Oligopoly and Game Theory

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1 Chapter 15 MODERN PRINCIPLES OF ECONOMICS Third Edition Oligopoly and Game Theory

2 Outline Cartels The Prisoner s Dilemma Oligopolies When Are Cartels and Oligopolies Most Successful? Government Policy toward Cartels and Oligopolies Business Strategy and Changing the Game 2

3 Introduction An oligopoly is an industry that is dominated by a small number of firms. A cartel is an oligopoly that tries to act together to reduce supply, raise prices, and increase profits. Even when an oligopoly is not able to collude, prices are likely to be higher than in a competitive market. Game theory is used to model decisions in situations where the players interact. 3

4 Definition Oligopoly: a market that is dominated by a small number of firms. Cartel: a group of suppliers who try to act as if they were a monopoly. 4

5 Definition Strategic decision making: decision making in situations that are interactive. 5

6 Self-Check An oligopoly is a market that is: a. Dominated by one firm. b. Dominated by cartels. c. Dominated by a few firms. Answer: c an oligopoly is a market that is dominated by a few firms. 6

7 Cartels The Organization of Petroleum Exporting Countries (OPEC) is a cartel of oil-exporting countries. Between 1970 and 1974 OPEC cut back on their production of oil. The price of oil shot up from $7 per barrel to almost $38 a barrel. 7

8 Cartels The Price of Oil

9 Cartels Price Competitive Market (constant cost) Price As if controlled by a monopolist P M Profit shared by members of cartel P C Supply MC = AC D MR D Q C Quantity Q M Q C Quantity A cartel tries to move a market from Competitive toward As If Controlled By a Monopolist. 9

10 Self-Check Cartels try to increase their profits by: a. Reducing costs. b. Reducing quantity. c. Increasing quantity. Answer: b cartels try to increase profits by reducing quantity and therefore increasing price. 10

11 Cartels Cartels tend to collapse and lose their power for three reasons: 1. Cheating by the cartel members. 2. New entrants and demand response. 3. Government prosecution and regulation. 11

12 The Incentive to Cheat If a cartel succeeds, each member makes high profits. These profits create an incentive to cheat When everyone reduces production and price rises, some members will then cheat by producing more. REUTERS/CORBIS Venezuelan President Hugo Chavez hugs Saudi Crown Prince Abdullah bin Abdul Aziz Al Saud during an OPEC summit in

13 The Incentive to Cheat Price Monopoly Price Four-Firm Cartel P O P 1 Revenue lost Revenue gained P O P 1 Other members Revenue lost Revenue gained D D Q O Q 1 Quantity Q O Q 1 Quantity Monopoly quantity: it bears all of the loss due to the lower price. Cartel member quantity: losses are shared with the other members. Conclusion: A member of a cartel has a greater incentive to cheat. 13

14 Self-Check One of the ways cartels lose their market power is through: a. Competing with each other for customers. b. Going bankrupt. c. Members cheating on the agreement. Answer: c a member of a cartel can increase profits even further by cheating and producing more than they had originally agreed on. 14

15 Prisoner s Dilemma A cartel cheating is one version of a game called the prisoner s dilemma. It suggests that cooperation is difficult to maintain. Political scientist Elinor Ostrom showed that members of communities with repeated interaction generally find rules or norms that limit the prisoner s dilemma. 15

16 Definition Prisoner s dilemma: a situation where the pursuit of individual interest leads to a group outcome that is in the interest of no one; the negative counterpart to the invisible hand. 16

17 Prisoner s Dilemma A Payoff Table In this game, Cheat is a better strategy for each player no matter what the other player s strategy. 17

18 Definition Dominant strategy: a strategy that has a higher payoff than any other strategy no matter what the other player does. 18

19 Self-Check A game where pursuing one s own interest leads to an outcome that is in no one s interest is called the: a. Oligopoly outcome. b. Dominant strategy. c. Prisoner s dilemma. Answer: c this is called the prisoner s dilemma. 19

20 Collusion When only a handful of firms can realistically bid on a contract, it becomes profitable to collude. Firms can agree to take turns being the low bidder. Collusive outcomes may evolve even without explicit agreement. 20

21 Definition Tacit collusion: when firms limit competition with one another but they do so without explicit agreement or communication. 21

22 Oligopolies Oligopolies are markets dominated by a small number of firms. A firm in an oligopoly has some influence over price and therefore has an incentive to reduce output and increase price. Price in an oligopoly is likely to be below monopoly levels but above competitive levels. The more firms in an industry, the closer price will be to competitive levels. 22

23 Oligopolies Price Profit increase other firms. Four firm oligopoly: Firm 4 Q price to P 1 Profit Other firms P their profits Profit increase firm 4 P 1 P 0 MC = AC Demand Q 1 Q 0 Quantity 23

24 Self-Check Oligopoly prices tend to be: a. Lower than monopoly but higher than competitive prices. b. Lower than monopoly or competitive prices. c. Higher than monopoly but lower than competitive prices. Answer: a oligopoly prices tend to be lower than monopoly but higher than competitive prices. 24

25 Definition Barriers to entry: factors that increase the cost to new firms of entering an industry. 25

26 Oligopolies Cartels and oligopolies tend to be most successful when there are barriers to entry. Important barriers to entry include: 1. Control over a key resource or input. 2. Economies of scale. 3. Network effects. 4. Government barriers. 26

27 Government Policy Most cartels have been illegal in the United States since the Sherman Antitrust Act of Antitrust laws are used to prosecute cartels, block mergers, and break up very large firms. Sometimes governments reduce competition and create barriers to entry by supporting cartels. For example, the U.S. government raises the price of milk through subsidies and quotas. 27

28 Government Policy Government-enforced monopolies and cartels are a serious problem facing poor nations. Government-supported cartels usually mean higher prices, lower-quality service, and less innovation. People spend their energies trying to get monopoly or cartel privileges from governments. Government becomes more corrupt. 28

29 Business Strategy Price Matching Suppose competing firms offer to match lower prices and give customers 10% of the difference. If one sets price at $1000 and the other at $800, customers can buy from the higher-priced firm at $800 (10% x 800) = $780. A firm has no incentive to drop price, because its competitor will get all the customers. 29

30 Business Strategy Lowe s and Home Depot face the Prisoner s Dilemma. The price matching game. 30

31 Business Strategy Loyalty Plans Loyalty plans reward regular customers with special treatment or a better price. Once customers are locked in, firms don t have to compete as much. If a firm raises price, its customers will remain loyal; if it lowers price, other firms customers will also remain loyal. Loyalty increases monopoly power and results in higher prices. 31

32 Business Strategy Innovation Pursuit of market power can lead to innovation and product differentiation. One reason firms innovate is to produce a product with fewer substitutes. Fewer substitutes mean more inelastic demand, leading to higher prices and profits. Firms also compete by differentiating their products with different styles or features. 32

33 Self-Check Loyalty plans lead to: a. Higher prices. b. Lower prices. c. More competition. Answer: a by encouraging lock-in, loyalty plans lead to monopoly power and thus higher prices. 33

34 Takeaway An oligopoly is a market dominated by a small number of firm. Oligopolies form when there are significant barriers to entry. Prices in an oligopoly tend to be below monopoly prices but above competitive prices. A cartel is an oligopoly that maximizes profits by limiting competition and producing the monopoly quantity. 34

35 Takeaway Most cartels are not stable; either members cheat or new competitors enter the market. Governments break up some cartels, but enforce many others. Game theory is the study of strategic interaction. The prisoner s dilemma game explains why cheating is common in cartels. Firms can reduce competitive pressures through price matching, loyalty programs, and innovation. 35

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