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OligopolyEconomicsPRINCIPLESOFN.GregoryMankiwPremiumPowerPointSlides

byRonCronovich17OligopolyEconomicsPRINCIInthischapter,

lookfortheanswerstothesequestions:Whatoutcomesarepossibleunderoligopoly?Whyisitdifficultforoligopolyfirmstocooperate?Howareantitrustlawsusedtofostercompetition?11OLIGOPOLYInthischapter,

lookfortheMeasuringMarketConcentrationConcentrationratio:thepercentageofthemarket’stotaloutputsuppliedbyitsfourlargestfirms.Thehighertheconcentrationratio,

thelesscompetition.Thischapterfocusesonoligopoly,

amarketstructurewithhighconcentrationratios.02OLIGOPOLYMeasuringMarketConcentrationConcentrationRatiosinSelectedU.S.IndustriesIndustryConcentrationratioVideogameconsoles100%Tennisballs100%Creditcards99%Batteries94%Softdrinks93%Websearchengines92%Breakfastcereal92%Cigarettes89%Greetingcards88%Beer85%Cellphoneservice82%Autos79%03OLIGOPOLYConcentrationRatiosinSelectOligopolyOligopoly:amarketstructureinwhichonlyafewsellersoffersimilaroridenticalproducts.Strategicbehaviorinoligopoly:

Afirm’sdecisionsaboutPorQcanaffectotherfirmsandcausethemtoreact.Thefirmwillconsiderthesereactionswhenmakingdecisions.Gametheory:thestudyofhowpeoplebehaveinstrategicsituations.4OLIGOPOLYOligopolyOligopoly:amarketPQ$0140513010120151102010025903080357040604550EXAMPLE:CellPhoneDuopolyinSmalltownSmalltownhas140residentsThe“good”:

cellphoneservicewithunlimitedanytimeminutesandfreephoneSmalltown’sdemandscheduleTwofirms:T-Mobile,Verizon

(duopoly:anoligopolywithtwofirms)Eachfirm’scosts:FC=$0,MC=$1005OLIGOPOLYPQ$014051301012015110201002590504560407035803090251002011015120101305140$0QP1,7501,8001,7501,6001,3501,0005500–650–1,400Profit5006007008009001,0001,1001,2001,300$1,400Cost2,2502,4002,4502,4002,2502,0001,6501,200650$0RevenueEXAMPLE:CellPhoneDuopolyinSmalltownCompetitiveoutcome:P=MC=$10Q=120Profit=$0Monopolyoutcome:P=$40Q=60Profit=$1,80006OLIGOPOLY504560407035803090251002011015EXAMPLE:CellPhoneDuopolyinSmalltownOnepossibleduopolyoutcome:collusionCollusion:anagreementamongfirmsinamarketaboutquantitiestoproduceorpricestochargeT-MobileandVerizoncouldagreetoeachproducehalfofthemonopolyoutput:Foreachfirm:Q=30,P=$40,profits=$900Cartel:agroupoffirmsactinginunison,

e.g.,T-MobileandVerizonintheoutcomewithcollusion07OLIGOPOLYEXAMPLE:CellPhoneDuopolyiACTIVELEARNING1

Collusionvs.self-interest8Duopolyoutcomewithcollusion:

EachfirmagreestoproduceQ=30,

earnsprofit=$900.IfT-MobilerenegesontheagreementandproducesQ=40,whathappenstothemarketprice?T-Mobile’sprofits?IsitinT-Mobile’sinteresttorenegeontheagreement?IfbothfirmsrenegeandproduceQ=40,determineeachfirm’sprofits.PQ$014051301012015110201002590308035704060455008OLIGOPOLYACTIVELEARNINGIfbothfirmssticktoagreement,eachfirm’sprofit=$900IfT-MobilerenegesonagreementandproducesQ=40:Marketquantity=70,P=$35T-Mobile’sprofit=40x($35–10)=$1000T-Mobile’sprofitsarehigherifitreneges.Verizonwillconcludethesame,so

bothfirmsrenege,eachproducesQ=40:Marketquantity=80,P=$30Eachfirm’sprofit=40x($30–10)=$800ACTIVELEARNING1

