Chapter 15 Oligopoly

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1 Goldwasser AP Microeconomics Chapter 15 Oligopoly BEFORE YOU READ THE CHAPTER Summary This chapter explores oligopoly, a market structure characterized by a few firms producing a product that mayor may not be differentiated. The chapter discusses the incentives for oligopolists to act cooperatively or competitively and the results of these actions on the level of oligopoly profits. The chapter discusses formal as well as tacit collusion, the formation of cartels, and the reasons why cartels fail. In addition, the chapter discusses game theory and its usefulness in exploring some of the issues confronting oligopolies. The chapter also explores the relationship between oligopolies and antitrust policy. Chapter Objectives Objective #1. Oligopolies are characterized as an industry in which there are a few producers. Each of these individual producers has some market power (like a monopoly) that enables them to affect market prices, but each of these producers also competes against the other producers in the industry. This competition is different from perfect competition in that each producer is aware of the other firms in the industry and recognizes that each firm's behavior affects the other firms. The key aspect of oligopoly is the tension between cooperation and competition: each firm must decide whether and to what degree it wants to cooperate or compete with the other firms in their industry. Objective #2. With an oligopolistic industry what matters is not the size of the firm, but rather the number of firms serving the industry. Oligopolies primarily exist because each firm benefits from increasing returns to scale and these returns to scale result in a few producers in the industry rather than many small-scale producers in the industry. Analysis of oligopoly presents several challenging puzzles not presented in our analysis of perfectly competitive markets or monopolies. Objective #3. The Herfindahl-Hirschman Index (HHI) allows economists to measure the degree of concentration in an industry. This index is the square of the share of market sales summed over the firms in the industry. An HHI greater than 1,800 indicates an oligopoly; an HHI between 1,000 and 1,800 indicates a somewhat competitive market; and an HHI less than 1,000 indicates a strongly competitive market. When a proposed merger is likely to significantly increase the HHI over 1,000, the merger is closely analyzed and is likely to be disallowed by government antitrust enforcement.

2 Objective #4. The simplest type of oligopoly to analyze is a duopoly, a situation in which there are only two firms in the industry. These two firms face two strategies: they can decide to cooperate with one another or they can decide to compete with each other by adopting noncooperative behavior. By cooperating and forming a cartel, these two firms can work together to select the level of output that will maximize their joint profits. Even with an agreement to cooperate, the firms will each find that they have an incentive to cheat on this arrangement. Cartels are inherently unstable because each firm recognizes that they have an incentive to produce more of the good than was agreed. Like a monopolist, each firm in an oligopoly recognizes that selling a greater amount of output creates both a quantity and a price effect; however, the price effect is smaller for the oligopolist than it is for the monopolist, which means that the marginal revenue from selling additional units of the good is higher for the oligopolist than it would be for the monopolist. Ultimately, collusion is more profitable than noncooperative behavior, but it is difficult to achieve since formal agreements to collude are illegal in many nations. Some oligopolies find ways to collude without a formal agreement. Objective #5. An oligopolist would prefer to have no firms to compete against. An oligopolist can create a monopoly through the establishment of exclusive dealing whereby the oligopolist provides the good to buyers who agree to only buy its product. This allows the oligopolist to have greater market power and therefore higher profits than it would earn if it faced competition from other firms. Alternatively, the oligopolistic firm can distinguish its product through differentiation: the more differentiated the firm's product, the closer the market structure is to monopoly. Objective #6. There are two basic types of oligopoly behavior based on production decisions and pricing decisions: (1) quantity competition, or Cournot behavior; and (2) price competition, or Bertrand behavior. With quantity competition, or Cournot behavior, the firms find it relatively easy to achieve an outcome that looks like collusion without having to make a formal agreement to collude. This oligopoly situation occurs when each firm lacks the ability to change quickly the level of output they produce. In such a setting, the firms in the oligopoly, constrained by the quantity of output they can produce, find it easier to divide the market, sell their product at a price greater than marginal cost, and earn positive economic profit. In this setting, the oligopolistic outcome resembles the monopoly outcome with regard to market price and market output.

3 With price competition, or Bertrand behavior, the firms find it relatively difficult to achieve an outcome that looks like collusion and instead find that each firm produces the quantity where price equals marginal cost, and the resultant market outcome is like perfect competition. In this situation, each firm's product is a perfect substitute for the' other firms' products, and each firm has the capacity to expand output quickly. Oligopolistic firms in this setting compete on price, and price falls until it reaches the level where price equals marginal cost. In this setting, the oligopolistic outcome resembles the perfectly competitive outcome with regard to market price and market output. Oligopolistic firms that lack an environment that imposes quantity constraints often differentiate their products to avoid direct price competition and its resultant outcome. The more differentiated its product, the more each firm resembles a monopoly. Objective #7. Oligopolistic firms are interdependent: one firm's profit depends on what its competitors do and vice versa. This interdependence can be modeled using game theory, in which a payoff matrix is constructed to represent the different outcomes that each firm achieves depending on the decisions made by the other firms. In this chapter, game theory is used to model this interdependence between two firms. The prisoner's dilemma is an example of game theory in which each player in the game has an incentive to cheat or take an action that benefits the player at the other player's expense, and the outcome of this behavior leaves both players worse off than they would have been if neither player had cheated. This example helps illustrate the peculiar, and often puzzling, behavior of oligopolistic firms. Figure 15.1 illustrates a payoff matrix between player 1 and player 2. Both players have a choice of two strategies-strategy 1 and strategy 2-and the payoff for each player is given in the individual cells, with player 1's payoff given first, followed by player 2's payoff.

