978-1259723223 Chapter 14

Chapter 14 – Oligopoly and Strategic Behavior

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Chapter 14 – Oligopoly and Strategic Behavior

McConnell Brue Flynn 21e

DISCUSSION QUESTIONS

1. Why do oligopolies exist? List five or six oligopolists whose products you own or regularly

purchase. What distinguishes oligopoly from monopolistic competition? LO1

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2. Answer the following questions, which relate to measures of concentration: LO1

a. What is the meaning of a four-firm concentration ratio of 60 percent? 90 percent? What are the

shortcomings of concentration ratios as measures of monopoly power?

b. Suppose that the five firms in industry A have annual sales of 30, 30, 20, 10, and 10 percent of

total industry sales. For the five firms in industry B, the figures are 60, 25, 5, 5, and 5 percent.

Calculate the Herfindahl index for each industry and compare their likely competitiveness.

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3. Explain the general meaning of the following profit payoff matrix for oligopolists C and D. All

profit figures are in thousands. LO2

a. Use the payoff matrix to explain the mutual interdependence that characterizes oligopolistic

industries.

b. Assuming no collusion between C and D, what is the likely pricing outcome?

c. In view of your answer to 8b, explain why price collusion is mutually profitable. Why might

there be a temptation to cheat on the collusive agreement?

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4. What assumptions about a rival’s response to price changes underlie the kinked-demand curve

for oligopolists? Why is there a gap in the oligopolist’s marginal-revenue curve? How does the

kinked-demand curve explain price rigidity in oligopoly? What are the shortcomings of the

kinked-demand model? LO3

5. Why might price collusion occur in oligopolistic industries? Assess the economic desirability

of collusive pricing. What are the main obstacles to collusion? Speculate as to why price

leadership is legal in the United States, whereas price-fixing is not. LO3

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6. Why is there so much advertising in monopolistic competition and oligopoly? How does such

advertising help consumers and promote efficiency? Why might it be excessive at times? LO4

7. ADVANCED ANALYSIS Construct a game-theory matrix involving two firms and their

decisions on high versus low advertising budgets and the effects of each on profits. Show a

circumstance in which both firms select high advertising budgets even though both would be

more profitable with low advertising budgets. Why won’t they unilaterally cut their advertising

budgets? LO4

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8. Is the game shown by Figure 14.1 a zero-sum game or is it a positive-sum game? How can you

tell? Are there dominant strategies in this game? If so, what are they? What cell represents a Nash

equilibrium and why? Explain why it is so difficult for Uptown and RareAir to achieve and

maintain a more favorable cell than the Nash equilibrium in this single-period pricing game. LO6

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9. Refer to the payoff matrix in question 8 at the end of this chapter. First, assume this is a one–

time game. Explain how the $60/$57 outcome might be achieved through a credible threat. Next,

assume this is a repeated game (rather than a one-time game) and that the interaction between the

two firms occurs indefinitely. Why might collusion with a credible threat not be necessary to

achieve the $60/$57 outcome? LO6

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10. Refer to the payoff matrix below. LO6

Assuming this is a sequential game with no collusion, what is the outcome if Firm A

moves first to build a new type of commercial aircraft? Explain why first-mover strategies in the

real-world are only as good as the profit projections on which they are based. How could a

supposed “win” from moving first turn out to be a big loss, whereas the “loss” of being

preempted turn out to be a blessing in disguise?

11. ADVANCED ANALYSIS Suppose you are playing a game in which you and one other

person each picks a number between 1 and 100, with the person closest to some randomly

selected number between 1 and 100 winning the jackpot. (Ask your instructor to fund the

jackpot.) Your opponent picks first. What number do you expect her to choose? Why?

What number would you then pick? Why are the two numbers so close? How might this

example relate to why Home Depot and Lowes, Walgreens and Rite-Aid, McDonald’s

and Burger King, and other major pairs of rivals locate so close to each other in many

well-defined geographical markets that are large enough for both firms to be profitable?

LO6

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12. Are the subgames of a sequential game visible when the entire game is presented in strategic

form? Explain. LO6

13.Can backward induction be readily applied when a sequential game is presented as a

payoff matrix?LO6

14. LAST WORD Why have tech firms near monopolies in their own sectors sought to compete

with tech firms that have extremely strong, near-monopoly positions in other sectors?

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REVIEW QUESTIONS

1. Which of the following apply to oligopoly industries? Select one or more answers from the

choices shown. LO1

a. A few large producers.

b. Many small producers.

c. Strategic behavior.

d. Price taking.

2. Faceblock, Gargle+, and MyMace are rival firms in an oligopoly industry. If kinked-demand

theory applies to these three firms, Faceblock’s demand curve will be: LO3

a. More elastic above the current price than below it.

b. Less elastic above the current price than below it.

c. Of equal elasticity both above and below the current price.

d. None of the above.

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3. Consider an oligopoly industry whose firms have identical demand and cost conditions. If the

firms decide to collude, then each one will want to produce the amount of output that it would if it

were: LO3

a. A monopolistic competitor.

b. A pure competitor.

c. A pure monopolist.

d. None of the above.

Chapter 14 – Oligopoly and Strategic Behavior

4. In an oligopoly, each firm’s share of the total market is typically determined by: LO4

a. Scarcity and competition.

b. Kinked demand curves and payoff matrices.

c. Homogeneous products and import competition.

d. Product development and advertising.

