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304
Chapter 16
Oligopoly
WHAT’S NEW IN THE SEVENTH EDITION:
There is a new
In the News
box on ”Should the N.C.A.A Be Taken to Court?”
LEARNING OBJECTIVES:
what outcomes are possible when a market is an oligopoly.
the prisoners’ dilemma and how it applies to oligopoly and other issues.
CONTEXT AND PURPOSE:
Chapter 17 is the final chapter in a five-chapter sequence dealing with firm behavior and the organization
competition
. There are two types of imperfect competition—monopolistic competition, which we
addressed in the previous chapter, and oligopoly, which is the topic of the current chapter.
market.
KEY POINTS:
OLIGOPOLY
17
Chapter 17/Oligopoly ❖ 305
The prisoners’ dilemma shows that self-interest can prevent people from maintaining cooperation,
even when cooperation is in their mutual interest. The logic of the prisoners’ dilemma applies in many
situations including arms races, advertising, common-resource problems, and oligopolies.
Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces
competition. The application of these laws can be controversial, because some behavior that can
appear to reduce competition may in fact have legitimate business purposes.
CHAPTER OUTLINE:
identical products.
II. Definition of game theory: the study of how people behave in strategic situations.
A. By strategic, we mean a situation in which each person, in deciding what actions to take, must
B. Each firm in an oligopoly must act strategically, because its profit not only depends on how much
output it produces, but also on how much other firms produce as well.
III. Markets with Only a Few Sellers
1. The group of oligopolists is better off cooperating and acting like a monopolist, producing a
2. Yet, because the oligopolist cares about his own profit, there is an incentive to act on his
own. This will limit the ability of the group to act as a monopoly.
B. A Duopoly Example
2. Example: Jack and Jill own the only water wells in town. They have to decide how much
water to bring to town to sell. (Assume that the marginal cost of pumping each gallon of
water is zero.)
Use this example and show the competitive equilibrium first. Then, show the
monopoly price and output. Finally, explain how the two suppliers would end up
producing a quantity between the competitive and monopoly output and charging a
price between the competitive price and the monopoly price.
306 ❖ Chapter 17/Oligopoly
3. The demand for the water is as follows:
Quantity (gallons)
Price
Total Revenue (and Total Profit)
0
$120
$0
10
110
1,100
20
100
2,000
30
90
2,700
40
80
3,200
50
70
3,500
60
60
3,600
70
50
3,500
80
40
3,200
90
30
2,700
100
20
2,000
110
10
1,100
120
0
0
C. Competition, Monopolies, and Cartels
1. If the market for water were perfectly competitive, price would equal marginal cost ($0). This
2. If a monopoly controlled the supply of water, profit would be maximized at a price of $60
and an output of 60 gallons.
b. This level of output is lower than the socially efficient level of output (120 gallons).
3. The duopolists may agree to act together to set the price and quantity of water.
to produce or prices to charge.
b. Definition of cartel: a group of firms acting in unison.
a price of $60.
d. The cartel must also decide how to split the production of water. Each member will want
4.
In the News: Public Price Fixing
Table 1
Chapter 17/Oligopoly ❖ 307
b. This article from
The Wall Street Journal
suggests that firms may collude by publicly
posting prices.
D. The Equilibrium for an Oligopoly
1. It is often difficult for oligopolies to form cartels.
a. Antitrust laws prohibit agreements among firms.
3. Assume that Jack expects Jill to produce 30 gallons of water (half of the monopoly outcome).
b. However, he could produce 40 gallons and earn a profit of $2,000.
c. Jack will want to produce 40 gallons.
4. Jill might reason the same way. If she expects Jack to produce 30 gallons, she could increase
5. If duopolists pursue their own self-interest when deciding how much to produce, they
6. Definition of Nash equilibrium: a situation in which economic actors interacting
other actors have chosen.
