PPT

1. Oligopoly and
Strategic
Behavior13

2. Previously…
• Monopolistic competition is a market
structure characterized by free entry,
many different firms, and differentiated
products
• Differentiated products are substitutable,
but not identical
• Firms advertise in order to increase
demand for their product

3. Big Questions
1. What is oligopoly?
2. How does game theory explain strategic
behavior?
3. How do government policies affect
oligopoly behavior?
4. What are network externalities?

4. Oligopoly
• Oligopoly is a market structure with the
following characteristics:
– Small number of firms
– Differentiated products
– Significant entry barriers
– Firms interact strategically

5. Comparing Market Structures

6. Measuring Concentrations
of Industries
• Concentration ratio
– Used to measure oligopoly power in an
industry
– What percentage of industry sales are owned
by the biggest firms?
• Four-firm concentration ratio
• Eight-firm concentration ratio

7. Four-Firm Concentration
Ratios in the United States

8. Duopoly
• Duopoly
– An oligopoly with only two firms
– May happen in localized markets with cell
phones or utilities
• Duopoly behavior
– Firms feel competitive pressure, but can
enjoy advantages of market power
– Firms may have the incentive and the ability
to cooperate, or collude.

9. Duopoly
• Collusion
– Agreement among rivals specifying prices or
quantities
– Firms ask: “What would a monopoly do?”
and then do that action
• Cartel
– Two or more firms acting in unison to form a
joint monopoly

10. Cartels
• Cartels tend to be unstable over a long
period of time. Why?
– Each firm in the cartel often has an incentive
to “cheat”
– Could occur by one firm lowering its price
– Firm could also overproduce output (in
situations with homogenous output, such as
oil cartels)

11. Cellphone Duopoly
Price/Month
(P)
Number of
Customers
(Q)
Total Revenue
(TR)
TR = P × Q
$180 0 $0
165 100 16,500
150 200 30,000
135 300 40,500
120 400 48,000
105 500 52,500
90 600 54,000
75 700 52,500
60 800 48,000
45 900 40,500
30 1,000 30,000
15 1,100 16,500
0 1,200 0
• Assume MC = 0
• Perfect Competition
– Result: P = MC
– P = $0
– Q = 1,200
– Socially efficient
• Monopoly
– No competition to drive price
down
– P = $90
– Q = 600
– Loss of efficiency compared to
competition

12. Cellphone Duopoly
Price/Month
(P)
Number of
Customers
(Q)
Total Revenue
(TR)
TR = P × Q
$180 0 $0
165 100 16,500
150 200 30,000
135 300 40,500
120 400 48,000
105 500 52,500
90 600 54,000
75 700 52,500
60 800 48,000
45 900 40,500
30 1,000 30,000
15 1,100 16,500
0 1,200 0
• Duopoly
– AT-Phone and Horizon
• Collusion result: act like a
joint monopoly by charging
the monopoly price
– P = $90
– Q = 600 (each firm produces
300)
– Profit of $27,000 for each,
assuming equal split
– Does each firm have an
incentive to undercharge the
competitor? What if that
happens?

13. Cellphone Duopoly
Price/Month
(P)
Number of
Customers
(Q)
Total Revenue
(TR)
TR = P × Q
$180 0 $0
165 100 16,500
150 200 30,000
135 300 40,500
120 400 48,000
105 500 52,500
90 600 54,000
75 700 52,500
60 800 48,000
45 900 40,500
30 1,000 30,000
15 1,100 16,500
0 1,200 0
• Duopoly Competition
– AT-Phone still believes Horizon
will serve 300 customers
– AT-Phone lowers its price to
P = $75
– Market demand is Q = 700
– AT-Phone profit:
• 400 x $75 = $30,000
• Horizon’s reaction
– Also wants 400 consumers
– For both firms to do this, price
must by P = $60
– Horizon and AT-Phone lower
price to P = $60.
• Profits now $24,000 for each.

