Oligopoly

CHAPTER 1
2010 Pearson Education

In some markets, there are only a few firms compete.
For example, computer chips are made by Intel and

Advanced Micro Devices and each firm must pay close
attention to what the other firm is doing.
How does competition between just two chip makers

work?
When a market has only a small number of firms, do they

operate in the social interest, like firms in perfect
competition? Or do they restrict output to increase profit,
like a monopoly?
The models of perfect competition and monopoly dont

predict the behavior of the firms weve just described. To
understand how these markets work, we need the richer
models.
What Is Oligopoly?
Oligopoly is a market structure in which

Natural or legal barriers prevent the entry of new firms.
A small number of firms compete.

What Is Oligopoly?
Barriers to Entry
Either natural or legal

barriers to entry can
create oligopoly.
Figure 15.1 shows two

oligopoly situations.
In part (a), there is a

natural duopolya
market with two firms.

What Is Oligopoly?
In part (b), there is a

natural oligopoly market
with three firms.
A legal oligopoly might

arise even where the
demand and costs leave
room for a larger number
of firms.

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 to cooperate.
Interdependence: With a small number of firms, each firms

profit depends on every firms actions.
Cartel: A cartel and is an illegal group of firms acting together

to limit output, raise price, and increase profit.
Firms in oligopoly face the temptation to form a cartel, but

aside from being illegal, cartels often break down.

Two Traditional Oligopoly Models
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm

believes that if it raises its price, its competitors will not
follow, but if it lowers its price all of its competitors will
follow.

Figure 15.2 shows the

kinked demand curve
model.
The firm believes that the

demand for its product has
a kink at the current price
and quantity.

Above the kink, demand is

relatively elastic because
all other firms prices
remain unchanged.
Below the kink, demand is

relatively inelastic because
all other firms prices
change in line with the
price of the firm shown in
the figure.

The kink in the demand

curve means that the MR
curve is discontinuous at
the current quantityshown
by that gap AB in the figure.

Fluctuations in MC that
remain within the
discontinuous portion of the
MR curve leave the profit-
maximizing quantity and
price unchanged.
For example, if costs
increased so that the MC
curve shifted upward from
MC0 to MC1, the profit-
maximizing price and
quantity would not change.

The beliefs that generate

the kinked demand curve
are not always correct and
firms can figure out this
fact.
If MC increases enough, all

firms raise their prices and
the kink vanishes.
A firm that bases its actions

on wrong beliefs doesnt
maximize profit.

Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that

has a significant cost advantage over many other, smaller
competing firms.
The large firm operates as a monopoly, setting its price

and output to maximize its profit.
The small firms act as perfect competitors, taking as given

the market price set by the dominant firm.

Figure 15.3 shows10 small firms in part (a). The
demand curve, D, is the market demand and the supply
curve S10 is the supply of the 10 small firms.

At a price of $1.50, the 10 small firms produce the quantity

demanded. At this price, the large firm would sell nothing.

But if the price was $1.00, the 10 small firms would supply only
half the market, leaving the rest to the large firm.

The demand curve for the large firms output is the curve XD on
the right.

The large firm can set the price and receives a marginal revenue
that is less than price along the curve MR.

The large firm maximizes profit by setting MR = MC. Lets

suppose that the marginal cost curve is MC in the figure.

The profit-maximizing quantity for the large firm is 10 units. The

price charged is $1.00.

The small firms take this price and supply the rest of the quantity
demanded.

In the long run, such an industry might become a monopoly as

the large firm buys up the small firms and cuts costs.

Oligopoly Games
Game theory is a tool for studying strategic behavior, which
is behavior that takes into account the expected behavior of
others and the mutual recognition of interdependence.
The Prisoners Dilemma
The prisoners dilemma game illustrates the four features of

a game.
Rules
Strategies
Payoffs
Outcome

Oligopoly Games
Rules
The rules describe the setting of the game, the actions the
players may take, and the consequences of those actions.
In the prisoners dilemma game, two prisoners (Art and

Bob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicate

with each other.

Oligopoly Games
Each is told that both are suspected of committing a more

serious crime.
If one of them confesses, he will get a 1-year sentence for

cooperating while his accomplice get a 10-year sentence for
both crimes.
If both confess to the more serious crime, each receives 3

years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the

minor 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 are
four 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 himcan work

out his payoffin 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 every

possible action by each player for every possible action by
the 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 own
best 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 this
way, the outcome is an equilibrium called Nash
equilibriumfirst proposed by John Nash.
Finding the Nash Equilibrium
The following slides show how to find the Nash
equilibrium.

Bobs
view
of the
world

Bobs
view
of the
world

Arts
view
of the
world

Arts
view
of the
world

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 two

producers that compete.
Duopoly captures the essence of oligopoly.
Cost and Demand Conditions
Figure 15.4 on the next slide describes the cost and

demand situation in a natural duopoly.

Oligopoly Games
Part (a) shows each firms cost curves.
Part (b) shows the market demand curve.

Oligopoly Games
This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.

