Oligopoly

1. Oligopoly Chapter 16

2. What we learn in this chapter? • Ch.13 established the cost structure of the firm as the unit of production in a market economy • Ch.14 looked at the equlibrium of the firm and of the market assuming perfect competition • Ch.15 studied the the causes and the implications of monopoly as theonly seller in a market • Now we enter the gray area between the two extremes of perfect competition and monopoly • These are markets with imperfect competition • Ch.16 deals with markets dominated by a small number of firms producing homogenous goods • Oligopoly implies more than one but not many firms in a market

3. Imperfect competition • In real life both perfect competition or pure monopoly exist very rarely • Most sectors in the economy have a limited number of firms who supply the market • They compete among themselves yet also keep their ability to be price makers • From cars to banks, household appliances to retail trade, the names of the large companies are well known by the public everywhere in the world • Imperfect competition constitutes the gray area of microeconomics • Where some characteristics resemble competition yet others monopoly

4. The Spectrum of Market Structures

5. Oligopoly and monopolistic competition • Market structures that fall between perfect competi-tion and pure monopoly or • Alternatively industries in which firms have competitors but do not face so much competition that they are price takers • Can be analysed under two headings: • Oligopoly • Only a few sellers, each offering a similar or identical product to the others • Monopolistic competition • Many firms selling products that are similar but not identical

6. Oligopoly: markets with only few sellers • A firm in an oligopolistic market faces an interesting situation compared with both perfect competition and monopoly • Because of there are only few sellers, the actions of any one seller in the market can have a large impact on the profits of all the other sellers • Characteristics of an oligopoly market • Few sellers offering similar or identical products • Independent firms • They are best-off when cooperating and acting like a monopolist by producing small quantity of output and charging a price above marginal cost

7. Duopoly exemple • We start with another extreme case by assuming that there are only two firms in a market • A duopoly is an ologopoly with only two members • It is the simplest type of oligopoly • Imagine a town with only two water wells, owned by two different persons (A and B) • Every week, they get together to decide on the quantity of water to pump, then bring it into town and sell it for the market price • To keep the analysis simple it is better to assume that the marginal cost of pumping and bringing water to the town is zero • Let’s look at the market demand for water

8. Duopoly:Demand schedule

9. Duopoly: price and quantity supplied • The price and quantity of water in a perfectly competitive market would be: P = MC = 0 $ Q = 120 gallons • The price and quantity in a monopoly market would be: P = 60 $ Q = 60 gallons • Socially efficient quantity of water is reached under perfect competition: 120 gal. • Monopoly produces less than socially efficient quantity of water yet makes large profits: 60 gal. • What happens to profits and quantity in a duopoly?

10. Competition, collusion and cartels • Obviously the rational and intelligent road is for the two firms to agree among themselves and behave like a monopoly collectively • Thus share the high monopoly profits • Collusion • The two firms may agree on the quantity to produce and the price to charge • Cartel • The two firms may join together and act in unison • In both cases they will produce together 60 gal. of water and sell it at 60 $ per gallon • Each will produce 30 gal. of water and therefore earn profits of 1800 $

11. Cheating in oligopoly • At first sight, this seems like an excellent outcome for the duopolist and that they should keep it • This is misleading because there is a major problem for all types of collusions and cartels: cheating • If duopolist A pumps 40 gal. instead 30 gal. the price of water falls to 50 $ and he earns 2000 $ while B gets only 1500 $ • B will then also pump 40 gal. bringing the price down to 40 $ and each earn 1600 $ • At this point any further cheating by A will be counterproductive: at 50 gal. of water, A earns less than at 40 gal. even if B stays at 40 gal. • This outcome is called Nash Equilibrium

12. Nash equilibrium • Nobel prize winner economist John Nash was made famous by the film “A Beautiful Mind” • Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen • When n is the number of firms in the industry, Nash equilibrium becomes n / ( n + 1 ) • If n = 2 then the joint output would be 2/3 of the competitive market Qjoint = 2 / 3 (120 gallons ) = 80 gallons Qeach firm = 80 / 2 = 40 gallons

13. Equilibrium of an oligopoly • Opportunity to cheat and benefit from cheating limits the possibility of collusion among oligopoly firms • If oligopoly firms pursue their own interests instead of collusion the resulting outcome means • Joint output is greater than monopoly quantity but less than competitive quantity • Market prices are lower than monopoly price but greater than competitive price • Total profits are less than the monopoly profit but still positive • This is an interesting result: the equilibrium in an oligopoly markat is somewhere between perfect competition and pure monopoly

