Chapter 16 Oligopoly

1. Chapter 16 Oligopoly • T1 Between Monopoly and Perfect Competition • T2 Markets with only a few sellers • T3 Game theory and the economics of cooperation • T4 Public policy toward oligopolies

2. T1 Between Monopoly and Perfect Competition • The cases of perfect competition and monopoly illustrate some important ideas about how markets work. Most markets in the economy, however, include elements of both these cases and therefore, are not completely described by either of them. • The typical firm in the economy faces competition and also has some degree of market power; however, the competition and market power are not exactly described and analyzed by the perfect competition and monopoly. In other words, the typical firm in our economy is imperfectly competitive. • There are two types of imperfectly competitive markets. • An oligopoly is a market with only a few sellers, each offering a product similar or identical to the others.

3. Examples: the market for hockey skates; the world market for crude oil. • Monopolistic competition describes a market structure in which there are many firms selling products that are similar but not identical. • Examples: the markets for novels, movies, CDs and computer games. • See Figure 16-1 on page 353, four types of market structure. T2 Markets with only a few sellers • Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. • The group of oligopolists is best off cooperating and acting like a monopolist-producing a small quantity of output and charging a price above MC.

4. Yet because each oligopolist cares about only its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the monopoly outcome. A duopoly example • Image a town in which only two residents, Jack and Jill, own wells that produce water safe for drinking. • Each Saturday, Jack and Jill decide how many litres of water to pump, bring the water to town, and sell it for whatever price the market will bear. • We assume that Jack and Jill can pump as much water as they want without cost. That is, the marginal cost of water equals zero. • See Table 16-1 on page 354. It shows the town’s demand schedule for water.

5. Competition, monopolies and cartels • Suppose the market for water is perfectly competitive Price = MC ( = 0)  Price=0 and Quantity = 120L. • Suppose the market for water is monopoly Table 16-1 shows that the total profit is maximized at a quantity of 60 L and a price of 60 a litre. This result would be inefficient, for the quantity of water produced and consumed would fall short of the socially efficient level of 120 L. What outcome should we expect from our duopolists? • If Jack and Jill were to collude  monopoly outcome • Our two producers would produce a total of 60 L, which would be sold at a price of $60 a litre. • Price exceeds marginal cost and the outcome is socially inefficient

6. Collusion: an agreement among firms in a market about quantities to produce or prices to charge • Cartel: a group of firms acting in unison • A cartel must agree not only on the total level of production but also on the amount produced by each member. • Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Why? Pursuing own self-interest • Oligopolists would be better off cooperating and reaching the monopoly outcome. Yet because they pursue their own self-interest, they do not end up reaching the monopoly outcome and maximizing their joint profit. • Each oligopolist is tempted to raise production and capture a larger share of the market. As each of them tries to do this, total production rises and the price falls.

7. At the same time, self-interest does not drive the market all the way to the competitive outcome. Oligopolists are aware that increases in the amount they produce reduce the price of their product.. • In summary, when firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price ( which equals marginal cost) • As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost and the quantity produced approaches the socially efficient level.

8. T3 Game theory and the economics of cooperation • Game theory: the study of how people behave in strategic situations. By “ strategic” we mean a situation in which each person, when deciding what actions to take, must consider how others might respond to that action. • Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces, but also on how much the other firm produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all the other firms. • Game theory is not necessary for understanding competitive or monopoly markets. Why?

9. Prisoners’ Dilemma: a particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial • Three elements of a game: player, strategy and payoff. • Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players. • Dominated strategy:a strategy that is worst for a player in a game regardless of the strategies chosen by the other players. It also can be eliminated • Nash Equilibrium: a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. • We can get the Nash Equilibrium by dominant strategy, dominated strategy or cell by cell inspection.

