Oligopoly and Strategic Behavior13

Previously…

• Monopolistic competition is a market structure characterized by free entry, many different firms, and differentiated products

• Differentiated products are substitutable, but not identical

• Firms advertise in order to increase demand for their product

Big Questions

1. What is oligopoly?

2. How does game theory explain strategic behavior?

3. How do government policies affect oligopoly behavior?

4. What are network externalities?

Oligopoly

• Oligopoly is a market structure with the following characteristics:– Small number of firms– Differentiated products– Significant entry barriers– Firms interact strategically

Comparing Market Structures

Measuring Concentrations of Industries• Concentration ratio

– Used to measure oligopoly power in an industry

– What percentage of industry sales are owned by the biggest firms?

• Four-firm concentration ratio• Eight-firm concentration ratio

Four-Firm Concentration Ratios in the United States

Duopoly

• Duopoly– An oligopoly with only two firms– May happen in localized markets with

cell phones or utilities

• Duopoly behavior– Firms feel competitive pressure, but can

enjoy advantages of market power– Firms may have the incentive and the

ability to cooperate, or collude.

Duopoly

• Collusion– Agreement among rivals specifying

prices or quantities– Firms ask: “What would a monopoly do?”

and then do that action

• Cartel– Two or more firms acting in unison to

form a joint monopoly

Cartels

• Cartels tend to be unstable over a long period of time. Why?– Each firm in the cartel often has an

incentive to “cheat”– Could occur by one firm lowering its

price– Firm could also overproduce output (in

situations with homogenous output, such as oil cartels)

Cellphone Duopoly

Price/Month

(P)

Number of

Customers

(Q)

Total Revenue

(TR)TR = P × Q

$180 0 $0165 100 16,500150 200 30,000135 300 40,500120 400 48,000105 500 52,50090 600 54,00075 700 52,50060 800 48,00045 900 40,50030 1,000 30,00015 1,100 16,5000 1,200 0

• Assume MC = 0• Perfect Competition

– Result: P = MC– P = $0– Q = 1,200– Socially efficient

• Monopoly– No competition to drive

price down– P = $90– Q = 600– Loss of efficiency compared

to competition

Cellphone Duopoly

Price/Month

(P)

Number of

Customers

(Q)

Total Revenue

(TR)TR = P × Q

$180 0 $0165 100 16,500150 200 30,000135 300 40,500120 400 48,000105 500 52,50090 600 54,00075 700 52,50060 800 48,00045 900 40,50030 1,000 30,00015 1,100 16,5000 1,200 0

• Duopoly– AT-Phone and Horizon

• Collusion result: act like a joint monopoly by charging the monopoly price– P = $90– Q = 600 (each firm produces

300)– Profit of $27,000 for each,

assuming equal split– Does each firm have an

incentive to undercharge the competitor? What if that happens?

Cellphone Duopoly

Price/Month

(P)

Number of

Customers

(Q)

Total Revenue

(TR)TR = P × Q

$180 0 $0165 100 16,500150 200 30,000135 300 40,500120 400 48,000105 500 52,50090 600 54,00075 700 52,50060 800 48,00045 900 40,50030 1,000 30,00015 1,100 16,5000 1,200 0

• Duopoly Competition– AT-Phone still believes Horizon

will serve 300 customers– AT-Phone lowers its price to

P = $75– Market demand is Q = 700– AT-Phone profit:

• 400 x $75 = $30,000

• Horizon’s reaction– Also wants 400 consumers– For both firms to do this, price

must by P = $60– Horizon and AT-Phone lower

price to P = $60.• Profits now $24,000 for each.

Cellphone Duopoly

Price/Month

(P)

Number of

Customers

(Q)

Total Revenue

(TR)TR = P × Q

$180 0 $0165 100 16,500150 200 30,000135 300 40,500120 400 48,000105 500 52,50090 600 54,00075 700 52,50060 800 48,00045 900 40,50030 1,000 30,00015 1,100 16,5000 1,200 0

• Would a price war result in which the price falls to zero?– No, duopolist will try to gain

more market shares and wait to see how competitor responds

– Each firm has what is called a response function. Each firm will respond to what the other firm does.

