Slide 1Knowledge RecapOligopolyOligopolyOligopolyOligopolyOligopolyOligopolyOligopolyOligopolyOligopolyOligopolyOligopolyECON 203: Principles of MicroeconomicsClass 19: Oligopolies1Knowledge Recap•Imperfect competition is a type of market structure that lies in between perfect competition and monopoly.•Types of imperfect competition:–Monopolistic competition.–Oligopoly. 2Oligopoly•Oligopoly.–A market structure in which there are few firms selling very similar or identical products (e.g. duopoly).3Characteristics of the MarketPerfect Competition Monopoly OligopolyMany firms. One firm. Few firms.Homogenous product (many substitutes).Unique product (no substitutes).Homogenous product.No barriers to entry. Barriers to entry. Barriers to entry.Oligopoly•Firms’ decisions.– Each firm’s decision affect market quantity and price.• Firms know that to increase quantity sold they must lower price.•Downward facing demand curve.– The small number of firms allows for cooperation leading to monopolistic behavior.•Collusion is an agreement among firms in a market about the quantities to produce or prices to charge.•A cartel is a group of firms acting together as a monopoly.• The gains from cooperation often conflict with self-interest on division of profits leading to ineffective collusion. 4Oligopoly•Market equilibrium.–Final outcome that is affected by each firm’s decisions.•Effective collusion leads to monopoly outcomes with division of profits among the firms in the cartel.•Lack of collusion leads to an outcome between perfect competition and monopoly equilibrium.–With more firms in the market collusion becomes harder.•Ineffective monitoring.•Smaller marginal effect of each firm on market outcomes.5Oligopoly•Market equilibrium.–Example: Jack and Jill (a duopoly).6Q Price Revenue/Profit0 $100 $010 $90 $90020 $80 $1,60030 $70 $2,10040 $60 $2,40050 $50 $2,50060 $40 $2,40070 $30 $2,10080 $20 $1,60090 $10 $900100 $0 $0Oligopoly•Market equilibrium.– In case of effective collusion:• Qo = Qm and Po = Pm•Each producer makes profit equal to monopoly profit divided by number of producers.– In case of lack of collusion:• Qo > Qm and Po < Pm•Each producer makes profit equal to oligopoly profit (positive but lower than monopoly profit).7Oligopoly•Market equilibrium.–Equilibrium outcomes are analyzed using game theory.•The study of how people behave in strategic situations.–Elements of a game: •Players: the agents involved in the strategic interaction.•Actions: the possible decisions each player can make.•Payouts: what each player gets for each combination of actions.–Prisoners’ Dilemma is a common example of a game: •Players: two prisoners.•Actions: confess or remain silent.•Payouts: –If both confess, both go to jail for 8 years.–If one confesses and the other doesn’t, the one who confesses goes free and the other goes to jail for 20 years.–If both remain silent, both go to jail for 1 year.8Oligopoly•Market equilibrium.–Strategy: a plan that determines a players’ actions.•Nash equilibrium: a situation in which economic actors choose the best strategy given the strategies chosen by the others.•Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players.–Prisoners’ Dilemma9Bonnie’s DecisionConfess SilentClyde’sDecisionConfess (8 years, 8 years)(free, 20 years)Silent (20 years, free) (1 year, 1 year)Oligopoly•Market equilibrium.– An oligopoly is a real world example of prisoners’ dilemma.• Players: two (or more) firms – example Jack and Jill.•Actions: cooperate or cheat.• Payouts: –If both cooperate, they both get monopoly profits (PM).–If both cheat, they get oligopoly profits (PO).– If one cheats and the other cooperates, the one who cheats gets a profit higher than PO and the one who doesn’t gets a profit lower than PO.10Oligopoly•Market equilibrium.–Example: Investment Bank game.•Two investment banks (A and B) have to decide how many startups to underwrite for an IPO.•Each investment bank can underwrite 1 or 2 startups.–If both underwrite 1 startup, they both get $100.–If both underwrite 2 startups, they both get $50.–If one underwrites 1 startup and the other underwrites 2, the one that underwrites 2 gets $130 and the other gest $25.11Bank B Decision1 IPO 2 IPOsBank ADecision1 IPO ($100, $100) ($25, $130)2 IPOs ($130, $25) ($50, $50)Oligopoly•Market equilibrium.– Factors that help collusion.• Repeated, long-term interaction•Ability to communicate.• Small number of firms.12Oligopoly•Welfare effects.–With collusion.•Monopolistic outcomes lead to deadweight losses for society.–With strategic individual behavior.•QM < QO < QC•PM > PO > PC •Without collusion, an oligopoly leads to outcomes that are better for society than a monopoly (or cartel) but worse than perfect