PowerPoint Lecture Notes for Chapter 16: Oligopoly Principles of Microeconomics 4th edition, by N.

Gregory Mankiw PowerPoint Slides by Ron Cronovich

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Oligopoly

PRINCIPLES OF

MICROECONOMICS
F OURT H E DITIO N

At this point, students have learned about the costs of production, and they have seen how these costs affect production and pricing decisions in two extreme market structures: perfect competition and monopoly. This chapter and the next explore the intermediate market structures of oligopoly and monopolistic competition. As with the PowerPoint presentations for most of the other chapters, this one illustrates the textbook material using (mostly) different examples than students will find when they read the textbook. (An exception is the Bonnie & Clyde example that introduces the prisoners dilemma.) Mostly, students find this chapter to be of average difficulty. Some students, however, have a little extra trouble with the simple game theory concepts introduced in the chapter, such as understanding how to read a payoff matrix. Ive included an Active Learning exercise on this material, and there are more good exercises among the end-ofchapter problems and study guide.

N. G R E G O R Y M A N K I W
PowerPoint Slides by Ron Cronovich
2007 Thomson South-Western, all rights reserved

In this chapter, look for the answers to these questions: What market structures lie between perfect
competition and monopoly, and what are their characteristics?

What outcomes are possible under oligopoly? Why is it difficult for oligopoly firms to cooperate? How are antitrust laws used to foster competition?

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Introduction: Between Monopoly and Competition

Two extremes Competitive markets: many firms, identical products Monopoly: one firm In between these extremes Oligopoly: only a few sellers offer similar or identical products. Monopolistic competition: many firms sell similar but not identical products.
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In the preceding two chapters, we studied the two extremes of the competition spectrum. This chapter focuses on oligopoly, one of the market structures in between the two extremes. Examples of each market type: * perfect competition: wheat, milk * monopoly: tap water, cable TV * oligopoly: tennis balls, cigarettes * monopolistic competition: novels, movies

Measuring Market Concentration Concentration ratio: the percentage of the

markets total output supplied by its four largest firms.

The higher the concentration ratio,

the less competition.

This chapter focuses on oligopoly,

a market structure with high concentration ratios.

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Concentration Ratios in Selected U.S. Industries

Industry Video game consoles Tennis balls Credit cards Batteries Soft drinks Web search engines Breakfast cereal Cigarettes Greeting cards Beer Cell phone service Autos Concentration ratio 100% 100% 99% 94% 93% 92% 92% 89% 88% 85% 82% 79%

Sources: U.S. Census Bureau (www.census.gov), Federal Trade Commission (www.ftc.gov), and various periodicals and microeconomics textbooks.

EXAMPLE: Cell Phone Duopoly in Smalltown

P $0 5 10 15 20 25 30 35 40 45 Q 140 130 120 110 100 90 80 70 60 50
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Smalltown has 140 residents The good:

cell phone service with unlimited anytime minutes and free phone

To understand the behavior of oligopoly, we will consider an oligopoly with just two members a duopoly. The textbooks example (water) is simpler, because it uses zero marginal cost (as well as zero fixed cost). This is appropriate, because students will not have the instructors assistance when reading the textbook. But in class, with the instructors guidance, a slightly more complex example is appropriate. The added complexity in this example is nonzero marginal cost. (However, fixed costs are still zero.) Students probably think cell phones are more interesting than water, so they may like this example better than the one in the textbook. To keep the example manageably simple, we assume unlimited anytime minutes & free cell phone. Without either of these assumptions, then the product consumers buy would not have a single well-defined price, but the price would vary based on how many minutes the customer used, or what kind of phone the customer wanted with her service plan. Regarding the zero fixed cost assumption: This merely makes the math easier. As students will recall from Chapter 13, fixed costs are sunk costs and do not affect decisions or outcomes.

