Chapter 16 Oligopoly What Is Oligopoly? 1) Describe the characteristics of an oligopoly.

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1 Chapter 16 Oligopoly 16.1 What Is Oligopoly? 1) Describe the characteristics of an oligopoly. Answer: There are a small number of firms that act interdependently. They are tempted to form a cartel and collude to increase profits. They can compete on price only (if they produce identical products) or compete on price, product quality and marketing (if they produce slightly different products). Natural or legal barriers prevent the entry of new firms. Topic: Oligopoly, definition Skill: Level 1: Definition Objective: Checkpoint 16.1 Author: CD 2) "Because firms in an oligopoly are so large, they do not need to consider each other's actions." Is the previous statement correct or incorrect? Explain your answer. Answer: The statement is most definitely incorrect. Oligopoly is an industry in which only a few firms compete. Because there are only a few firms, the hallmark of oligopoly is mutual interdependence, that is, one firm's action will affect the other firms. The fact that in oligopoly each firm's actions affect its rivals is unlike the case in perfect competition or monopolistic competition, in which there are so many firms that one firm's actions have no effect on its rivals, or monopoly, in which there is only one firm and hence no rivals. Topic: Oligopoly Objective: Checkpoint 16.1 Author: SA 3) What market structures other than oligopoly have the characteristic of one firm's actions affecting the actions of its competitors? Explain your answer. Answer: No other market structure has the characteristic that one firm's actions can affect the actions of its competitors. In monopoly, there are no competitors to affect. And in perfect competition and monopolistic competition, there are so many competitors that any one firm's actions have no measurable impact on its competitors. Oligopoly is unique in that it is the only market structure in which one firm's actions affect the actions of its competitors. Topic: Oligopoly Objective: Checkpoint 16.1 Author: TS

2 332 Bade/Parkin œ Foundations of Economics, Third Edition 4) What is a cartel? Answer: A cartel is a group of firms acting together to limit output, raise price and increase economic profit. Cartels are illegal in the United States. Cartels operate in a market structure with oligopolies. If firms can stick to the cartel agreement, the firms can earn an economic profit. However, cartels tend to break down because firms are tempted to cheat on their cartel partners and increase their own profit at the expense of their partners. Topic: Cartel Skill: Level 1: Definition Objective: Checkpoint 16.1 Author: CD 5) Explain what a cartel is and the difficulties faced in maintaining a cartel. Answer: A cartel is a group of firms acting together to decrease output, raise price, and increase economic profit. The difficulty faced by a cartel is the fact that each member has the incentive to cheat on the cartel and increase its output. If a member increases its output and the rest of the cartel members do not, the cheating member's profits will increase substantially. Each member reasons that if it is the only cheater, it can significantly increase its profit and so each firm has an incentive to cheat. Topic: Cartel Objective: Checkpoint 16.1 Author: TS 6) Why are cartels among firms usually kept secret? Answer: Cartels are typically kept secret because they are illegal. In the United States and many other countries, it is illegal for firms to collude to form a cartel. It is illegal because when firms collude they do so in order to restrict output, raise prices, and capture consumer surplus in order to increase their economic profit. Topic: Cartel Objective: Checkpoint 16.1 Author: JC 7) What is the legal status of a cartel among firms in the United States? Answer: Cartels are illegal in the United States and in many other countries. Topic: Cartel Objective: Checkpoint 16.1 Author: JC

3 Chapter 16 Oligopoly Alternative Oligopoly Outcomes 1) "If firms in an oligopoly operate as a monopoly, the industry produces the most output and if they operate as perfect competitors, the industry produces the least output." Is the previous statement correct or incorrect? Why? Answer: The statement is incorrect; it reverses the outcomes. If the firms in an oligopoly operate as a monopoly, the industry produces the least output and if they operate as perfect competitors, the industry produces the most output. Topic: Range of outcomes Objective: Checkpoint 16.2 Author: MR 2) What is the best outcome for society: When firms in an oligopoly operate as a monopoly or when they act as perfect competitors? Briefly explain your answer. Answer: The best outcome for society is when the firms act as perfect competitors. Perfect competition produces the efficient quantity of output. A monopoly restricts the quantity of output it produces and creates a deadweight loss, which harms society So society is better off if the firms compete rather than collude and operate as a monopoly. Topic: Range of outcomes Skill: Level 5: Critical thinking Objective: Checkpoint 16.2 Author: MR 3) In the Boeing/Airbus oligopoly example discussed in the text, why did Boeing and Airbus have an incentive to produce more planes than the monopoly outcome? Answer: Both Boeing and Airbus wanted to produce more planes than the monopoly outcome because each realized that if and if alone produced an additional plane, its profit increased. Of course, the profit of its competitor would decrease, but that does not matter to the calculations made by Boeing and Airbus. Topic: Range of outcomes Skill: Level 3: Using models Objective: Checkpoint 16.2 Author: MR