14. Cellphone Duopoly
Price/Month
(P)
Number of
Customers
(Q)
Total Revenue
(TR)
TR = P × Q
$180 0 $0
165 100 16,500
150 200 30,000
135 300 40,500
120 400 48,000
105 500 52,500
90 600 54,000
75 700 52,500
60 800 48,000
45 900 40,500
30 1,000 30,000
15 1,100 16,500
0 1,200 0
• Would a price war result in
which the price falls to zero?
– No, duopolist will try to gain
more market shares and wait to
see how competitor responds
– Each firm has what is called a
response function. Each firm will
respond to what the other firm
does.
– Duopoly outcome is more
efficient than monopoly

15. Mutual Interdependence
• Mutual interdependence
– A market situation in which the actions of one
firm have an impact on the price and output
of its competitors
– AT-Phone’s response depends on the actions
of Horizon, and Horizon’s response depends
on the actions of AT-Phone
– Note the difference between interdependence
and independence

16. Competition, Duopoly,
and Monopoly
Competitive
Markets
Duopoly Monopoly
Price $0 $60 $90
Output 1200 800 600
Socially
Efficient?
Yes No No
Explanation
Since the
marginal cost of
providing
cellphone
service is zero,
the price is
eventually
driven to zero
Each firm is mutually
interdependent and
adopts a strategy
based on the actions
of its rival. This leads
both firms to charge
$60 and service 400
customers
The monopolist is
free to choose the
profit-maximizing
output. In this
example it
maximizes its total
revenue.

17. Cheating in a Cartel
• OPEC cartel
• 1988 Iraq
– Virtually bankrupt
– Economy depended mostly on exporting oil
– Low oil prices hurting Iraq further
– Iraq accused Kuwait of “cheating” and
overproducing oil, which lowered the price
– What did Iraq do?

18. Cheating in a Cartel
• Gulf War
• Iraq invades Kuwait City

19. Nash Equilibrium
• Nash Equilibrium
– An economic decision maker has nothing to gain by
changing its own strategy without collusion
– Nobody wants to change their strategy given that the
other firm does not change their strategy
– A “stable” outcome where nobody wants to move
from their current position
– Often discussed with game theory, and easier to see
when games are drawn in matrix form

20. Oligopoly with More Than
Two Firms
• Imagine if a third firm entered the phone
market and builds a cell tower
• Price effect
– The total number of cellphone contracts sold
(supply) increases, and the price firms are
able to charge decreases
• Output effect
– The new firm sells an additional unit in which
it generates additional profits

21. Oligopoly with More Than
Two Firms
• Price and output effects make maintaining
a cartel (joint monopoly) difficult
– As firms enter, each individual firm will have a
smaller impact on market price. Firms will
produce more as long as it is profitable.
• Not all firms in oligopoly are the same size
– Each firm’s actions affect price and output,
and thus affect decisions made by other firms
(interdependence)
– Small firms and large firms will behave
differently, yet will act strategically

22. Game Theory
• Game theory
– Branch of mathematics that economists use to
analyze the strategic behavior of decision makers
– Can help us determine what level of cooperation is
most likely among players in a game
• Basic components of a game
– Players
– Strategies
– Payoffs

23. Strategic Behavior and the
Dominant Strategy
• Prisoner’s dilemma
– Two suspects are interrogated separately
– They each have the option to confess or keep quiet
• Possible outcomes of prisoner’s dilemma
– If both suspects keep quiet, each suspect will serve
only a small time in jail
– If both confess, both will serve 10 years in jail
– If one suspect confesses and the other remains
quiet, the suspect who confesses goes free, while the
suspect who kept quiet serves 25 years in jail

24. Presenting
The Prisoner’s Dilemma
Players
Thelma
Confess Keep Quiet
Louise
Confess
10 years
in jail
25 years
in jail
10 years
in jail
goes
free
Keep
Quiet
goes
free
1 year in
jail
25 years
in jail
1 year in
jail
Strategies Payoffs

25. Analyzing
The Prisoner’s Dilemma
Thelma
Confess Keep Quiet
Louise
Confess
10 years
in jail
25 years
in jail
10 years
in jail
goes
free
Keep
Quiet
goes
free
1 year in
jail
25 years
in jail
1 year in
jail
• Louise
– Best to Confess or Keep Quiet?
– Best for Louise to Confess no
matter what Thelma does!
• Thelma
– Best to Confess or Keep Quiet?
– Best for Thelma to Confess no
matter what Louise does!

26. Interesting Result of this
Game
Thelma
Confess Keep Quiet
Louise
Confess
10 years
in jail
25 years
in jail
10 years
in jail
goes
free
Keep
Quiet
goes
free
1 year in
jail
25 years
in jail
1 year in
jail
Nash equilibrium
Payoffs that will result
Outcome with
the overall
best sum of
payoffs

27. Game Theory
• Dominant strategy
– A best response for a player to choose no matter
what the other player chooses
– Not all games or players in a game have a dominant
strategy
• Nash equilibrium implications?
– If both players have a dominant strategy, the
intersection of those dominant strategies will be the
Nash equilibrium.
– Neither player will want to unilaterally deviate.

