Microeconomics

Oligopolies

Game Theory

Microeconomics

Umut Türk

December 2, 2019
 Market Structure

Microeconomics

Oligopolies

Game Theory
Microeconomics

Oligopolies

Game Theory

Monopolistic competition involves many firms competing

against each other, but selling products that are distinctive
in some way.
Examples: stores selling different styles of clothing,
restaurants or grocery stores that sell a variety of food
 Perceived Demand for a Monopolistic Competitor

Microeconomics

Oligopolies

Game Theory
 Monopolistic Competition and Efficiency

Microeconomics

In the long-run price is equal to average cost thus

Oligopolies economic profits are zero.
Game Theory
In perfect competition, goods are produced at the lowest
possible average cost (production efficiency).
However, in monopolistic competition, the end result of
entry and exit is that firms end up with a price that lies on
the downward-sloping portion of the average cost curve,
not at the very bottom of the AC curve.
Thus, monopolistic competition will not be productively
efficient.
P > MC
any potential benefits of this market?
 Oligopolies

Microeconomics

Oligopolies

Game Theory
Oligopoly is a market structure in which only a few sellers
offer similar or identical products.
A few companies control the entire market.
Examples: the auto industry, television channels, and
commercial air travel.
When the number of firms is two, the market is defined as
Duopoly Market.
 Oligopoly Example

Microeconomics

Oligopolies

Game Theory
 Market Structures

Microeconomics

Oligopolies

Game Theory
 Why Do Oligopolies Exist?

Microeconomics

Oligopolies

Game Theory

Entry barriers: patents etc.

Quantity demanded in the market would have room for
only two or three oligopoly firms.
Combination of economies of scale and market demand
creates the barrier to entry,
 Oligopolies

Microeconomics

Oligopolies

Game Theory
Firms act strategically: A firm’s decisions about P or Q
can affect other firms and cause them to react.The firm
will consider these reactions when making decisions.
We use game theory to analyze interactive thinking.
Game theory: the study of how people behave in
strategic situations
 A Duopoly Example

Microeconomics

Imagine there are only two suppliers of safe water in a

Oligopolies town. Below is the demand schedule for the water and
Game Theory
corresponding price (MC=0). Perfect competitive price
and quantity? Duopoly?
 Collusion and Cartels or Competition

Microeconomics

Oligopolies
Oligopoly firms would enjoy acting like a monopolist.
Game Theory
By acting together oligopolistic firms can hold down
industry output, charge a higher price, and divide the
profit among themselves.
Collusion: an agreement among firms in a market about
quantities to produce or prices to charge.
A group of firms that have a formal agreement to collude
to produce the monopoly output and sell at the monopoly
price is called a cartel.
 Another example of Duopoly

Microeconomics

Suppose there are two Cell phone operators in the country

Oligopolies with 140 residents.
Game Theory
Each firm’s costs: FC = 0,MC = 10 Tl
Find perfectly competitive and duopoly profits provided
that firms successfully collude.
 Example cont.ed

Microeconomics

Oligopolies what happens if one of the firms does not obey the rules
Game Theory of the collusion and produce q=40?
 Collusion vs. Self-Interest

Microeconomics

Oligopolies

Game Theory Both firms would be better off if both stick to the cartel
agreement
But each firm has incentive to cheat on the agreement.
It is difficult for oligopoly firms to form cartels and honor
their agreements.
Although the logic of self-interest increases the duopoly’s
output above the monopoly level, it does not push the
duopolists to reach the competitive allocation.
 Example cont.ed

Microeconomics

Oligopolies
Would any firm choose to increase its output to 50?
Game Theory
 THE EQUILIBRIUM FOR AN OLIGOPOLY

Microeconomics

Oligopolies
Nash equilibrium: a situation in which economic
Game Theory
participants interacting with one another each choose their
best strategy given the strategies that all the others have
chosen.
Previous example has a Nash equilibrium in which each
firm produces Q=40
Firms reason in the following way:
Given that my rival produces Q = 40, my best move is to
produce Q=40
 A Comparison of Market Outcomes

Microeconomics

Oligopolies

Game Theory
When firms in an oligopoly individually choose production
to maximize profit,
oligopoly Q is greater than monopoly Q but smaller than
competitive Q.
oligopoly P is greater than competitive P but less than
monopoly P.
 The Output & Price Effects

Microeconomics

Oligopolies
What happens if firms expand their outputs: Two affects
Game Theory
are expected:
Output effect: If P > MC , selling more output raises
profits.
Price effect: Raising production increases market
quantity, which reduces market price and reduces profit on
all units sold.
If output effect > price effect the firm increases production
If price effect > output effect the firm reduces production.
 The Size of the Oligopoly

Microeconomics

Oligopolies

Game Theory As the number of firms in the market increases: the price
effect becomes smaller
the oligopoly looks more and more like a competitive
market
P approaches MC
the market quantity approaches the socially efficient
quantity.
International trade?
 Game Theory

Microeconomics

Oligopolies
Game theory helps us understand oligopoly and other
Game Theory
situations where players interact and behave strategically.
Game theory is the study of how people behave in
strategic situations.
Strategic means a situation in which each person, when
deciding what actions to take, must consider how others
might respond to that action.
In an oligopoly, firms know their profits depend not only
on their decisions but also other firms in the market.
 The Prisoner’s Dilemma Game