10. Simultaneous game vs. Sequential game • See Figure 16-2 on page 360 (Prisoners’ Dilemma) • (Confess, Confess) is the Nash Equilibrium • This result is the inferior outcome. • Dominant strategy • See Figure 16-3 on page 362 (Crude Oil production game) • (High Production, High Production) is the Nash Equilibrium • This result is the inferior outcome with low profits for each country. • Dominant strategy • See Figure 16-4 on page 363 Arms-race game ( to build new weapons or to disarm) • (Arm, Arm) is the Nash Equilibrium

11. This result is the inferior outcome in which both countries are at risk • Dominant strategy • See Figure 16-5 on page 364 Advertising Game • (Advertise, Advertise) is the Nash Equilibrium • This result is the inferior outcome with lower profits for each company • Dominant strategy • See Figure 16-6 on page 365 A Common Resources Game • ( Drill Two Wells, Drill Two Wells) is the Nash Equilibrium • This result is the inferior outcome with lower profits for each company • Dominant strategy.

12. See Figure 16-7 on page 366 Jack and Jill’s Oligopoly Game • ( Sell 40 L, Sell 40 L) is the Nash Equilibrium • This result is the inferior outcome with lower profits for each company • Dominant strategy. T4 Public policy toward oligopolies • Restraint of trade and the competition Act • Freedom to make contracts is an essential part of a market economy. However, Canadian judges have refused to enforce agreements that restrain trade among competitors (reducing quantities and raising prices, or price-fixing) to be against the public interest.

13. Canada’s Competition Act codifies and reinforces this policy. See Section 45(1) of the Act. • The Competition Act contains both civil and criminal provisions. • Civil provision: • such as merger cases are heard by Competition Tribunal • Criminal provision: • such as conspiracies in restraint of trade, bid-rigging, price discrimination, resale price maintenance and predatory pricing • The Attorney General of Canada

14. Controversies over competition policy • Over time, much controversy has centred on the question of what kinds of behaviour competition laws should prohibit. Most commentators agree that price-fixing agreements among competing firms should be illegal. • However, the competition laws have been used to condemn some business practices whose effects are not obvious. The followings are three examples. • Ex1 Resale Price Maintenance ( also called fair trade) • The manufacturer requires the retailers to charge customers a certain price. Charging any price lower than the requested price would be treated as the retailers’ violation of contract with the manufacturer. • Resale price maintenance might seem anticompetitive and therefore, detrimental to society. Like an agreement among members of a cartel, it prevents the retailers

15. from competing on price. For this reason, the courts have often viewed resale price maintenance as a violation of competition laws. • Economists defend resale price maintenance on two grounds. First, they deny that it is aimed at reducing competition. To the extent that the manufacturer has any market power, it can exert that power through the wholesale price rather than through resale price maintenance. Moreover, a cartel of retailers sells less than a group of competitive retailers, the manufacturer would be worse off if its retailers were a cartel. So, the manufacturer has no incentive to discourage competition among its retailers. Second, economists believe that resale price maintenance has a legitimate goal. The manufacturer may want its retailers to provide customers with a pleasant showroom and a knowledgeable sales force.

16. Yet without resale price maintenance, some customers would take advantage of one store’s service to learn about the product and then buy the product at a discount retailer that does not provide this service.Resale price maintenance is one way for the manufacturer to solve this free-rider problem. • An important principle: business practices that appear to reduce competition may in fact have legitimate purposes. • Therefore, this principle makes the application of the competition laws all the more difficult. • Ex2 Predatory Pricing • Firms with market power normally use that power to raise prices above the competitive level. But should policymakers ever be concerned that firms with market

17. power might charge prices that are too low? • Imagine that price war among Air Can and other small airline companies. Air Can’s price cuts may be intended to drive small companies out of the market; so Air Can may recapture its monopoly and raise prices again. • Some economists are skeptical of this argument and believe that predatory pricing is rarely, and perhaps never, a profitable business strategy. Why? For a price war to drive out a rival, prices have to be driven below cost. • Ex3 Tying (selling products as a bundle) • The practice of tying is banned under the civil provisions of the Competition Act because tying allows a firm to extend its market power to other goods. • Economists, however, are skeptical of this argument.