28. Economics in The Dark
Knight
• The Joker sets up an ethical
experiment that pins two ferries full of
passengers against one another.

29. Economics in Golden Balls
• Golden Balls (2008)
The prisoner’s dilemma often shows up in
TV game shows as well…

30. Duopoly and the
Prisoner’s Dilemma
AT-Phone
Low High
Horizon
Low
$27,000 $30,000
$27,000 $22,500
High
$22,500 $24,000
$30,000 $24,000
Nash equilibrium
payoffs that will result
An outcome that is better
for both players

31. Advertising and the
Prisoner’s Dilemma
Coca-Cola
Advertises Does Not Advertise
Pepsico
Advertises
$100 M $75 M
$100 M $150 M
Does Not
Advertise
$150 M $125 M
$75 M $125 M
Nash equilibrium
payoffs that will result An outcome that is better
for both players

32. Intuition of Advertising
Prisoner’s Dilemma
• Advertising
– Costly
– Purpose: increase
product demand
– If both firms advertise,
expenses go up, but
demand increases;
each cancels other out
– “Arms race” of
advertising

33. Cigarette Advertising on TV
• In 1970, Congress enacted a law making
cigarette advertising on TV illegal
– Reasoning: too many ads being seen by
children and teens
– Goal: reduce smoking among all ages
• Unintended consequence
– This actually increased the economic profits
of cigarette makers
– The law ended their prisoner’s dilemma of
advertising

34. Economics in Dilbert
• Dilbert gets caught in a prisoner’s dilemma
• He mistakenly believes that his coworkers will
deviate from the dominant strategy

35. Escaping the Prisoner’s
Dilemma in the Long Run
• The Nash equilibrium in prisoner dilemma
games may give the best short run
payoffs
• However,
– Many games are repeated
– This repetition occurs over a longer time span
– Dominant strategies may not consider long-
run benefits of cooperation

36. Escaping the Prisoner’s
Dilemma in the Long Run
• Tit for tat
– A long run strategy designed to create
cooperation among participants
– Strategy: mimic the decision your opponent
made in the previous round.
– Changes the incentives and encourages
cooperation
– Useful because interactions in life occur over
the long run. Relationships between people
and businesses involve mutual trust.

37. Caution About Game Theory
• Not all games are like the prisoner’s
dilemma
– Not all games have a dominant strategy
– Not all games have a pure strategy like the
Nash equilibrium
• Think about Paper, Rock, Scissors
– Your best response is differen,t depending on
what your opponent throws. There is no
dominant hand to play.

38. No Dominant Strategy

39. Oligopoly Policy:
Antitrust
• Antitrust policy
– Government efforts that attempt to prevent
oligopolies from behaving like monopolies
• Sherman Act of 1890
– “Every person who shall monopolize, or
attempt to monopolize, or combine or
conspire with any other person or persons, to
monopolize any part of the trade or commerce
among the several States, or with foreign
nations, shall be deemed guilty of a felony.”

40. Oligopoly Policy:
Antitrust
• Clayton Act of 1914 added a few more
items that were considered detrimental
– Price discrimination that lessens competition
– Exclusive dealings that restrict the ability of a buyer
to deal with competitors
– Tying arrangements (similar to bundling)
– Mergers that lessen competition
– Prevents a person from serving as a director on more
than one board in the same industry

41. Predatory Pricing
• Predatory pricing
– Firms set prices below AVC with the
intent of driving rivals from the market
– Illegal, but difficult to prosecute
– Often difficult to distinguish between
predatory pricing and intense market
competition
• Examples:
– Wal-Mart is often assumed to be a
predator but is never prosecuted
– Microsoft was prosecuted eventually for
tying, but not for predatory pricing

42. $
Time
AVC,MC
Competitor
Enters
Competitor
Leaves
Incumbent
Firm’s
Price
Predatory Pricing Scheme

43. Network Externalities
• Network externality
– Occurs when the number of customers
who purchase a good influences the
quantity demanded
– Often is a factor in whether the resulting
market structure is oligopoly
– Classic examples include technologies
such as cell phones and fax machines
• A new technology has to reach “critical mass”
before it is effective for consumers
• How useful would a fax machine be if only 10
people had the machine?

