CHAPTER 17 Oligopoly Goals in this chapter you will Examine what outcomes are possible when a market is an oligopoly Learn about the prisoners dilemma and how it applies to oligopoly and other issues Consider how the antitrust laws try to foster competition in oligopolistic markets Outcomes after accomplishing these goals, you should be able to Describe the conditions under which an oligopolistic market generates the same outcome as a monopolistic market Show why the outcome of the prisoners dilemma may change if the game is repeated Show why some business practices that appear to reduce competition may have a legitimate business purpose 169
170 Chapter 17 Oligopoly Strive for a Five Oligopolistic competition is the final chapter on market structures in the textbook. The AP microeconomics test will want you to understand: Oligopolistic interdependence, cartels, and collusion How a payoff matrix game theory leads to strategic behavior Public policy as it pertains to competition 1. Antitrust policy 2. Regulation Key Terms Oligopoly A market structure in which only a few sellers offer similar or identical products Game theory The study of how people behave in strategic situations Duopoly An oligopoly with only two firms Collusion An agreement among firms in a market about quantities to produce or prices to charge Cartel A group of firms acting in unison Nash equilibrium A situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen Prisoners dilemma A particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial Dominant strategy A strategy that is best for a player in a game regardless of the strategies chosen by the other players Chapter Overview Context and Purpose Chapter 17 is the final chapter in a five-chapter sequence dealing with firm behavior and the organization of industry. Chapters 14 and 15 discussed the two extreme forms of market structure competition and monopoly. The market structure that lies between competition and monopoly is known as imperfect competition. There are two types of imperfect competition monopolistic competition, which we addressed in the previous chapter, and oligopoly, which is the topic of the current chapter.. The purpose of Chapter 17 is to address oligopoly a market structure in which only a few sellers offer similar or identical products. Because there are only a few sellers in an oligopolistic market, oligopolistic firms are interdependent while competitive firms are not. That is, in a competitive market, the decisions of one firm have no impact on the other firms in the market while in an oligopolistic market, the decisions of any one firm may affect the pricing and production decisions of the other firms in the market. Chapter Review Introduction The market structure that lies between competition and monopoly is known as imperfect competition. One type of imperfectly competitive market is oligopoly a market structure in which only a few sellers offer similar or identical products. Oligopoly differs from competition because in a competitive market, the decisions of one firm have no impact on the other firms in the market while in an oligopolistic market, the decisions of any one firm may affect the pricing and production decisions of other firms in the market. Oligopolistic firms are interdependent. Game theory is the study of how people
Chapter 17 Oligopoly 171 behave in strategic situations. Strategic situations are when decision makers must consider how others might respond to their actions. Markets with Only a Few Sellers A duopoly is an oligopoly with only two firms. If a market were perfectly competitive, the price of output would equal marginal cost. If a market were monopolistic, the profitmaximizing price would exceed marginal cost and the result would be inefficient. Collusion is an agreement among firms in a market about quantities to produce or prices to charge. A cartel is a group of firms acting in unison. If duopolists collude and form a cartel, the market solu tion is the same as if it were served by a monopolist and the two firms divide the monopoly profits. Oligopolists may fail to cooperate because self-interest makes it difficult to agree on how to divide the profits or because antitrust laws prohibit collusion. Without a binding agreement, each oligopolist will maximize its profit given the production levels of the other firms. A Nash equilibrium is a situa tion in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. A Nash equilibrium is a type of oligopolistic equilib rium. When oligopolists individually choose production levels to maximize individual profits, they produce a quantity that is greater than the level produced by monopoly but less than that produced by competition and they will charge a price that is less than the monopoly price but greater than the competitive price. The larger the oligopoly (more firms), the more difficult it is for them to form a cartel and behave as a monopolist. If they each choose their own level of production to maximize individual profits, they will make the marginal decision of whether to produce an additional unit based on the following: The output effect: Because price is above marginal cost, selling one more unit at the going price will raise profit. The price effect: Raising production one unit will increase the total sold, but it will lower the price and the profit on all of the other units sold. If the output effect exceeds the price effect, the oligopolist will produce another unit and it will continue to expand output until these two effects balance. The greater the number of sellers in an oligopoly, the smaller the price effect because each individual firm s impact on the price is small. Thus, the level of output increases. As the number of sellers in an oligopoly grows larger, the