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16 Oligopoly
PRINCIPLES OF
MICROECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
CHAPTER 16 OLIGOPOLY 2
Introduction: 0
CHAPTER 16 OLIGOPOLY 3
0
Measuring Market Concentration
Concentration ratio: the percentage of the
market’s total output supplied by its four largest
firms.
The higher the concentration ratio,
the less competition.
This chapter focuses on oligopoly,
a market structure with high concentration ratios.
CHAPTER 16 OLIGOPOLY 4
Concentration Ratios in Selected U.S. Industries
0
CHAPTER 16 OLIGOPOLY 8
ACTIVE LEARNING 1: 0
Answers
If both firms stick to agreement,
P Q
each firm’s profit = $900
$0 140
If Cingular reneges on agreement and
5 130
produces Q = 40:
10 120
Market quantity = 70, P = $35
15 110
Cingular’s profit = 40 x ($35 – 10) = $1000
20 100
Cingular’s profits are higher if it reneges.
25 90
30 80 Verizon will conclude the same, so
both firms renege, each produces Q = 40:
35 70
Market quantity = 80, P = $30
40 60
Each firm’s profit = 40 x ($30 – 10) = $800
45 50
0
Collusion vs. Self-Interest
Both firms would be better off if both stick to the
cartel agreement.
But each firm has incentive to renege on the
agreement.
Lesson:
It is difficult for oligopoly firms to form cartels
and honor their agreements.
CHAPTER 16 OLIGOPOLY 11
ACTIVE LEARNING 2: 0
Answers
P Q If each firm produces Q = 40,
$0 140 then each firm’s profit = $800.
5 130 If Cingular increases output to Q = 50:
10 120 Market quantity = 90, P = $25
15 110 Cingular’s profit = 50 x ($25 – 10) = $750
20 100
Cingular’s profits are higher at Q = 40
25 90
than at Q = 50.
30 80
The same is true for Verizon.
35 70
40 60
45 50 13
0
The Equilibrium for an Oligopoly
Nash equilibrium: a situation in which
economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
• Given that Verizon produces Q = 40,
Cingular’s best move is to produce Q = 40.
• Given that Cingular produces Q = 40,
Verizon’s best move is to produce Q = 40.
CHAPTER 16 OLIGOPOLY 14
A Comparison of Market 0
Outcomes
When firms in an oligopoly individually choose
production to maximize profit,
• Q is greater than monopoly Q
but smaller than competitive market Q
• P is greater than competitive market P
but less than monopoly P
CHAPTER 16 OLIGOPOLY 15
0
The Output & Price Effects
Increasing output has two effects on a firm’s profits:
• 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.
CHAPTER 16 OLIGOPOLY 16
0
The Size of the Oligopoly
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
CHAPTER 16 OLIGOPOLY 18
Demand Curve for Water
0 120 0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
MC = 0
50 70 3,500
Qd = 120 – 1P
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,100
120 0 0
CHAPTER 16 OLIGOPOLY 19
Case 1
120
120
CHAPTER 16 OLIGOPOLY 20
Case 1
120
Firms can’t raise price
because entry will drive
price back to MC = zero
120
Producer Surplus = 0
Consumer Surplus = (½)(120*120) = 7,200
Total Welfare = 7,200
CHAPTER 16 OLIGOPOLY 21
Case 2
120
40
80 120
CHAPTER 16 OLIGOPOLY 22
Case 2
120
From demand curve,
N Q = 80; P = 40
40
Revenue per firm =
40*40 = 1600
80 120
Check for Nash EQBM:
2) If one firm produces 10 more to 50, output goes to 90, price
drops to 30 and its revenue decreases to 1,500
3) If one firm produces 10 less to 30, output goes to 70, price
rises to 50, its revenue decreases to 1,500
Welfare: CS = (80*80)/2 = 3,200; PS = 40*80 = 3,200
; thus Total Welfare = 6,400
CHAPTER 16 OLIGOPOLY 23
Case 3
5 firms
N/(N+1) = 5/6 of competitive output
(5/6)*120 = Q = 100, thus 20 units per firm
120
20 D
100 120
CHAPTER 16 OLIGOPOLY 24
Case 3
120
From demand curve,
N Q = 100; P = 20
20
Revenue per firm =
20*20 = 400
100 120
Check for Nash EQBM:
2) If one firm produces 10 more to 30, output goes to 110,
price drops to 10 and a firm earns 10*30 = 300.
3) If one firm produces 10 less to 10, output goes to 90, price
rises to 30, and a firm earns 300.
