Oligopoly Market. PC War Games

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1 Oligopoly Market PC War Games In some markets there are only two firms. Computer chips are an example. The chips that drive most PCs are made by Intel and Advanced Micro Devices. How does competition between just two chip makers work? Do they operate in the social interest, like the firms in perfect competition? Or do they restrict output to increase profit, like a monopoly? 1

2 Oligopoly Oligopoly Only a few sellers Offer similar or identical products Interdependent Between monopoly and perfect competition Ex. Tennis ball produced by Wilson, Penn, Dunlop Auto industry, Cigarette Industry Airlines: Boeing and Airbus No single general model of oligopoly behavior exists 3 A small group of sellers Tension between cooperation and self interest Is best off cooperating Acting like a monopolist Produce a small quantity of output Charge P >MC Each cares only about its own profit Powerful incentives not to cooperate Game theory The study how people behave in strategic situations Choose among alternative courses of action Must consider how others might respond to the action he takes 4 2

3 A Duopoly example Duopoly: One form of Oligopoly Oligopoly with only two members Decide quantity to sell Price determined on the market By demand Ex. Airtel and Vodafone Boeing and Airbus 5 EXAMPLE: Cell Phone Duopoly in Smalltown P Q Rs Smalltown has 140 residents The good : cell phone service with unlimited anytime minutes and free phone Smalltown s demand schedule Two firms: AirTel, Vodafone (duopoly: an oligopoly with two firms) Each firm s costs: FC = Rs. 0, MC = Rs.10 per unit 6 3

4 EXAMPLE: Cell Phone Duopoly in Smalltown P Rs Q Total Revenue Rs ,200 1,650 2,000 2,250 Cost Rs ,300 1,200 1,100 1, Profit 1, ,000 1,350 Price and Quantity Supplied 1. Competitive mkt. outcome: P = MC = Rs.10 Q = 120 Profit = Rs ,400 2,450 2,400 2, ,600 1,750 1,800 1, Monopoly mkt. outcome: P>MC P = Rs.40 Q = 60 Profit = Rs.1,800 7 EXAMPLE: Cell Phone Duopoly in Smalltown Price Rs45 In a competitive market, quantity would equal 120 and P = MC = Rs. 10. Rs. 40 Rs. 10 A monopoly would produce 60 gallons and charge Rs.40. Note that P > MC. Demand Total industry output with a duopoly will probably exceed 60, but be less than 120. MC is constant = Rs Rs Marginal Revenue Quantity of Output 8 4

5 Competition, monopolies, and cartels Perfectly competitive firm Price = marginal cost Quantity = efficient Monopoly Price > marginal cost Quantity < efficient quantity 9 Competition, monopolies, and cartels Duopoly Collude and form a cartel Act as a monopoly Total level of production Quantity produced by each member Don t collude self interest Difficult to agree; Antitrust laws Higher quantity; lower price; lower profit Not competitive allocation Nash equilibrium 10 5

6 Competition, monopolies, and cartels Duopoly: Collusion: an agreement among firms in a market about quantities to produce or prices to charge by each member. Act like a monopoly Cartel: a group of firms acting in unison, e.g., Air Tel and Vodafone in the outcome with collusion 11 Competition, monopolies, and cartels Collusion vs. Don t Collude (Self Interest) Outcome Both firms would be better off if both stick to the cartel agreement. But each firm has incentive to default on the agreement. Lesson: It is difficult for oligopoly firms to form cartels and honor their agreements. 12 6

7 EXAMPLE: Cell Phone Duopoly in Smalltown Collusion vs. Don t Collude (self interest) P Q Rs Duopoly outcome with collusion: Each firm agrees to produce Q = 30, P = Rs. 40, Profits = Rs. 900, Total Profit = RS i.e (2*900) If Air Tel default on the agreement and produces Q = 40, what happens to the market price? Air Tel s profits? Is it in Air Tel s interest to default on the agreement? If both firms default and produce Q = 40, determine each firm s profits EXAMPLE: Cell Phone Duopoly in Smalltown Collusion vs. Don t Collude (self interest) :Answer P Q Rs If both firms stick to agreement, each firm s profit = Rs.900 If Air Tel defaults on agreement and produces Q = 40: Market quantity = 70, P = Rs.35 Air Tel s profit = 40 x (Rs.35 10) = Rs.1000 Air Tel s profits are higher if it defaults. Vodafone will conclude the same, so both firms default, each produces Q = 40: Market quantity = 80, P = Rs.30 Each firm s profit = 40 x (Rs.30 10) = Rs

8 The equilibrium for an oligopoly Nash equilibrium a situation in which Economic actors/participants interacting with one another and Each Choose their best strategy Given the strategies that all the other actors have chosen 15 EXAMPLE: Cell Phone Duopoly in Smalltown The oligopoly equilibrium: Nash Equilibrium P Q Rs If each firm produces Q = 40, market quantity = 80, P = Rs.30 each firm s profit = Rs.800 Is it in Airtel s interest to increase its output further, to Q = 50? Is it in Vodafone s interest to increase its output to Q = 50? 16 8

9 EXAMPLE: Cell Phone Duopoly in Smalltown Answers P Q Rs If each firm produces Q = 40, then each firm s profit = Rs.800. If Airtel increases output to Q = 50: Market quantity = 90, P = Rs.25 Airtel s profit = 50 x (Rs.25 10) = Rs.750 Airtel s profits are higher at Q = 40 than at Q = 50. The same is true for Vodafone. So Nash Equilibrium is Given that Vodafone on produces Q = 40, Air tel s best move is to produce Q = 40. Given that Airtel produces Q = 40, Vodafone s best move is to produce Q = How the size of an oligopoly affects the market outcome If More sellers Form a cartel then firm Maximize profit by produce monopoly quantity and charging monopoly price. Do not form a cartel then each firm maximize profit by increasing Q which has two effect The output effect P > MC, selling more output raises profit The price effect Increase production increases total amount sold which reduces market t price and reduces profit Oligopoly Q > monopoly Q but < competitive Q. Oligopoly P > competitive P but < monopoly P. 18 9