4 334 Bade/Parkin œ Foundations of Economics, Third Edition 4) The figure above shows a the market demand curve for a market with three firms. It also shows a firm's marginal cost curve. In this oligopoly, what is the range of output and prices? Why does this range of outcomes exist? Answer: If the firms operate as a monopoly, they produce a total of 200 units per day and set a price of $12 per unit. If the firms compete and operate as perfect competitors, they produce 400 units per day and the price is $4 per unit. The range of possible outcomes exists because firms in oligopoly have the choice of colluding to decrease output to monopoly levels or cheating on the cartel and increase output to its efficient level. A range of prices also exists between the monopoly price and the perfectly competitive price. Topic: Range of outcomes for an oligopoly Skill: Level 3: Using models Objective: Checkpoint 16.2 Author: CD

5 Chapter 16 Oligopoly 335 Price (dollars per unit) Quantity (units) ) The table above has the market demand schedule in an industry that has two firms in it. The marginal cost of this product is zero because these two firms have exclusive ownership of the resource and it does not cost any additional amount to produce additional units. a. If the firms cooperate with each other so that they operate as a monopoly, what price will they charge and what (total) output will they produce? b. If the firms cannot cooperate but instead behave as perfect competitors, what will be the price and the (total) output they produce? Answer: a. As a monopoly, the price will be $15 and the total output will be 30 units. This price and output combination is where they maximize their total profit because it is here that the marginal revenue equals zero. (The marginal revenue equals zero because this is the price and output combination for which total revenue is maximized and marginal revenue equals zero when total revenue is maximized.) b. The perfectly competitive price is equal to marginal cost. Because marginal cost is equal to zero, the price will be $0 and the output will be 60 units. Topic: Range of outcomes for an oligopoly Skill: Level 4: Applying models Objective: Checkpoint 16.2 Author: SA 16.3 Game Theory 1) What three characteristics do all games have in common? Answer: The all have rules, strategies, and payoffs. Topic: Games Author: SB 2) What is a payoff matrix in game theory? Answer: A payoff matrix is a table that shows the payoffs for each player for every possible combination of actions by the other players. Topic: Payoff matrix Skill: Level 1: Definition Author: PH

6 336 Bade/Parkin œ Foundations of Economics, Third Edition 3) What is a Nash equilibrium? Is this equilibrium the best outcome for the players? Give an example. Answer: John Nash proposed the concept of an equilibrium in a game where each player takes the best possible action given the action of other players. A Nash equilibrium is not necessarily the best one for the players. This can be seen in the prisoners' dilemma. Typically the prisoners' dilemma is a game where two prisoners are given rules and payoffs to encourage them to confess to a crime. The prisoners, acting in their own self interest, confess to the crime to minimize their jail time and so confession is the Nash equilibrium. But if the players can communicate with each other, they can improve their position. If they can communicate, they both deny the crime and so both wind up doing less time in jail. Topic: Nash equilibrium Skill: Level 1: Definition Author: CD 4) "A Nash equilibrium occurs when both parties to a game end up worse off as a result of the decisions that are made." Is the previous definition of a Nash equilibrium correct or incorrect? Answer: The definition is incorrect. A Nash equilibrium is an equilibrium in which each player takes the best possible action given the action of the other player. Topic: Nash equilibrium Author: JC