Oligopoly Games
How does this market work?
What is the price and quantity produced in equilibrium?

Oligopoly Games
Collusion
Suppose that the two firms enter into a collusive

agreement.
A collusive agreement is an agreement between two (or

more) firms to restrict output, raise the price, and increase
profits.
Such agreements are illegal in the United States and are

undertaken 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 four
possible combinations of actions for the firms:
1. Both comply.
2. Both cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.

Oligopoly Games
Colluding to Maximize Profits
Firms in a cartel act like a monopoly and maximum

economic profit.

Oligopoly Games
To find that profit, we set marginal cost for the cartel equal to
marginal revenue for the cartel.

Oligopoly Games
The cartels marginal cost curve is the horizontal sum of the

MC curves of the two firms and the marginal revenue curve
is like that of a monopoly.

Oligopoly Games
The firms maximize economic profit by producing the

quantity at which MCI = MR.

Oligopoly Games
Each firm agrees to produce 2,000 units and each firm
shares the maximum economic profit.
The blue rectangle shows each firms economic profit.

Oligopoly Games
When each firm produces 2,000 units, the price is greater

than the firms marginal cost, so if one firm increased
output, its profit would increase.

Oligopoly Games
One Firm Cheats on a Collusive Agreement
Suppose the cheat increases its output to 3,000 units.

Industry output increases to 5,000 and the price falls.

Oligopoly Games
For the complier, ATC now exceeds price.
For the cheat, price exceeds ATC.

Oligopoly Games
The complier incurs an economic loss.
The cheat makes an increased economic profit.

Oligopoly Games
Both Firms Cheat
Suppose that both increase their output to 3,000 units.

Oligopoly Games
Industry output is 6,000 units, the price falls, and both firms
make zero economic profitthe same as in perfect
competition.

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 an
economic loss of $1 million and Gear makes an
economic profit of $4.5 million.
If Gear complies and Trick cheats, Gear incurs an
economic loss of $1 million and Trick makes an
economic profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly game.

Payoff Matrix

Tricks
view
of the
world

Tricks
view
of the
world

Gears
view
of the
world

Gears
view
of the
world

Equilibrium

Oligopoly Games
Nash Equilibrium in Duopolists Dilemma
The Nash equilibrium is that both firms cheat.
The quantity and price are those of a competitive market, and

the firms make zero economic profit.
Other Oligopoly Games
Advertising and R&D games are also prisoners dilemmas.

An R&D Game
Procter & Gamble and Kimberley Clark play an R&D game in

the market for disposable diapers.

Oligopoly Games
The payoff matrix for the Pampers Versus Huggies game.

Oligopoly Games
The Disappearing Invisible Hand
In all the versions of the prisoners dilemma that weve

examined, the players end up worse off than they would if
they were able to cooperate.
The pursuit of self-interest does not promote the social

interest in these games.

Oligopoly Games
A Game of Chicken
In the prisoners dilemma game, the Nash equilibrium is a

dominant strategy equilibrium, by which we mean the
best strategy for each player is independent of what the
other player does.
Not all games have such an equilibrium.
One that doesnt is the game of chicken.

Payoff Matrix

KCs
view
of the
world

KCs
view
of the
world

P&Gs
view
of the
world

P&Gs
view
of the
world

Equilibrium

Repeated Games and Sequential Games
A Repeated Duopoly Game
If a game is played repeatedly, it is possible for duopolists

to successfully collude and make a monopoly profit.
If the players take turns and move sequentially (rather than

simultaneously as in the prisoners dilemma), many
outcomes are possible.
In a repeated prisoners dilemma duopoly game, additional

punishment strategies enable the firms to comply and
achieve a cooperative equilibrium, in which the firms
make and share the monopoly profit.

One possible punishment strategy is a tit-for-tat strategy.
A tit-for-tat strategy is one in which one player cooperates

this period if the other player cooperated in the previous
period but cheats in the current period if the other player
cheated in the previous period.
A more severe punishment strategy is a trigger strategy.
A trigger strategy is one in which a player cooperates if the

other player cooperates but plays the Nash equilibrium
strategy forever thereafter if the other player cheats.

Table 15.5 shows that a tit-for-tat strategy is sufficient to

produce a cooperative equilibrium in a repeated duopoly
game.

Price wars might result from a tit-for-tat strategy where

there is an additional complicationuncertainty about
changes in demand.
A fall in demand might lower the price and bring forth a
round of tit-for-tat punishment.

A Sequential Entry Game in a Contestable Market
In a contestable marketa market in which firms can

enter and leave so easily that firms in the market face
competition from potential entrantsfirms play a
sequential entry game.

Figure 15.8 shows the game tree for a sequential entry

game in a contestable market.

In the first stage, Agile decides whether to set the

monopoly price or the competitive price.

In the second stage, Wanabe decides whether to enter or

stay out.

In the equilibrium of this entry game,
Agile sets a competitive price and makes zero economic

profit to keep Wanabe out.
A less costly strategy is limit pricing, which sets the price

at the highest level that is consistent with keeping the
potential entrant out.