– Duopoly outcome is more efficient than monopoly

Mutual Interdependence

• Mutual interdependence– A market situation in which the actions

of one firm have an impact on the price and output of its competitors

– AT-Phone’s response depends on the actions of Horizon, and Horizon’s response depends on the actions of AT-Phone

– Note the difference between interdependence and independence

Competition, Duopoly, and Monopoly

Competitive Markets

Duopoly Monopoly

Price $0 $60 $90Output 1200 800 600Socially

Efficient?Yes No No

Explanation

Since the marginal cost of providing cellphone service is

zero, the price is eventually driven to zero

Each firm is mutually

interdependent and adopts a

strategy based on the actions of its rival. This leads

both firms to charge $60 and

service 400 customers

The monopolist is free to choose

the profit-maximizing

output. In this example it

maximizes its total revenue.

Cheating in a Cartel

• OPEC cartel• 1988 Iraq

– Virtually bankrupt– Economy depended mostly on exporting

oil– Low oil prices hurting Iraq further– Iraq accused Kuwait of “cheating” and

overproducing oil, which lowered the price

– What did Iraq do?

Cheating in a Cartel

• Gulf War• Iraq invades Kuwait City

Nash Equilibrium

• Nash Equilibrium– An economic decision maker has nothing to

gain by changing its own strategy without collusion

– Nobody wants to change their strategy given that the other firm does not change their strategy

– A “stable” outcome where nobody wants to move from their current position

– Often discussed with game theory, and easier to see when games are drawn in matrix form

Oligopoly with More Than Two Firms

• Imagine if a third firm entered the phone market and builds a cell tower

• Price effect– The total number of cellphone contracts

sold (supply) increases, and the price firms are able to charge decreases

• Output effect– The new firm sells an additional unit in

which it generates additional profits

Oligopoly with More Than Two Firms• Price and output effects make maintaining

a cartel (joint monopoly) difficult– As firms enter, each individual firm will have a

smaller impact on market price. Firms will produce more as long as it is profitable.

• Not all firms in oligopoly are the same size– Each firm’s actions affect price and output,

and thus affect decisions made by other firms (interdependence)

– Small firms and large firms will behave differently, yet will act strategically

Game Theory

• Game theory– Branch of mathematics that economists use to

analyze the strategic behavior of decision makers

– Can help us determine what level of cooperation is most likely among players in a game

• Basic components of a game– Players– Strategies– Payoffs

Strategic Behavior and the Dominant Strategy

• Prisoner’s dilemma– Two suspects are interrogated separately– They each have the option to confess or keep quiet

• Possible outcomes of prisoner’s dilemma– If both suspects keep quiet, each suspect will serve

only a small time in jail– If both confess, both will serve 10 years in jail– If one suspect confesses and the other remains

quiet, the suspect who confesses goes free, while the suspect who kept quiet serves 25 years in jail

PresentingThe Prisoner’s Dilemma

Players

ThelmaConfess Keep Quiet

Louise

Confess

10 years in jail

25 years in jail

10 years in jail

goes free

Keep Quiet

goes free

1 year in jail

25 years in jail

1 year in jail

Strategies Payoffs

AnalyzingThe Prisoner’s Dilemma

ThelmaConfess Keep Quiet

Louise

Confess

10 years in jail

25 years in jail

10 years in jail

goes free

Keep Quiet

goes free

1 year in jail

25 years in jail

1 year in jail

• Louise– Best to Confess or Keep Quiet?– Best for Louise to Confess no

matter what Thelma does!

• Thelma– Best to Confess or Keep

Quiet?– Best for Thelma to Confess

no matter what Louise does!

Interesting Result of this Game

ThelmaConfess Keep Quiet

Louise

Confess

10 years in jail

25 years in jail

10 years in jail

goes free

Keep Quiet

goes free

1 year in jail

25 years in jail

1 year in jail

Nash equilibriumPayoffs that will

result

Outcome with the

overall best sum of payoffs

Game Theory

• Dominant strategy– A best response for a player to choose no

matter what the other player chooses– Not all games or players in a game have a

dominant strategy

• Nash equilibrium implications?– If both players have a dominant strategy, the

intersection of those dominant strategies will be the Nash equilibrium.