Welfare: CS = (100*100)/2 = 5,000; PS = 20*100 = 2,000
; thus Total Welfare = 7,000
CHAPTER 16 OLIGOPOLY 25
Case 4
Monopolist
N/(N+1) = 1/2 of competitive output
(1/2)*120 = Q = 60
120
60
60 120
CHAPTER 16 OLIGOPOLY 26
Case 4
120
From demand curve,
N Q = 60; P = 60
60
Revenue = 60*60 =
3,600
60 120
CHAPTER 16 OLIGOPOLY 27
Summary : Results for Nash EQBM
CHAPTER 16 OLIGOPOLY 28
0
Game Theory
Game theory: the study of how people behave
in strategic situations
Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial
CHAPTER 16 OLIGOPOLY 29
0
Prisoners’ Dilemma Example
The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
The police question each in separate rooms,
offer each the following deal:
• If you confess and implicate your partner,
you go free.
• If you do not confess but your partner implicates
you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.
CHAPTER 16 OLIGOPOLY 30
Prisoners’ Dilemma Example 0
CHAPTER 16 OLIGOPOLY 31
0
Prisoners’ Dilemma Example
Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.
Both would have been better off if both remained
silent.
But even if Bonnie and Clyde had agreed before
being caught to remain silent, the logic of self-
interest takes over and leads them to confess.
CHAPTER 16 OLIGOPOLY 32
Oligopolies as a Prisoners’ 0
Dilemma
When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
Our earlier example:
• Cingular and Verizon are duopolists in
Smalltown.
• The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
Here is the “payoff matrix” for this example…
CHAPTER 16 OLIGOPOLY 33
Cingular & Verizon in the Prisoners’ 0
Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
Cingular
Q = 30 Q = 40
Cingular’s Cingular’s
profit = $900 profit = $1000
Q = 30
Verizon’s Verizon’s
profit = $900 profit = $750
Verizon
Cingular’s Cingular’s
profit = $750 profit = $800
Q = 40
Verizon’s Verizon’s
profit = $1000 profit = $800
CHAPTER 16 OLIGOPOLY 34
ACTIVE LEARNING 3: 0
Answers
Nash equilibrium:
both firms cut fares American Airlines
Cut fares Don’t cut fares
$400 million $200 million
Cut fares
Dilemma
Ad Wars
Two firms spend millions on TV ads to steal
business from each other. Each firm’s ad
cancels out the effects of the other,
and both firms’ profits fall by the cost of the ads.
CHAPTER 16 OLIGOPOLY 37
Other Examples of the Prisoners’ 0
Dilemma
Arms race between military superpowers
Each country would be better off if both disarm,
but each has a dominant strategy of arming.
Common resources
All would be better off if everyone conserved
common resources, but each person’s dominant
strategy is overusing the resources.
CHAPTER 16 OLIGOPOLY 38
Prisoners’ Dilemma and Society’s 0
Welfare
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.
• e.g., arms race, overuse of common resources
CHAPTER 16 OLIGOPOLY 39
Why People Sometimes 0
Cooperate
When the game is repeated many times,
cooperation may be possible.
Strategies which 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 renege or cooperate),
you do in the following round.
CHAPTER 16 OLIGOPOLY 40
0
Public Policy Toward Oligopolies
Recall one of the Ten Principles from Chap.1:
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.
CHAPTER 16 OLIGOPOLY 41
Restraint of Trade and Antitrust 0
Laws
Sherman Antitrust Act (1890):
forbids collusion between competitors
Clayton Antitrust Act (1914):
strengthened rights of individuals damaged by
anticompetitive arrangements between firms
CHAPTER 16 OLIGOPOLY 42
Controversies Over Antitrust 0
Policy
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.
We consider three such practices…
CHAPTER 16 OLIGOPOLY 43
1. Resale Price Maintenance (“Fair0
Trade”)
Occurs when a manufacturer imposes lower limits
on the 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.
CHAPTER 16 OLIGOPOLY 44
2. Predatory Pricing 0
CHAPTER 16 OLIGOPOLY 47
0
CHAPTER SUMMARY
Oligopolists can maximize profits if they form a
cartel and act like a monopolist.
Yet, self-interest leads each oligopolist to a higher
quantity and lower price than under the monopoly
outcome.
The larger the number of firms, the closer will be
the quantity and price to the levels that would
prevail under competition.
CHAPTER 16 OLIGOPOLY 48
0
CHAPTER SUMMARY
The prisoners’ dilemma shows that self-interest
can prevent people from cooperating, even when
cooperation is in their mutual interest. The logic of
the prisoners’ dilemma applies in many situations.
Policymakers use the antitrust laws to prevent
oligopolies from engaging in anticompetitive
behavior such as price-fixing. But the application
of these laws is sometimes controversial.
CHAPTER 16 OLIGOPOLY 49