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Oligopoly and Game Theory
ETP Economics 101
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Imperfect Competition
Imperfect competition refers to those marketstructures that fall between perfectcompetition and pure monopoly.
Imperfect competition includes industries inwhich firms have competitors but do notface so much competition that they are price
takers.
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Types
Types of Imperfectly Competitive Markets
Oligopoly
Only a few sellers, each offering a similar or identical
product to the others.
Monopolistic Competition
Many firms selling products that are similar but notidentical.
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Copyright 2004 South-Western
Tap waterCable TV
Monopoly(Chapter 15)NovelsMovies
MonopolisticCompetition(Chapter 17)
Tennis ballsCrude oil
Oligopoly(Chapter 16)
Number of Firms?
Perfect
Wheat Milk
Competition(Chapter 14)
Type of Products?
IdenticalproductsDifferentiatedproductsOnefirm Fewfirms
Manyfirms
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Key Feature
Because of the few sellers, the key featureof oligopoly is the tension betweencooperation and self-interest.
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Characteristics
Characteristics of an Oligopoly Market
Few sellers offering similar or identical products
Interdependent firms
Best off cooperating and acting like amonopolist by producing a small quantity ofoutput and charging a price above marginal cost
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Simple Type: Duopoly
A duopoly is an oligopoly with only twomembers. It is the simplest type of oligopoly.
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Collusion and Cartel
The duopolists may agree on a monopolyoutcome.
Collusion
An agreement among firms in a market aboutquantities to produce or prices to charge.
Cartel
A group of firms acting in unison.
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Is Cartel Possible?
Although oligopolists would like to formcartels and earn monopoly profits, often thatis not possible. Antitrust laws prohibit
explicit agreements among oligopolists as amatter of public policy.
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The Equilibrium for an Oligopoly
A Nash equilibrium is a situation in whicheconomic actors interacting with oneanother each choose their best strategy
given the strategies that all the others havechosen.
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The equilibrium for an Oligopoly
When firms in an oligopoly individually chooseproduction to maximize profit, they producequantity of output greater than the level produced
by monopoly and less than the level produced bycompetition.
The oligopoly price is less than the monopoly pricebut greater than the competitive price (which
equals marginal cost).
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Size of an Oligopoly
How increasing the number of sellers affectsthe price and quantity:The output effect: Because price is above
marginal cost, selling more at the going priceraises profits.
The price effect: Raising production willincrease the amount sold, which will lower the
price and the profit per unit on all units sold.
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Size of an Oligopoly
As the number of sellers in an oligopolygrows larger, an oligopolistic market looksmore and more like a competitive market.
The price approaches marginal cost, andthe quantity produced approaches thesocially efficient level.
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Strategic Action
Because the number of firms in anoligopolistic market is small, each firm mustact strategically.
Each firm knows that its profit depends notonly on how much it produces but also onhow much the other firms produce.
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Game Theory
Game theoryis the study of how peoplebehave in strategic situations.
Strategic decisions are those in which eachperson, in deciding what actions to take,must consider how others might respond tothat action.
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Prisoners Dilemma
Theprisoners dilemma provides insight into thedifficulty in maintaining cooperation.
Often people (firms) fail to cooperate with one
another even when cooperation would makethem better off.
The prisoners dilemma is a particulargamebetween two captured prisoners that illustrateswhy cooperation is difficult to maintain even whenit is mutually beneficial.
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Bonnie s Decision
Confess
ConfessBonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes freeBonnie goes free
Clyde gets 20 years
gets 1 yearBonnie
Clyde gets 1 year
Remain Silent
RemainSilent
ClydesDecision
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Dominant Strategy
The dominant strategyis the best strategy for aplayer to follow regardless of the strategieschosen by the other players.
Dominant strategies in Prisoners dilemma:
_ Clyde: Confess
_ Bonnie: Confess
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Nash Equilibrium & BestOutcome
Nash Equilibrium (self-interest):
_ Clyde: Confess & Bonnie: Confess
Best Outcome (cooperation):
_ Clyde: Silent & Bonnie: Silent
Cooperation is difficult to maintain, becausecooperation is not in the best interest of theindividual player.
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Game Example: OPEC
Iraq and Iran: Members of OPEC
Their decisions on oil production.
