304
Chapter 16
Oligopoly
WHAT’S NEW IN THE SIXTH EDITION:
There is a new
In the News
box on ”The Next Big Antitrust Target?”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ what outcomes are possible when a market is an oligopoly.
CONTEXT AND PURPOSE:
Chapter 17 is the final chapter in a five-chapter sequence dealing with firm behavior and the organization
of industry. Chapters 14 and 15 discussed the two extreme forms of market structure—competition and
monopoly. The market structure that lies between competition and monopoly is known as
imperfect
KEY POINTS:
• Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. Yet, if
oligopolists make decisions about production levels individually, the result is a greater quantity and a
lower price than under the monopoly outcome. The larger the number of firms in the oligopoly, the
closer the quantity and price will be to the levels that would prevail under perfect competition.
OLIGOPOLY
17
Chapter 17/Oligopoly ❖ 305
CHAPTER OUTLINE:
I. Definition of oligopoly: a market structure in which only a few sellers offer similar or
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
consider how others might respond to that action.
III. Markets with Only a Few Sellers
A. A key feature of oligopoly is the tension between cooperation and self-interest.
B. A Duopoly Example
1. A duopoly is an oligopoly with only two members.
2. Example: Jack and Jill own the only water wells in town. They have to decide how much
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
40
3,200
50
3,500
60
3,600
70
3,500
2,000
1,100
C. Competition, Monopolies, and Cartels
1. If the market for water were perfectly competitive, price would equal marginal cost ($0). This
means that 120 gallons of water would be sold.
2. If a monopoly controlled the supply of water, profit would be maximized at a price of $60
and an output of 60 gallons.
3. The duopolists may agree to act together to set the price and quantity of water.
a. Definition of collusion: an agreement among firms in a market about quantities
to produce or prices to charge.
Chapter 17/Oligopoly ❖ 307
4.
In the News: Public Price Fixing
a. Firms that meet in secret to set prices run the risk of prosecution.
D. The Equilibrium for an Oligopoly
1. It is often difficult for oligopolies to form cartels.
2. In the absence of a binding agreement, the monopoly outcome is unlikely.
3. Assume that Jack expects Jill to produce 30 gallons of water (half of the monopoly outcome).
4. Jill might reason the same way. If she expects Jack to produce 30 gallons, she could increase
her profits by raising her output to 40 gallons.
7. In this example, the Nash equilibrium occurs when both Jack and Jill are producing 40
gallons.
8. Note that the oligopolists could earn a higher total profit if they cooperated with one another,
but instead pursue their own self-interest and earn a lower level of profit.
9. When firms in an oligopoly individually choose production to maximize profit, they end up
somewhere between perfect competition and monopoly.
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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).
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
.
2. The larger the number of sellers in the industry, the less concerned each seller is about its
own impact on market price.
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
You might want to point out that the Nash equilibrium will be (
n/n
+ 1) of the
Chapter 17/Oligopoly ❖ 309
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 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.
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
large variation in the individual bids. Typically the bids range from a low of $0.25 to nearly a
dollar.
310 ❖ Chapter 17/Oligopoly
IV. The Economics of Cooperation
A. Definition of prisoners’ dilemma: a particular “game” between two captured prisoners
that illustrates why cooperation is difficult to maintain even when it is mutually
beneficial.
B. The Prisoners’ Dilemma
1. Example: Bonnie and Clyde have been captured. The police have enough evidence to convict
2. The police lock the two in separate rooms and offer each of them a deal:
“We can lock you up for one year. However, if you confess to the bank robbery
3. The decision for both Bonnie and Clyde can be described using a payoff matrix:
Bonnie’s Decision
Confess
Remain Silent
4. Definition of dominant strategy: a strategy that is best for a player in a game
regardless of the strategies chosen by the other players.
5. Bonnie’s dominant strategy is to confess.
Figure 1
Chapter 17/Oligopoly ❖ 311
6. Clyde’s dominant strategy is to confess.
7. If they had both remained silent, they would have been better off collectively (with a
8. Cooperation between the two prisoners is difficult to maintain, because cooperation is
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
reaching an agreement, each person must decide whether to follow the agreement.