7 Chapter 16 Oligopoly 337 5) OPEC, the Organization of Petroleum Exporting Countries, was formed in Baghdad in Since its formation, this cartel has suffered from a major problem with respect to the quota (limit) of output it assigns each member nation. What is OPEC's goal and what sort of quota do you think the cartel assigns? How and why do nations cheat on their quota? What happens when a nation cheats on its quota? Answer: In order to keep oil prices high, as has been the case since 1999, OPEC creates a target level of output designed to achieve a particular high price. OPEC's goal is to set a price high enough so that its member nations earn the maximum economic profit. Once the target output is set, OPEC assigns a production quota to each member. As long as each member adheres to its quota the price will remain high and stable. However, from time to time, individual nations cheat on the agreement by producing more oil than they are allowed. Nations cheat because they realize that if they alone cheat, the impact on oil prices will be slight but the impact on their profit will be large. Once this oil shows up on world markets, the supply of oil increases and prices begin to fall. Then, once prices begin to fall other members begin to panic and they start selling more oil too in order to get the highest price they can before a collapse takes place. If every nation cheats, the supply will increase more than if just a few do and the collapse in price becomes a self-realizing prophecy. Topic: Cartel cheating Skill: Level 5: Critical thinking Author: JC 6) Why do oligopoly firms find it difficult to cooperate and not cheat on a cartel agreement? Answer: Firms in an oligopoly have large market shares. When they change their output or price, the firm affects not only its own revenue and profit but also the revenue and profit of other firms. For example, if a firm cheats on a cartel agreement by lowering its price, it will capture a larger market share. The competitors will see a decrease in their total revenue and their profit but the cheating firm's profit increases. If the firms cooperate, they could act like a monopoly and have the maximum joint profit but each firm has the temptation to cheat and produce more than its share. This temptation is strong because cheating will increase the cheater's revenue and profit substantially. Topic: Cartel cheating Author: PH

8 338 Bade/Parkin œ Foundations of Economics, Third Edition 7) In a cartel, how does the number of firms affect the likelihood that the cartel will be able to successfully maintain a high price? Answer: The more firms that are involved in the cartel, the lower the likelihood that the cartel will be able to maintain a high price. Essentially, the larger the number of firms, the greater the probability that someone will cheat! Topic: Cartel cheating Author: PH 8) What is the dilemma faced by firms in oligopoly? Answer: Because there are just a few large firms in an oligopoly, output and pricing decisions made by one firm affect the demand for other firms' goods. To maximize the total joint profit, the firms must cooperate, act like a monopoly so as to restrict output and earn monopoly profits. But each firm has an incentive to cheat on an agreement to restrict output because if it increases production it can (temporarily, at least) earn higher profits. But if all firms increase production, total profits will fall and the market will move toward the competitive equilibrium. Topic: Oligopolists' dilemma Skill: Level 4: Applying models Author: SB 9) "The duopolists' dilemma occurs when firms in a duopoly coordinate their decisions to achieve the best possible outcome." Is the previous statement correct or incorrect? Why? Answer: The statement is incorrect. The duopolists' dilemma occurs precisely because the firms do not coordinate their decisions and so the duopolists attain the worst combined outcome. Topic: Duopolists' dilemma Author: JC

9 Chapter 16 Oligopoly ) What is game theory and what light does it shed on the duopolists' dilemma? Answer: Game theory is a tool economists use to analyze the behavior of oligopolistic firms because game theory is a tool to study strategic behavior. Game theory shows that because these firms are interdependent, the decisions they make to promote their own self-interest can wind up harming all the firms. Thus the duopolists' dilemma is illustrated using game theory: Firms looking to earn for themselves the maximum possible profit can wind up earning less profit than if they had behaved less self-interestedly and more cooperatively. Topic: Duopolists' dilemma Author: SA 11) Does an oligopoly produce the efficient quantity of output or does it create a deadweight loss? Do the firms want to produce the efficient quantity of output? Explain your answer. Answer: An oligopoly might or might not operate efficiently. It operates efficiently if the firms cheat on any agreement and increase output so that it is the same as the perfectly competitive level. In this case, price equals marginal cost and the outcome is efficient. There is no deadweight loss. From the firms' perspectives, this outcome is undesirable because the firms earn only a normal profit. If the firms can play repeated games, detecting and punishing overproduction, the oligopoly is more likely to restrict output to the monopoly level. This outcome is inefficient because marginal cost does not equal marginal benefit. A deadweight loss is created. From the firms' perspective, this outcome is more desirable because the firms earn an economic profit. Topic: Efficiency of oligopoly Skill: Level 3: Using models Author: CD

