lecture #15: microeconomics chapter 17 [chapter 16 in 4th edition]

LECTURE #15: MICROECONOMICS

CHAPTER 17

[Chapter 16 in 4th Edition] OligopoliesOligopolies

Game TheoryGame TheoryPublic PolicyPublic Policy

IMPORTANT DEFINITIONS IMPORTANT DEFINITIONS A.A. OligopolyOligopoly: : a market structure with a few a market structure with a few

sellers offering similar or identical products.sellers offering similar or identical products.B.B. Game TheoryGame Theory: the study of how people : the study of how people

behave in strategic situations.behave in strategic situations.1.1. By strategic, we mean a situation in which each By strategic, we mean a situation in which each

person, in deciding what actions to take, must person, in deciding what actions to take, must consider how others might respond to that consider how others might respond to that action.action.

2.2. Each firm in an oligopoly must act strategically, Each firm in an oligopoly must act strategically, because its profit not only depends on how because its profit not only depends on how much output it produces, but also on how much much output it produces, but also on how much other firms produce as well.other firms produce as well.

MARKETS WITH A FEW MARKETS WITH A FEW SELLERSSELLERS

A.A. A key feature of oligopoly is the A key feature of oligopoly is the tension between cooperation and self-tension between cooperation and self-interest.interest.

1.1. The group of oligopolists is better off The group of oligopolists is better off cooperating and acting like a monopolist, cooperating and acting like a monopolist, producing a small quantity of output and producing a small quantity of output and charging a price above marginal cost.charging a price above marginal cost.

2.2. Yet, because the oligopolist cares about Yet, because the oligopolist cares about his own profit, there is an incentive to act his own profit, there is an incentive to act on his own. This will limit the ability of the on his own. This will limit the ability of the group to act as a monopoly.group to act as a monopoly.


C.C. Competition, Monopolies, and CartelsCompetition, Monopolies, and Cartels1.1. If the market for water were perfectly If the market for water were perfectly

competitive, price would equal marginal cost competitive, price would equal marginal cost ($0). This means that 120 gallons of water ($0). This means that 120 gallons of water would be sold.would be sold.

2.2. If a monopoly controlled the supply of water, If a monopoly controlled the supply of water, profit would be maximized at a price of $60 profit would be maximized at a price of $60 and an output of 60 gallons.and an output of 60 gallons.

a.a. Note that in this case, Price ($60) exceeds MC ($0).Note that in this case, Price ($60) exceeds MC ($0).b.b. This level of output is lower than the socially This level of output is lower than the socially

efficient level of output (120 gallons).efficient level of output (120 gallons).


3.3. The duopolists may agree to act together The duopolists may agree to act together to set the price and quantity of water.to set the price and quantity of water.a.a. Collusion: an agreement among firms in a Collusion: an agreement among firms in a

market about quantities to produce or prices to market about quantities to produce or prices to chargecharge

b.b. CartelCartel: a group of firms acting in unison (OPEC): a group of firms acting in unison (OPEC)c.c. If Jill and Jack did collude, they would agree on If Jill and Jack did collude, they would agree on

the monopoly outcome of 60 gallons and a the monopoly outcome of 60 gallons and a price of $60.price of $60.

d.d. The cartel must also decide how to split the The cartel must also decide how to split the production of water. Each member will want a production of water. Each member will want a larger share because that means more profit.larger share because that means more profit.


D.D. The Equilibrium for an OligopolyThe Equilibrium for an Oligopoly1.1. It is often difficult for oligopolies to form cartels.It is often difficult for oligopolies to form cartels.

a.a. Antitrust laws prohibit agreements among firms.Antitrust laws prohibit agreements among firms.b.b. Squabbling among cartel members over their shares is Squabbling among cartel members over their shares is

also likely to occur.also likely to occur.2.2. In the absence of a binding agreement, the In the absence of a binding agreement, the

monopoly outcome is unlikely.monopoly outcome is unlikely.3.3. Assume that Jack expects Jill to produce 30 Assume that Jack expects Jill to produce 30

gallons of water (half of the monopoly outcome).gallons of water (half of the monopoly outcome).a.a. Jack could also produce 30 gallons and earn a profit of Jack could also produce 30 gallons and earn a profit of

$1,800.$1,800.b.b. However, he could produce 40 gallons and earn a However, he could produce 40 gallons and earn a

profit of $2,000.profit of $2,000.c.c. Jack will want to produce 40 gallons.Jack will want to produce 40 gallons.