Answers9PQ$014051301012015110201002590308035704060455009OLIGOPOLYIfbothfirmssticktoagreemeCollusionvs.Self-InterestBothfirmswouldbebetteroffifbothsticktothecartelagreement.Buteachfirmhasincentivetorenegeontheagreement.Lesson:

Itisdifficultforoligopolyfirmstoformcartelsandhonortheiragreements.010OLIGOPOLYCollusionvs.Self-InterestBotIfeachfirmproducesQ=40,marketquantity=80P=$30eachfirm’sprofit=$800IsitinT-Mobile’sinteresttoincreaseitsoutputfurther,toQ=50?IsitinVerizon’sinteresttoincreaseitsoutputtoQ=50?ACTIVELEARNING2

Theoligopolyequilibrium11PQ$0140513010120151102010025903080357040604550011OLIGOPOLYIfeachfirmproducesQ=40,AIfeachfirmproducesQ=40,

theneachfirm’sprofit=$800.IfT-MobileincreasesoutputtoQ=50:Marketquantity=90,P=$25T-Mobile’sprofit=50x($25–10)=$750T-Mobile’sprofitsarehigheratQ=40

thanatQ=50.ThesameistrueforVerizon.ACTIVELEARNING2

Answers12PQ$0140513010120151102010025903080357040604550012OLIGOPOLYIfeachfirmproducesQ=40,TheEquilibriumforanOligopolyNashequilibrium:asituationinwhich

economicparticipantsinteractingwithoneanothereachchoosetheirbeststrategygiventhestrategiesthatalltheothershavechosenOurduopolyexamplehasaNashequilibrium

inwhicheachfirmproducesQ=40.GiventhatVerizonproducesQ=40,

T-Mobile’sbestmoveistoproduceQ=40.GiventhatT-MobileproducesQ=40,

Verizon’sbestmoveistoproduceQ=40.013OLIGOPOLYTheEquilibriumforanOligopoAComparisonofMarketOutcomesWhenfirmsinanoligopolyindividuallychooseproductiontomaximizeprofit,oligopolyQisgreaterthanmonopolyQ

butsmallerthancompetitiveQ.oligopolyPisgreaterthancompetitiveP

butlessthanmonopolyP.014OLIGOPOLYAComparisonofMarketOutcomeTheOutput&PriceEffectsIncreasingoutputhastwoeffectsonafirm’sprofits:Outputeffect:

IfP>MC,sellingmoreoutputraisesprofits.Priceeffect:

Raisingproductionincreasesmarketquantity,whichreducesmarketpriceandreducesprofitonallunitssold.Ifoutputeffect>priceeffect,

thefirmincreasesproduction.Ifpriceeffect>outputeffect,

thefirmreducesproduction.015OLIGOPOLYTheOutput&PriceEffectsIncrTheSizeoftheOligopolyAsthenumberoffirmsinthemarketincreases,thepriceeffectbecomessmallertheoligopolylooksmoreandmorelikeacompetitivemarketPapproachesMCthemarketquantityapproachesthesociallyefficientquantityAnotherbenefitofinternationaltrade:

Tradeincreasesthenumberoffirmscompeting,increasesQ,bringsPclosertomarginalcost016OLIGOPOLYTheSizeoftheOligopolyAsthGameTheoryGametheoryhelpsusunderstandoligopolyandothersituationswhere“players”interactandbehavestrategically.Dominantstrategy:astrategythatisbest

foraplayerinagameregardlessofthestrategieschosenbytheotherplayersPrisoners’dilemma:a“game”between

twocapturedcriminalsthatillustrates

whycooperationisdifficultevenwhenitismutuallybeneficial017OLIGOPOLYGameTheoryGametheoryhelpsuPrisoners’DilemmaExampleThepolicehavecaughtBonnieandClyde,

twosuspectedbankrobbers,butonlyhaveenoughevidencetoimprisoneachfor1year.Thepolicequestioneachinseparaterooms,

offereachthefollowingdeal:Ifyouconfessandimplicateyourpartner,

yougofree.Ifyoudonotconfessbutyourpartnerimplicatesyou,youget20yearsinprison.Ifyoubothconfess,eachgets8yearsinprison.018OLIGOPOLYPrisoners’DilemmaExampleThePrisoners’DilemmaExampleConfessRemainsilentConfessRemain