price approaches marginal cost and the quantity approaches the socially efficient level. When there are a large number of firms, the price effect disappears altogether and the market becomes competitive. Unrestricted international trade increases the number of firms in domestic oligopolies and moves the outcome of the market closer to the competitive solution where prices are equal to marginal cost. An example of a cartel is OPEC (Organization of Petroleum Exporting Countries), which limits the production of oil. The Economics of Cooperation Within the area of economic study known as game theory, 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. The game applies to oligopoly because oligopolistic firms would always be better off to cooperate yet they often do not. An example of a prisoners dilemma is the following: Two criminals are captured. If one confesses and the other does not, the confessor goes free while the other receives a long sentence. If both con fess, they both receive an intermediate term. If neither confesses, they both receive a very short term. If the two could cooperate, the best strategy is for both of them to keep quiet. However, because they cannot guarantee cooperation after they are caught, the best strategy for each is to confess. That is, confessing is a dominant strategy a strategy that is best for a player in a game regardless of the strategies chosen by the other players. The prisoners dilemma applies to oligopoly in the following manner: Two oligopolists are better off if they cooperate by keeping production low and sharing the monopoly profits. However, after the agreement is made, the dominant strategy for each is to cheat
172 Chapter 17 Oligopoly and produce more than they agreed to produce to enhance their individual profits. The result is that profits fall for both. Self-interest makes it difficult to maintain cooperation. The prisoners dilemma applies to the following: Arms races: Each country prefers to live in a safe world, but the dominant strategy is to increase armaments and the world is less safe. Common resources: Users of a common resource would find it more profitable to jointly limit their use of the resource, but the dominant strategy is to overuse the resource and joint profits fall. Lack of cooperation in the cases previously described is harmful to society. However, lack of cooperation between oligopolists regarding the level of production may be bad for the oligopolists but it is good from the standpoint of society as a whole. Although cooperation is difficult to maintain, it is not impossible. If the game is repeated, the prisoners dilemma can be solved and agreements can be maintained. For example, oligopolies may include a penalty for violation of the agreement. If the penalty is that they all maintain high produc tion forever if someone cheats, then all should maintain low production levels and share monopoly profits. If the game is played on a periodic basis (each week, month, or year new production levels are chosen), then a simple strategy of tit-for-tat generates the greatest likelihood of cooperation. Tit-for-tat is when a player in a game starts by cooperating and then does whatever the other player did last period. If the first player cooperated last period, then the second player should cooperate the next period. If the first player defected (cheated) last period, then the second player should cheat the next period, and so on. Public Policy Toward Oligopolies Because cooperating oligopolists reduce output and raise prices, policymakers try to induce firms in an oligopoly market to compete rather than cooperate. The Sherman Antitrust Act of 1890 makes agreements to not compete (to reduce quantities or raise prices) a criminal conspiracy. The Clayton Act of 1914 allows individuals harmed by such agreements the right to sue for triple damages. Price fixing clearly reduces economic welfare and is illegal. There is some disagreement over the use of antitrust laws against some business practices that appear like price fixing. For example: Resale price maintenance or fair trade is when a manufacturer requires retailers to charge a certain price. This appears to prevent retailers from competing on price. However, some economists defend the practice as legitimate because (1) if the manufacturer has market power, it is at whole sale not retail, and the manufacturer would not gain from eliminating competition at the retail level, and (2) resale price maintenance stops discount retailers from free riding on the services provided by full-service retailers. The Supreme Court recently lifted the century-old blanket ban on resale price maintenance, and moved toward a case-by-case approach. Predatory pricing occurs when a firm cuts prices with the intention of driving competitors out of the market so that the firm can become a monopolist and later raise prices. Some economists think that this behavior is unlikely because it hurts the firm that is engaged in predatory pricing the most. Tying occurs when a manufacturer bundles two products together and sells them for one price. Courts argue that tying gives the firm more market power by connecting a weak product with a strong product. Some economists disagree. They suggest that it allows the firm to price discrimi nate, which may actually increase efficiency. Tying remains controversial. Conclusion Oligopolies will look more like a competitive market if there are a large number of firms and more like a monopoly if there are a small number of firms. The prisoners dilemma shows why cooperation is difficult to maintain even when it is in the best interest of the oligopolists. The use of antitrust laws against price fixing improves economic efficiency but their use in other areas is more controversial.