4 Objective #8. A dominant strategy is a strategy that the player will adhere to no matter what the other players do. When each player takes the strategy that is best for them given the actions of the other players, this generates a game equilibrium that is referred to as a Nash equilibrium. The Nash equilibrium is a noncooperative equilibrium, since none of the players take into account the effects of their actions on the other players. Figure 15.2 illustrates a payoff matrix for two firms, firm 1 and firm 2, where both firms are deciding whether they should cooperate or compete with one another. Each cell provides information about the level of profits the firms earn depending on their strategy. Both firm 1 and firm 2 have dominant strategies: they will both compete, since their profit is greater when electing this strategy no matter what strategy the other firm chooses. However, when both firms select this strategy, their total profits fall below the level they could achieve if both firms were willing to commit to the strategy to cooperate. The Nash equilibrium for this game leaves both firms worse off than they would be if it were possible for them to creditably maintain the other strategy. Objective #9. Some games are played only once (Figure 15.2 is an example of this kind of game). These one-shot games do not offer the complexities found in games that are played multiple times. For businesses that hope to stay in business for many years, game theory suggests the need to consider strategic behavior that takes into account the impact of the firm's decision on the future actions of other players in the game. These multishot games often start with firms behaving cooperatively. When a firm deviates from cooperative behavior, the other firms may respond with a tit-for-tat strategy wherein they repeat what the other firm did in the previous period. This tit-for-tat strategy offers a reward to firms for cooperative behavior while punishing firms who opt to cheat on the other firms. Over time each firm recognizes that they are better off cooperating with the other firms in the industry rather than competing with these firms. When firms reach this point, this is referred to as tacit collusion, since the firms are implicitly colluding with one another without the necessity of a formal, explicit agreement.

5 Objective #10. The kinked demand curve model of oligopoly can be used to illustrate the tacit collusion outcome. The oligopolist produces the quantity associated with the tacit collusion outcome (Q*) and prices this quantity at P*, the tacitly agreed upon price. The oligopolist recognizes that a deviation from this outcome is likely to be punished by the other firms in the industry: producing a quantity greater than Q* will likely cause the other firms to produce a higher level of output and to sell this output at a lower price; and producing a lower level of output than Q* and selling this output at a price greater than P* will cause the firm to lose sales as the other firms continue to sell their output at P*. This knowledge of how rivals will respond to the firm's production and pricing decision results in the firm perceiving its demand curve has a kink in it that occurs at the level of output Q* and the price P*. Figure 15.3 illustrates the kinked demand curve model. Notice that the firm profit maximizes by producing the level of output where marginal revenue equals marginal cost (MR = MC), but that because of the kink in the demand curve there are many different MC curves (for example, MC 1 and MC 2 ) that will result in the firm producing Q* and. Selling each unit for P*. Objective #11. The United States legally restricts the behavior of oligopolistic firms and prohibits the creation of monopolies. The Sherman Antitrust Act of 1890 marks the beginning of antitrust policy and the government's commitment to prevent oligopolistic industries from becoming monopolies or behaving like a monopoly.

6 Objective #12. Although tacit collusion is common, it is hard for firms to push prices up to the monopoly level due to a number of different factors. Monopolistic prices are hard to achieve for at least four reasons: (1) when there are many firms in the industry, firms are less likely to behave cooperatively; (2) when firms produce a variety of products and offer these products at different prices it is hard to discern when a firm is cheating on the tacit agreement; (3) firms do not always agree on what is fair and in their interests, and this can lead to firms deviating from the tacit agreement; and (4) firms may find that the buyers of their products are large enough relative to the entire market to be able to bargain for lower prices. When tacit collusion breaks down, this is often due to price wars in which each firm reduces the price of its product below the cooperative level. In a worse-case scenario prices can fall below the noncooperative level as each seller tries to drive the other sellers out of the business. Objective #13. Another form of oligopolistic behavior is that of price leadership. Here a firm acts to set the price tacitly for the whole industry. In industries that follow a price leadership model, the firms often compete with each other with regard to other product characteristics. This nonprice competition injects competition into an otherwise cooperative environment.