44. Network Externalities
• Positive network externalities
– Bandwagon effect
– Individual preferences for a good
increase as the number of people
buying the good increases
– Internet, social networks, cell
phones, fax machines,
MMORPGs, video game
consoles, fads, night clubs

45. Network Externalities
• Negative network externalities
– Snob effect
– Individual preferences for a good
decrease as the number of people buying the
good increases
– Exotic pets and sports cars
– Hipsters
– Services that are prone to “congestion.” Pool,
beach, student union gets “too crowded,” and you
don’t want to go.

46. Network Externalities
• Switching costs
– Costs that are incurred by a consumer when he
switches suppliers
– Another advantage to a firm having a large network
– Demand for existing product becomes more
inelastic if costs of switching to a new product are
higher
• Example: cellphone providers
– Early termination fees
– Free in-network calls
– FTC reduced switching costs in 2003 by requiring
phone companies to allow a consumer to take their
old phone number to a new provider

47. Price Taking Price Making
Perfect Competition
Monopolistic
Competition
Oligopoly Monopoly
1. Many firms 1. Many firms 1. Few firms 1. One firm
2. Atomistic assumption—firms
are so small that no single
buyer or seller has ANY control
over price
2. Each firm has
some control over
price
2. Medium to high
entry barriers to
entry. The firm has
more control over
price.
2. Extremely high
barriers to entry.
The firm has
significant control
over price.
3. Firms are so small that no
single buyer or seller has ANY
control over price
3. Product
differentiation
3. Mutual
interdependence
3. The firm IS the
industry
4 Homogeneous output 4. Easy entry/exit
4. Long run
economic profit
possible
4. Long run
economic profit
probable
5. There is perfect information
about product price and quantity
5. Output can be
homogenous or
differentiated
6. Easy entry/exit

48. More Game Theory in Media
• This link provides further examples of game
theory in media and contains links to video clips

49. Conclusion
• Oligopoly
– A market structure in which there are a small number
of firms
– Firms interact strategically
– Can be competitive (results closer to monopolistic
competition)
– Can be collusive (results closer to monopoly)
• Antitrust policies
– Restrain excessive market power
– Give incentives to compete instead of collude
– Each industry examined on a case-by-case basis

50. Summary
• Oligopoly: a small number of firms sell a
differentiated product in a market with significant
barriers to entry. The small number of sellers in
oligopoly leads to mutual interdependence.
– An oligopolist is like a monopolistic competitor in that
it sells differentiated products.
– It is also like a monopolist in that it enjoys significant
barriers to entry.
• Oligopolists have a tendency to collude and to
form cartels in hope of achieving monopolylike
profits.

51. Summary
• Oligopolistic markets are socially inefficient since
P > MC. The result under oligopoly will fall
somewhere between the competitive and
monopoly outcomes.
• Game theory helps determine when cooperation
among oligopolists is most likely.
– In many cases, cooperation fails to materialize
because decision-makers have dominant strategies
that lead them to be uncooperative.
– This causes firms to compete with price, advertising,
or R & D when they could potentially earn more profit
by curtailing these activities.

52. Summary
• A dominant strategy ignores the long run
benefits of cooperation and focuses solely on
the short run gains
– Whenever repeated interaction exists, decision-
makers fare better under tit for tat, an approach that
maximizes the long run profit
• Antitrust laws are complex and cases are hard to
prosecute, but they provide firms an incentive to
compete rather than collude
• The presence of significant positive network
externalities causes small firms to be driven out
of business or to merge with larger competitors

53. Practice What You Know
Which of the following is most likely to
become an oligopoly industry?
A. An industry without entry barriers
B. An industry where economies of scale are
very small
C. An industry with sizeable network effects
D. An industry with hundreds of competitors

54. Practice What You Know
Which of the following is true about
oligopoly?
A. Oligopolies are illegal in the United
States
B. All oligopoly industries will try to collude
C. Oligopoly industries generally have a high
concentration ratio
D. Firms in an oligopoly act independently
from other firms in the oligopoly

55. Practice What You Know
Why do cartel deals tend not to last?
A. Each firm in the cartel has a dominant
strategy to be uncooperative and defect
from the cartel agreement
B. Cartel profits are lower than competitive
profits
C. Cartels create more competition
D. Firms know that cartels are often illegal
so they break the deal to escape

56. Practice What You Know
What is an example of a good with a
positive network effect?
A. An online multiplayer game
B. A fast-food burger
C. A dry-cleaning service
D. A cable TV subscription

57. Practice What You Know
How can a pure strategy Nash
equilibrium be accurately described?
A. It is always the overall best outcome
B. It’s an outcome in which neither player
wants to change strategies
C. It can only be reached by collusion
D. One exists in all games