CHAPTER 15: OLIGOPOLY

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.

Barriers to EntryEither 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.

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.

Small Number of Firms Because an oligopoly market has a small number of firms, the firms 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.Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit.

Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down.

Two Traditional Oligopoly Models

The Kinked Demand Curve Model

In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.Figure 15.2 shows the kinked demand curve model.The firm believes that the demand for its product has a kink at the current price and quantity.

Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged.Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.

The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by that gap AB in the figure

The next diagram helps to envisage why the kink in the demand curve puts a break in the marginal revenue curve.

Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit-maximizing price and quantity would not change

The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact.If MC increases enough, all firms raise their prices and the kink vanishes.A firm that bases its actions on wrong beliefs doesn’t maximize profit

Dominant Firm Oligopoly

In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms.

The large firm operates as a monopoly, setting its price and output to maximize its profit.

The small firms act as perfect competitors, taking as given the market price set by the dominant firm.

Figure 15.3 shows10 small firms in part (a). The demand curve, D, is the market demand and the supply curve S10 is the supply of the 10 small firms

The demand curve for the large firm’s output is the curve XD on the right.

The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.

The large firm maximizes profit by setting MR = MC. Let’s suppose that the marginal cost curve is MC in the figure.

The profit-maximizing quantity for the large firm is 10 units. The price charged is $1.00.

The small firms take this price and supply the rest of the quantity demanded In the long run, such an industry might become a monopoly as the large firm

buys up the small firms and cuts costs

Game Theory:

Game theory is a tool for studying strategic behaviour, which is behaviour that takes into account the expected behaviour of others and the mutual recognition of interdependence.

We will discuss the following games:

• Original prisoner’s dilemma

• Oligopoly game

• Battle of the sexes

• Game of Chicken

• Sequential games

The Prisoners’ Dilemma

The prisoners’ dilemma game illustrates the four features of a game. Rules Strategies Payoffs Outcome

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 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.

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.

PayoffsEach 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.

“A Nash equilibrium (NE) is a set of strategies for

which there are NO profitable UNILATERAL

deviations for ANY PLAYER.”

A Dominant strategy is a best response to ANY

strategy the rival may choose.

Prisoner’s dilemma : A game in which it is a

DOMINANT STRATEGY for players NOT to choose

the cooperative strategy .

1. Original prisoner’s dilemma

Pay-offs

Both confess: 10 years each

Both don’t confess: 1 year each

Only 1 confesses: Confess 0, Don’t confess

20

Pay-off matrixPrisoner B

ConfessDon’t

confess

Prisoner A

ConfessA gets ___B gets ___

A gets ___B gets ___

Don’t confess

A gets ___B gets ___

A gets ___B gets ___

• A’s best response function

If B confesses then A __________ because

____

If B doesn’t confess then A ______because

____

• Similarly for B, therefore NE is ________

because if either player unilaterally altered their

strategy their punishment would ____ from ___ to

___.

2. Oligopoly game: United and American Airlines’ duopoly competition on the Los Angeles- Chicago route as estimated by Brander and Zhang (1990).

United Airlines

American Airlines

QA = 64 QA = 48

Qu = 64$ 4.1 million, $ 4.1 million

$ 5.1 million,$ 3.8 million

QA = 48$ 3.8 million,$ 5.1 million

$ 4.6 million, $ 4.6 million

3. Currently, two groups of firms are fighting to determine the standard for the next generation of DVD players, which feature six-times longer playing time and sharper images than previous models. A group led by Toshiba and NEC, with software from Microsoft, produce HD DVD disc. They are opposed by a group led by Sony that includes Dell, Hewlett- Packard, Panasonic, Samsung and Sharp, which champions Blu-ray technology. Each group apparently believes that its product will be more successful if all DVD players can handle its forma, but each group wants to choose its own format.

HD DVD group Blu-ray group

HD DVD Standard

Blu-ray Standard

HD DVD Standard

3, 1 -1, -1

Blu-ray Standard -1, -1 1,3

4. Battle of the sexes: Bart and Lisa has come to Canada with their family for a vacation. They are now fighting over whether to go to Canada’s Wonderland or to visit the Ontario Science Center. They face the following payoff.

Bart

Lisa

Wonderland Science Center

Wonderland 2,2 -1, -1

Science Center -1, -1 1,1

5. Game of Chicken: Two California teenagers Bill and Ted are playing Chicken. Bill drives his hot rod south down a one-lane road, and Ted drives his hot rod north along the same road. Each has two strategies: stay or swerve. If one player chooses swerve he looses face; if both swerve, they both loose face. However, if both choose to stay, they are both killed. The payoff matrix for Chicken looks like this:

Bill

Ted

Stay Swerve

Stay -3, -3 2, 0

Swerve 0, 2 1,1

Sequential games

Assumptions

• Players choose in sequence

• First mover can’t change their move once the

second mover has chosen. (1st mover is

committed)

Solution method

• Can be illustrated using a game tree

• Is referred to as backward induction

• Involves a two step procedure

Step 1 : Find 2nd mover’s best response

function.

Step 2 : Find 1st mover’s choice which takes

into account the 2nd mover’s best response

function

Consider the following pay-offs for a game in which CTV and Global must decide whether to broadcast Sports or News at 7pm.

GlobalSports News

CTVSports CTV earns $12

billion

Global earns $30 billion

CTV earns $36 billion

Global earns $60 billion

News CTV earns $24 billion

Global earns $120 billion

CTV earns $48 billion

Global earns $90 billion

Firm 2

Firm 1

Enter Do not enter

Enter -40, -40 250, 0

Do not enter

0, 250 0, 0