1.1. Jill might reason the same way. If she expects Jill might reason the same way. If she expects Jack to produce 30 gallons, she could increase Jack to produce 30 gallons, she could increase her profits by raising her output to 40 gallons.her profits by raising her output to 40 gallons.

2.2. If duopolists pursue their own self-interest when If duopolists pursue their own self-interest when deciding how much to produce, they produce a deciding how much to produce, they produce a quantity greater than the monopoly quantity, quantity greater than the monopoly quantity, charge a price lower than the monopoly price, charge a price lower than the monopoly price, and earn total profit less than the monopoly and earn total profit less than the monopoly profit.profit.

3.3. Nash equilibriumNash equilibrium: a situation in which economic : a situation in which economic actors interacting with one another each actors interacting with one another each choose their best strategy given the strategies choose their best strategy given the strategies that all the other actors have chosen.that all the other actors have chosen.

Nash EquilibriumNash EquilibriumStated simply, Jack and Jill are in Nash equilibrium if Jill Stated simply, Jack and Jill are in Nash equilibrium if Jill is making the best decision she can, taking into is making the best decision she can, taking into account Jack's decision, and Jack is making the best account Jack's decision, and Jack is making the best decision he can, taking into account Jill's decision. decision he can, taking into account Jill's decision. Likewise, many players are in Nash equilibrium if each Likewise, many players are in Nash equilibrium if each one is making the best decision that they can, taking one is making the best decision that they can, taking into account the decisions of the others. However, into account the decisions of the others. However, Nash equilibrium does not necessarily mean the best Nash equilibrium does not necessarily mean the best cumulative payoff for all the players involved; in many cumulative payoff for all the players involved; in many cases all the players might improve their payoffs if cases all the players might improve their payoffs if they could somehow agree on strategies different from they could somehow agree on strategies different from the Nash equilibrium (e.g. competing businesspersons the Nash equilibrium (e.g. competing businesspersons forming a forming a cartelcartel in order to increase their profits). * in order to increase their profits). * Source: WikipediaSource: Wikipedia

http://en.wikipedia.org/wiki/Cartel

CartelsCartelsA A cartelcartel is a formal (explicit) agreement among firms. It is a formal (explicit) agreement among firms. It is a formal organization of producers that agree to is a formal organization of producers that agree to coordinate prices and production. Cartels usually occur coordinate prices and production. Cartels usually occur in an oligopolistic industry, where there is a small in an oligopolistic industry, where there is a small number of sellers and usually involve homogeneous number of sellers and usually involve homogeneous products. Cartel members may agree on such matters products. Cartel members may agree on such matters as price fixing, total industry output, market shares, as price fixing, total industry output, market shares, allocation of customers, allocation of territories, bid allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and rigging, establishment of common sales agencies, and the division of profits or combination of these. The aim the division of profits or combination of these. The aim of such collusion is to increase individual members' of such collusion is to increase individual members' profits by reducing competition. Competition laws forbid profits by reducing competition. Competition laws forbid cartels. Identifying and breaking up cartels is an cartels. Identifying and breaking up cartels is an important part of the competition policy in most important part of the competition policy in most countries, although proving the existence of a cartel is countries, although proving the existence of a cartel is rarely easy, as firms are usually not so careless as to rarely easy, as firms are usually not so careless as to put agreements to collude on paperput agreements to collude on paper.* Source: Wikipedia.* Source: Wikipedia


E.E. How the Size of an Oligopoly Affects the Market How the Size of an Oligopoly Affects the Market OutcomeOutcome

1.1. When an oligopolist decides to increase output, two things When an oligopolist decides to increase output, two things occur.occur.

a.a. Because price is greater than marginal cost, increasing output Because price is greater than marginal cost, increasing output will increase profit. This is the will increase profit. This is the output effectoutput effect..

b.b. Because increasing output will raise the total quantity sold, the Because increasing output will raise the total quantity sold, the price will fall and will therefore lower profit. This is theprice will fall and will therefore lower profit. This is the price price effecteffect..

2.2. The larger the number of sellers in the industry, the less The larger the number of sellers in the industry, the less concerned each seller is about its own impact on market concerned each seller is about its own impact on market price.price.