Antitrust Law
Antitrust law provides an alternative way in which the

government may influence the marketplace.
The Antitrust Laws
The first antitrust law, the Sherman Act, was passed in

1890. It outlawed any combination, trust, or conspiracy
that restricts interstate trade, and prohibited the attempt
to monopolize.

Antitrust Law

Antitrust Law
A wave of merger activities at the beginning of the

twentieth century produced a stronger antitrust law, the
Clayton Act, and created the Federal Trade Commission.
The Clayton Act was passed in 1914.
The Clayton Act made illegal specific business practices

such as price discrimination, interlocking directorships,
and acquisition of a competitors shares if the practices
substantially lessen competition or create monopoly.

Antitrust Law
Table 15.7 (next slide) summarizes the Clayton Act and its
amendments, the Robinson-Patman Act passed in 1936
and the Cellar-Kefauver Act passed in 1950.
The Federal Trade Commission, formed in 1914, looks for

cases of unfair methods of competition and unfair or
deceptive business practices.

Antitrust Law

Antitrust Law
Price Fixing Always Illegal
Price fixing is always a violation of the antitrust law.
If the Justice Department can prove the existence of price

fixing, there is no defense.

Antitrust Law
Three Antitrust Policy Debates
But some practices are more controversial and generate

debate. Three of them are
Resale price maintenance
Tying arrangements
Predatory pricing

Antitrust Law
Resale Price Maintenance
Most manufacturers sell their product to the final consumer

through a wholesale and retail distribution chain.
Resale price maintenance occurs when a manufacturer

agrees with a distributor on the price at which the product will
be resold.
Resale price maintenance is inefficient if it promotes

monopoly pricing.
But resale price maintenance can be efficient if it provides

retailers with an incentive to provide an efficient level of retail
service in selling a product.
Antitrust Law
Tying Arrangements
A tying arrangement is an agreement to sell one product

only if the buyer agrees to buy another different product as
well.
Some people argue that by tying, a firm can make a larger

profit.
Where buyers have a differing willingness to pay for the

separate items, a firm can price discriminate and take a
larger amount of the consumer surplus by tying.

Antitrust Law
Predatory Pricing
Predatory pricing is setting a low price to drive

competitors out of business with the intention of then
setting the monopoly price.
Economists are skeptical that predatory pricing actually

occurs.
A high, certain, and immediate loss is a poor exchange for

a temporary, uncertain, and future gain.
No case of predatory pricing has been definitively found.

Antitrust Law
Merger Rules
The Federal Trade Commission (FTC) uses guidelines to

determine which mergers to examine and possibly block.
The Herfindahl-Hirschman index (HHI) is one of those

guidelines (explained in Chapter 9).
If the original HHI is between 1,000 and 1,800, any
merger that raises the HHI by 100 or more is challenged.
If the original HHI is greater than 1,800, any merger that
raises the HHI by more than 50 is challenged.

Oligopoly

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CHAPTER 1

2010 Pearson Education

For example, computer chips are made by Intel and

How does competition between just two chip makers

When a market has only a small number of firms, do they

The models of perfect competition and monopoly dont

Oligopoly is a market structure in which

2010 Pearson Education

Either natural or legal

Figure 15.1 shows two

In part (a), there is a

2010 Pearson Education

In part (b), there is a

A legal oligopoly might

2010 Pearson Education

Small Number of Firms

Because an oligopoly market has a small number of firms, the

Interdependence: With a small number of firms, each firms

Cartel: A cartel and is an illegal group of firms acting together

Firms in oligopoly face the temptation to form a cartel, but

2010 Pearson Education

The Kinked Demand Curve Model

In the kinked demand curve model of oligopoly, each firm

2010 Pearson Education

Figure 15.2 shows the

The firm believes that the

2010 Pearson Education

Above the kink, demand is

Below the kink, demand is

2010 Pearson Education

The kink in the demand

2010 Pearson Education

2010 Pearson Education

The beliefs that generate

If MC increases enough, all

A firm that bases its actions

2010 Pearson Education

Dominant Firm Oligopoly

In a dominant firm oligopoly, there is one large firm that

The large firm operates as a monopoly, setting its price

The small firms act as perfect competitors, taking as given

2010 Pearson Education

2010 Pearson Education

At a price of $1.50, the 10 small firms produce the quantity

2010 Pearson Education

2010 Pearson Education

2010 Pearson Education

2010 Pearson Education

The large firm maximizes profit by setting MR = MC. Lets

2010 Pearson Education

The profit-maximizing quantity for the large firm is 10 units. The

2010 Pearson Education

2010 Pearson Education

In the long run, such an industry might become a monopoly as

2010 Pearson Education

The Prisoners Dilemma

The prisoners dilemma game illustrates the four features of

2010 Pearson Education

In the prisoners dilemma game, two prisoners (Art and

Each is held in a separate cell and cannot communicate

2010 Pearson Education

Each is told that both are suspected of committing a more

If one of them confesses, he will get a 1-year sentence for