BETWEEN MONOPOLY AND PERFECT COMPETITION

Oligopoly 17 BETWEEN MONOPOLY AND PERFECT COMPETITION Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly 1

BETWEEN MONOPOLY AND PERFECT COMPETITION Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers. 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. 2

Figure 1 The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Few firms Differentiated products Identical products Monopoly (Chapter 15) Oligopoly (Chapter 17) Monopolistic Competition (Chapter 16) Perfect Competition (Chapter 14) Tap water Cable TV Chocolate Crude oil Novels Restaurants Wheat Milk Copyright 2010 2011 Cengage South-Western Learning MARKETS WITH ONLY A FEW SELLERS Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. 3

MARKETS WITH ONLY A FEW SELLERS Characteristics of an Oligopoly Market Few sellers offering similar or identical products Interdependent firms Firms are best off cooperating and acting like a monopolist - producing a small quantity of output and charging a price above marginal cost A Duopoly Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. 4

Table 1 The Demand Schedule for Water Q P TotRev 0 120 0 10 110 1100 20 100 2000 30 90 2700 40 80 3200 50 70 3 TotCost Profit - 600 1 2200 2700 3000 P=120-Q TC= MR=120-2Q MC=0 60 60 3600 70 50 3 80 40 3200 90 30 2700 100 20 2000 110 10 1100 3100 3000 2700 2200 1 600 MR=MC Q*=60 Soc. eff. P=MC P=0 & Q E =120 120 0 0 - Copyright 2011 South-Western 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 litres The price and quantity in a monopoly market would be where total profit is maximized: P = 60 Q = 60 litres 5

A Duopoly Example Price and Quantity Supplied The socially efficient quantity of water is 120 litres, but a monopolist would produce only 60 litres 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. 6

Competition, Monopolies, and Cartels Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Competition 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. 7

The Equilibrium for a Duopoly Two firms, A and B x A =30 and x B =30 is a Nash equilibrium? max π A (x A x B =30) x A *=30??? Q=x A +x B P=120-Q P=120-x A -30 P=90-x A MR=90-2x A MR=MC 90-2x A =0 30 x A =45 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. 8

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. Figure 3 An Oligopoly Game: NORMAL form Saudi Arabia s Decision Iran s Decision High Production Low Production High Production Iran gets 40 billion Iran gets 30 billion Saudi Arabia gets 40 billion Saudi Arabia gets 60 billion Low Production Saudi Arabia gets 30 billion Iran gets 60 billion Saudi Arabia gets 50 billion Iran gets 50 billion NASH EQUILIBRIUM??? (High, High) Copyright 2011 Cengage South-Western Learning 9

Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player. Oligopolies as a Prisoners Dilemma Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. 10

The Equilibrium for an Oligopoly When firms in an oligopoly individually choose production to maximize profit, they produce a 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). Figure 5 An Advertising Game Marlboro s Decision Camel s Decision Advertise Don t Advertise Advertise Camel gets $3 billion profit Camel gets $2 billion profit Marlboro gets $3 billion profit Marlboro gets $5 billion profit Don t Advertise Camel gets $5 billion profit Camel gets $4 billion profit Marlboro gets $2 billion profit Marlboro gets $4 billion profit Copyright 2011 Cengage South-Western Learning 11

Figure 6 A Common Resources Game Shell s Decision Drill Two Wells Drill One Well BP s Decision Drill Two Wells Drill One Well BP gets 4 million profit BP gets 3 million profit Shell gets 4 million profit Shell gets 6 million profit BP gets 6 million profit BP gets 5 million profit Shell gets 3 million profit Shell gets 5 million profit Copyright Copyright 2011 2011 Cengage South-Western Learning Figure 4 An Arms Race Game Decision of Iran Arm Disarm Iran at risk Iran at risk and weak Arm Decision of Israel Israel at risk Iran safe and powerful Israel safe and powerful Iran safe Disarm Israel at risk and weak Israel safe Copyright 2011 Cengage South-Western Learning 12

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. 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. 13

The Prisoners Dilemma Confess Mr Green s Decision Remain Silent Mr Green gets 8 years Mr Green gets 20 years Mr Blue s Decision Confess Remain Silent Mr Blue gets 8 years Mr Green goes free Mr Blue gets 20 years Mr Blue goes free Mr Green gets 1 year Mr Blue gets 1 year Copyright 2011 South-Western Why People Sometimes Cooperate Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-off gain. 14