3.3. Thus, as the number of sellers in an oligopoly grows larger, Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a an oligopolistic market looks more and more like a competitive market.competitive market.

a.a. Price will approach marginal cost.Price will approach marginal cost.b.b. The quantity of output produced will approach the socially The quantity of output produced will approach the socially

efficient level.efficient level.

ECONOMICS OF COOPERATION ECONOMICS OF COOPERATION A.A. Prisoners’ DilemmaPrisoners’ Dilemma: a particular : a particular

“game” between two captured “game” between two captured prisoners that illustrates why prisoners that illustrates why cooperation is difficult to maintain cooperation is difficult to maintain even when it is mutually beneficialeven when it is mutually beneficial

Bonnie and ClydeBonnie and ClydePrisoner’s DilemmaPrisoner’s Dilemma

Bonnie and Clyde are captured. The Bonnie and Clyde are captured. The police have enough evidence to police have enough evidence to convict them on a weapons charge convict them on a weapons charge (sentence = one year) but suspect that (sentence = one year) but suspect that they have been involved in a bank they have been involved in a bank robbery. Because they lack hard robbery. Because they lack hard evidence in the crime, they need at evidence in the crime, they need at least one of them to confess. least one of them to confess.


The police lock the two in separate rooms The police lock the two in separate rooms and offer each of them a deal:and offer each of them a deal:"We can lock you up for one year. However, "We can lock you up for one year. However, if you confess to the bank robbery and if you confess to the bank robbery and implicate your partner, we will give you implicate your partner, we will give you immunity. You will go free and your partner immunity. You will go free and your partner will get 20 years in jail. If you both confess, will get 20 years in jail. If you both confess, we won’t need your testimony and avoid the we won’t need your testimony and avoid the cost of a trial so you will both get an cost of a trial so you will both get an intermediate sentence of eight years."intermediate sentence of eight years."


Dominant Strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players.


5.5. Bonnie’s dominant strategy is to confess.Bonnie’s dominant strategy is to confess.a.a. If Clyde remains silent, Bonnie can go free by If Clyde remains silent, Bonnie can go free by

confessing.confessing.b.b. If Clyde confesses, Bonnie can lower her If Clyde confesses, Bonnie can lower her

sentence by confessing.sentence by confessing.6.6. Clyde’s dominant strategy is to confess.Clyde’s dominant strategy is to confess.

a.a. If Bonnie remains silent, Clyde can go free by If Bonnie remains silent, Clyde can go free by confessing.confessing.

b.b. If Bonnie confesses, Clyde can lower his If Bonnie confesses, Clyde can lower his sentence by confessing.sentence by confessing.


7.7. If they had both remained silent, they If they had both remained silent, they would have been better off collectively would have been better off collectively (with a sentence of only one year (with a sentence of only one year instead of eight). But, by each pursuing instead of eight). But, by each pursuing his or her own self-interests, the two his or her own self-interests, the two prisoners together reach an outcome prisoners together reach an outcome that is worse for both of them.that is worse for both of them.

8.8. Cooperation between the two prisoners Cooperation between the two prisoners is difficult to maintain, because is difficult to maintain, because cooperation is individually irrational.cooperation is individually irrational.

ECONOMICS OF COOPERATIONECONOMICS OF COOPERATIONC.C. Oligopolies as a Prisoners’ DilemmaOligopolies as a Prisoners’ Dilemma

1.1. Example: Jack and Jill are trying to keep the sale of Example: Jack and Jill are trying to keep the sale of water low to keep the price high. After reaching an water low to keep the price high. After reaching an agreement, each person must decide whether to follow agreement, each person must decide whether to follow the agreement.the agreement.

2.2. Suppose that they are faced with the following decision: Suppose that they are faced with the following decision:

ECONOMICS OF COOPERATIONECONOMICS OF COOPERATION3.3. The dominant strategy for Jack is to produce The dominant strategy for Jack is to produce

at a high rate.at a high rate.a.a. If Jill produces at a high rate, Jack will earn a higher If Jill produces at a high rate, Jack will earn a higher

amount of profit if he too produces at a high rate.amount of profit if he too produces at a high rate.b.b. If Jill produces at a low rate, Jack will earn a higher If Jill produces at a low rate, Jack will earn a higher

profit if he produces at a high rate as well.profit if he produces at a high rate as well.4.4. For the same reasons, the dominant strategy For the same reasons, the dominant strategy

for Jill is to produce at a high rate.for Jill is to produce at a high rate.5.5. Even though total profit would be highest if Even though total profit would be highest if

both individuals produced at a low rate, self-both individuals produced at a low rate, self-interest will encourage them to produce at a interest will encourage them to produce at a high rate.high rate.

