15 OLIGOPOLY After studying this chapter you will be able to Define and identify oligopoly Use game theory to explain how price and output are determined in oligopoly Use game theory to explain other strategic decisions Describe the antitrust laws that regulate oligopoly 2014 Pearson Addison Wesley The chip in your laptop was made by Intel or AMD the battery in your TV remote by Duracell or Energizer and the airplane that takes you on a long distance trip was made by Boeing or the European firm Airbus In the markets for computer chips batteries and big airplanes two producers compete for market share in the pursuit of maximum profit How does a market work when only two firms compete The models of perfect competition and monopoly don t predict the behavior of the firms we ve just described To understand how these markets work we use the model of oligopoly 2014 Pearson Addison Wesley What Is Oligopoly Oligopoly is a market structure in which Natural or legal barriers prevent the entry of new firms A small number of firms compete 2014 Pearson Addison Wesley What Is Oligopoly Barriers to Entry Either natural or legal barriers to entry can create oligopoly Figure 15 1 shows two oligopoly situations In part a there is a natural duopoly a market with two firms 2014 Pearson Addison Wesley What Is Oligopoly In part b there is a natural oligopoly market with three firms A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms 2014 Pearson Addison Wesley What Is Oligopoly Small Number of Firms Because an oligopoly market has only a few firms they are interdependent and face a temptation to cooperate Interdependence With a small number of firms each firm s profit depends on every firm s actions Temptation to Cooperate Firms in oligopoly face the temptation to form a cartel A cartel is a group of firms acting together to limit output raise price and increase profit Cartels are illegal 2014 Pearson Addison Wesley Oligopoly Games Game theory is a tool for studying strategic behavior which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence All games have four common features Rules Strategies Payoffs Outcome 2014 Pearson Addison Wesley Oligopoly Games The Prisoners Dilemma In the prisoners dilemma game two prisoners Art and Bob have been caught committing a petty crime Rules The rules describe the setting of the game the actions the players may take and the consequences of those actions Each is held in a separate cell and cannot communicate with the other 2014 Pearson Addison Wesley Oligopoly Games Each is told that both are suspected of committing a more serious crime If one of them confesses he will get a 1 year sentence for cooperating while his accomplice will get a 10 year sentence for both crimes If both confess to the more serious crime each receives 3 years in jail for both crimes If neither confesses each receives a 2 year sentence for the minor crime only 2014 Pearson Addison Wesley Oligopoly Games Strategies Strategies are all the possible actions of each player Art and Bob each have two possible actions 1 Confess to the larger crime 2 Deny having committed the larger crime With two players and two actions for each player there are four possible outcomes 1 Both confess 2 Both deny 3 Art confesses and Bob denies 4 Bob confesses and Art denies 2014 Pearson Addison Wesley Oligopoly Games Payoffs Each prisoner can work out what happens to him can work out his payoff in each of the four possible outcomes We can tabulate these outcomes in a payoff matrix A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player The next slide shows the payoff matrix for this prisoners dilemma game 2014 Pearson Addison Wesley Art s payoff from each combination of actions is shown in the top of each payoff box and Bob s is shown as the bottom of each payoff box Note that there are four possible outcomes Bob and Art both confess top left box both Bob and Art deny bottom right box Bob confesses but Art does not top right box and Art confesses but Bob does not bottom left box 2014 Pearson Addison Wesley Oligopoly Games Outcome If a player makes a rational choice in pursuit of his own best interest he chooses the action that is best for him given any action taken by the other player If both players are rational and choose their actions in this way the outcome is an equilibrium called a Nash equilibrium first proposed by John Nash Finding the Nash Equilibrium The following slides show how to find the Nash equilibrium 2014 Pearson Addison Wesley Bob s view of the world Bob s view of the world Art s view of the world Art s view of the world Equilibrium Dominant strategy equilibrium This outcome is not the best one If the players could have cooperated communicated and committed they would have chosen to deny and each get 2 years Oligopoly Games The Dilemma The dilemma arises as each prisoner contemplates the consequences of his decision and puts himself in the place of his accomplice Each knows that it would be best if both denied But each also knows that if he denies it is in the best interest of the other to confess The dilemma leads to the equilibrium of the game 2014 Pearson Addison Wesley Oligopoly Games A Bad Outcome For the prisoners the equilibrium of the game is not the best outcome If neither confesses each gets a 2 year sentence Can this better outcome be achieved No it can t because each prisoner can figure out that there is a best strategy for each of them Each knows that it is not in his best interest to deny 2014 Pearson Addison Wesley Oligopoly Games An Oligopoly Price Fixing Game A game like the prisoners dilemma is played in duopoly A duopoly is a market in which there are only two producers that compete Duopoly captures the essence of oligopoly Cost and Demand Conditions Figure 15 2 on the next slide describes the cost and demand situation in a natural duopoly in which two firms Trick and Gear compete 2014 Pearson Addison Wesley Oligopoly Games Part a shows each firm s cost curves Part b shows the market demand curve 2014 Pearson Addison Wesley Oligopoly Games This industry is a natural duopoly Two firms can meet the market demand at the least cost 2014 Pearson Addison Wesley Oligopoly Games How does this market work What is the price and quantity produced in equilibrium 2014 Pearson Addison Wesley Oligopoly Games