silentBonnie’sdecisionClyde’s

decisionBonniegets

8yearsClyde

gets8yearsBonniegets

20yearsBonniegets

1yearBonniegoesfreeClyde

goesfreeClyde

gets1yearClyde

gets20yearsConfessingisthedominantstrategyforbothplayers.Nashequilibrium:

bothconfess019OLIGOPOLYPrisoners’DilemmaExampleConfPrisoners’DilemmaExampleOutcome:BonnieandClydebothconfess,

eachgets8yearsinprison.Bothwouldhavebeenbetteroffifbothremainedsilent.ButevenifBonnieandClydehadagreedbeforebeingcaughttoremainsilent,thelogicofself-interesttakesoverandleadsthemtoconfess.020OLIGOPOLYPrisoners’DilemmaExampleOutcOligopoliesasaPrisoners’DilemmaWhenoligopoliesformacartelinhopes

ofreachingthemonopolyoutcome,

theybecomeplayersinaprisoners’dilemma.Ourearlierexample:T-MobileandVerizonareduopolistsinSmalltown.Thecarteloutcomemaximizesprofits:

EachfirmagreestoserveQ=30customers.Hereisthe“payoffmatrix”forthisexample…021OLIGOPOLYOligopoliesasaPrisoners’DiT-Mobile&VerizoninthePrisoners’DilemmaQ=30Q=40Q=30Q=40T-MobileVerizonT-Mobile’sprofit=$900Verizon’sprofit=$900T-Mobile’sprofit=$1000T-Mobile’sprofit=$800T-Mobile’sprofit=$750Verizon’sprofit=$750Verizon’sprofit=$800Verizon’sprofit=$1000Eachfirm’sdominantstrategy:renegeonagreement,

produceQ=40.022OLIGOPOLYT-Mobile&VerizoninthePrisTheplayers:AmericanAirlinesandUnitedAirlinesThechoice:cutfaresby50%orleavefaresaloneIfbothairlinescutfares,

eachairline’sprofit=$400millionIfneitherairlinecutsfares,

eachairline’sprofit=$600millionIfonlyoneairlinecutsitsfares,

itsprofit=$800million

theotherairline’sprofits=$200millionDrawthepayoffmatrix,findtheNashequilibrium.ACTIVELEARNING3

The“farewars”game2323OLIGOPOLYTheplayers:AmericanAirlineACTIVELEARNING3

Answers24Nashequilibrium:

bothfirmscutfaresCutfaresDon’tcutfaresCutfaresDon’tcutfaresAmericanAirlinesUnitedAirlines$600million$600million$200million$800million$800million$200million$400million$400million024OLIGOPOLYACTIVELEARNINGOtherExamplesofthePrisoners’DilemmaAdWars

TwofirmsspendmillionsonTVadstostealbusinessfromeachother.Eachfirm’sad

cancelsouttheeffectsoftheother,

andbothfirms’profitsfallbythecostoftheads.OrganizationofPetroleumExportingCountries

Membercountriestrytoactlikeacartel,agreeto

limitoilproductiontoboostprices&profits.

Butagreementssometimesbreakdown

whenindividualcountriesrenege.025OLIGOPOLYOtherExamplesofthePrisonerOtherExamplesofthePrisoners’DilemmaArmsracebetweenmilitarysuperpowers

Eachcountrywouldbebetteroffifbothdisarm,

buteachhasadominantstrategyofarming.Commonresources

Allwouldbebetteroffifeveryoneconservedcommonresources,buteachperson’sdominantstrategyisoverusingtheresources.026OLIGOPOLYOtherExamplesofthePrisonerPrisoners’DilemmaandSociety’sWelfareThenoncooperativeoligopolyequilibriumBadforoligopolyfirms:

preventsthemfromachievingmonopolyprofitsGoodforsociety:

Qisclosertothesociallyefficientoutput

PisclosertoMCInotherprisoners’dilemmas,theinabilitytocooperatemayreducesocialwelfare.e.g.,armsrace,overuseofcommonresources027OLIGOPOLYPrisoners’DilemmaandSocietyAnotherExample:NegativeCampaignAdsElectionwithtwocandidates,“R”and“D.”IfRrunsanegativeadattackingD,

3000fewerpeoplewillvoteforD:

