Econ 12, Foldvary

Mankiw, Chapter 16, Oligopoly

Oligopoly occurs when there are only a few firms in an industry.

From Greek "olig" meaning few or small, as also in oligarchy.

You know when you are in an oligopoly if the actions of one firm have effects on the others.

Unlike atomistic competition and monopoly, there is no determined outcome for oligopoly.

The structure gives rise to strategic behavior and games, as in chess.

Some economists call this "imperfect competition," but you should note that "competition" in this context refers to absence of market power, and "imperfect" means there is some market power.

"Perfect" means complete and pure.

There is no moral or normative aspect to this so-called imperfection.

There are two types of oligopolies: with identical, and with differentiated products.

Oligopoly is determined by the relevant market.

For example, there are hundreds of gas stations in the Bay Area, but you won't go to Oakland just to buy gas. So the relevant number of gas stations is the number in the area you would normally buy gas at. And that number is typically small enough so that the market structure is an oligopoly.

Usually, retail stores are in oligopoly.

"Sticky" prices refer to the relative stability of prices, a characteristic associated with many oligopolistic markets. According to the kinked demand curve model, firms are reluctant to raise price because of the belief that the firm will lose customers to competing firms who do not raise price. Firms are similarly reluctant to lower price because of the expectation that rival firms will match any price reduction and therefore prevent the firm from increasing its share of the market. In this environment, prices may remain unchanged for long periods of time even if costs or demand change.

The simplest oligopoly case is a duopoly.

A duopoly consists of two sellers.

Textbook has the case of two sellers of water, with a zero marginal cost, Jack and Jill.

Jack and Jill went up the hill

To fetch a pail of water;

Jack fell down

and broke his crown,

And Jill came tumbling after

The crown (a "crown" gets broken) in question is Charles I of England who, during the 1640s, attempted to increase tax revenue by reducing the liquid measure of a jack.

He maintained the same tax rate on the decreased volume. Less drink for the same money. This lead to a protest in verse that became "Jack and Gill". A gill was measured as 2 jacks or quarts. The term "jack" "fell" into disuse because of the inequity and soon after the gill was no longer used as well. Charles I reign lead to a protracted civil war over oppressive rule, religion, and taxation that resulted in Charles I beheading in 1649. A broken crown indeed. The strength of The Crown (British Monarchy as a whole) was significantly weakened by these events.

In the example with a linear demand and zero cost,

in atomistic competition, the price would be zero.

That is the socially efficient and optimal amount of production.

A monopolist would sell half the quantity, where MR=0.

The most profitable option for the duopolists is to act together as a monopolist.

Such an agreement is called collusion.

The colluding group is called a cartel.

In the US, such collusion is illegal.

Internationally, cartels exist, such as OPEC for oil production.

P. 350: shipping cartels, legal; has exemption from anti-trust laws. Why?

In a cartel, a member may make extra profit by selling just a bit under the cartel price, since the extra quantity sold will be relatively large.

So cartels often break down due to cheating.

A firm has an incentive to lower the price if this will bring more profit to it.

If the cartel breaks down and the firms are on their own, they will produce a quantity between that of monopoly and atomistic competition.

In a duopoly without collusion, each firm might maximize profit at a lower price and greater quantity than is the case with a monopoly. But the price is higher than in atomistic competition.

A stable outcome is called a Nash equilibrium after John Nash, named after the mathematician who worked on economic game theory and won the Nobel prize in economics.

He developed the concept of the Nash Equilibrium for his dissertation. The movie A Beautiful Mind tells the story of his life.

In a Nash equilibrium, the players choose their best strategy given the strategies chosen by the others. Neither firm has an incentive to change its price.

In some cases, oligopolistic firms engage in a price war, driving the price down to marginal cost, but this is not an equilibrium as it is not sustainable. Firms can increase profit by increasing price.

Game theory

A game consists of interaction among players, rules, and payoffs for each player.

A game can be cooperative or rival (non-cooperative)

Game outcomes can be positive sum, negative sum, or zero sum.

A game can be one-time or repeated.

Game theory explains decision making with incomplete information.

A dominant strategy is one that is the best for a player,

regardless of the strategies chosen by the others.

Economic games, like chess, involve strategies.

Strategic action means each player takes into account the likely reactions of other players.

A dominant strategy is one that is the best for a player.

One basic game is called the prisoners' dilemma.

The story is that there are two thieves who get caught.

Mankiw calls them Bonny and Clyde. Movie 1967. Also song, 1968.

They are partners in crime, but unlike the real Bonny and Clyde, they don't love each other.

They are questioned in separate rooms.

If one confesses and the other does not, the confessor goes free and the other 20 years in prison.

If they both confess they get 8 years.

If neither confesses, they get a lesser charge, and only 1 year in prison.

The incentive is for both to confess, unless they are in love.

Confessing is the dominant strategy.

During the Cold War, the arms race was also a prisoners' dilemma.

Advertising another example.

Also, OPEC, common resources.

In experiments, the prisoner-dilemma outcome was not achieved in 40% of the cases.

This shows that altruism changes the outcome.

In repeated games, there is communication, and the outcome can be different.

Tit-for-tat strategy in repeated games is:

cooperate with others who do so, otherwise, not.

This is a successful long-term strategy.

In common law, cartel agreements to raise prices have not been enforceable.

In the U.S. , the Sherman Antitrust Act of 1890 and Clayton Act of 1914 made the government have an active policy to break up "trusts" or cartel agreements, as well as to prevent high industry concentration (C>.5). Other companies could sue and get three times damages.

What incentives does this provide for competitors?

Who benefits when there are many lawsuits?

Government policy to increase competition has to be weighed against possible government failure, including the abuse of power, ignorance, and reducing productivity.

How do we know when there is too much market power?

How do we know consumers are being harmed?

How do we know that there is no offsetting benefit, such as more research?

Problem: If the price is high, it is restricting output, but

if the price is low, it is predatory pricing, trying to eliminate the competition.

Problem of retail price maintenance.

Can restrain trade, but also provide better service.

The Microsoft case.

Tying or bundling: offering two or more products as a package deal, with one price.

Microsoft ties the Windows operating system and its Explorer browser.

Microsoft claims this improves the technology and performance.

The products work together.

Does it make a high monopoly profit?