Smalltowns demand schedule Two firms: Cingular, Verizon

(duopoly: an oligopoly with two firms)

Each firms costs: FC = $0, MC = $10

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EXAMPLE: Cell Phone Duopoly in Smalltown

P $0 5 10 15 20 25 30 35 40 45 Q 140 130 120 110 100 90 80 70 60 50 Revenue 650 1,200 1,650 2,000 2,250 2,400 2,450 2,400 2,250
OLIGOPOLY

Cost 1,300 1,200 1,100 1,000 900 800 700 600 500

Profit 650 0 550 1,000 1,350 1,600 1,750 1,800 1,750

$0 $1,400 1,400

Competitive Competitive outcome: outcome: P P= = MC MC = = $10 $10 Q Q= = 120 120 Profit = $0 Profit = $0

Monopoly Monopoly outcome: outcome: P P= = $40 $40 Q Q= = 60 60 Profit Profit = = $1,800 $1,800
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EXAMPLE: Cell Phone Duopoly in Smalltown

One possible duopoly outcome: collusion Collusion: an agreement among firms in a

market about quantities to produce or prices to charge

Cingular and Verizon could agree to each produce

half of the monopoly output: For each firm: Q = 30, P = $40, profits = $900

Cartel: a group of firms acting in unison,

e.g., Cingular and Verizon in the outcome with collusion
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ACTIVE LEARNING

1: Collusion vs. selfself-interest

P $0 5 10 15 20 25 30 35 40 45 Q 140 130 120 110 100 90 80 70 60 50

Duopoly outcome with collusion: Each firm agrees to produce Q = 30, earns profit = $900. If Cingular reneges on the agreement and produces Q = 40, what happens to the market price? Cingulars profits? Is it in Cingulars interest to renege on the agreement? If both firms renege and produce Q = 40, determine each firms profits.
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This exercise leads students to discover that each firm has an incentive to cheat on the agreement, causing a breakdown of the profitmaximizing cartel outcome.

ACTIVE LEARNING

Answers
P $0 5 10 15 20 25 30 35 40 45 Q 140 130 120 110 100 90 80 70 60 50

1:

If both firms stick to agreement, each firms profit = $900 If Cingular reneges on agreement and produces Q = 40: Market quantity = 70, P = $35 Cingulars profit = 40 x ($35 10) = $1000 Cingulars profits are higher if it reneges. Verizon will conclude the same, so both firms renege, each produces Q = 40: Market quantity = 80, P = $30 Each firms profit = 40 x ($30 10) = $800

Collusion vs. Self-Interest Both firms would be better off if both stick to the
cartel agreement.

But each firm has incentive to renege on the

agreement.

Lesson:
It is difficult for oligopoly firms to form cartels and honor their agreements.

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ACTIVE LEARNING

2: The oligopoly equilibrium

P $0 5 10 15 20 25 30 35 40 45 Q 140 130 120 110 100 90 80 70 60 50
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This exercise shows students that Q = 40 is the profit-maximizing output for each firm. In the previous exercise, students were instructed to find the new market price an important intermediate step before determining the effect on profit. In this exercise, the instructions do not ask students to determine the effect on market price. The intention is to see if they will remember to do this critical intermediate step themselves.

If each firm produces Q = 40, market quantity = 80 P = $30 each firms profit = $800 Is it in Cingulars interest to increase its output further, to Q = 50? Is it in Verizons interest to increase its output to Q = 50?

ACTIVE LEARNING

Answers
P $0 5 10 15 20 25 30 35 40 45 Q 140 130 120 110 100 90 80 70 60 50

2:

If each firm produces Q = 40, then each firms profit = $800. If Cingular increases output to Q = 50: Market quantity = 90, P = $25 Cingulars profit = 50 x ($25 10) = $750 Cingulars profits are higher at Q = 40 than at Q = 50. The same is true for Verizon.

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The Equilibrium for an Oligopoly

Nash equilibrium: a situation in which
economic participants interacting with one another each choose their best strategy given the strategies that all the others have chosen

Our duopoly example has a Nash equilibrium

in which each firm produces Q = 40.

Given that Verizon produces Q = 40, Cingulars best move is to produce Q = 40. Given that Cingular produces Q = 40, Verizons best move is to produce Q = 40.
OLIGOPOLY 13

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A Comparison of Market Outcomes

When firms in an oligopoly individually choose production to maximize profit,

Our cell phone duopoly example demonstrates that the noncooperative oligopoly outcome falls in between the monopoly and competitive outcomes.

Q is greater than monopoly Q

but smaller than competitive market Q

P is greater than competitive market P

but less than monopoly P

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The Output & Price Effects Increasing output has two effects on a firms profits:

output effect: If P > MC, selling more output raises profits. price effect: Raising production increases market quantity, which reduces market price and reduces profit on all units sold. the firm increases production.