10 How the size of an oligopoly affects the market outcome As the number of sellers in an oligopoly grows larger Oligopolistic market looks more like a competitive market Price approaches marginal cost Market quantity produced approaches socially efficient level 19 Oligopoly Games Oligopoly and Game Theory A Key characteristic of oligopoly is that firms are mutually interdependent. Each firm must take into account the expected reaction of other firms. Interdependencies leads to strategic behavior. Strategic behavior is the behavior that occurs when what is best for A depends upon what B does and vice versa. Strategic behavior can be well analyzed using game theory

11 Oligopoly and Game Theory Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence. It helps us understand oligopoly and other situations where players interact and behave strategically. The Prisoners Dilemma It is a game between two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial. It illustrates the four features of a game. Rules Strategies Payoffs Outcome Oligopoly and Game Theory Prisoners Dilemma Example: The police have caught Gabbar and Mogambo, two suspected bank robbers, but only have enough evidence to imprison each for 1 year. Rules : The police question each in separate rooms, Offer each the following deal: If you confess and implicate your partner, you go free. If you do not confess but your partner implicates you, you get 20 years in prison. If you both confess, each gets 8 years in prison

12 Oligopoly and Game Theory Prisoners Dilemma Example: Strategies Strategies are all the possible actions of each player. Gabbar and Mogambo each have two possible action: Confess or Deny. Four possible outcomes: 1. Both confess. 2. Both deny. 3. Gabbar confesses and Mogambo denies. 4. Mogambo confesses and Gabba denies. Dominant strategy: a strategy that is best for a player in a game regardless of the strategies chosen by the other players Mogambo s decision Oligopoly and Game Theory Prisoners Dilemma Example: Payoff Matrix Confessing is the dominant strategy for both players. Nash equilibrium: both confess Confess Remain silent Gabbar s decision Confess Remain silent Gabbar gets Gabbar gets 8 years 20 years Mogambo gets 8 years Mogambo gets 20 years Gabbar goes free Mogambo goes free Mogambo gets 1 year Gabbar gets 1 year 24 12

13 Oligopoly and Game Theory Prisoners Dilemma Example: Outcome Gabbar and Mogambo both confess, each gets 8 years in prison. Both would have been better off if both remained silent. But even if Gabbar and Mogambo had agreed before being caught to remain silent, the logic of self interest takes over and leads them to confess. The Outcome is Nash Equilibrium i.s. both confess which leads to suboptimal solution 25 Oligopoly and Game Theory Prisoners Dilemma : Oligopoly Plays When oligopolies form a cartel in hopes of reaching the monopoly outcome, they become players in a prisoners dilemma. Firms are self interest and do not cooperate even though cooperation (cartel) would increase profits, each firm has incentive to cheat Our earlier example: Airtel and Vodafone are duopolists in Smalltown. The cartel outcome maximizes profits: Each firm agrees to serve Q = 30 customers. Here is the payoff matrix for this example 26 13

14 Airtel & Vodafone in the Prisoners Dilemma Q = 30 Vodafone Oligopoly and Game Theory Each firm s dominant strategy: default on agreement, produce Q = 40. Airtel Q = 30 Q = 40 Q = 40 Vodafone s profit = Rs.900 Airtel s profit = Rs.900 Airtel s profit = Rs.750 Vodafone s profit = Rs.1000 Vodafone s profit = Rs.750 Vodafone s profit = Rs.800 Airtel s profit = Rs.1000 Airtel s profit = Rs Case Application-1 REPEATED GAMES Competition and Collusion in Airline Industry In March 1983, American Airlines proposed that all airlines adopt a uniform fare schedule based on mileage. The rate per mile would depend on the length of the trip, with the lowest rate of 15 cents per mile for trips over 2500 miles and the highest rate, 53 cents per mile, for trips under 250 miles. Why did American propose this plan, and what made it so attractive to the other airlines? The aim was to reduce price competition and achieve a collusive pricing arrangement. Fixing prices illegal. Instead, the companies would implicitly fix prices by agreeing to use the same fare-setting formula. The plan failed, a victim of the prisoners dilemma. Pan Am, which was dissatisfied with its small share of the U.S. market, dropped its fares. American, United, and TWA, afraid of losing their own shares of the market, quickly dropped their fares to match Pan Am. The price-cutting continued, and fortunately for consumers, the plan was soon dead. 14

15 Case Application-2 OPEC and the world oil market Organization of Petroleum Exporting Countries (OPEC) Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia, Venezuela By 1973: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon join Control about three fourths of the world s oil reserves Tries to raise the price of its product Coordinated reduction in quantity produced 29 Case Application-2 OPEC and the world oil market OPEC Tries to set production levels for each of the member countries Problem The countries want to maintain a high price of oil Each member of the cartel Tempted to increase its production Get a larger share of the total profit Cheat on agreement 30 15

16 Case Application-2 OPEC and the world oil market OPEC successful at maintaining cooperation and high prices From 1973 to 1985: increase in price Mid 1980s member countries began arguing about production levels OPEC ineffective at maintaining cooperation Decrease in price significant increase in price Primary cause: increased demand in the world Booming Chinese economy 31 Thanks 32 16