10 340 Bade/Parkin œ Foundations of Economics, Third Edition 12) Sally's Mom is pretty sure her twins, Tim and John, together cut the hair off Sally's Barbie doll. She talks to them separately and gives them the following options. If they both confess they will have to pay Sally $10 each. If Tim confesses and John does not confess, Tim pays $15 and John pays $8. If Tim does not confess and John confesses, Tim has to pay $8 and John $15. If both do not confess, they both pay her $14. Sally's Mom has them in separate rooms and they cannot talk to each other. a. Complete the payoff matrix above. b. If they reach the Nash equilibrium, what will Tim and John do? Answer: a. The complete payoff matrix is above. b. Tim and John will both deny involvement. Sally's doll remains bald, but Tim and John each pay Sally $14 so Sally has $28 for a new doll.

11 Chapter 16 Oligopoly 341 Topic: Prisoners' dilemma Skill: Level 4: Applying models Author: SA 13) Two competing firms in a duopoly must decide whether or not to offer consumers a coupon for their good. The payoff matrix above represents the daily profit available to the firms under the different coupon strategies. a. What strategies and payoffs are represented by quadrant A? b. What strategy will Firm 1 pursue if it believes that Firm 2 is offering a coupon? c. What quadrant represents the equilibrium that will result if the firms act independently (compete)? d. What quadrant represents the equilibrium that will result if the firms successfully collude? Answer: a. In quadrant A, Firm 1 offers a coupon while Firm 2 does not. As a result, Firm 1 earns $150 in profits and Firm 2 earns $60. b. If Firm 2 is offering a coupon and Firm 1 does not, Firm 1 will earn $75. If Firm 1 also offers a coupon, it will earn $100. Therefore, Firm 1 will also offer a coupon. c. Quadrant C. d. Quadrant B. Topic: Duopolists' dilemma Skill: Level 4: Applying models Author: SB

12 342 Bade/Parkin œ Foundations of Economics, Third Edition 14) Two firms are introducing an improved version of their toothpastes. They must decide whether or not to advertise their products. The table above gives the payoff matrix in terms of the economic profits they expect in each case. The payoffs are in terms of millions of dollars. a. What is the Nash equilibrium for the game? b. If they could cooperate, what strategy would they prefer? What would be the payoff? Answer: a. The Nash equilibrium has each firm advertising and hence each firm receiving $100 million in economic profit because both decided to advertise. b. If they could cooperate, they would both choose not to advertise. In this case, each would earn $140 million in economic profit. Topic: Duopolists' dilemma Skill: Level 4: Applying models Author: SA

13 Chapter 16 Oligopoly ) Two firms are competing in a duopoly and are trying to decide which price to set. The two prices under consideration are a high monopoly price and a low competitive level. If both seller A and seller B chose the monopoly price, each will earn $20 million of economic profit. However, if one picks the monopoly price while the other picks the competitive price, the high-price firm will lose $1 million while the low-price firm will earn $32 million. If both sell at the competitive level, they both earn a normal profit. Complete the above payoff matrix and determine the Nash equilibrium. Answer: The completed payoff matrix is above and has the economic profits in millions of dollars. The Nash equilibrium is for both to charge the competitive, low, price and earn a normal profit. Topic: Duopolists' dilemma Skill: Level 4: Applying models Author: TS

14 344 Bade/Parkin œ Foundations of Economics, Third Edition 16) Suppose two companies, Sony and Magnavox, are competing in a duopoly. If both companies charge a high price, they each earn $700 million in economic profit. If both companies charge a low price, they each earn $500 million in economic profit. If one company charges a high price and the other a low price, the company charging the higher price earns $450 million in economic profit and the company charging the lower price earns $800 million in economic profit. a. Complete the above payoff matrix for Sony and Magnavox. b. Find the Nash equilibrium.

15 Chapter 16 Oligopoly 345 Answer: a. The completed payoff matrix is above, with the entries in millions of dollars. b. The Nash equilibrium has each firm charging a low price and earning $500 million in economic profit. Topic: Duopolists' dilemma Skill: Level 4: Applying models Author: SB

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