286
Chapter 16
Oligopoly
WHAT’S NEW IN THE EIGHTH EDITION:
Two new features have been added to this chapter,
Ask the Experts
on “Nash Equilibrium” and
In the
News
on ”EU Files Formal Antitrust Charges against Google.”
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
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.
The purpose of Chapter 17 is to address
oligopoly
—a market structure in which only a few sellers
offer similar or identical products. Because there are only a few sellers in an oligopolistic market,
oligopolistic firms are interdependent whereas competitive firms are not. That is, in a competitive market,
the decisions of one firm have no effect on the other firms in the market while in an oligopolistic market,
the decisions of any one firm may affect the pricing and production decisions of the other firms in the
market.
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 ❖ 287
• 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:
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.
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
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
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.
288 ❖ 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
70
3,500
80
3,200
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.
a. Note that in this case, price ($60) exceeds marginal cost ($0).
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.
a. Definition of collusion: an agreement among firms in a market about quantities
to produce or prices to charge.
b. Definition of cartel: a group of firms acting in unison.
D. The Equilibrium for an Oligopoly
1. It is often difficult for oligopolies to form cartels.
Chapter 17/Oligopoly ❖ 289
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).
a. Jack could also produce 30 gallons and earn a profit of $1,800.
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.
5. If duopolists pursue their own self-interest when deciding how much to produce, they
produce a quantity greater than the monopoly quantity, charge a price lower than the
monopoly price, and earn total profit less than the monopoly profit.
6. Definition of 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.
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.
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).
10.
Ask the Experts:
Nash Equilibrium
a. 100 percent of economic experts agreed that behavior in complex settings can be
understood better by considering what each player will choose, given that others will be
solving the same problem.
290 ❖ 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
2. The larger the number of sellers in the industry, the less concerned each seller is about its
own effect 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.
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
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.
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 ❖ 291
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
them on a weapons charge (sentence = one year) but suspect that they have been involved
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.
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
large variation in the individual bids. Typically, the bids range from a low of $0.25 to nearly a
dollar.
Large numbers of competitors lead to prices at the cost of production, because higher prices
will be underbid.
292 ❖ Chapter 17/Oligopoly
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 and
3. The decision for both Bonnie and Clyde can be described using a payoff matrix:
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
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.
a. If Clyde remains silent, Bonnie can go free by confessing.
b. If Clyde confesses, Bonnie can lower her sentence by confessing.
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.
2. Suppose that they are faced with the following decision:
Chapter 17/Oligopoly ❖ 293
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
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
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.
6.
Case Study: OPEC and the World Oil Market
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).
b. OPEC tries to raise the price of its product through a coordinated reduction in the
quantity of oil produced.
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
agreements. (The rise in oil prices has been largely because of an increase in the
demand.)
D. Other Examples of the Prisoners’ Dilemma
1. Arms Races
a. The decision matrix could look like this:
Figure 2
294 ❖ Chapter 17/Oligopoly
Decision of United States (U.S.)
Arm
Disarm
USSR at risk and weak
USSR safe
Decision of
Arm
U.S. at risk
USSR at risk
U.S. at risk and weak
USSR safe and powerful
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
E. The Prisoners’ Dilemma and the Welfare of Society
1. In some cases, the non-cooperative equilibrium is bad from society’s standpoint.
2. However, in the case of a cartel trying to maintain monopoly profits, the non-cooperative
solution is an improvement from the standpoint of society.
F. Why People Sometimes Cooperate
1. While cooperation is difficult to maintain, it is not impossible.
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.
Figure 3
Chapter 17/Oligopoly ❖ 295
b. The winner was the program that received the fewest total years in jail.
c. The winning strategy, called “tit-for-tat,” occurred where a player would start out
cooperating and then do whatever the other player did during the previous time period.
In other words, the strategy starts out friendly, penalizes unfriendly players, and then
forgives them if warranted.
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.
b. In the phone conversation, Crandall suggested to Putnam that they each raise their
fares.
c. Putnam turned the tape over to the Justice Department, which filed suit against Crandall.
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.
b. Economists have argued that this policy has a legitimate goal. Customers often go to one
store with good service, knowledgeable sales people, and higher prices for information
on a product and then buy the product at a discount superstore. Resale price
maintenance limits the superstore’s ability to “free ride” on the service provided by other
retailers.
3. Predatory Pricing
296 ❖ Chapter 17/Oligopoly
c. Economists doubt whether this strategy is used often, because it would mean that the
monopoly would have to sustain large losses. It is also difficult to expect that courts are
able to determine which price cuts are competitive and which are predatory.
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.
c. In November 1999, a judge issued a ruling that Microsoft had a great amount of
monopoly power and had illegally abused this power.
d. In June 2000, the judge ordered that Microsoft be broken up into two companies, one
that sold the operating system and one that sold applications software. An appeals court
overturned the verdict and handed the case to a new judge.
6.
In the News: Europe versus Google
a. Regulators in the European Union are concerned about Google favoring its own services
when reporting search results.
b. This article from
The Wall Street Journal
discusses the antitrust concerns of the European
Union and the possible repercussions for Google from being labeled a dominant firm.
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.
Chapter 17/Oligopoly ❖ 297
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 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
3. It is illegal for businesses to make an agreement about reducing output or raising prices.
Chapter Quick Quiz
1. d
Questions for Review
298 ❖ Chapter 17/Oligopoly
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 both better
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
Problems and Applications
b. With only one supplier of diamonds, quantity would be set where marginal cost equals
marginal revenue. The following table derives marginal revenue:
Price
Quantity
Total Revenue
Marginal Revenue
c. If Russia and South Africa formed a cartel, they would set price and quantity like a
Chapter 17/Oligopoly ❖ 299
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.
b. The owners of baseball teams would like to keep players’ salaries low. This goal is
b. A Nash equilibrium is a situation in which economic actors interacting with one another
c. The NAFTA agreement represents cooperation between the two countries. Each country
d. The payoffs in the upper left and lower right parts of the box do reflect a nation’s
300 ❖ Chapter 17/Oligopoly
5. a. Synergy does not have a dominant strategy. If Synergy believes that Dynaco will go with
6. a. The payoffs are:
Your Decision
Work
Shirk
You get 5 units of
happiness
You get 10 units of
happiness
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
c. If you are likely to work with the same person again, you have a greater incentive to
d. The payoff matrix would become:
Your Decision
Work
Shirk
happiness
happiness
You get 5 units of
happiness
You get 10 units of
happiness
Work is a dominant strategy for this new classmate. Therefore, the Nash equilibrium will
be for you to shirk and your classmate to work. You would get a B and thus would prefer
Chapter 17/Oligopoly ❖ 301
7. a. The decision box for this game is:
Braniff’s Decision
Low Price
High Price
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. American has a dominant strategy to set a low price.
c. A better outcome would be for both airlines to set a high price; they would both get
8. a. The playoff matrix for this game is:
Player One’s Decision
Take Drug
Don’t Take Drug
302 ❖ Chapter 17/Oligopoly