7 Key Terms Notes oligopoly an industry with only a small number of producers. oligopolist a firm in an industry with only a small number of producers. imperfect competition a market structure in which no firm is a monopolist, but producers nonetheless have market power they can use to affect market prices. duopoly an oligopoly consisting of only two firms. duopolist one of the two firms in a duopoly. collusion cooperation among producers to limit production and raise prices so as to raise one another's profits. cartel an agreement among several producers to obey output restrictions in order to increase their joint profits. noncooperative behavior actions by firms that ignore the effects of those actions on the profits of other firms. interdependence the relationship among firms when their decisions significantly affect one another's profits; characteristic of oligopolies. game theory the study of behavior in situations of interdependence. Used to explain the behavior of an oligopoly. payoff in game theory, the reward received by a player (for example, the profit earned by an oligopolist). payoff matrix in game theory, a diagram that shows how the payoffs to each of the participants in a two-player game depend on the actions of both; a tool in analyzing interdependence. prisoner's dilemma a game based on two premises in which (1) each player has an incentive to choose an action that benefits itself at the other player's expense; and (2) both players are then worse off than if they had acted cooperatively.

8 dominant strategy in game theory, an action that is a player's best action regardless of the action taken by the other player. Nash equilibrium in game theory, the equilibrium that results when all players choose the action that maximizes their payoffs given the actions of other players, ignoring the effect of that action on the payoffs of other players; also known as noncooperative equilibrium. noncooperative equilibrium in game theory, the equilibrium that results when all players choose the action that maximizes their payoffs given the actions of other players, ignoring the effect of that action on the payoffs of other players; also known as Nash equilibrium. strategic behavior actions taken by a firm that attempt to influence the future behavior of other firms. tit for tat in game theory, a strategy that involves playing cooperatively at first, then doing whatever the other player did in the previous period. tacit collusion cooperation among producers, without a formal agreement, to limit production and raise prices so as to raise one anothers' profits. kinked demand curve a model used to explain the stability of oligopoly pricing; a demand curve that kinks (bends) because the oligopolist will lose sales if output is reduced and price is increased but gain only a few additional sales if output is increased and price is lowered (because the lower price will be matched at once by other oligopolists), the curve will be very flat above the kink and very steep below the kink.

9 antitrust policy legislative and regulatory efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies. price war a collapse of prices when tacit collusion breaks down. product differentiation the attempt by firms to convince buyers that their products are different from those of other firms in the industry. If firms can so convince buyers, they can charge a higher price. price leadership a pattern of behavior in which one firm sets its price and other firms in the industry follow. nonprice competition competition in areas other than price to increase sales, such as new product features and advertising; especially engaged in by firms that have a tacit understanding not to compete on price.

10 AFTER YOU READ THE CHAPTER Tips Tip #1. Students often find reading a payoff matrix challenging. Here's a suggestion for making this task easier. First, consider the payoff matrix from player l's perspective as two separate columns: each column represents player 2 taking a particular strategy and sticking with it, while player l's task is to decide which of the available strategies is the best strategy for player 1 to pursue. For example, Figure 15.4 represents the payoff matrix given in Figure 15.2 from firm 1's perspective. Now, consider the payoff matrix from player 2's perspective as two separate rows: each row represents player 1 taking a particular strategy and sticking with it, while player 2's task is to decide which of the available strategies is the best strategy for player 2 to pursue. Figure 15.5 represents the payoff matrix given in Figure 15.2 from firm 2's perspective.

11 Tip #2. This chapter presents the kinked demand curve model. It is important that you understand why there is a kink in the demand curve for the oligopolistic firm. Use Figure 15.6 to help guide your thinking on this issue. In the kinked demand curve model, it is assumed that the firms tacitly agree to collude and that each firm will set price at P* and produce Q* units of the good. Figure 15.6 illustrates this situation for an oligopolistic firm. This firm essentially views its demand curve as having two components: D 1 and D 2. If the firm drops the price below P*, then the relevant demand curve for the firm to consider is D 2, and if the firm increases the price above P*, then the relevant demand curve for the firm to consider is D 1. This oligopolistic firm realizes that a decision to decrease its price below the tacitly agreed upon price will cause the other firms to retaliate. These firms will also drop their price, and all the firms will sell more units of the good but not as many units as would have been the case if only one firm dropped the price. The firm also realizes that the decision to raise the price above P* will cause the demand for its product to fall by a relatively larger amount (compare the effect of a price increase on the quantity demanded on demand curve D 1 versus demand curve D 2 ) as consumers opt to purchase the good from the other firms that are still providing the good at P*.

12 Tip #3. A second concept to understand with regard to the kinked demand curve model is that firms can have different MC curves and still opt to produce Q* units of the good and sell this quantity at P*. The vertical segment of the MR curve makes this a possibility, and it implies that firms with very different MC curves can abide by the same quantity and pricing decision. Tip #4. This chapter entails less certainty about how the market structure works relative to the chapters on perfect competition and monopoly. After you study the chapter and work through the problems, you should have an appreciation for the puzzles presented by the oligopolistic market structure. These puzzles typically reflect the trade-offs between cooperation and competition and the benefits firms receive from these two strategies.

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