5. Some analysts consider oligopolies to be potentially less efficient than monopoly firms because

at least monopoly firms tend to be regulated. Arguments in favor of a more benign view of

oligopolies include: LO5

a. Oligopolies are self-regulating.

b. Oligopolies can be kept in line by foreign competition.

c. Oligopolistic industries may promote technological progress.

d. Oligopolies may engage in limit pricing to keep out potential entrants.

6. Collusive agreements can be established and maintained by: LO6

a. Credible threats.

b. One-time games.

c. Empty threats.

d. First-mover advantage.

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7. True or false. Potential rivals may be more likely to collude if they view themselves as playing

a repeated game rather than a one-time game. LO6

8. Property developers who build shopping malls like to have them “anchored” with the outlets of

one or more famous national retail chains, like Target or Nordstrom. Having such “anchors” is

obviously good for the mall developers because anchor stores bring in a lot of foot traffic that can

help generate sales for smaller stores that lack well-known national brands. But what’s in it for

the national retail chains? Why become an anchor? Choose the best answer from the following

list. LO6

a. The anchor stores want to make a credible threat against the developer.

b. The anchor stores may feel there is a first-mover advantage to becoming one of only a few

anchor stores at a new mall.

c. The property developers are making empty threats to smaller stores.

d. The smaller stores face a negative-sum game.

9. Look back at Figure 14.7. Suppose that the payouts at terminal node B change to (13,12) while

everything else in the game stays the same. The new subgame perfect Nash equilibrium will

consist of the two line segments: LO6

a. Build at BB followed by Build at HB1.

b. Build at BB followed by Don’t Build at HB1.

c. Don’t Build at BB followed by Build at HB2.

d. Don’t Build at BB followed by Don’t Build at HB2.

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would choose Don’t Build. This makes the subgame perfect Nash equilibrium consist of

BB choosing Don’t build and Huge Box then choosing Build, resulting in node B.

10. Look back at Figure 14.8. Suppose that the two firms switch places—the firm that was the

follower now gets to go first while the firm that was the leader now has to go second. The new

subgame perfect Nash equilibrium will lead to terminal node: LO6

a. A.

b. B.

c. C.

d. D.

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PROBLEMS

1. Consider a “punishment” variation of the two-firm oligopoly situation shown in Figure 13.3 in

the chapter. Suppose that if one firm sets a low price while the other sets a high price, then the

firm setting the high price can fine the firm setting the low price. Suppose that whenever a fine is

imposed, X dollars is taken from the low-price firm and given to the high-price firm. What is the

smallest amount that the fine X can be such that both firms will want to always set the high price?

LO6

Feedback: Let’s look at the following example. Consider a “punishment” variation of the two–

firm oligopoly situation shown in Figure 13.3 in the chapter (not in this appendix). Suppose that

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2. Consider whether the promises and threats made toward each other by duopolists and

oligopolists are always credible (believable). Look at the figure below. Imagine that the two

firms will play this game twice in sequence and that each firm claims the following policy. Each

says that if both it and the other firm choose the high price in the first game, then it will also

choose the high price in the second game (as a reward to the other firm for cooperating in the first

game). LO6

a. As a first step toward thinking about whether this policy is credible, consider the situation

facing both firms in the second game. If each firm bases its decision on what to do in the second

game entirely on the payouts facing the firms in the second game, which strategy will each firm

choose in the second game?

b. Now move backward in time one step. Imagine that it is the start of the first game and each

firm must decide what to do during the first game. Given your answer to part a, is the publicly

stated policy credible? (Hint: No matter what happens in the first game, what will both firms do

in the second game?)

c. Given your answers to a and b, what strategy will each firm choose in the first game?

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Feedback: Let’s look at the following example. Consider whether the promises and threats made

toward each other by duopolists and oligopolists are always credible (believable). Look back at

Figure 13.3 in the chapter (not in this appendix). Imagine that the two firms will play this game

a. As a first step toward thinking about whether this policy is credible, consider the situation

facing both firms in the second game. If each firm bases its decision on what to do in the second

game entirely on the payouts facing the firms in the second game, which strategy will each firm

b. Now move backward in time one step. Imagine that it is the start of the first game and each

firm must decide what to do during the first game. Given your answer to part a, is the publicly

stated policy credible? (Hint: No matter what happens in the first game, what will both firms do

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c. Given your answers to a and b, what strategy will each firm choose in the first game?

3. Examine the following game tree. Fred and Sally are planning on running competing

restaurants. Each must decide whether to rent space or buy space. Fred goes first at decision node

F. Sally goes second at either decision node S1 or decision node S2 (depending on what Fred

chose to do at decision node F). Note that the payoff to Sally at terminal node A is X. LO6

a. If X < 12, what terminal node will the subgame perfect Nash equilibrium path

lead to?

b. If X > 12, what terminal node will the subgame perfect Nash Equilibrium path

lead to?

c. Suppose that X = 11 and that it is now possible for Fred to make a side payment

of value V to Sally that will boost her payout at terminal node A from X = 11 to X

= 11 + V. What is the minimum amount that V can be such that the subgame

perfect Nash equilibrium path will lead to terminal node A? Assume that V can

take on only discrete units (0, 1, 2, 3,…).

Chapter 14 – Oligopoly and Strategic Behavior

a. In this case, it will lead to terminal node D. If Sally is at S1, and X < 12, she will choose

b. In this case, it will lead to terminal node A. If Sally is at S1, and X > 12, she will

c. The minimum payment is V = 2. That will be enough to get Sally to prefer terminal

node A to terminal node B in the subgame that begins at decision