1000ofthesepeoplevoteforR,therestabstain.IfDrunsanegativeadattackingR,

Rloses3000votes,Dgains1000,2000abstain.RandDagreetorefrainfromrunningattackads.Willeachonesticktotheagreement?28OLIGOPOLYAnotherExample:NegativeCamAnotherExample:NegativeCampaignAdsDonotrunattackads(cooperate)R’sdecisionD’sdecisionnovoteslostorgainednovotes

lostorgainedRgains1000votesRloses2000votesRloses3000votesDloses

3000votesDloses

2000votesDgains

1000votesEachcandidate’sdominantstrategy:runattackads.0Runattackads(defect)Donotrunattackads(cooperate)Run

attackads(defect)29OLIGOPOLYAnotherExample:NegativeCamAnotherExample:NegativeCampaignAdsNasheq’m:bothcandidatesrunattackads.Effectsonelectionoutcome:NONE.

Eachside’sadscancelouttheeffectsoftheotherside’sads.Effectsonsociety:NEGATIVE.

Lowervoterturnout,higherapathyaboutpolitics,lessvoterscrutinyofelectedofficials’actions.30OLIGOPOLYAnotherExample:NegativeCamWhyPeopleSometimesCooperateWhenthegameisrepeatedmanytimes,cooperationmaybepossible.Thesestrategiesmayleadtocooperation:Ifyourrivalrenegesinoneround,

yourenegeinallsubsequentrounds.“Tit-for-tat”

Whateveryourrivaldoesinoneround

(whetherrenegeorcooperate),

youdointhefollowinground.031OLIGOPOLYWhyPeopleSometimesCooperatePublicPolicyTowardOligopoliesRecalloneoftheTenPrinciplesfromChap.1:

Governmentscansometimes

improvemarketoutcomes.Inoligopolies,productionistoolowandpricesaretoohigh,relativetothesocialoptimum.Roleforpolicymakers:

Promotecompetition,preventcooperation

tomovetheoligopolyoutcomecloserto

theefficientoutcome.032OLIGOPOLYPublicPolicyTowardOligopoliRestraintofTradeandAntitrustLawsShermanAntitrustAct(1890):

ForbidscollusionbetweencompetitorsClaytonAntitrustAct(1914):

Strengthenedrightsofindividualsdamagedbyanticompetitivearrangementsbetweenfirms033OLIGOPOLYRestraintofTradeandAntitruControversiesOverAntitrustPolicyMostpeopleagreethatprice-fixingagreementsamongcompetitorsshouldbeillegal.Someeconomistsareconcernedthatpolicymakersgotoofarwhenusingantitrustlawstostiflebusinesspracticesthatarenotnecessarilyharmful,andmayhavelegitimateobjectives.Weconsiderthreesuchpractices…034OLIGOPOLYControversiesOverAntitrustP1.ResalePriceMaintenance(“FairTrade”)Occurswhenamanufacturerimposeslowerlimitsonthepricesretailerscancharge.Isoftenopposedbecauseitappearstoreducecompetitionattheretaillevel.Yet,anymarketpowerthemanufacturerhas

isatthewholesalelevel;manufacturersdonotgainfromrestrictingcompetitionattheretaillevel.Thepracticehasalegitimateobjective:

preventingdiscountretailersfromfree-riding

ontheservicesprovidedbyfull-serviceretailers.035OLIGOPOLY1.ResalePriceMaintenance(“2.PredatoryPricingOccurswhenafirmcutspricestoprevententry

ordriveacompetitoroutofthemarket,

sothatitcanchargemonopolypriceslater.Illegalunderantitrustlaws,buthardforthecourtstodeterminewhenapricecutispredatoryandwhenitiscompetitive&beneficialtoconsumers.Manyeconomistsdoubtthatpredatorypricingisarationalstrategy:Itinvolvessellingataloss,whichisextremelycostlyforthefirm.Itcanbackfire.036OLIGOPOLY2.PredatoryPricingOccurswhe3.TyingOccurswhenamanufacturerbundlestwoproductstogetherandsellsthemforoneprice(e.g.,Microsoftincludingabrowserwithitsoperatingsystem)Criticsarguethattyinggivesfirmsmoremarketpowerbyconnectingweakproductstostrongones.Otherscounterthattyingcannotchangemarketpower:Buyersarenotwillingtopaymorefortwogoodstogetherthanforthegoodsseparately.Firmsmayusetyingforpricediscrimination,