PUBLIC POLICY TOWARD PUBLIC POLICY TOWARD OLIGOPOLIES OLIGOPOLIES

A.A. Restraint of Trade and the Antitrust Restraint of Trade and the Antitrust LawsLaws

1.1. The Sherman Act of 1890 elevated The Sherman Act of 1890 elevated agreements among oligopolists from an agreements among oligopolists from an unenforceable contract to a criminal unenforceable contract to a criminal conspiracy.conspiracy.

2.2. The Clayton Act of 1914 strengthened The Clayton Act of 1914 strengthened the Sherman Act and allowed individuals the Sherman Act and allowed individuals the right to sue to recover three times the right to sue to recover three times the damages sustained from an illegal the damages sustained from an illegal agreement to restrain trade.agreement to restrain trade.

PUBLIC POLICY TOWARD PUBLIC POLICY TOWARD OLIGOPOLIESOLIGOPOLIES

A.A. Controversies over Antitrust PolicyControversies over Antitrust Policy1.1. Business practices that appear to reduce Business practices that appear to reduce

competition may in fact have legitimate competition may in fact have legitimate purposes.purposes.

2.2. Resale Price MaintenanceResale Price Maintenancea.a. Resale price maintenance (also called “fair trade”) is a Resale price maintenance (also called “fair trade”) is a

restriction by a manufacturer on the price that sellers restriction by a manufacturer on the price that sellers can charge for a product, usually used to keep the can charge for a product, usually used to keep the price from being lower at one retailer than another.price from being lower at one retailer than another.

b.b. Economists have argued that this policy has a Economists have argued that this policy has a legitimate goal. Customers often go to one store with legitimate goal. Customers often go to one store with good service, knowledgeable sales people, and higher good service, knowledgeable sales people, and higher prices for information on a product and then buy the prices for information on a product and then buy the product at a discount superstore. Resale price product at a discount superstore. Resale price maintenance limits the superstore’s ability to "free maintenance limits the superstore’s ability to "free ride" on the service provided by other retailers.ride" on the service provided by other retailers.


3.3. Predatory PricingPredatory Pricinga.a. When firms with monopoly power are faced When firms with monopoly power are faced

with new competition, they may cut prices with new competition, they may cut prices drastically to drive the new competition drastically to drive the new competition out of business and restore their monopoly out of business and restore their monopoly power.power.

b.b. This behavior is called This behavior is called predatory pricingpredatory pricing..c.c. Economists doubt whether this strategy is Economists doubt whether this strategy is

used often, because it would mean that the used often, because it would mean that the monopoly would have to sustain large monopoly would have to sustain large losses. losses.


4.4. TyingTyinga.a. Tying occurs when two products are sold Tying occurs when two products are sold

together.together.b.b. Economists do not believe this to be a Economists do not believe this to be a

problem because people will not be willing to problem because people will not be willing to pay more for two products sold together than pay more for two products sold together than they would be willing to pay for the goods they would be willing to pay for the goods separately. Thus, this practice cannot change separately. Thus, this practice cannot change market power.market power.

c.c. Instead, tying may simply be a form of price Instead, tying may simply be a form of price discrimination. Profits may rise if a firm discrimination. Profits may rise if a firm charges a combined price closer to the charges a combined price closer to the buyers’ total willingness to pay. buyers’ total willingness to pay.

HOMEWORK HOMEWORK A.A. Questions for Review: 1, 2, 4, 8 Questions for Review: 1, 2, 4, 8

(Same questions for Chapter 16 in (Same questions for Chapter 16 in 4th edition)4th edition)

B.B. Problems and Applications: 1 (a, b, Problems and Applications: 1 (a, b, c), 6 (a, b, c) c), 6 (a, b, c)

3 (a, b, c) and 6 (a, b, c) Chapter 16 3 (a, b, c) and 6 (a, b, c) Chapter 16 in 4th Edition in 4th Edition

lecture #15: microeconomics chapter 17 [chapter 16 in 4th edition]

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