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OLIGOPOLY

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									              OLIGOPOLY

Oligopoly is a market with few sellers selling
similar or identical products. “Few” means more
than one, but not so many that each firm doesn’t
have a substantial influence over market price.
                   OLIGOPOLY

Price Quantity   The market demand for a product is
  (P)   (Q)
                 given on the left. The technology for
 10      0
  9      1
                 producing the product has zero fixed
  8      2       cost and constant marginal cost of $1.
  7      3
  6      4       Then ATC=AVC=MC=1 for any firm
  5      5       regardless of size. We will consider
  4      6
  3      7       three ways of organizing production
  2      8
  1      9
                 (perfect competition, monopoly, and
  0     10       oligopoly), and examine the economic
                   OLIGOPOLY

Price Quantity   efficiency of each.
  (P)   (Q)

 10      0
  9      1
  8      2
  7      3
  6      4
  5      5
  4      6
  3      7
  2      8
  1      9
  0     10
      PERFECT COMPETITION

Price Quantity   Each perfectly competitive firm will
  (P)   (Q)
                 produce where Ppc=MC=1, so that a
 10      0
  9      1
                 total of Qpc=9 units will be produced.
  8      2       This is the socially optimal level of
  7      3
  6      4       output. Each firm will have zero
  5      5       economic profit since ATC=MC=P,
  4      6
  3      7       and (P-ATC) x Q = 0.
  2      8
  1      9
  0     10
               MONOPOLY

P    Q    TR   MR
                    The monopolist will produce
10    0    0    -   where P>MR=MC=1, which
 9    1    9    9
 8    2   16    7   occurs at Qm=5 units of
 7    3   21    5
 6    4   24    3
                    output. Monopoly price will
 5    5   25    1   be Pm=5, and monopoly
 4    6   24   -1
 3    7   21   -3   profits will be
 2    8   16   -5   (Pm-ATC) x Qm = (5-1)x5
 1    9    9   -7
 0   10    0   -9   =20.
               MONOPOLY

P    Q    TR   MR      $
                                  DEADWEIGHT
10    0    0    -                  LOSS
 9    1    9    9   Pm=5
 8    2   16    7
                                               ATC=MC
 7    3   21    5   Ppc=1
                                           D
 6    4   24    3           Qm=    Qpc=9       Q
 5    5   25    1            5      MR
 4    6   24   -1
 3    7   21   -3    The perfectly competitive
 2    8   16   -5
 1    9    9   -7
                     industry is efficient in
 0   10    0   -9    allocating resources, while the
               MONOPOLY

P    Q    TR   MR      $
                                  DEADWEIGHT
10    0    0    -                  LOSS
 9    1    9    9   Pm=5
 8    2   16    7
                                               ATC=MC
 7    3   21    5   Ppc=1
                                           D
 6    4   24    3           Qm=    Qpc=9       Q
 5    5   25    1            5      MR
 4    6   24   -1
 3    7   21   -3    monopoly allocates too few
 2    8   16   -5
 1    9    9   -7
                     resources producing a
 0   10    0   -9    deadweight loss of
               MONOPOLY

P    Q    TR   MR      $
                                  DEADWEIGHT
10    0    0    -                  LOSS
 9    1    9    9   Pm=5
 8    2   16    7
                                               ATC=MC
 7    3   21    5   Ppc=1
                                           D
 6    4   24    3           Qm=    Qpc=9       Q
 5    5   25    1            5      MR
 4    6   24   -1
 3    7   21   -3    (1/2) x (Qpc-Qm) x (Pm-Ppc)
 2    8   16   -5
 1    9    9   -7
                     =(1/2)(9-5)(4-1)=8.
 0   10    0   -9
               DUOPOLY

P    Q    TR   MR   The special case of oligopoly,
10    0    0    -   where there are only two
 9    1    9    9
 8    2   16    7
                    firms, is called duopoly.
 7    3   21    5   Assume that the two firms
 6    4   24    3
 5    5   25    1   are identical. Then they can
 4    6   24   -1   maximize their combined
 3    7   21   -3
 2    8   16   -5   profits by together producing
 1    9    9   -7
 0   10    0   -9
                    the monopoly output of 5 and
                    charging the monopoly price
               DUOPOLY

P    Q    TR   MR   of 5. If each of the duopolists
10    0    0    -   produce 2.5 units of output,
 9    1    9    9
 8    2   16    7
                    they will each have a profit of
 7    3   21    5   (P-ATC) x Q = (5-1) x 2.5=10.
 6    4   24    3
 5    5   25    1   Then their combined profit
 4    6   24   -1   will be 20 -- the same as a
 3    7   21   -3
 2    8   16   -5   monopolist’s profit. When
 1    9    9   -7
 0   10    0   -9
                    firms enter into an agreement
                    about their production levels
                  DUOPOLY

and price to charge, this is called collusion, and the
group of firms in the agreement is a cartel. Then
a cartel may allocate resources in the same way as
a monopoly. However there are often strong
incentives for duopolists (oligopolists) to jointly
produce a larger output than a monopolist. When
duopoly firm A sees its competitor, firm B,
producing 2.5 units of output, A can increase its
profit by producing more than 2.5 units.
                            DUOPOLY

