# BETWEEN MONOPOLY AND PERFECT COMPETITION. Oligopoly BETWEEN MONOPOLY AND PERFECT COMPETITION

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1 BETWEEN MONOPOLY AND PERFECT COMPETITION Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly. Oligopoly Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers. Copyright 2004 South-Western BETWEEN MONOPOLY AND PERFECT COMPETITION Types of Imperfectly Competitive Markets Oligopoly Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition Many firms selling products that are similar but not identical. Each firm has a monopoly over the product that it makes, but many other similar products compete for the same customers Figure 1 The Four Types of Market Structure One firm Monopoly Tap water Cable TV Number of Firms? Few firms Oligopoly Tennis balls Crude oil Many firms Differentiated products Monopolistic Competition Novels Movies Type of Products? Identical products Perfect Competition Wheat Milk 1

2 MARKETS WITH ONLY A FEW SELLERS Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. A Duopoly Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. Characteristics of an Oligopoly Market Few sellers offering similar or identical products Interdependent firms Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost Table 1 The Demand Schedule for Water A Duopoly Example Price and Quantity Supplied The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = \$0 Q = 120 gallons The price and quantity in a monopoly market would be where total profit is maximized: P = \$60 Q = 60 gallons 2

3 A Duopoly Example Price and Quantity Supplied The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water. So what outcome then could be expected from duopolists? Competition, Monopolies, and Cartels The duopolists may agree on a monopoly outcome. Collusion An agreement among firms in a market about quantities to produce or prices to charge. Cartel A group of firms acting in unison. Competition, Monopolies, and Cartels Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy. The Equilibrium for an Oligopoly A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen. OR: any combination of strategies in which each player s strategy is her or his best choice, given the other player s strategies 3

4 The Equilibrium for an Oligopoly When firms in an oligopoly individually choose production to maximize profit, they produce 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). Equilibrium for an Oligopoly Summary Possible outcome if oligopoly firms pursue their own self-interests: Joint output is greater than the monopoly quantity but less than the competitive industry quantity. Market prices are lower than monopoly price but greater than competitive price. Total profits are less than the monopoly profit. How the Size of an Oligopoly Affects the Market Outcome How increasing the number of sellers affects the price and quantity: The output effect: Because price is above marginal cost, selling more at the ongoing price raises profits. The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold. If the OE is larger than the PE, production will be increased (and vice versa). Each oligopolist increases production until these two marginal effects are equal. How the Size of an Oligopoly Affects the Market Outcome As the number of firms in the oligopoly increases, the price effect becomes weaker, because each oligopolist is less concerned about its impacts on price. As a result, the output effect determines firms behavior: firms feel encouraged to boost production as long as P > MC. 4

5 How the Size of an Oligopoly Affects the Market Outcome 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. [Note: a competitive firm considers only the OE, since it is a price-taker] GAME THEORY AND THE ECONOMICS OF COOPERATION Game theory is the study of how people behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action. GAME THEORY AND THE ECONOMICS OF COOPERATION 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 firms produce. Each firm would like to reach the monopoly outcome, but doing so requires cooperation, which is difficult to maintain The Prisoners Dilemma The prisoners dilemma provides insight into the difficulty in maintaining cooperation. Often people (firms) fail to cooperate with one another even when cooperation would make them better off. 5

6 The Prisoners Dilemma Figure 2 The Prisoners Dilemma The prisoners dilemma is a particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial. Clyde s Decision Confess Remain Silent Confess Bonnie gets 8 years Clyde gets 8 years Bonnie goes free Bonnie s Decision Remain Silent Clyde goes free Bonnie gets 20 years Bonnie gets 1 year Clyde gets 20 years Clyde gets 1 year Copyright 2003 Southwestern/Thomson Learning The Prisoners Dilemma The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. In the Prisoners Dilemma game, each player s dominant strategy is to confess. And yet, they would both be better off if they remained silent The pursuit of self interest leads to misery for all. (Sorry, Mr. Adam Smith.) The Prisoners Dilemma Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player. The Prisoners Dilemma is an apt metaphor for many social situations in which we d all be better off if we cooperated, but we don t 6