If output effect > price effect, If price effect > output effect,
the firm reduces production.
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The Size of the Oligopoly

As the number of firms in the market increases,

Example from the textbook: Suppose the U.S., Germany, and Japan each have two automakers: * Ford and GM in the U.S. * BMW and Mercedes in Germany * Honda and Toyota in Japan
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the price effect becomes smaller the oligopoly looks more and more like a competitive market P approaches MC the market quantity approaches the socially efficient quantity

Another Another benefit benefit of of international international trade: trade: Trade Trade increases increases the the number number of of firms firms competing, competing, increases increases Q Q,, keeps keeps P P closer closer to to marginal marginal cost cost
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Without international trade in autos, each country has a duopoly. With international trade, the number of sellers competing with each other increases to six, which drives prices down toward marginal cost and increases the market quantity toward the socially efficient quantity.

Game Theory Game theory: the study of how people behave

in strategic situations

Dominant strategy: a strategy that is best

for a player in a game regardless of the strategies chosen by the other players

Prisoners dilemma: a game between

two captured criminals that illustrates why cooperation is difficult even when it is mutually beneficial

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Prisoners Dilemma Example The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have enough evidence to imprison each for 1 year.

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.
OLIGOPOLY 18

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Prisoners Dilemma Example

Confessing is the dominant strategy for both players. Nash equilibrium: Bonnies decision both confess
Confess Bonnie gets 8 years Clyde gets 8 years Bonnie goes free Clyde goes free Bonnie gets 1 year Clyde gets 1 year
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This slide is animated carefully as follows: 1) If Clyde confesses, then Bonnie gets 8 years if she confesses or 20 years if she does not. 2) If Clyde remains silent, Bonnie goes free if she confesses or gets 1 year if she does not. At this point, it may be worth mentioning that Bonnies best move is to confess, regardless of Clydes decision hence, confess is Bonnies dominant strategy. 3) If Bonnie confesses, Clyde gets 8 years if he confesses or 20 years if he does not. 4) If Bonnie remains silent, Clyde goes free if he confesses or gets 1 year if he does not. Regardless of Bonnies decision, Clydes best move is to confess. Both players have a dominant strategy of confessing.

Remain silent Bonnie gets 20 years

Confess Clydes decision

Remain silent Clyde gets 20 years

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Prisoners Dilemma Example Outcome: Bonnie and Clyde both confess,

each gets 8 years in prison.

The prisoners dilemma illustrates why cooperation is so difficult even when it is in both players mutual interest.

Both would have been better off if both remained

silent.

But even if Bonnie and Clyde had agreed before

being caught to remain silent, the logic of selfinterest takes over and leads them to confess.

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Oligopolies as a Prisoners Dilemma When oligopolies form a cartel in hopes

of reaching the monopoly outcome, they become players in a prisoners dilemma.

The term payoff matrix is fairly standard in microeconomics, so it may be worth mentioning to your students. However, the textbook does not use this term, so you may wish to delete it from this presentation. If so, please note that the term appears in two different places in this presentation once on this slide, and once on the bottom of the slide containing the instructions for Active Learning 3.
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Our earlier example:

Cingular and Verizon 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

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Cingular & Verizon in the Prisoners Dilemma

Each firms dominant strategy: renege on agreement, produce Q = 40.
Cingular Q = 30 Cingulars profit = $900 Verizons profit = $900 Cingulars profit = $750 Verizons profit = $1000
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Q = 40 Cingulars profit = $1000 Verizons profit = $750 Cingulars profit = $800 Verizons profit = $800
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Q = 30 Verizon Q = 40

ACTIVE LEARNING

3: The fare wars wars game

The players: American Airlines and United Airlines The choice: cut fares by 50% or leave fares alone.

The title I have given this game (the fare wars game) kind of tips off what will happen in the Nash equilibrium.

If both airlines cut fares, each airlines profit = $400 million If neither airline cuts fares, each airlines profit = $600 million If only one airline cuts its fares, its profit = $800 million the other airlines profits = $200 million
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Draw the payoff matrix, find the Nash equilibrium.