Chapter 17 Oligopoly 173 Helpful Hints 1. Oligopoly lies between monopoly and perfect competition. If oligopolists are able to collude and form a cartel, the market solution is the same as that for a monopoly. If oligopolists are unable to collude and form a cartel, the production and pricing in the market depend on the number of firms. The fewer the number of firms, the more the result appears like monopoly where the price exceeds marginal cost and the quantity is below the efficient level. The greater the number of firms, the more the result appears like competition where the price equals marginal cost and the quantity is efficient. Self-Test Multiple-Choice Questions 1. An oligopoly is a market in which a. there are only a few sellers, each offering a product similar or identical to the products offered by other firms in the market. b. there are many sellers, each offering a product similar or identical to the products offered by other firms in the market. c. barrier to entry of new firms is minimal. d. firms are price takers. e. each firm pursues an independent pricing strategy. 2. One key difference between an oligopoly market and a perfectly competitive market is that oligopolistic firms a. are price takers whereas perfectly competitive firms are not. b. can affect the profit of others firms in the market by choices they make whereas firms in perfectly competitive markets do not affect each other by choice they make. c. sell their product at a price equal to marginal cost whereas perfectly competitive firms do not. d. sell a homogeneous product whereas perfectly competitive firms do not. e. do not compete based on product differentiation whereas perfectly competitive firms do. 3. If, in a particular market, firms sell identical products, then the market is (i) perfectly competitive. (ii) monopolistically competitive. (iii) an oligopoly. a. (i) only b. (ii) only c. (iii) only d. (i) or (ii) e. (i) or (iii) 4. A market structure in which there are many firms selling products that are similar but not identical is known as a. perfect competition. b. monopolistic competition. c. oligopoly. d. single price monopoly. e. price discriminating monopoly.
174 Chapter 17 Oligopoly 5. The equilibrium quantity in markets characterized by oligopoly is a. higher than in monopoly markets and higher than in perfectly competitive markets. b. higher than in monopoly markets and lower than in perfectly competitive markets. c. higher than in monopoly markets and higher than in monopolistically competitive markets. d. lower than in monopoly markets and higher than in perfectly competitive markets. e. lower than in monopoly markets and lower than in perfectly competitive markets. 6. Consider a market that is initially perfectly competitive with many firms selling an identical product. Over time, however, suppose the merging of firms results in the market being served by only three or four firms selling this same product. As a result, we would expect a. an increase in market output and an increase in the price of the product. b. an increase in market output and a decrease in the price of the product. c. an increase in market output and an indeterminate effect on the price of the product. d. a decrease in market output and a decrease in the price of the product. e. a decrease in market output and an increase in the price of the product. 7. The prisoners dilemma is an important game to study because a. most games present zero-sum alternatives. b. it identifies the fundamental difficulty in maintaining cooperative agreements. c. strategic decisions faced by prisoners are identical to those faced by firms engaged in competitive agreements. d. all interactions among firms are represented by this game. e. it identifies the best strategy for the participants when their actions are independent. Figure 17-1 Katie and Taylor are roommates. On a particular day, their lawn needs to be mowed. Each person has to decide whether to take part in mowing the lawn. At the end of the day, either the lawn will be mowed (if one or both roommates take part in mowing), or it will remain un-mowed (if neither roommate mows). With happiness measured on a scale of 1 (very unhappy) to 10 (very happy), the possible outcomes are as follows: Katie s Decision Mow Katie s happiness = 7 Don t mow Katie s happiness = 10 Mow Taylor s Decision Don t mow Taylor s happiness = 7 Katie s happiness = 5 Taylor s happiness = 2 Katie s happiness = 4 Taylor s happiness = 8 Taylor s happiness = 4