whichisnotillegal,andwhichsometimes

increaseseconomicefficiency.037OLIGOPOLY3.TyingOccurswhenamanufactCONCLUSIONOligopoliescanenduplookinglikemonopoliesorlikecompetitivemarkets,dependingonthenumberoffirmsandhowcooperativetheyare.Theprisoners’dilemmashowshowdifficultitisforfirmstomaintaincooperation,evenwhendoingsoisintheirbestinterest.Policymakersusetheantitrustlawstoregulateoligopolists’behavior.Theproperscopeoftheselawsisthesubjectofongoingcontroversy.038OLIGOPOLYCONCLUSIONOligopoliescanendCHAPTERSUMMARYOligopolistscanmaximizeprofitsiftheyformacartelandactlikeamonopolist.Yet,self-interestleadseacholigopolisttoahigherquantityandlowerpricethanunderthemonopolyoutcome.Thelargerthenumberoffirms,thecloserwillbethequantityandpricetothelevelsthatwouldprevailundercompetition.3939OLIGOPOLYCHAPTERSUMMARYOligopolistscaCHAPTERSUMMARYTheprisoners’dilemmashowsthatself-interestcanpreventpeoplefromcooperating,evenwhencooperationisintheirmutualinterest.Thelogicoftheprisoners’dilemmaappliesinmanysituations.Policymakersusetheantitrustlawstopreventoligopoliesfromengaginginanticompetitivebehaviorsuchasprice-fixing.Buttheapplicationoftheselawsissometimescontroversial.4040OLIGOPOLYCHAPTERSUMMARYTheprisoners’OligopolyEconomicsPRINCIPLESOFN.GregoryMankiwPremiumPowerPointSlides

byRonCronovich17OligopolyEconomicsPRINCIInthischapter,

lookfortheanswerstothesequestions:Whatoutcomesarepossibleunderoligopoly?Whyisitdifficultforoligopolyfirmstocooperate?Howareantitrustlawsusedtofostercompetition?4242OLIGOPOLYInthischapter,

lookfortheMeasuringMarketConcentrationConcentrationratio:thepercentageofthemarket’stotaloutputsuppliedbyitsfourlargestfirms.Thehighertheconcentrationratio,

thelesscompetition.Thischapterfocusesonoligopoly,

amarketstructurewithhighconcentrationratios.043OLIGOPOLYMeasuringMarketConcentrationConcentrationRatiosinSelectedU.S.IndustriesIndustryConcentrationratioVideogameconsoles100%Tennisballs100%Creditcards99%Batteries94%Softdrinks93%Websearchengines92%Breakfastcereal92%Cigarettes89%Greetingcards88%Beer85%Cellphoneservice82%Autos79%044OLIGOPOLYConcentrationRatiosinSelectOligopolyOligopoly:amarketstructureinwhichonlyafewsellersoffersimilaroridenticalproducts.Strategicbehaviorinoligopoly:

Afirm’sdecisionsaboutPorQcanaffectotherfirmsandcausethemtoreact.Thefirmwillconsiderthesereactionswhenmakingdecisions.Gametheory:thestudyofhowpeoplebehaveinstrategicsituations.45OLIGOPOLYOligopolyOligopoly:amarketPQ$0140513010120151102010025903080357040604550EXAMPLE:CellPhoneDuopolyinSmalltownSmalltownhas140residentsThe“good”:

cellphoneservicewithunlimitedanytimeminutesandfreephoneSmalltown’sdemandscheduleTwofirms:T-Mobile,Verizon

(duopoly:anoligopolywithtwofirms)Eachfirm’scosts:FC=$0,MC=$10046OLIGOPOLYPQ$014051301012015110201002590504560407035803090251002011015120101305140$0QP1,7501,8001,7501,6001,3501,0005500–650–1,400Profit5006007008009001,0001,1001,2001,300$1,400Cost2,2502,4002,4502,4002,2502,0001,6501,200650$0RevenueEXAMPLE:CellPhoneDuopolyinSmalltownCompetitiveoutcome:P=MC=$10Q=120Profit=$0Monopolyoutcome:P=$40Q=60Profit=$1,800047OLIGOPOLY504560407035803090251002011015EXAMPLE:CellPhoneDuopolyinSmalltownOnepossibleduopolyoutcome:collusionCollusion:anagreementamongfirmsinamarketaboutquantitiestoproduceorpricestochargeT-MobileandVerizoncouldagreetoeachproducehalfofthemonopolyoutput:Foreachfirm:Q=30,P=$40,profits=$900Cartel:agroupoffirmsactinginunison,

e.g.,T-MobileandVerizonintheoutcomewithcollusion048OLIGOPOLYEXAMPLE:CellPhoneDuopolyiACTIVELEARNING1

