monopolists find that they
can increase their profits by charging different
customers different prices for the same good: they
engage in price discrimination.
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Perfect Price
Discrimination
In the case of perfect price discrimination, a monopolist
charges each consumer his or her willingness to pay; the
monopolist’s profit is given by the shaded triangle.
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Some Oligopolistic Industries
Economics in Action - To get a better picture of
market structure, economists often use the “fourfirm concentration ratio” which asks what share of
industry sales is accounted for by the top four firms.
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Understanding Oligopoly
Some of the key issues in oligopoly can be
understood by looking at the simplest case, a
duopoly.
With only two firms in the industry, each would
realize that by producing more it would drive down
the market price. So each firm would, like a
monopolist, realize that profits would be higher if it
limited its production.
So how much will the two firms produce?
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Understanding Oligopoly
One possibility is that the two companies will engage
in collusion— Sellers engage in collusion when
they cooperate to raise each others’ profits.
The strongest form of collusion is a cartel, an
agreement by several producers that increases their
combined profits by telling each one how much to
produce. (Acting like single Monopoly)
They may also engage in non-cooperative
behavior, ignoring the effects of their actions on
each others’ profits.
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The Prisoners’ Dilemma
The Prisoners’ Dilemma
The reward received by a player in a game, such as
the profit earned by an oligopolist, is that player’s
payoff.
A payoff matrix shows how the payoff to each of
the participants in a two player game depends on the
actions of both. Such a matrix helps us analyze
interdependence.
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The Prisoners’ Dilemma
The game is based on two premises:
(1) Each player has an incentive to choose an
action that benefits itself at the other player’s
expense.
(2) When both players act in this way, both are
worse off than if they had chosen different actions.
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The Prisoners’
Dilemma
It is in the joint interest of both
prisoners not to confess; it is in
each one’s individual interest to
confess.
Each of two prisoners,
held in separate cells, is
offered a deal by the
police—a light sentence if
she confesses and
implicates her accomplice
but her accomplice does
not do the same, a heavy
sentence if she does not
confess but her
accomplice does, and so
on.
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Game Theory
When the decisions of two or more firms significantly
affect each others’ profits, they are in a situation of
interdependence.
The study of behavior in situations of interdependence
is known as game theory.
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The Prisoners’ Dilemma
An action is a dominant strategy when it is a
player’s best action regardless of the action taken by
the other player. Depending on the payoffs, a player
may or may not have a dominant strategy.
A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each
player in a game chooses the action that maximizes
his or her payoff given the actions of other players,
ignoring the effects of his or her action on the payoffs
received by those other players.
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The Rise and Fall and Rise of OPEC
Economics in Action
The Organization of Petroleum Exporting Countries,
usually referred to as OPEC, includes 11 national
governments (Algeria, Indonesia, Iran, Iraq, Kuwait,
Libya, Nigeria, Qatar, Saudi Arabia, United Arab
Emirate, and Venezuela). Two other oil-exporting
countries, Norway and Mexico, are not formally part
of the cartel but act as if they were. (Russia, also an
important oil exporter, has not yet become part of the
club.)
Unlike corporations, which are often legally prohibited
by governments from reaching agreements about
production and prices, national governments can talk
about whatever they feel like.
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The Ups and
Downs of the
Oil Cartel
The Organization of Petroleum Exporting Countries (OPEC) is a
legal cartel that has had its ups and downs. From 1974 to 1985
it succeeded in driving world oil prices to unprecedented levels;
then it collapsed. In 1998 the cartel once again became
effective.
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Oligopoly in Practice
The Legal FrameworkOligopolies operate under legal restrictions in the
form of antitrust policy. But many succeed in
achieving tacit collusion.
Tacit collusion is limited by a number of factors,
including
large
numbers of firms,
complex
pricing, and
conflicts
of interest among firms.
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