Jack’s Decision
3. The dominant strategy for Jack is to produce at a high rate.
a. If Jill produces at a high rate, Jack will earn a higher amount of profit if he too produces
at a high rate.
4. For the same reasons, the dominant strategy for Jill is to produce at a high rate.
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.
Figure 2
312 ❖ Chapter 17/Oligopoly
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).
d. OPEC was fairly successful in maintaining cooperation and high prices from 1973 to
1985.
D. Other Examples of the Prisoners’ Dilemma
1. Arms Races
a. The decision matrix could look like this:
Decision of United States (U.S.)
Arm
Disarm
b. The dominant strategy for each country in this example is to arm.
2. Common Resources
a. The decision matrix could look like this:
Exxon’s Decision
Drill two wells
Drill one well
Figure 3
Figure 4
Chapter 17/Oligopoly ❖ 313
b. The dominant strategy for both firms will be to drill two wells.
E. The Prisoners’ Dilemma and the Welfare of Society
1. In some cases, the noncooperative equilibrium is bad from society’s standpoint.
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
a. Political scientist Robert Axelrod held a tournament in which people entered by sending
computer programs designed to play repeated prisoners’ dilemma games.
V. Public Policy toward Oligopolies
A. Restraint of Trade and the Antitrust Laws
1. The Sherman Act of 1890 elevated agreements among oligopolists from an unenforceable
contract to a criminal conspiracy.
3.
Case Study: An Illegal Phone Call
a. In the early 1980s, Howard Putnam, the president of Braniff Airways, taped a telephone
call from Robert Crandall, the president of American Airlines.
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B. Controversies over Antitrust Policy
1. Business practices that appear to reduce competition may in fact have legitimate purposes.
2. Resale Price Maintenance
a. Resale price maintenance is a restriction by a manufacturer on the price that sellers can
charge for a product, usually used to keep the price from being lower at one retailer than
another.
3. Predatory Pricing
a. When firms with monopoly power are faced with new competition, they may cut prices
drastically to drive the new competition out of business and restore their monopoly
power.
4. Tying
a. Tying occurs when two products are sold together.
5.
Case Study: The Microsoft Case
a. In 1998, the U.S. Justice Department filed suit against Microsoft Corporation.
b. A central issue in the case involved the tying of Microsoft’s Internet browser to its
Windows operating system.
Chapter 17/Oligopoly ❖ 315
6.
In the News: The Next Big Antitrust Target?
a. Google is now attracting the attention of government lawyers.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. If the members of an oligopoly could agree on a total quantity to produce, they would
choose to produce the monopoly quantity, acting in collusion as if they were a monopoly.
2. The prisoners’ dilemma is the story of two criminals suspected of committing a crime, in
which the sentence that each receives depends both on his or her decision whether to
confess or remain silent and on the decision made by the other. The following table shows
the prisoners’ choices:
Bonnie’s Decision
Confess
Remain Silent
The likely outcome is that both will confess, since that is a dominant strategy for both.
The prisoners’ dilemma teaches us that oligopolies have trouble maintaining the cooperative
outcome of low production, high prices, and monopoly profits because each oligopolist has an
incentive to cheat.
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Questions for Review
1. If a group of sellers could form a cartel, they would try to set quantity and price like a
3. Firms in an oligopoly produce a quantity of output that is less than the level produced by a
4. As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and
5. The prisoners’ dilemma is a game between two people or firms that illustrates why it is
difficult for opponents to cooperate even when cooperation would make them all better off.
6. The arms race and common resources are some examples of how the prisoners’ dilemma
helps to explain behavior. In the arms race during the Cold War, the United States and the
7. Antitrust laws prohibit firms from trying to monopolize a market. They are used to prevent
8. Resale price maintenance occurs when a wholesaler sets a minimum price that retailers can
charge. This might seem to be anticompetitive because it prevents retailers from competing
Problems and Applications
1. a. If there were many suppliers of diamonds, price would equal marginal cost ($1,000), so
the quantity would be 12,000.