Collusionvs.self-interest49Duopolyoutcomewithcollusion:

EachfirmagreestoproduceQ=30,

earnsprofit=$900.IfT-MobilerenegesontheagreementandproducesQ=40,whathappenstothemarketprice?T-Mobile’sprofits?IsitinT-Mobile’sinteresttorenegeontheagreement?IfbothfirmsrenegeandproduceQ=40,determineeachfirm’sprofits.PQ$0140513010120151102010025903080357040604550049OLIGOPOLYACTIVELEARNINGIfbothfirmssticktoagreement,eachfirm’sprofit=$900IfT-MobilerenegesonagreementandproducesQ=40:Marketquantity=70,P=$35T-Mobile’sprofit=40x($35–10)=$1000T-Mobile’sprofitsarehigherifitreneges.Verizonwillconcludethesame,so

bothfirmsrenege,eachproducesQ=40:Marketquantity=80,P=$30Eachfirm’sprofit=40x($30–10)=$800ACTIVELEARNING1

Answers50PQ$0140513010120151102010025903080357040604550050OLIGOPOLYIfbothfirmssticktoagreemeCollusionvs.Self-InterestBothfirmswouldbebetteroffifbothsticktothecartelagreement.Buteachfirmhasincentivetorenegeontheagreement.Lesson:

Itisdifficultforoligopolyfirmstoformcartelsandhonortheiragreements.051OLIGOPOLYCollusionvs.Self-InterestBotIfeachfirmproducesQ=40,marketquantity=80P=$30eachfirm’sprofit=$800IsitinT-Mobile’sinteresttoincreaseitsoutputfurther,toQ=50?IsitinVerizon’sinteresttoincreaseitsoutputtoQ=50?ACTIVELEARNING2

Theoligopolyequilibrium52PQ$0140513010120151102010025903080357040604550052OLIGOPOLYIfeachfirmproducesQ=40,AIfeachfirmproducesQ=40,

theneachfirm’sprofit=$800.IfT-MobileincreasesoutputtoQ=50:Marketquantity=90,P=$25T-Mobile’sprofit=50x($25–10)=$750T-Mobile’sprofitsarehigheratQ=40

thanatQ=50.ThesameistrueforVerizon.ACTIVELEARNING2

Answers53PQ$0140513010120151102010025903080357040604550053OLIGOPOLYIfeachfirmproducesQ=40,TheEquilibriumforanOligopolyNashequilibrium:asituationinwhich

economicparticipantsinteractingwithoneanothereachchoosetheirbeststrategygiventhestrategiesthatalltheothershavechosenOurduopolyexamplehasaNashequilibrium

inwhicheachfirmproducesQ=40.GiventhatVerizonproducesQ=40,

T-Mobile’sbestmoveistoproduceQ=40.GiventhatT-MobileproducesQ=40,

Verizon’sbestmoveistoproduceQ=40.054OLIGOPOLYTheEquilibriumforanOligopoAComparisonofMarketOutcomesWhenfirmsinanoligopolyindividuallychooseproductiontomaximizeprofit,oligopolyQisgreaterthanmonopolyQ

butsmallerthancompetitiveQ.oligopolyPisgreaterthancompetitiveP

butlessthanmonopolyP.055OLIGOPOLYAComparisonofMarketOutcomeTheOutput&PriceEffectsIncreasingoutputhastwoeffectsonafirm’sprofits:Outputeffect:

IfP>MC,sellingmoreoutputraisesprofits.Priceeffect:

