Ch 17: OligopolyMonday, November 17, 20144:35 AM -Oligopoly: a market structure in which only a few sellers offer similar or identical products-The actions of any one seller in the market can have a large impact on the profits of all the other sellers. -Oligopolistic firms are interdependent in a way that competitive firms are not. -Game theory: the study of how people behave in strategic situations-In a market that is either perfectly competitive or monopolistically competitive, each firm is so small compared to the market that strategic interactions with other firms are not important-In a monopolized market, strategic interactions are absent because the market has only one firm. Markets with Only a Few Sellers-A key feature of oligopoly is the tension between cooperation and self-interest. -Oligopolists are best off when they cooperate and act like a monopolist -A Duopoly ExampleoDuopoly: an oligopoly with only two members. (the simplest type of oligopoly)oImagine a town where only two residents - Jack and Jill - own wells that produce water safe for drinking. oEach Saturday Jack and Jill decide how many gallons of water to pump, bring the water to town, and sell it for whatever price the market will bear. oAssume that marginal cost is zero-Competition, Monopolies, and CartelsoIf the market were perfectly competitive, the production decisions of each firm would drive price to equal marginal cost. oA profit maximizing monopoly would produce the quantity that maximizes profit and sellit for that price. Price would exceed marginal cost so the result would be inefficient. oCollusion: an agreement among firms in a market about quantities to produce or prices to chargeoCartel: a group of firms acting in unisonoOnce a cartel is formed, the market is in effect served by a monopoly. oIf Jack and Jill were to collude, they would agree on the monopoly outcome because thatoutcome maximizes the total profit that the producers get from the market. Once again, price exceeds MC, and the \outcome is socially inefficientoA cartel must agree not only on the total level of production but also on the amount produced by each member. -The Equilibrium of an OligopolyoConsider what happens if Jack and Jill decide separately how much water to produce. oIf the duopolists individually pursue their own self-interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge a price lower than the monopoly price, and earn total profit less than the monopoly profit. oAlthough 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. oNash equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen.oWhen 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 MC).-How the Size of an Oligopoly Affects the Market OutcomeoHow would an increase in the number of sellers from two to four affect the price and quantity of water in the town?oIf the sellers of water could for a cartel, they would once again try to maximize total profit by producing the monopoly quantity and charging the monopoly price. The members would need to agree on production levels for each member and find some way to enforce the agreement. -Reaching and forcing an agreement becomes more difficult as the size of the group increases. oIf the oligopolists do not form a cartel, they must each decide on their own how much toproduce. oIn deciding whether or not to raise production by one gallon, the well owner weight two effects:-The output effect: because price is above marginal cost, selling on more gallon of water at the going price will raise profit. -The price effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold oEach oligopolist continues to increase production until these two marginal effects exactlybalance, taking the other firms' production as given. oThe larger the number of sellers, the less each seller is concerned about its own impact on the market price. oAs the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. The Economics of Cooperation-The Prisoner's Dilemma: a particular "game" between two captures prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial oConsider a story about two criminals, Bonnie and Clyde, who have been captured by the police. oIn this game, between two criminals suspected of committing a crime, the sentence that each receives depends on his or her decision to confess or remain silent and on the decision made by the other.oDominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players-In this case, confessing is the dominant strategy for both Bonnie and Clyde. They spends less time in jail if they confesses, regardless of whether the other confesses or remainssilent. oIn the end, both Bonnie and Clyde confess, and both spend 8 years in jail. If they had BOTH remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. Because each pursues his or her own interests, the two prisoners together reachan outcome that is worse for each of them.oCooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational-Oligopolies as a Prisoners' DilemmaoThe game that oligopolists play in trying to reach the monopoly outcome is similar to thegame that the two prisoners play in the prisoners' dilemmaoThe monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners' dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcomewith low production, high prices, and monopoly profits. -Case Study: OPEC and the World Oil MarketoMuch of