Chapter 14. Oligopoly

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1 Chapter 14. Oligopoly Instructor: JINKOOK LEE Department of Economics / Texas A&M University ECON Principles of Microeconomics

2 Oligopoly Market Oligopoly: A market structure in which a small number of interdependent firms compete. In analyzing oligopoly, we cannot rely on the same types of graphs we used before for two reasons. We need to use the more complex business strategies of large oligopoly firms. demand curves and cost curves are not useful. To analyze competition among oligopolists, we use game theory. game theory is the study of how people make decisions in situations in which attaining their goals depends on their interactions with others.

3 Barriers to Entry Barrier to entry: Anything that keeps new firms from entering an industry in which firms are earning economic profits. A. Economies of Scale: the situation when a firm long-run average costs fall as the firm increases output. The industry will be an oligopoly if the minimum point comes at a level of output that is a large fraction of industry sales, such as Q2.

4 Barriers to Entry B. Ownership of a Key Input: If production of a good requires a particular input, then control of that input can be a barrier to entry. De Beers controlled most of the world s diamond mines. Major airlines in U.S. are controlling most of arriving/departing gates at their hub airports. C. Government-Imposed Barriers Patent: the exclusive right to a product (for 20 years). Occupational licensing: doctors and dentists in every state need licenses to practice. Tariff: a tax on imports Quota: limit on the quantity of a good that can be imported into a country.

5 Game Theory Game theory: the study of the decisions of firms in industries where the profits of each firm depend on its interactions with other firms. Games share three key characteristics. Rules that determine what actions are allowable. Strategies that players employ to attain their objectives in the game. Payoffs that are the results of the interactions among the players strategies.

6 A Duopoly Game: Price Competition between Two Firms Game theory can be used to analyze price competition in a duopoly (an oligopoly with two firms). if they both charged $1,200, they would each make profits of $10 million. however, each firm has an incentive to undercut the other by charging a lower price. if both firms charged $1,000, they would each make a profit of only $7.5 million.

7 A Duopoly Game: Price Competition between Two Firms Payoff matrix: A table that shows the payoffs that each firm earns from every combination of strategies by the firms. Collusion: An agreement among firms to charge the same price or otherwise not to compete. Dominant strategy: A strategy that is the best for a firm, no matter what strategies other firms use. The result of a dominant strategy is an equilibrium in which each firm is maximizing profits, given the price chosen by the other firm. Nash equilibrium: A situation in which each firm chooses the best strategy, given the strategies chosen by other firms.

8 Firm Behavior and the Prisoner s Dilemma Cooperative equilibrium: An equilibrium in a game in which players cooperate to increase their mutual payoff. Noncooperative equilibrium: An equilibrium in a game in which players do not cooperate but pursue their own self-interest. Prisoner s dilemma: A game in which pursuing dominant strategies results in noncooperation that leaves everyone worse off.

9 Can Firms Escape the Prisoner s Dilemma? In this repeated game, firms have the incentive to cooperate by implicitly colluding. Suppose that Wal-Mart and Target sell PlaStation 3. each month they will decide what price they will charge for the PlayStation 3. they both are advertise that they will match the lowest price offered by competitor. the advertisement is one way of colluding implicitly. With the matching offer, the equilibrium shifts to both stores charging the high price and receiving high profits.

10 Real World Example of Lower Price Match

11 A Real World Example: OPEC Cartels Cartel: A group of firms that collude by agreeing to restrict output to increase prices and profits. OPEC (Organization of the Petroleum Exporting Countries) It has 12 members including Saudi Arabia, Kuwait, Nigeria, and others. They own 75% of the world s proven oil reserves. Cooperation: By reducing oil production, OPEC was able to raise the world price of oil in the mid-1970s and early 1980s. Noncooperation: Sustaining high prices has been difficult over the long run, because OPEC members often exceed their output quotas.

12 A Real World Example: OPEC Cartels Saudi Arabia can produce much more oil than Nigeria, its output decisions have a much larger effect on the price of oil. Low Output corresponds to cooperating with the OPEC-assigned quota. High Output corresponds to producing at maximum capacity. Saudi Arabia has a dominant strategy to cooperate (low output). Nigeria has a dominant strategy not to cooperate (high output). Equilibrium will occur with Saudi Arabia producing a low output and Nigeria producing a high output.

13 Deterring Entry Sequential games: one firm will act first, and then other firms will respond. Suppose that Apple has been successfully selling laptops, and Dell is considering whether it will enter the market or not. To break even, laptops must provide a minimum rate of return of 15 % on investment. What is the best decision for Apple?

14 Bargaining Suppose that Dell and TruImage begin bargaining over what price Dell will pay TruImage for its software. What is the best decision for Dell? TruImage threats Dell by telling that it will reject a $20 price. Is this threat credible? Subgame-perfect equilibrium: A Nash equilibrium in which no player can make himself or herself better off by changing his decision at any decision node.

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