NORMAL vs EXTENSIVE form Iran s Decision Saudi Arabia s Decision High Low High Low 40,40 60,30 30,60 50,50 Iran s Decision High Low The node is not singletone: Saudia Arabia doesn t know what Iran played (imperfect information) High Low High Saudi Arabia s Decision Low 40,40 60,30 30,60 50,50 Complete information: all players know all payoffs Copyright 2011 Cengage South-Western Learning Another Game: Matching Pennies Each of two people chooses either Head or Tail. If the choices differ, player 1 pays player 2 a euro; if they are the same, player 2 pays player 1 a euro. This is also a zero-sum or strictly competitive game No Nash Eq at all! What shall we do here? Head Tail Head Tail 1,-1-1,1-1,1 1,-1 15

Solution ideas A. Nash Cournot equilibrium B. Iterative elimination of weakly dominated strategies: it is irrational to play a dominated strategy Weakly Dominated Strategies A strategy a j * A j is weakly dominated if there exists a strategy a j such that for all strategy profiles a A: u j (a -j, a j ) u j (a -j, a j *) and for at least one profile a A: u j (a -j, a j ) > u j (a -j, a j *). 16

Iterated Elimination: Example Eliminate: b4, dominated by b3 a4, dominated by a1 b3, dominated by b2 a1, dominated by a2 b1, dominated by b2 a3, dominated by a2 Result: (a2,b2) b1 b2 b3 b4 a1 1,7 2,5 7,2 0,1 a2 5,2 3,3 5,2 0,1 a3 7,0 2,5 0,4 0,1 a4 0,0 0,-2 0,0 9,-1 Iterated Elimination: Prisoner s Dilemma Player 1 reasons that not confessing is strictly dominated and eliminates this option Player 2 reasons that player 1 will not consider not confessing. So he will eliminate this option for himself as well So, they both confess Don t confess Confess Don t confess 3,3 0,4 Confess 4,0 1,1 17

The Prisoners Dilemma The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players. Results of Iterative Elimination of Weakly Dominated Strategies The result is not necessarily unique Example: Eliminate T ( M) L ( R) Result: (1,1) Eliminate: B ( M) R ( L) Result (2,1) T M B L R 2,1 0,0 2,1 1,1 0,0 1,1 18

Takeaway points: Depending on the order of elimination, iterated elimination of weakly dominated strategies can produce different results. Iterated elimination of strictly dominated strategies does not suffer from this problem. Any equilibrium in a game created with iterated elimination of weakly dominated strategies will be an equilibrium in the overall game, but you must check for other equilibria in the original game. Perfect information: deterrence game Acc In & Acc Out IN 1,1 OUT 0,2 Acc In & Fight Out 1,1 0,3 Three NASH equilibria, but only one is subgame perfect: BACKWARD INDUCTION Fight In & Acc Out -1,-1 0, 2 Fight Out & Fight In -1,-1 0, 3 OUT Incumbent Reduce quantity Keep same quantity (accommodate) (fight) 0; 2 Entrant IN Reduce quantity Keep same quantity (accommodate) (fight) 0; 3 1; 1-1,-1 19

Conclusions The game outcome is the action profile resulting from the individual choices. Each player gets a payoff based on its payoff function and the resulting action profile. Iterated elimination of strictly dominated strategies is a convincing solution concept, but unfortunately, most of the time it does not yield a unique solution Nash equilibrium is another solution concept: Action profiles, where no player has an incentive to deviate It also might not be unique and there can be even infinitely many NEs. Also, there is no guarantee for the existence of a NE 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. 20

Restraint of Trade and Competition Law It is illegal to restrain trade or attempt to monopolize a market. Articles 101 and 102 of the Treaty of Rome The European Commission has a number of investigative powers to help it apply the EU antitrust rules and may fine business undertakings that violate them Controversies over Competition Policy Competition policies sometimes may prohibit business practices that have potentially positive effects: Resale price maintenance Predatory pricing Tying 21

Controversies over Competition Policy Resale Price Maintenance occurs when suppliers (like wholesalers) require retailers to charge a specific amount 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. 22

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. Summary Policy makers use the antitrust laws to prevent oligopolies from engaging in behaviour that reduces competition. 23