Decisions: High Production or LowProduction
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Iraqs Decision
HighProduction
High ProductionIraq gets $40 billion
Iran gets $40 billion
Iraq gets $30 billion
Iran gets $60 billionIraq gets $60 billion
Iran gets $30 billion
Iraq gets $50 billion
Iran gets $50 billion
Low Production
LowProduction
IransDecision
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Nash Equilibrium
Dominant strategies:_ Iran: High Production_ Iraq: High Production
Nash Equilibrium (self-interest):_ Iran: High Production & Iraq: High Production
Best Outcome (cooperation):_ Iran: low production & Iraq: low production
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Game Example: Arm Race
Game Players: USA & Russia
Decisions: Arm or Disarm
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Decision of the United States (U.S.)
Arm
ArmU.S. at risk
USSR at risk
U.S. at risk and weak
USSR safe and powerfulU.S. safe and powerful
USSR at risk and weak
U.S. safe
USSR safe
Disarm
Disarm
Decision
of the
Soviet Union
(USSR)
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Nash Equilibrium
Dominant strategies:_ USA: Arm_ Russia: Arm
Nash Equilibrium (self-interest):_ USA: Arm & Russia: Arm
Best Outcome (cooperation):_ USA: Disarm & Russia: Disarm
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Game Example: Advertising
Players: Camel & Marlboro
Decisions: Advertise or Dont advertise
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Marlboro s Decision
Advertise
AdvertiseMarlboro gets $3
billion profitCamel gets $3billion profit Camel gets $5billion profit
Marlboro gets $2billion profit
Camel gets $2billion profit
Marlboro gets $5billion profit
Camel gets $4billion profit
Marlboro gets $4billion profit
Dont Advertise
DontAdvertise
CamelsDecision
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Nash Equilibrium
Dominant strategies:_ Camel: Advertise_ Marlboro: Advertise
Nash Equilibrium (self-interest):_ Camel: Advertise_ Marlboro: Advertise
Best Outcome (cooperation):_ Camel: Dont Advertise_ Marlboro: Dont Advertise
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Game Example: CommonResource such as Oil
Players: Texaco & Exxon
Decisions: Drill Two Wells or Drill one Well
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Copyright2003 Southwestern/Thomson Learning
Exxons Decision
Drill TwoWells
Drill Two WellsExxon gets $4
million profit
Texaco gets $4million profit Texaco gets $6million profit
Exxon gets $3million profit
Texaco gets $3million profit
Exxon gets $6million profit
Texaco gets $5million profit
Exxon gets $5million profit
Drill One Well
Drill OneWell
TexacosDecision
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Nash Equilibrium
Dominant strategies:_ Texaco: Drill Two Wells_ Exxon: Drill Two Wells
Nash Equilibrium (self-interest):_Texaco: Drill Two Wells_ Exxon: Drill Two Wells
Best Outcome (cooperation):_ Texaco: Drill One Well_ Exxon: Drill One Well
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Game Example: Where toAdvertise?
Players: Competitor.com or We.com
Decisions: NBA and NHL
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No Nash equilibrium in pure strategies
Competitor.com
NBA NHL
NBA W: 4,C: 3
W: 3,C: 4
We.comNHL W: 3,
C: 4
W: 4,
C: 3
Where to advertise?
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No Nash Equilibrium
Dominant strategies:_ We.com: none_ Competitor.com: none
Nash Equilibrium (self-interest):_ We.com: none_ Competitor.com: none
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Game Example: Evening News
Players: ATV and TVB
Decisions: 7:30 pm or 8:00 pm
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Evening News:
TVB
7:30pm 8:0pm
7:30pm A: 1,
B: 1
A: 3,
B: 4
ATV 8:0pm A: 4,B: 3
A: 2.5,B: 2.5
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Nash Equilibrium
Dominant strategies:_ ATV: none_ TVB: none
Two Nash Equilibria (self-interest):
_ ATV: 7:30pm & TVB: 8:00pmor
_ ATV: 8:00pm & TVB: 7:30pm
Wh P l S ti
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Why People SometimesCooperate
Firms that care about future profits willcooperate in repeated games rather thancheating in a single game to achieve a one-
time gain.