ECON 221 Lecture 19Outline of Last Lecture I. Monopolistic CompetitionII. Short Run effectsIII. Long Run effectsIV. Efficiency and Implications Outline of Current Lecture I. Oligopoly characteristics II. Game theory a. Strategic Interactionb. Dominant Strategy III. Maximizing Profits IV. Tacit Collusion Current LectureOligopolies – Lecture 20- Commonly there are just a few firms in an industryo Operating systems, phone providers, airplane manufacturers, airlineso Lands somewhere between the two extremes of perfect competition and monopolies  Perfect competition- competition, but no market power Monopoly- complete market power, no competitiono What do we mean by market power? PC – because there are thousands of firms, no matter how much one produces, they have no impact on market level supply or price Monopoly – only firm in the market, so changes in quantity affect market level Q’s and priceThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. Oligopoly – One of a handful of firms, so many actions impact the market, just asother firms’ actions impact the market- Game Theoryo Oligopolies engage in “Strategic Interaction” Strategic Interaction - Any situation where my best action depends on what you are doing and vice versa Prisoner’s dilemma Not strategic interaction – How many donuts to buy, how much to produce in a perfectly competitive market  “Game Theory” is the study of strategic interaction o Terms and Ideas Strategy – specifies a plan for what to do conditional on what the other guy is doing- Ex. Prisoner’s dilemma, “best” strategy is: RAT OUT PARTNER when he rats me out, and RAT OUT PARTNER when he stays quiet Dominant Strategy – if one action is better regardless of what the other guy does, it is a dominant strategy  (Nash) Equilibrium - a situation where no one has an incentive to change their strategy given what others are doing.- In P.D., the situation where both players play “ALWAYS RAT OUT OTHER PLAYER” strategy- Equilibrium Outcome (-5, -5)- John Nash – won Nobel Peace Prize in Economics in 1994.o Another example – Stag Hunt Game Only one best outcome Two equilibrium outcomes – both rabbit or both stagStag RabbitStag 5, 5 0,3Rabbit 3,0 3,3- Game Theory…o Both games mentioned are “one shot games” – they happen once and that’s it- Maximizing profits: The problemo Remember how monopolies maximized profits… Sold less than would be sold under perfect competition Why? With complete control of the market, lower quantity implied higher prices Like a monopolist, large market power implies that increasing output decreases prices (and therefore, eventually decreases profit)- An oligopolist prefers less total output in the market- Unlike a monopolist, an oligopolist is not in total control of market output (and therefore prices)o If another firm increases output, it decreases my revenue due tolower price – so I suffer “price effect” but do not enjoy “quantityeffect”o But if I respond by increasing my quantity, price goes down evenfurther. - Maximizing profits: A (potential) Solutiono The fact that there are few firms provides the opportunity to cooperate Not possible in PC or MC – too many firmso Firms can agree to collude or form a cartel to act as though they are a monopolist – limiting total output to the profit maximizing levelo But will this work? Ex. Assume there are two firms and MC = ATC = 0, so both firms just care about maximizing revenue Revenue in the market is maximized when total output (Q1 + Q2) is 60. So suppose the two firms agree to each produce 30 and share the profits (TR = 180 for each). However, eventually one firm will realize that it can produce more (q1 = 40  Q = 70) and increase profit- Drives price down to $5- Firm one revenue = $5 x 40 = $200- Firm two revenue = $5 x 30 = $150- Oligopoly profits and game theoryo It seems that incentives make collusion impossible – a self interested firm would never hold up their end of the agreement o Prisoner’s dilemma parallel- Tacit Collusiono This sort of repeated interaction can (and does) occur without any formal agreement – firms simply monitor each other’s behavior, and “punish” each other if deviation occurs. - In summary – o The analysis of oligopolies is very different than other market structures due to the possibility of strategic interaction o Cooperating to maintain a low output (and therefore high price) is useful to both producers, but there is no incentive to maintain that arrangement in a one-shot game. o However, when repeated, cooperation can occur (which is of course very good for the sellers and very bad for the buyers)Perf. Comp. Monopoly Mono. Comp. Oligopoly# of sellers? Many One Large Number A fewIdentical Products? Yes No close substitutes(irrelevant)No – slightdifferentiationMaybe – but not adefining characteristicLong run outcome forfirms ?Zero profits – firmsenter shifting marketsupply up, reducingpricePositive profit Zero profit – firms entershifting firm demanddown, reducing price atQ*ComplicatedLong run outcome forsociety?Efficient Inefficient –Deadweight lossAmbiguous