W H AT I S E C O N O M I C S ? 2 5 3
A n s w e r s t o t h e R e v i e w Q u i z z e s
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1. What are the two distinguishing characteristics of oligopoly?
2. Why are %rms in oligopoly interdependent?
3. Why do %rms in oligopoly face a temptation to collude?
4. Can you think of some examples of oligopolies that you buy from?
The market for graphic accelerator cards is close to an oligopoly; the market for
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1. What are the common features of all games?
2. Describe the prisoners’ dilemma game and explain why the Nash equilibrium
delivers a bad outcome for both players.
In the prisoners’ dilemma game, each prisoner faces two strategies: confess or
deny. There are four outcomes: i) Both prisoners confess and each receives more
years in prison than if they both did not confess, ii) both prisoners deny, iii)
3. Why does a collusive agreement to restrict output and raise price create a
game like the prisoners’ dilemma?
Each %rm has the possibility of sharing monopoly pro%ts with other members of
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OLIGOPOLY
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4. What creates an incentive for %rms in a collusive agreement to cheat and
increase output?
All %rms in a collusive agreement face the same optimal strategies: their payo3 is
5. What is the equilibrium strategy for each %rm in a duopolists’ dilemma and
why do the %rms not succeed in colluding to raise the price and pro%ts?
Each %rm sees that its own pro%t is higher if it cheats on the agreement, and this
6. Describe the payo3s for an R&D game of chicken and contrast them with the
payo3s in a prisoners’ dilemma.
In the R&D game of chicken, a %rm can use the R&D if either it conducts the R&D
or if its competitor conducts the R&D. So if one %rm conducts the R&D, it bears the
cost and reaps the reward but the other %rm reaps only the reward because it pays
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1. If a prisoners’ dilemma game is played repeatedly, what punishment
strategies might the players employ and how does playing the game
repeatedly change the equilibrium?
Two strategies for motivating compliance in a repeated prisoner’s dilemma game
are: i) a tit-for–tat strategy, where cheating by one %rm in the current period is
2. If a market is contestable, how does the equilibrium di3er from that of a
monopoly?
A contestable market occurs when the %rms in a market face potential entry from
other %rms due to low barriers to entry. While a monopoly free from the threat of
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1. What are the two main antitrust laws and when were they enacted?
The two acts of Congress that make up our main antitrust law and the years of
their enactment are:
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2. When is price %xing not a violation of the antitrust laws?
Price %xing among competitors always is a violation of antitrust law, whether or
not the act was found to be harmful to consumers. If the Justice Department can
3. What is an attempt to monopolize an industry?
In theory, attempts to monopolize an industry mean a %rm is trying to become a
monopoly. In practice, attempts to monopolize an industry are more diEcult to
de%ne and are a matter of interpretation by the courts. The “rule of reason”
4. What are resale price maintenance, tying arrangements, and predatory
pricing?
Resale price maintenance occurs when a manufacturer agrees with a distributor
about the minimum price at which the product will be resold. Resale price
Tying arrangements occur when the seller agrees to sell one product to a buyer
Predatory pricing is setting a low price to drive competitors out of business to then
set a high, monopoly price when the competition has gone. If predatory pricing
5. Under what circumstances is a merger unlikely to be approved?
A merger is likely to be approved by the Justice Department as long as the
pre-merger HHI is less than 1,500. If the pre-merger HHI is between 1,500 and
A nsw e r s t o t h e S t ud y P l a n Pr ob l e ms a nd
A p p l i c a t i o n s
1. Intel and Advanced Micro Devices
make most of the chips that power a
PC. What makes the market for PC
chips a duopoly? Sketch the market
demand and cost curves that describe
the situation in this market and that
prevent other %rms from entering.
The market for PC chips, in particular
the processor, is a natural oligopoly,
most likely a natural duopoly. There are
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2. Sparks Fly for Energizer
Energizer is gaining market share against competitor Duracell and its pro%t is
rising despite the sharp rise in the price of zinc, a key battery ingredient.
Source: www.businessweek.com, August 2007
In what type of market are batteries sold? Explain your answer.
3. Oil City
In the late 1990s, Reliance spent $6 billion to build a world-class oil re%nery at
Jamnagar, India. Now Reliance’s expansion will make it the world’s biggest
producer of gasoline—1.2 million gallons of gasoline per day, or about 5% of
global capacity. Reliance plans to sell the gasoline in the United States and
Europe where it’s too expensive and politically diEcult to build new re%neries.
The bulked-up Jamnagar will be able to move the market and Singapore
traders expect a drop in fuel prices as soon as it’s going at full steam.