– Neither player will want to unilaterally deviate.

Economics in The Dark Knight

• The Joker sets up an ethical experiment that pins two ferries full of passengers against one another.

Economics in Golden Balls

• Golden Balls (2008)The prisoner’s dilemma often shows up in

TV game shows as well…

Duopoly and thePrisoner’s Dilemma

AT-Phone

Low High

Horizon

Low$27,000 $30,000

$27,000 $22,500

High$22,500 $24,000

$30,000 $24,000

Nash equilibriumpayoffs that will

result

An outcome that is better for both

players

Advertising and thePrisoner’s Dilemma

Coca-Cola

AdvertisesDoes Not Advertise

Pepsico

Advertises

$100 M $75 M

$100 M $150 M

Does Not Advertise

$150 M $125 M

$75 M $125 M

Nash equilibriumpayoffs that will

result

An outcome that is better for both

players

Intuition of AdvertisingPrisoner’s Dilemma

• Advertising– Costly– Purpose: increase

product demand– If both firms advertise,

expenses go up, but demand increases; each cancels other out

– “Arms race” of advertising

Cigarette Advertising on TV• In 1970, Congress enacted a law

making cigarette advertising on TV illegal– Reasoning: too many ads being seen

by children and teens– Goal: reduce smoking among all ages

• Unintended consequence– This actually increased the economic

profits of cigarette makers– The law ended their prisoner’s dilemma

of advertising

Economics in Dilbert

• Dilbert gets caught in a prisoner’s dilemma• He mistakenly believes that his coworkers will

deviate from the dominant strategy

Escaping the Prisoner’s Dilemma in the Long Run

• The Nash equilibrium in prisoner dilemma games may give the best short run payoffs

• However,– Many games are repeated– This repetition occurs over a longer time

span– Dominant strategies may not consider

long-run benefits of cooperation

Escaping the Prisoner’s Dilemma in the Long Run• Tit for tat

– A long run strategy designed to create cooperation among participants

– Strategy: mimic the decision your opponent made in the previous round.

– Changes the incentives and encourages cooperation

– Useful because interactions in life occur over the long run. Relationships between people and businesses involve mutual trust.

Caution About Game Theory

• Not all games are like the prisoner’s dilemma– Not all games have a dominant strategy– Not all games have a pure strategy like

the Nash equilibrium

• Think about Paper, Rock, Scissors– Your best response is differen,t

depending on what your opponent throws. There is no dominant hand to play.

No Dominant Strategy

Oligopoly Policy:Antitrust• Antitrust policy

– Government efforts that attempt to prevent oligopolies from behaving like monopolies

• Sherman Act of 1890– “Every person who shall monopolize, or attempt

to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.”

Oligopoly Policy:Antitrust

• Clayton Act of 1914 added a few more items that were considered detrimental– Price discrimination that lessens competition– Exclusive dealings that restrict the ability of a

buyer to deal with competitors– Tying arrangements (similar to bundling)– Mergers that lessen competition– Prevents a person from serving as a director on

more than one board in the same industry

Predatory Pricing

• Predatory pricing– Firms set prices below AVC with the

intent of driving rivals from the market– Illegal, but difficult to prosecute– Often difficult to distinguish between

predatory pricing and intense market competition

• Examples:– Wal-Mart is often assumed to be a

predator but is never prosecuted– Microsoft was prosecuted eventually

for tying, but not for predatory pricing

$

Time

AVC,MC

Competitor Enters

Competitor Leaves

Incumbent Firm’s Price

Predatory Pricing Scheme

Network Externalities

• Network externality– Occurs when the number of

customers who purchase a good influences the quantity demanded

– Often is a factor in whether the resulting market structure is oligopoly

– Classic examples include technologies such as cell phones and fax machines

• A new technology has to reach “critical mass” before it is effective for consumers

• How useful would a fax machine be if only 10 people had the machine?

Network Externalities

• Positive network externalities– Bandwagon effect– Individual preferences for a

good increase as the number of people buying the good increases

– Internet, social networks, cell phones, fax machines, MMORPGs, video game consoles, fads, night clubs

Network Externalities

• Negative network externalities– Snob effect– Individual preferences for a good

decrease as the number of people buying the good increases

– Exotic pets and sports cars– Hipsters– Services that are prone to “congestion.”