7. In this example, the Nash equilibrium occurs when both Jack and Jill are producing 40
gallons.
output level than 40 gallons.
output level than 40 gallons.
8. Note that the oligopolists could earn a higher total profit if they cooperated with one another,
9. When firms in an oligopoly individually choose production to maximize profit, they end up
somewhere between perfect competition and monopoly.
a. The quantity of output produced by the oligopoly is greater than the level produced by a
monopoly but less than the level produced by a competitive market.
b. The oligopoly price is less than the monopoly price but greater than the competitive price
(which implies that it is greater than marginal cost).
308 ❖ Chapter 17/Oligopoly
E. How the Size of an Oligopoly Affects the Market Outcome
1. When an oligopolist decides to increase output, two things occur.
a. Because price is greater than marginal cost, increasing output will increase profit. This is
the
output effect
.
b. Because increasing output will raise the total quantity sold, the price will fall and will
therefore lower profit. This is the
price effect
.
2. The larger the number of sellers in the industry, the less concerned each seller is about its
own impact on market price.
3. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks
more and more like a competitive market.
a. Price will approach marginal cost.
b. The quantity of output produced will approach the socially efficient level.
Activity 1—Four Markets for Widgets
Type: In-class demonstration
Topics: Market structure and price
Materials needed: Seven volunteers, money ($2.50 to $4.00)
Time: 15 minutes
Class limitations: Works in any class with more than 15 students
Purpose
This illustrates how different market structures can result in wide differences in price for the
consumer. It also shows how communication can increase oligopoly profits. The opportunity
to win real money creates great student interest.
Instructions
Divide the class into four groups. Group A consists of one student (the first volunteer). Group
B consists of the next three volunteers. Group C consists of the other three volunteers. Group
D is the rest of the class.
Each group manufactures a unique type of widget. The firms within a group compete, but
there is no competition across groups. Widgets are produced by writing the word “widget” on
a sheet of paper.
Group A represents a monopoly. The monopolist does not need to consider the actions of any
other firms. The professor will buy one widget from Group A. The professor is willing to pay
up to $1 for this widget.
You might want to point out that the Nash equilibrium will be
n /
(
n
+ 1) of the
competitive output. Therefore, with two suppliers, the joint output (80 units) will be
two-thirds of the competitive equilibrium (120 units). This will help to explain that as
the number of firms in an oligopoly market increases, the market output quickly
approaches the competitive outcome.
Chapter 17/Oligopoly ❖ 309
IV. The Economics of Cooperation
beneficial.
B. The Prisoners’ Dilemma
1. Example: Bonnie and Clyde have been captured. The police have enough evidence to convict
them to confess.
Group B represents an oligopoly. This group can communicate with each other and can
examine each other’s bids. (Have these students sit together.) They are allowed to make their
decisions jointly, and may make agreements to share profits. The professor will buy one
widget from Group B. The professor is willing to pay up to $1.00 for this widget, but will buy
it from the lowest bidder.
Group C also represents an oligopoly. This group cannot communicate with each other. (Move
these students away from each other.) The professor will buy one widget from Group C. The
professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.
Group D represents competition. The professor will buy one widget from Group D. The
professor is willing to pay up to $1.00 for this widget, but will buy it from the lowest bidder.
Ask the students in each group to make a bid by writing his or her name and offer on a sheet
of paper. Remind them they will need to consider the possible bids by rivals within their own
group, because only the winning bid will be paid.
Collect the bids from each group in turn. Pay the low bid in each group.
Common Answers and Points for Discussion
The monopolist will bid $1, the maximum willingness to pay.
The colluding oligopolists usually each bid $1. They often will reach a profit-sharing
agreement.
The oligopolists who do not communicate will have a lower winning bid. They also display
The competitive group will also have a range of bids, but the lowest bid will be even lower
than Group C’s low bid. Typically, this widget will sell for $0.01.