Source: Fortune, April 28, 2008
a. Explain why the news clip implies that the global market for gasoline is not
perfectly competitive.
The news clip asserts that there is not free entry into the re%ning market. In
particular, in the United States and Europe political reasons make it extremely
b. What barriers to entry might limit competition and allow Reliance to
in-uence the price?
Political barriers to entry limit entry into the re%nery market. The public in the
United States and Europe apparently considers re%neries as undesirable neighbors
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4. Consider a game with two players who cannot communicate, and in which
each player is asked a question. The players can answer the question
honestly or lie. If both answer honestly, each receives $100. If one player
answers honestly and the other lies, the liar receives $500 and the honest
player gets nothing. If both lie, then each receives $50.
a. Describe the strategies and payo3s of this game.
The game has 2 players (A and B), and each player has 2 strategies: to answer
honestly or to lie. There are 4 payo3s: Both answer honestly and both receive
b. Construct the payo3
matrix.
The payo3 matrix has the
following cells: Both answer
honestly: A gets $100, and
c. What is the equilibrium of this game?
The equilibrium is that each player lies and gets $50. If B answers honestly, the
best strategy for A is to lie because he would get $500 rather than $100. If B lies,
d. Compare this game to the prisoners’ dilemma. Are the two games similar or
di3erent? Explain.
The game is the same as a prisoners’ dilemma. In this game, as in the prisoners’
5. Soapy Inc. and Suddies Inc., the only soap-powder producers, collude and
agree to share the market equally. If neither %rm cheats, each makes $1
million pro%t. If one %rm cheats, it makes $1.5 million, while the complier
incurs a loss of $0.5 million. If both cheat, they break even. Neither %rm can
monitor the other’s actions.
a. What are the strategies in this game? Construct the payo3 matrix for this
game.
Each %rm has two strategies: to comply with the agreement or to cheat on the
agreement.
The payo3 matrix has the following cells: Both comply by the agreement: Soapy
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b. If the game is played
only once what is the
equilibrium? Is it a
dominant-strategy
equilibrium? Explain.
The equilibrium is that
The equilibrium is a dominant strategy equilibrium because for each %rm,
regardless of the opponent’s choice, the best strategy is to cheat. If Suddies
complies with the agreement, the best strategy for Soapy is to cheat because it
6. The World’s Largest Airline
United Airlines and Continental Airlines announced a $3 billion merger to
create the world’s biggest airline. The new airline will be able to better
compete with low-cost domestic and foreign airlines. Travelers could face
higher fares, although the merged airline has no such plans. But one rationale
for any merger is to cut capacity.
Source: The New York Times, June 7, 2010
Explain how this airline merger might (i) increase air travel prices or (ii) lower
air travel production costs.
(i) If the airline is competitive, the rationale that the %rms can cut capacity will
decrease supply and raise the price of air travel. However, some routes are
(ii) The merged %rms might be able to enjoy economies of scale from the increased
production. For instance, they might be able to eliminate duplicate services (such
b. Explain how cost savings arising from a cut in capacity might be passed on
to travelers or boost producers’ pro%ts. Which might happen from this airline
merger and why?
If, after the merger and cut in capacity, the market remains competitive, the
competition forces the price down toward the (lower) average total cost. Hence
competition can lead to the cost savings being passed along to consumers. On the
other hand, if the merger and cut in capacity makes the market signi%cantly less
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7. If Soapy Inc. and Suddies Inc. play the game in Problem 5 repeatedly, on each
round of play:
a. What strategies might each %rm might adopt?
b. Can the %rms adopt a strategy that gives the game a cooperative
equilibrium?
The game has a cooperative equilibrium. If the %rms employ a trigger strategy or a
tit-for-tat strategy, they can reach the cooperative comply/comply outcome. Take
c. Would one %rm still be tempted to cheat in a cooperative equilibrium?
Explain your answer.
If the %rms employ a trigger strategy or a tit-for-tat strategy, they can reach the
cooperative comply/comply outcome. In these cases, the long-run pro%t from
8. AT&T o3ers iPhone users a $15 a month plan for 200 megabytes of data and
a $25 a month plan for 2 gigabytes of data. It won’t take Verizon Wireless
long to begin o3ering data plans too.
Source: Cnet News, June 3, 2010
a. Is AT&T likely to be using predatory pricing?
AT&T is unlikely to use predatory pricing. If AT&T tried to use predatory pricing to
drive, say, Verizon Wireless out of the market, AT&T might or might not succeed.
b. If a price war develops in the market for data services, who bene%ts most?
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