QB    QA    Q    P   TRA    MRA    TCA PROFIT

2.5   0.5    3   7    3.5     -
                                   If B continues to
                                    0.5     3
2.5
2.5
      1.5
      2.5
             4
             5
                 6
                 5
                      9
                     12.5
                             5.5
                             3.5
                                   produce and sell
                                   1.5
                                   2.5    10
                                            7.5

2.5
2.5
      3.5
      4.5
             6
             7
                 4
                 3
                     14
                     13.5
                             1.5
                            -0.5
                                   2.5 units, A can
                                   3.5
                                   4.5
                                          10.5
                                           9
2.5
2.5
      5.5
      6.5
             8
             9
                 2
                 1
                     11
                      6.5
                            -1.5
                            -4.5
                                   increase profits
                                   5.5
                                   6.5
                                           5.5
                                           0
2.5   7.5   10   0    0     -6.5   to 10.5 by selling
                                   7.5    -7.5

3.5 units of output. Price will fall to 4 so that B’s
profit will now be (P-ATC)xQ=(4-1)x2.5=7.5, a
decrease of 2.5. Therefore, when A increases its
sales, B’s profit is affected. Similarly, if B changes
                 DUOPOLY

the quantity that it sells, A’s profit will change.
Therefore the two firms are interdependent.
When each firm believes that the other will
produce and sell 2.5 units, each has the incentive
to produce and sell 3.5 units to increase their
profit. However, when each firm produces 3.5
units, total output is 7 and market price is 3. Then
each firm’s profit is (P-ATC)xQ=(3-1)X3.5=7. Each
firm does worse than when they each produce 2.5.
                  DUOPOLY

              Firm A        The table at the left
           2.5       3.5    summarizes the results of
               10      10.5
                            the two duopolists’ actions.
      2.5
 Firm
          10       7.5      A’s profits for each output
               7.5       7
  B 3.5
          10.5     7
                            pair is given in the upper
                            right of each cell; B’s profit
for each output pair is in the lower left of each cell.
When B sells 2.5 and A sells 3.5, A’s profit is 10.5
and B’s profit is 7.5.
            GAME THEORY

Since the duopolists’ actions affect each other, they
must develop strategies for deciding how much
output to produce. Strategic decision making can
be conveniently analyzed using game theory. An
elementary game is known as the prisoners’
dilemma.
      PRISONERS’ DILEMMA

                            Butch                  Each prisoner
                  Remain                           will get a 5
                    Silent         Confess
                        5 years           0 years year sentence
          Remain                                   if they both
 Sundance Silent 5 years         20 years          remain silent.
                        20 years          10 years
          Confess                                  However, each
                  0 years        10 years
                                                   has an
incentive to confess and have their sentence
reduced to 0 years. But if both confess, they will
       PRISONERS’ DILEMMA

                              Butch                 both be worse
                   Remain                           off than if they
                     Silent         Confess
                         5 years           0 years both remain
           Remain                                   silent. The
  Sundance Silent 5 years         20 years          actions of each
                         20 years          10 years
           Confess                                  will have not
                   0 years        10 years
                                                    only an effect
on themselves, but also on the other. The results
of their actions are interdependent. If Butch
    PRISONERS’ DILEMMA

                            Butch                      confesses and
                  Remain                               Sundance
                   Silent           Confess
                        5 years              0 years   remains silent,
         Remain                                        Sundance’s
Sundance Silent   5 years        20 years              sentence will
                        20 years          10 years
        Confess                                        increase from
                  0 years         10 years
                                                       5 to 20 years.
                  DUOPOLY

              Firm A        The duopolists’ game is
           2.5       3.5    similar to the prisoners’
               10      10.5
                            dilemma. Each has an
      2.5
 Firm
          10       7.5      incentive to choose an
               7.5       7
  B 3.5
          10.5     7
                            action that is not jointly
                            optimal. The actions of
each duopolist has an effect on the profits of the
other.
                    OPEC

Founded in 1960, the Organization of Petroleum
Exporting Countries (OPEC) is a cartel of 11
countries that collectively produce about 75% of
the world’s oil. Periodically, the cartel assigns
production quotas to each of its members to limit
production in order to increase price and profits
of its members. The cartel has no legal means of
enforcing the production quotas. They are simply
accepted by mutual consent. When price is high,
                    OPEC

each country has an incentive to increase its
production to increase its own profits. But when
a number of countries increase production, price
will fall and so will the OPEC members’ profits.
In fact the history of OPEC has seen output quotas
raise petroleum (and gasoline) prices, only to have
some members eventually cheat on the agreement.
Saudi Arabia (which is an OPEC member) has
attempted to penalize the cheaters by flooding the
                     OPEC

world market with oil, and driving down world
price and the profits of oil producers. The idea
that Saudi Arabia is attempting to convey is that
countries who cheat will be “punished” with low
prices and profits when they do not follow their
production quotas. Repeatedly playing this game
OPEC members should eventually learn that the
best strategy to play is to adhere to their production
quotas.

								
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