Chapter 17/Oligopoly ❖ 317
Price
(thousands of dollars)
Quantity
(thousands)
Total Revenue
(millions of dollars)
Marginal Revenue
(millions of dollars)
8
5
40
—-
With marginal cost of $1,000 per diamond, or $1 million per thousand diamonds, the
monopoly will maximize profits at a price of $7,000 and a quantity of 6,000. Additional
production beyond this point would lead to a situation where marginal revenue is lower
than marginal cost.
c. If Russia and South Africa formed a cartel, they would set price and quantity like a
monopolist, so the price would be $7,000 and the quantity would be 6,000. If they split
the market evenly, they would share total revenue of $42 million and costs of $6 million,
2. a. OPEC members were trying to reach an agreement to cut production so they could raise
the price.
3. a. Buyers who are oligopolists try to decrease the prices of goods they buy.
4. a. If Mexico imposes low tariffs, then the United States is better off with high tariffs,
because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico
imposes high tariffs, then the United States is better off with high tariffs, because it gets
7
6
42
6
7
42
5
8
40
4
9
36
3
30
2
22
1
12
318 ❖ Chapter 17/Oligopoly
$20 billion with high tariffs and only $10 billion with low tariffs. So the United States has
a dominant strategy of high tariffs.
b. A Nash equilibrium is a situation in which economic actors interacting with one another
each choose their best strategy given the strategies others have chosen. The Nash
equilibrium in this case is for each country to have high tariffs.
c. The NAFTA agreement represents cooperation between the two countries. Each country
reduces tariffs and both are better off as a result.
5. a. Synergy does not have a dominant strategy. If Synergy believes that Dynaco will go with
a large budget, it will also choose a large budget. However, if Synergy believes that
Dynaco will go with a small budget, it will want a small budget as well.
6. a. The payoffs are:
Your Decision
Work
Shirk
You get 15 units of
happiness
You get 30 units of
happiness
b. The likely outcome is that both of you will shirk. If your classmate works, you’re better
off shirking, because you would rather have 30 units of happiness rather than 15. If your
classmate shirks, you are better off shirking because you would rather have 10 units of
Chapter 17/Oligopoly ❖ 319
happiness rather than 5. So your dominant strategy is to shirk. Your classmate faces the
same payoffs, so he or she will also shirk.
d. The payoff matrix would become:
Your Decision
Work
Shirk
units of happiness
of happiness
You get 15 units of
happiness
You get 30 units of
happiness
7. a. The decision box for this game is:
Braniff’s Decision
Low Price
High Price
Price
Very low profits for American
Medium profits for American
American’s
Low
Price
Low profits for Braniff
Low profits for American
Very low profits for Braniff
High Profits for American
b. If Braniff sets a low price, American will set a low price. If Braniff sets a high price,
American will set a low price. So American has a dominant strategy to set a low price.
320 ❖ Chapter 17/Oligopoly
8. a. The playoff matrix for this game is:
Player One’s Decision
Take Drug
Don’t Take Drug
Player
Two’s
Take Drug
Player 1 gets 5,000 –
X
Player 2 gets 5,000 –
X
Player 1 gets 0
Player 2 gets 10,000 –
X
b. Taking the drug will be a dominant strategy for each player as long as
X
is less than
5,000.
c. Making the drug safer (lowering
X
) raises the likelihood of taking the drug because it
increases the payoff.
9. a. If Kona enters, Big Brew would want to maintain a high price. If Kona does not enter, Big
Brew would want to maintain a high price. Thus, Big Brew has a dominant strategy of
maintaining a high price.
b. There is only one Nash equilibrium. Big Brew will maintain a high price and Kona will
enter.
c. Little Kona should not believe this threat from Big Brew because it is not in Big Brew’s
interest to carry out the threat. If Little Kona enters, Big Brew can set a high price, in
which case it makes $3 million, or Big Brew can set a low price, in which case it makes
$1 million. Thus the threat is an empty one, which Little Kona should ignore; Little Kona
should enter the market.
10. a. Using Table 1 in the chapter, if 80 gallons are produced, the price would be $40 and
profit would be $3,200. Divided three ways, John would get $3,200/3 = $1,066.67. Each
seller would sell 80/3 = 26.67 gallons.
Player 1 gets 10,000 –
Player 1 gets 5,000