Chapter 17 Oligopoly 175 8. Refer to Figure 17-1. The dominant strategy for Taylor is to a. mow, and the dominant strategy for Katie is to mow. b. mow, and the dominant strategy for Katie is to refrain from mowing. c. refrain from mowing, and the dominant strategy for Katie is to mow. d. refrain from mowing, and the dominant strategy for Katie is to refrain from mowing. e. refrain from mowing, and there is no dominant strategy for Katie. 9. Refer to Figure 17-1. If this game is played only once, then which of the following outcomes is the most likely one? a. Katie and Taylor both mow. b. Katie mows and Taylor does not mow. c. Taylor mows and Katie does not mow. d. Neither Katie nor Taylor mow. e. All of the above outcomes are equally likely. 10. In a game, a dominant strategy is a. the best strategy for a player to follow only if other players are cooperative. b. the best strategy for a player to follow, regardless of the strategies followed by other players. c. a strategy that must appear in every game. d. a strategy that leads to one player s interests dominating the interests of the other players. e. increases the total payoff for the player. Table 17-1 Consider a small town that has two grocery stores from which residents can choose to buy a gallon of milk. The store owners each must make a decision to set a high milk price or a low milk price. The payoff table, showing profit per week, is provided. The profit in each cell is shown as (Store 1, Store 2). Store 1 Low Price Store 2 High Price Low Price (500, 500) (800, 100) High Price (100, 800) (650, 650) 11. Refer to Table 17-1. If grocery store 2 sets a low price, what price should grocery store 1 set? And what will grocery store 1 s payoff equal? a. Low price, $500 b. High price, $800 c. Low price, $100 d. High price, $100 e. High Price, $650 12. Which of the following statements is (are) true of the prisoners dilemma? (i) Rational self-interest leads neither party to confess. (ii) Cooperation between the prisoners is difficult to maintain. (iii) Cooperation between the prisoners is individually rational. a. (i) only b. (ii) only c. (ii) and (iii) d. (i) and (iii) e. (i), (ii), and (iii)
176 Chapter 17 Oligopoly Free Response Questions 1. Describe the source of tension between cooperation and self-interest in a market characterized by oligopoly. Use an example of an actual cartel arrangement to demonstrate why this tension creates instability in cartels. 2. Ford and General Motors are considering expanding into the Vietnamese automobile market. Given the payoffs in the box, answer the following questions. Ford GM Expand Do Not Expand Expand (2, 2) (4, 1) Do Not Expand (1, 4) (3, 3) A. Does GM have a dominant strategy? Explain. B. Does Ford have a dominant strategy? Explain. C. If both GM and Ford only play this game one time, what will be each of their payoffs?
Chapter 17 Oligopoly 177 Solutions Multiple-Choice Questions 1. a TOP: Oligopoly 2. b TOP: Oligopoly/Cooperation 3. e TOP: Oligopoly 4. c TOP: Game Theory 5. b TOP: Game Theory 6. e TOP: Game Theory 7. b TOP: Prisoners dilemma 8. e TOP: Game Theory/Dominant strategy 9. b TOP: Game Theory 10. b TOP: Dominant strategy 11. a TOP: Game Theory 12. b TOP: Prisoners dilemma Free Response Questions 1. The source of the tension exists because total profits are maximized when oligopolists cooperate on price and quantity by operating as a monopolist. However, individual profits can be gained by individuals cheating on their cooperative agreement. This is why cooperative agreements among members of a cartel are inherently unstable. This is evident in the problem OPEC experiences in enforcing the cooperative agreement on production and price of crude oil. TOP: Cartels 2. A. Yes, the dominant strategy for GM is to expand. Expansion is better for GM regardless of what Ford does. B. Yes, the dominant strategy for Ford is to expand. Expansion is better for Ford regardless of what GM does. C. They will each follow their dominant strategy and wind up with two each. TOP: Prisoners dilemma