Pool, beach, student union gets “too crowded,” and you don’t want to go.

Network Externalities

• Switching costs– Costs that are incurred by a consumer when he

switches suppliers– Another advantage to a firm having a large network– Demand for existing product becomes more

inelastic if costs of switching to a new product are higher

• Example: cellphone providers– Early termination fees– Free in-network calls– FTC reduced switching costs in 2003 by requiring

phone companies to allow a consumer to take their old phone number to a new provider

Price Taking Price Making

Perfect CompetitionMonopolistic Competition

Oligopoly Monopoly

1. Many firms 1. Many firms 1. Few firms 1. One firm

2. Atomistic assumption—firms are so small that no single buyer or seller has ANY control over price

2. Each firm has some control over price

2. Medium to high entry barriers to entry. The firm has more control over price.

2. Extremely high barriers to entry. The firm has significant control over price.

3. Firms are so small that no single buyer or seller has ANY control over price

3. Product differentiation

3. Mutual interdependence

3. The firm IS the industry

4 Homogeneous output 4. Easy entry/exit4. Long run economic profit possible

4. Long run economic profit probable

5. There is perfect information about product price and quantity

 5. Output can be homogenous or differentiated

 

6. Easy entry/exit      

More Game Theory in Media• This link provides further examples of

game theory in media and contains links to video clips

Conclusion

• Oligopoly– A market structure in which there are a small

number of firms– Firms interact strategically– Can be competitive (results closer to

monopolistic competition)– Can be collusive (results closer to monopoly)

• Antitrust policies– Restrain excessive market power– Give incentives to compete instead of collude– Each industry examined on a case-by-case basis

Summary

• Oligopoly: a small number of firms sell a differentiated product in a market with significant barriers to entry. The small number of sellers in oligopoly leads to mutual interdependence.– An oligopolist is like a monopolistic competitor in that

it sells differentiated products.– It is also like a monopolist in that it enjoys significant

barriers to entry.

• Oligopolists have a tendency to collude and to form cartels in hope of achieving monopolylike profits.

Summary

• Oligopolistic markets are socially inefficient since P > MC. The result under oligopoly will fall somewhere between the competitive and monopoly outcomes.

• Game theory helps determine when cooperation among oligopolists is most likely.– In many cases, cooperation fails to materialize

because decision-makers have dominant strategies that lead them to be uncooperative.

– This causes firms to compete with price, advertising, or R & D when they could potentially earn more profit by curtailing these activities.

Summary

• A dominant strategy ignores the long run benefits of cooperation and focuses solely on the short run gains– Whenever repeated interaction exists, decision-

makers fare better under tit for tat, an approach that maximizes the long run profit

• Antitrust laws are complex and cases are hard to prosecute, but they provide firms an incentive to compete rather than collude

• The presence of significant positive network externalities causes small firms to be driven out of business or to merge with larger competitors

Practice What You Know

Which of the following is most likely to become an oligopoly industry?

A. An industry without entry barriersB. An industry where economies of scale

are very smallC. An industry with sizeable network

effectsD. An industry with hundreds of

competitors

Practice What You Know

Which of the following is true about oligopoly?

A. Oligopolies are illegal in the United States

B. All oligopoly industries will try to colludeC. Oligopoly industries generally have a

high concentration ratioD. Firms in an oligopoly act independently

from other firms in the oligopoly

Practice What You Know

Why do cartel deals tend not to last?A. Each firm in the cartel has a dominant

strategy to be uncooperative and defect from the cartel agreement

B. Cartel profits are lower than competitive profits

C. Cartels create more competitionD. Firms know that cartels are often illegal

so they break the deal to escape

Practice What You Know

What is an example of a good with a positive network effect?

A. An online multiplayer gameB. A fast-food burgerC. A dry-cleaning serviceD. A cable TV subscription

Practice What You Know

How can a pure strategy Nash equilibrium be accurately described?

A. It is always the overall best outcomeB. It’s an outcome in which neither

player wants to change strategiesC. It can only be reached by collusionD. One exists in all games