7 Figure 3 An Oligopoly Game Oligopolies as a Prisoners Dilemma High Production Iraq s Decision High Production Low Production Iraq gets \$40 billion Iraq gets \$30 billion Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. Iran s Decision Low Production Iran gets \$40 billion Iraq gets \$60 billion Iran gets \$30 billion Iran gets \$60 billion Iraq gets \$50 billion Iran gets \$50 billion Copyright 2003 Southwestern/Thomson Learning Figure 4 An Arms-Race Game Figure 5 An Advertising Game Decision of the United States (U.S.) Marlboro s Decision Arm Disarm Advertise Don t Advertise Decision of the Soviet Union (USSR) Arm Disarm U.S. at risk USSR at risk U.S. safe and powerful USSR at risk and weak U.S. at risk and weak USSR safe and powerful U.S. safe USSR safe Camel s Decision Advertise Don t Advertise Camel gets \$3 Camel gets \$2 Marlboro gets \$3 Marlboro gets \$5 Camel gets \$5 Camel gets \$4 Marlboro gets \$2 Marlboro gets \$4 Copyright 2003 Southwestern/Thomson Learning Copyright 2003 Southwestern/Thomson Learning 7

8 Why People Sometimes Cooperate Figure 7 Jack and Jill Oligopoly Game Sometimes non-cooperation is bad for society (i.e. the arms race), but in oligopolistic markets it is good for consumers because it does not make possible to reach the monopoly outcome of a cartel It is good also in the case of criminals However, firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain. Jill s Decision Sell 40 Gallons Sell 30 Gallons Sell 40 Gallons Jill gets \$1,600 profit Jill gets \$1,500 profit Jack s Decision Jack gets \$1,600 profit Jack gets \$2,000 profit Sell 30 Gallons Jill gets \$2,000 profit Jill gets \$1,800 profit Jack gets \$1,500 profit Jack gets \$1,800 profit Copyright 2003 Southwestern/Thomson Learning Jack and Jill form a cartel. To maximize total profit, they would agree to the cooperative outcome in which each produces 30 gallons. Yet, if Jack and Jill are to play this game only once, neither has any incentive to live up to this agreement. Self-interest drives each of them to renege and produce 40 gallons. Suppose Jack and Jill know that they will play the same game every week. When they make their initial agreement to keep production low, they can also specify what happens if one party reneges, for instance, that once one of them reneges and produces 40 gallons, both of them will produce 40 gallons forever after. This penalty is easy to enforce, for if one party is producing at a high level, the other has every reason to do the same. The threat of this penalty may be all that is needed to maintain cooperation. Each person knows that defecting would raise his or her profit from \$1,800 to \$2,000. But this benefit would last for only one week. Thereafter, profit would fall to \$1,600 and stay there. As long as the players care enough about future profits, they will choose to forgo the one-time gain from defection. Thus, in a game of repeated prisoners dilemma, the two players may well be able to reach the cooperative outcome. PUBLIC POLICY TOWARD OLIGOPOLIES Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high. 8

9 Restraint of Trade and the Antitrust Laws Antitrust laws make it illegal to restrain trade or attempt to monopolize a market. Sherman Antitrust Act of 1890 Clayton Act of 1914 Controversies over Antitrust Policy Antitrust policies sometimes may not allow business practices: Predatory pricing Tying Controversies over Antitrust Policy Predatory Pricing occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market Tying when a firm offers two (or more) of its products together at a single price, rather than separately Summary Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. 9

10 Summary The prisoners dilemma shows that self-interest can prevent people from maintaining cooperation, even when cooperation is in their mutual self-interest. The logic of the prisoners dilemma applies in many situations, including oligopolies. Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition. 10

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