Microeconomics

Oligopolies

Game Theory
 The Prisoner’s Dilemma Game

Microeconomics

Oligopolies

Game Theory
 Dominant strategy

Microeconomics

Oligopolies

Game Theory Outcome: Bonnie and Clyde both confess, each gets 8
years in prison
Both would have been better off if both remained silent
What if Bonnie and Clyde had agreed before being caught
to remain silent ?
Dominant Strategy is a strategy that is best for a player
in a game regardless of the strategies chosen by the other
players.
 Oligopolies as a Prisoners’ Dilemma

Microeconomics

Collusive agreements are difficult to enforce because of a

Oligopolies
prisoners’ dilemma type interaction between the firms.
Game Theory
 Example

Microeconomics

Oligopolies

Game Theory Consider an oligopoly with two members, called Iran and
Iraq.
Both countries sell crude oil. After prolonged negotiation,
the countries agree to keep oil production low in order to
keep the world price of oil high.
After they agree on production levels, each country must
decide whether to cooperate and live up to this agreement
or to ignore it and produce at a higher level.
 Example Cnt.ed

Microeconomics

Oligopolies

Game Theory
 Exercise: The ”fare wars” game

Microeconomics

Oligopolies
The players: American Airlines and United Airlines
Game Theory
The choice: cut fares by 50
If both airlines cut fares, each airline’s profit = $400
million
If neither airline cuts fares, each airline’s profit = $600
million
If only one airline cuts its fares, -its profit = $800
million-the other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium
 Example: AN ADVERTISING GAME

Microeconomics
Two firms spend millions on TV ads to steal business from
each other. Each firm’s ad -cancels out the effects of the
Oligopolies other, and both firms’ profits fall by the cost of the ads.
Game Theory
 Prisoners’ Dilemma and Society’s Welfare

Microeconomics

Oligopolies

Game Theory
The noncooperative oligopoly equilibrium
Bad for oligopoly firms: prevents them from achieving
monopoly profits.
Good for society: Q is closer to the socially efficient
output , P is closer to MC
In other prisoners’ dilemmas, the inability to cooperate
may reduce social welfare.
 Example

Microeconomics
consider the decisions of two countries-the United States
and the Soviet Union- about whether to build new
Oligopolies weapons or to disarm.
Game Theory Each country prefers to have more arms than the other
because a larger arsenal gives it more influence in world
affairs.
But each country also prefers to live in a world safe from
the other country’s weapons.
 Why People Sometimes Cooperate

Microeconomics

Oligopolies

Game Theory When the game is repeated many times, cooperation may
be possible.
These strategies may lead to cooperation:
If your rival reneges in one round, you renege in all
subsequent rounds.
”Tit-for-tat”Whatever your rival does in one round
(whether defect or cooperate), you do in the following
round.
 Public Policy Toward Oligopolies

Microeconomics

Oligopolies

Game Theory
Governments can sometimes improve market outcomes.
In oligopolies, production is too low and prices are too
high, relative to the social optimum
Role for policymakers: Promote competition, prevent
cooperation to move the oligopoly outcome closer to the
efficient outcome.
 RESTRAINT OF TRADE AND THE ANTITRUST
LAWS
Microeconomics

Oligopolies

Game Theory ”People of the same trade seldom meet together, but the
conversation ends in a conspiracy against the public, or in
some diversion to raise prices.” Adam Smith
Sherman Antitrust Act (1890):Forbids collusion between
competitors
Clayton Antitrust Act (1914):Strengthened rights of
individuals damaged by anticompetitive arrangements
between firms.
 Controversies Over Antitrust Policy

Microeconomics

Oligopolies

Game Theory
Most people agree that price-fixing agreements among
competitors should be illegal.
Some economists are concerned that policymakers go too
far when using antitrust laws to stifle business practices
that are not necessarily harmful, and may have legitimate
objectives.
 Resale Price Maintenance ”Fair Trade”

Microeconomics

Oligopolies Occurs when a manufacturer imposes lower limits on the

Game Theory prices retailers can charge.
Is often opposed because it appears to reduce competition
at the retail level.
Yet, any market power the manufacturer has is at the
wholesale level; manufacturers do not gain from restricting
competition at the retail level
The practice has a legitimate objective: preventing
discount retailers from free-riding on the services provided
by full-service retailers.
 Predatory Pricing

Microeconomics

Oligopolies Occurs when a firm cuts prices to prevent entry or drive a

Game Theory competitor out of the market, so that it can charge
monopoly prices later.
Illegal under antitrust laws, but hard for the courts to
determine when a price cut is predatory and when it is
competitive & beneficial to consumers.
Many economists doubt that predatory pricing is a rational
strategy:
It involves selling at a loss, which is extremely costly for
the firm.
It can backfire
 Tying

Microeconomics

Oligopolies Occurs when a manufacturer bundles two products

Game Theory together and sells them for one price (e.g., Microsoft
including a browser with its operating system)
Critics argue that tying gives firms more market power by
connecting weak products to strong ones.
Others counter that tying cannot change market power:
Buyers are not willing to pay more for two goods together
than for the goods separately.
Firms may use tying for price discrimination, which is not
illegal, and which sometimes increases economic efficiency.
 Exercise 1

Microeconomics

Oligopolies

Game Theory
 Exercise 2

Microeconomics

Oligopolies

Game Theory