Raisingproductionincreasesmarketquantity,whichreducesmarketpriceandreducesprofitonallunitssold.Ifoutputeffect>priceeffect,

thefirmincreasesproduction.Ifpriceeffect>outputeffect,

thefirmreducesproduction.056OLIGOPOLYTheOutput&PriceEffectsIncrTheSizeoftheOligopolyAsthenumberoffirmsinthemarketincreases,thepriceeffectbecomessmallertheoligopolylooksmoreandmorelikeacompetitivemarketPapproachesMCthemarketquantityapproachesthesociallyefficientquantityAnotherbenefitofinternationaltrade:

Tradeincreasesthenumberoffirmscompeting,increasesQ,bringsPclosertomarginalcost057OLIGOPOLYTheSizeoftheOligopolyAsthGameTheoryGametheoryhelpsusunderstandoligopolyandothersituationswhere“players”interactandbehavestrategically.Dominantstrategy:astrategythatisbest

foraplayerinagameregardlessofthestrategieschosenbytheotherplayersPrisoners’dilemma:a“game”between

twocapturedcriminalsthatillustrates

whycooperationisdifficultevenwhenitismutuallybeneficial058OLIGOPOLYGameTheoryGametheoryhelpsuPrisoners’DilemmaExampleThepolicehavecaughtBonnieandClyde,

twosuspectedbankrobbers,butonlyhaveenoughevidencetoimprisoneachfor1year.Thepolicequestioneachinseparaterooms,

offereachthefollowingdeal:Ifyouconfessandimplicateyourpartner,

yougofree.Ifyoudonotconfessbutyourpartnerimplicatesyou,youget20yearsinprison.Ifyoubothconfess,eachgets8yearsinprison.059OLIGOPOLYPrisoners’DilemmaExampleThePrisoners’DilemmaExampleConfessRemainsilentConfessRemain

silentBonnie’sdecisionClyde’s

decisionBonniegets

8yearsClyde

gets8yearsBonniegets

20yearsBonniegets

1yearBonniegoesfreeClyde

goesfreeClyde

gets1yearClyde

gets20yearsConfessingisthedominantstrategyforbothplayers.Nashequilibrium:

bothconfess060OLIGOPOLYPrisoners’DilemmaExampleConfPrisoners’DilemmaExampleOutcome:BonnieandClydebothconfess,

eachgets8yearsinprison.Bothwouldhavebeenbetteroffifbothremainedsilent.ButevenifBonnieandClydehadagreedbeforebeingcaughttoremainsilent,thelogicofself-interesttakesoverandleadsthemtoconfess.061OLIGOPOLYPrisoners’DilemmaExampleOutcOligopoliesasaPrisoners’DilemmaWhenoligopoliesformacartelinhopes

ofreachingthemonopolyoutcome,

theybecomeplayersinaprisoners’dilemma.Ourearlierexample:T-MobileandVerizonareduopolistsinSmalltown.Thecarteloutcomemaximizesprofits:

EachfirmagreestoserveQ=30customers.Hereisthe“payoffmatrix”forthisexample…062OLIGOPOLYOligopoliesasaPrisoners’DiT-Mobile&VerizoninthePrisoners’DilemmaQ=30Q=40Q=30Q=40T-MobileVerizonT-Mobile’sprofit=$900Verizon’sprofit=$900T-Mobile’sprofit=$1000T-Mobile’sprofit=$800T-Mobile’sprofit=$750Verizon’sprofit=$750Verizon’sprofit=$800Verizon’sprofit=$1000Eachfirm’sdominantstrategy:renegeonagreement,

produceQ=40.063OLIGOPOLYT-Mobile&VerizoninthePrisTheplayers:AmericanAirlinesandUnitedAirlinesThechoice:cutfaresby50%orleavefaresaloneIfbothairlinescutfares,

eachairline’sprofit=$400millionIfneitherairlinecutsfares,

eachairline’sprofit=$600millionIfonlyoneairlinecutsitsfares,

itsprofit=$800million

theotherairline’sprofits=$200millionDrawthepayoffmatrix,findtheNashequilibrium.ACTIVELEARNING3

The“farewars”game6464OLIGOPOLYTheplayers:AmericanAirlineACTIVELEARNING3

Answers65Nashequilibrium:

bothfirmscutfaresCutfaresDon’tcutfaresCutfaresDon’tcutfaresAmericanAirlinesUnitedAirlines$600million$600million$200million$800million$800million$200million$400million$400million065OLIGOPOLYACTIVELEARNINGOtherExamples