14. Size of an oligopoly and market outcome • What are the effects of larger number of firms in an oligopoly market? • As in monopoly, we must distinguish between • The output effect: because price is above marginal cost, selling more at the going price raises profits • The price effect: raising production lowers the price and the profit per unit on all units sold • The number of firms is important because • As the number of sellers increase, the market looks more and more like a competitive market • Price approaches marginal cost and quantity approaches the socially efficient level

15. OPEC and oil prices • Organisation of Petroleum Exporting Countries (OPEC) was established in 1960s to act like a cartel for oil producers • By 1973, its members controlled three quarters of world’s oil reserves • It sucessfully increased the price of one barrel of oil from $ 2.64 in 1973 to $ 35.10 in 1981 by lowering its production and exports • Increasing the oil revenues of its members • But members started to produce more than their quotas in order to benefit from high prices • By 1999 the price of oil had gone down to $ 10 and was actually lower in real terms than in 1973

16. Game theory and the economics of cooperation • Our understanding and analysis of markets with oligopoly firms were improved by new tools supp-lied by mathematics under the title of game theory • Game theory is the study of how people behave in strategic situations • Strategic decisions are those in which each person (firm) in deciding what actions to take must consider how others (firms) might respond to that action • Because the number of firms in an oligopolistic market is small, each firm must act strategically • Game theory makes an important contribution to our analysis of many real world problems and issues

17. Prisoners’ dilemma • It is difficult to maintain cooperation (collusion) under certain circumstances • The prisoners’ dilemma illustrates this difficulty • Two criminals are captured but the police has only limited evidence on them • They are kept seperately, unaware what the other is doing and offered a deal • If one confesses while the other does not, the one who confesses gets 1 year sentence, the other gets 20 years sentence • If both confess, they both get 8 years • If neither confess, they both go free • Should the prisoner confess or not confess?

18. Dominant strategy • We can think of the problem as strategies for each prisoner where his outcome depends both on what he chooses and what the other chooses • It shows why cooperation may not exist • Often people, firms and even states fail to cooperate with one another even when cooperation would make everyone better off • The dominant strategy is the best strategy for a player to follow regardless of the strategies pursued by other players • Cooperation is difficult to maintain because cooperation is not in the best interest of individual players

19. Prisoner A’s Decision Don’t confess Confess Both get 8 years A gets 20 years B gets 1 year Confess PrisonerB’s Decision A gets 1 year B gets 20 years Both go free Don’t confess Prisoners’ dilemma

20. Oligopolies’ dilemma • Self interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices and monopoly profits • The monopoly outcome is jointly rational for the oligopoly but each oligopolist has an incentive to cheat • We gave the exemple of OPEC before • Many oligopolistic markets have a cycle of collusion and high prices followed by periods of price wars and very low prices • This is also true for markets in Turkey • Newspapers and bus companies are well known examples of collusion and price wars

21. An example: oil game • We assume two countries, Iran and Iraq have the final say in world oil prices • If they can agree to a low level of production each earns 50 billion $ (total 100 billion $) • But if either cheats after the agreement and increases production of oil, the cheater gets 60 bn. $ while the honest one receives only 30 bn.$ due to price and quantitiy effects • If both end up at high level of production then each gets only 40 bn. $ (total 80 billion $) • Usually in real life there will periods collusion and cooperation with low production followed by periods of cheating and high production

22. High Production Low Production Oil prices as an example of the prisoners’ dilemma Iraq’s Decision $40 billion for each Iraq gets $30 billion Iran gets $60 billion High Production Iran’s Decision Iraq gets $60 billion Iran gets $30 billion $50 billion for Each Low Production

23. Other example: arms races • Game theory can also be applied to understant political problems such as disarmament • Two world superpowers face a decision either to arm or to disarm • If both disarm at the same time, then they are both safe from an attack from the other • If one disarms while the other arms the one who arms is safe the other is at risk of war • If both arms at the same time, then they are both at risk of war and also have the additional financial burden of the arms race • Again, periods of arms race will probably be followed by periods of disarmament

24. Arms race as an example of the prisoners’ dilemma U.S.’ Decision Disarm Arm U.S. at risk and weak USSR safe and powerful Both countries at risk Arm USSR’s Decision U.S. safe and powerful USSR at risk and weak Both countries safe Disarm