ACTIVE LEARNING

Answers
Nash equilibrium: both firms cut fares

3:

Understanding the Nash equilibrium: Consider Americans decision. If United cuts fares, American is better off cutting fares (profit = $400) rather than not cutting fares (profit = $200). If United doesnt cut fares, American is better off cutting fares than not. Hence, cutting fares is Americans dominant strategy. United is is the same position: cutting fares is the dominant strategy.

American Airlines Cut fares $400 million Dont cut fares $200 million

Cut fares United Airlines Dont cut fares $200 million $600 million
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$400 million $800 million

$800 million $600 million

So, in the Nash equilibrium, both airlines cut their fares and a fare war ensures, even though both firms would have higher profits if neither cut its fares. This game illustrates why fare wars (or, more generally, price wars) are so common.

Other Examples of the Prisoners Dilemma

Ad Wars Two firms spend millions on TV ads to steal business from each other. Each firms ad cancels out the effects of the other, and both firms profits fall by the cost of the ads. Organization of Petroleum Exporting Countries Member countries try to act like a cartel, agree to limit oil production to boost prices & profits. But agreements sometimes break down when individual countries renege.

The first example, ad wars, is not mentioned in the textbook. An interesting note: When Congress banned cigarette advertising on television in 1971, cigarette manufacturers profits rose. Prior to the ban, cigarette companies were stuck in a Nash equilibrium in which all were spending heavily on TV ads to steal business from each other. The ban, in effect, forced cigarette manufacturers to switch to the cooperative outcome in which none advertises on TV.

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The next three examples (OPEC on this slide, arms race & common resources on the next slide) are discussed in much more detail in the textbook. Instead of covering these same examples in detail in this PowerPoint, I chose to present different examples, so that students who read the book still have a reason to attend class (and vice versa). However, its still useful to mention the books examples here, and briefly discuss them if you wish, so they will be familiar to students when students read the chapter.

Other Examples of the Prisoners Dilemma

Arms race between military superpowers Each country would be better off if both disarm, but each has a dominant strategy of arming. Common resources All would be better off if everyone conserved common resources, but each persons dominant strategy is overusing the resources.

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Prisoners Dilemma and Societys Welfare

The noncooperative oligopoly equilibrium bad for oligopoly firms:

prevents them from achieving monopoly profits

In the arms race game, each of the superpowers would be better off if they could cooperate and sign an agreement to disarm. But the logic of self-interest dictates that each country will arm itself to the teeth. As a result, both countries are worse off for two reasons: 1) the risk of nuclear annihilation is higher

good for society: Q is closer to the socially efficient output P is closer to MC

In other prisoners dilemmas, the inability to

cooperate may reduce social welfare. e.g., arms race, overuse of common resources

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2) resources consumed in the arms race could have been used elsewhere
Why People Sometimes Cooperate When the game is repeated many times,
cooperation may be possible.

Strategies which may lead to cooperation: If your rival reneges in one round,
you renege in all subsequent rounds.

Tit-for-tat Whatever your rival does in one round (whether renege or cooperate), you do in the following round.

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Public Policy Toward Oligopolies Recall one of the Ten Principles from Chap.1:
Governments can sometimes improve market outcomes.

In oligopolies, production is too low and prices

are too high, relative to the social optimum.

Role for policymakers:

promote competition, prevent cooperation to move the oligopoly outcome closer to the efficient outcome.

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Restraint of Trade and Antitrust Laws

Sherman Antitrust Act (1890):

forbids collusion between competitors

Clayton Antitrust Act (1914):

strengthened rights of individuals damaged by anticompetitive arrangements between firms

If youre so inclined, this might be a good place to mention the infamous phone call in which Robert Crandall, CEO of American Airlines, tried to convince Braniffs CEO Howard Putnam to raise fares 20%. If you can dig up a transcript of the conversation to read in class (try a simple Google search), students will find it interesting: it has lots of curse words.

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Controversies Over Antitrust Policy Most people agree that price-fixing agreements
among competitors should be illegal.

Some economists are concerned that

policymakers go too far when using antitrust laws to stifle business practices that are not necessarily harmful, and may have legitimate objectives.

We consider three such practices

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1. Resale Price Maintenance (Fair Trade)

Occurs when a manufacturer imposes lower limits

on the prices retailers can charge.