Communication among oligopolists allows price fixing. Collusion can lead to the joint profit-
maximizing, or monopoly, price. Restricting communication greatly reduces the ability of
Large numbers of competitors lead to prices at the cost of production, because higher prices
will be underbid.
310 ❖ Chapter 17/Oligopoly
"We can lock you up for one year. However, if you confess to the bank robbery and
implicate your partner, we will give you immunity. You will go free and your partner will
get 20 years in jail. If you both confess, we won’t need your testimony and avoid the
cost of a trial so you will both get an intermediate sentence of eight years."
Bonnie’s Decision
Confess
Remain Silent
Clyde’s
Decision
Confess
Bonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes free
Remain
Silent
Bonnie goes free
Clyde gets 20 years
Bonnie gets 1 year
Clyde gets 1 year
5. Bonnie’s dominant strategy is to confess.
a. If Clyde remains silent, Bonnie can go free by confessing.
6. Clyde’s dominant strategy is to confess.
a. If Bonnie remains silent, Clyde can go free by confessing.
7. If they had both remained silent, they would have been better off collectively (with a
sentence of only one year instead of eight). But, by each pursuing his or her own self-
interests, the two prisoners together reach an outcome that is worse for both of them.
individually irrational.
C. Oligopolies as a Prisoners’ Dilemma
1. Example: Jack and Jill are trying to keep the sale of water low to keep the price high. After
2. Suppose that they are faced with the following decision:
Figure 1
Figure 2
Chapter 17/Oligopoly ❖ 311
Jack’s Decision
High Production
Low Production
Jill’s
Decision
High
Production
$1,600 profit for Jack
$1,600 profit for Jill
$1,500 profit for Jack
$2,000 profit for Jill
Low
Production
$2,000 profit for Jack
$1,500 profit for Jill
$1,800 profit for Jack
$1,800 profit for Jill
a. If Jill produces at a high rate, Jack will earn a higher amount of profit if he too produces
at a high rate.
b. If Jill produces at a low rate, Jack will earn a higher profit if he produces at a high rate as
well.
5. Even though total profit would be highest if both individuals produced at a low rate, self-
interest will encourage them to produce at a high rate.
a. Much of the world’s oil is produced by a few countries. These countries have formed a
cartel called the Organization of Petroleum Exporting Countries (OPEC).
quantity of oil produced.
c. Like any oligopoly, the member nations face the dilemma between cooperation and self-
interest.
1985.
e. In the early 1980s, member countries began arguing over production levels.
f. In recent years, the cartel has been largely unsuccessful at reaching and enforcing
demand.)
D. Other Examples of the Prisoners’ Dilemma
1. Arms Races
312 ❖ Chapter 17/Oligopoly
Decision of United States (U.S.)
Arm
Disarm
Decision of
Soviet Union
(USSR)
Arm
U.S. at risk
USSR at risk
U.S. at risk and weak
USSR safe and powerful
Disarm
U.S. safe and powerful
USSR at risk and weak
U.S. safe
USSR safe
2. Common Resources
a. The decision matrix could look like this:
Exxon’s Decision
Drill two wells
Drill one well
Texaco’s
Decision
Drill two
wells
$4 million profit for Exxon
$4 million profit for Texaco
$3 million profit for Exxon
$6 million profit for Texaco
Drill one
well
$6 million profit for Exxon
$3 million profit for Texaco
$5 million profit for Exxon
$5 million profit for Texaco
E. The Prisoners’ Dilemma and the Welfare of Society
1. In some cases, the noncooperative equilibrium is bad from society’s standpoint.
b. In the common resources game, the extra wells dug are wasteful.
2. However, in the case of a cartel trying to maintain monopoly profits, the noncooperative
solution is an improvement from the standpoint of society.
F. Why People Sometimes Cooperate
2. Cooperation is easier to enforce if the game is repeated.
3.
Case Study: The Prisoners’ Dilemma Tournament
Figure 3
Figure 4