25. Other example: advertising • Advertising is another example of strategic struggle between oligopolists • Take the case of two cigarette companies, Marlboro and Camel who must decide on advertising • If both refrain from advertising, both save costs and thus earn 4 bn.$ • If one advertises while the other does not, the one who advertises earns 5 bn.$ due to higher sales while the other gets only 2 bn.$ • If both companies advertise their profits are reduced to 3 bn.$ each due to advertising costs • Again, periods of expensive advertising will be followed by periods of low key advertising

26. Advertising as an example of the prisoners’ dilemma Marlboro’s Decision Advertise Don’t Advertise Marlboro gets $2 billion profit Camel gets $5 billion profit $3 billion profit for each Arm Camel’s Decision Marlboro gets $5 billion profit Camel gets $2 billion profit $4 billion profit for each Disarm

27. Other example: common resources • In Chapter 11 we had seen the problem caused by overusing of common resources • Two oil companies own a common oil field with estimated reserves worth 12 bn.$ • If both drill only one well, both earn 5 bn.$ profits • If one drills only one well while the other drills two wells, one well earns 3 bn.$ while two wells earn 6 bn. $ • If both drill two wells both earn 4 bn. $ profits • The result in very interesting for us • Society would be better off if the two companies reach a cooperative solution because less resources are used to get the same amount of oil

28. Common resources as an example of the prisoners’ dilemma Exxon’s Decision Drill one well Drill two wells Exxon gets $ 3 bn Arco gets $ 6 bn. Profits Both get $ 4 bn. profit Drill two wells Arco’s Decision Exxon gets $ 6 bn Arco gets $ 3 bn. Profits Both get $ 5 bn. profit Drill one well

29. Other example: water duopoly • We can now restate our duopoly exemple in game theory framework • A and B face the decision to pump and send 30 gal. or 40 gal. of water to the town • If both send 30 gal. both earn 1.800 $ profit (this is the monopoly solution) • If either cheat and sends 40 gal. while the other is sending only 30 gal. then the cheater earns 2.000 $ while the other gets 1.500 $ • If they send 40 gal. each then they each earn 1.600 $ • Again in real life we will have periods of collusion (30 gal.) with high profits for the duopoly followed by periods of competition (40 gal) and lower profits

30. Water duopoly as an example of the prisoners’ dilemma A’s Decision 30 gallons 40 gallons A gets $ 1.500 B gets $ 2.000. Profits Both earn 1.600 $ profit 40 gallons B’s Decision A gets $ 2.000 B gets $ 1.500. Profits Both earn 1.800 $ profit 30 gallons

31. Why people cooperate sometimes • Firms in oligopolies have a strong incentive to collude in order to reduce production, raise prices and increase profits • Cheating is profitable only in the short run • In real life, strategies and games are not one time events but repeated again and again • Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain • That’s why in most oligopoly markets periods of collusion and cooperation are longer than periods of competition and price wars • Cooperation pays well for oligopoly firms

32. Public policy toward oligopolies • From the perspective of society, cooperation among oligopolists is undesirable • It leads to production that is too low • It leads to prices that are too high • Antitrust laws make it illegal to restrain trade or attempt to monopolise the market • In the US, they go back to Sherman Antitrust Act of 1890 and Clayton Act of 1914 • Firms that jointly set prices face heavy punishment • Turkey began fighting against collusion and price-fixing only recently and has much more to do • Corruption and weak law enforcement prevent effective policies against lack of competition

33. Controversies over policy • Not all efforts to increase competition and to protect the consumer will be beneficial to society • Sometime these may also prohibit business practises that have potentially positive effects • Here are some examples of controversial business practises where arguments for and against are expressed by economists • Resale price maintenance: producers oblige retailers to sell at the list price • Predatory pricing: firms may charge a price below cost to scare away potential competitors • Tying: a popular product is coupled with an unpopular product and sold at a single price

34. The Microsoft case • Microsoft has a quasi-monopoly of the operations systems for PCs • And used its market power to gain a dominant position in application software (MS Office) • When it included MS Internet Explorer in Windows, US government sued Microsoft • Trying to prove that the market power of Microsoft is bad for owners and users of PCs • Microsoft disagreed, defending itself by the quality of the software programs it puts in the market as a result of its size • The trial ended recently with an agreement which reduced the power of Microsoft

35. Conclusion • Most real world markets are situated somewhere between perfect competition and pure monopoly • Imperfect competition covers this gray area • Most markets in real life have oligopoly or monopolistic competition • Oligopoly is the case of a small number of firms • An oligopoly may end up looking more like a monopoly or a competitive market, depending on the number of firms • Oligopolies can attempt to cooperate with each other leading to cartels or price fixing behaviour • Antitrust laws are used to regulate the behaviour of oligopolies