Is often opposed because it appears to reduce

competition at the retail level.

As I prepare this PowerPoint, I am shopping for a home theater sound system. My experience is relevant to this slide, and students have have had similar experiences when shopping for stereo components, computers, or other products. I visited a local store to check out different brands and models. The salesman at this store is very knowledgeable, and the store provided several comfortable, sound-proofed rooms where I could spend as much time as I wanted auditioning the various components without the intrusion of outside noise. Based on this shopping experience, I have selected a particular model made by Denon, a high-end brand that you really have to hear to appreciate. Now that I have decided on a brand and model, my incentive is to buy from a discount retailer. If I do, the discount retailer is, in effect, freeriding off of the full-service retailer I visited. If all consumers used the full-service retailers only for information, and then purchased from discount superstores, then full-service retailers would all go out of business. Denon knows this. They also know that consumers are less likely to choose their equipment over cheaper brands if consumers do not have the opportunity to hear how great Denons gear sounds. So, to prevent discount retailers from driving full-service retailers out of business, Denon engages in a variation of the fair trade practice discussed on this slide: Denon only honors its warranty if the consumer purchased the product from an authorized retailer. For a retailer to be authorized, it must agree to sell Denons products at prices not lower than Denon specifies. I can find unauthorized retailers who will sell me Denon gear at lower prices, but Denons practice of not honoring the warranty gives me an incentive to pay a few extra bucks to buy it from an authorized seller of Denon products.

Yet, any market power the manufacturer has

is at the wholesale level; manufacturers do not gain from restricting competition at the retail level.

The practice has a legitimate objective:

preventing discount retailers from free-riding on the services provided by full-service retailers.
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2. Predatory Pricing

Regarding the last two points: Predatory pricing requires selling products below cost, generating losses. The firm must have deep pockets to sustain such losses and survive until its competitor leaves the market. Afterward, there is no guarantee that the economic profits from charging the monopoly price will make up for the losses sustained during the period of predatory pricing.
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Occurs when a firm cuts prices to prevent entry

or drive a competitor out of the market, so that it can charge monopoly prices later.

Illegal under antitrust laws, but hard for the courts

to determine when a price cut is predatory and when it is competitive & beneficial to consumers.

Many economists doubt that predatory pricing is a

rational strategy: It involves selling at a loss, which is extremely costly for the firm. It can backfire.
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Suppose a firm engages in predatory pricing and sustains deep losses for a period of time, but succeeds in driving its competitor out of business. Even then, the pressure is not off a potential entrant may be standing by, ready to jump into the market to take a share of the monopoly profits the firm would otherwise enjoy all to itself. If so, then the firm is less likely to recover the losses it endures while it is engaging in predatory pricing. Economists have done a fair amount of research on predatory pricing, and there is not yet any consensus. Until there is, it might not be a good idea to prosecute predatory pricing under the antitrust laws.

3. Tying Occurs when a manufacturer bundles two products

together and sells them for one price (e.g., Microsoft including a browser with its operating system)

Critics argue that tying gives firms more market

power by connecting weak products to strong ones.

Others counter that tying cannot change market

power: Buyers are not willing to pay more for two goods together than for the goods separately.

Firms may use tying for price discrimination,

which is not illegal, and which sometimes increases economic efficiency.
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CONCLUSION Oligopolies can end up looking like monopolies

or like competitive markets, depending on the number of firms and how cooperative they are.

The prisoners dilemma shows how difficult it is

for firms to maintain cooperation, even when doing so is in their best interest.

Policymakers use the antitrust laws to regulate

oligopolists behavior. The proper scope of these laws is the subject of ongoing controversy.

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CHAPTER SUMMARY Oligopolists can maximize profits if they form a

cartel and act like a monopolist.

Yet, self-interest leads each oligopolist to a higher

quantity and lower price than under the monopoly outcome.

The larger the number of firms, the closer will be

the quantity and price to the levels that would prevail under competition.

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CHAPTER SUMMARY The prisoners dilemma shows that self-interest

can prevent people from cooperating, even when cooperation is in their mutual interest. The logic of the prisoners dilemma applies in many situations.

Policymakers use the antitrust laws to prevent

oligopolies from engaging in anticompetitive behavior such as price-fixing. But the application of these laws is sometimes controversial.

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