Chaper+16+-+Micro

=Oligopoly=

__Key Terms__ - oligopoly - monopolistic competition - collusion - cartel - Nash equilibrium - game theory - prisoners' dilemma - dominant strategy

Oligopolies are what they call //imperfect competition.// They are a mix between monopolies and perfectly competitive markets. One type of this that we will study this chapter is called an oligopoly. **Oligopoly** - type of market where only a few sellers often similar or identical products.

How are they like monopolies and perfectly competitive markets? You'll see. Although it is disputed, the main difference is that a oligopoly is a free entry, like a perfectly competitive market, but a few sellers, like a monopoly. They sell similar or near-identical products. The few sellers dominate the market much like monopolies. The //concentration ratio// measures how much the biggest four firms of a product control the market.

Another type of market between perfectly competitive markets and monopolies is called a **monopolistic comeptition.** That is a market where **many** firms sell products that are similar but not identical.

__Qualities__

The thing about oligopolies is that it is a balance between cooperation and self-interest. If the oligopolies cooperate and act like a monopoly, then their total profit would be high, and equally divided among its members. However, because each oligopolist cares for its own self-interest, there are incentives to hinder an oligopolist about cooperating. You'll see.


 * One Example**

One example of an oligopoly is an oligopoly with two members, called a //duopoly.// Imagine that there is are two people - Patrick and Patricia - who both control the well of the water. Becuase it doesn't cost any money to produce it, the marginal cost is 0. Here's a chart of the demand schedule:



The demand of the water is downward sloping curve.

Let's see what would happen if we compare this market to the other markets: perfect competition and monopoly.

If everyone could pump water and it was a perfect competition, because the marginal cost = 0, and price = MC, the equilibrium price would be 0, and quantity would be 120 gallons.

If it were a monopoly, the single producer would produce 60 gallons, and a price of 60$ per gallon. The price would exceed marginal cost, and there would be a profit. However, there would be a deadweight loss because the socially desirable quantity is 120 gallons and equilibrium price is 0 dollars.

Remember, the goal of a oligopoly, like monopolies and PCs (perfectly competitive markets), is to maximize profits. In order to do this, they want to sell and work together to sell water at the monopoly price of $60 at the quantity of 60 gallons. Working together like this is called a **collusion,** and the group of firms working together is called a **cartel.**

How do they do this? They both make 30 gallons each. So in total, they have 60 gallons, and both Patrick and Patricia each have a profit of $1,800.


 * The Dilemma**

However, there are anti-trust laws (look at the last chapter) that prevent this collusion.

Not only does this happen, but the duopolists' self-interest kicks in. One day, Patrick thinks, "I am making 30 gallons of water, and having a profit of $1800. But if I produce 40 gallons of water, and Patricia produces only 30, then the equilibrium price will be 50, the quantity will be 70 (40+30), and I will make $2000 of profit (40 gallons * $30 dollars).

Of course, Jill might feel the same way. And if she also increases her output to 40 gallons, then there would be 80 gallons of water, and each Patrick and Patricia would only earn $1,600 profit.

What was just demonstrated is called a **Nash equilibrium**, by John Nash. This is a situation where economic participants act after seeing the reaction of their partners. So when Patrick increased his output, Patricia fulfilled the Nash equilibrium by increasing hers, too.

This usually happens in real life to a certain extent, leading us to believe that some profits are usually lost in oligopolies.


 * Oligopoly Size**

Let's say that Peter and Petra discover water on their property, so they join the market, too. Well because there are now 4 people that are selling water, profit for everyone decreases, and becuase there are more people, the possibility for 1 making more has increased. When a seller increases production by 1 gallon, 2 things can happen:

__output effect__: selling 1 more gallon will increase profit __price effect:__ will increase total amount sold, which will lower price of water and lower profit.

If output effect > price effect, the well owner should increase production. But if the price effect < output effect, then the owner should not only stop production, but decrease production. Oligopolists try to balance these, until they reach an equilibrium.


 * Game Theory**

We're going to look at the problems of cooperation between "partners" in an oligopoly. One way we can do this is through **game theory.** Game theory is the study of how people behave in situations like in oligopolies.

They aren't necessary for PCs or monopolies because the firms in each are either too big or too small. One of the most effective ways of examining game theory is a situation called **prisoners' dilemma.** This game shows the difficulty in cooperation.

__Prisoner's Dilemma__ The prisoner's dilemma is a story about 2 criminals who get caught, A and B. The police have enough evidence to get them in 1 year of jail each if they both remain silent and don't confess. However, they know that the criminals were planning to hijack a plane, but they don't have evidence. They go to each criminal and say, "Look. We're going to lock you up for one year. If you confess to hijacking of the plane, and your partner doesn't confess, you'll be free and your partner will have 20 years in jail. If you both confess, you'll both get 5 years.

Let's look at a chart examining the choices.



Now let's look at the choice that's best for both, which is to both remain silent. Between A and B, they would spend 2 years in jail total. But the downfall is if one person chooses to remain silent, the drawback is 20 years of jail, which sucks. So both A and B examine their choices, and choose the confess. They made their choice regardless of what the other person chose.

In game theory, there's a term called **dominant strategy.** It is the strategy that is the best choice regardless of what other people pick. This is what person A and B did.

In the end, A and B could've stayed in jail for only 2 years, but because of self-interest and distrust, they have to spend 10 years total.

This ties to oligopoly because this type of cooperation is needed in a oligopoly.

Let's go back to Jack and Jill. We can produce a similar chart. What if one of them decides to produce 40 gallons?



They both can cooperate and both make $1800. Or not cooperate and leave one another in the cold. Just as self-interest and selfishness leads prisoners to choose to confess, it does the same to people in oligopolies.

This isn't only for oligopolies. The prisoners' dilemma applies to many facets of life.

__Arms Race__ One of my favorite applications of arms race was during the mid 1900s when the US and Soviet Union were struggling to create better and more nuclear weapons. Here's how the chart looked:



The fact was that the country with better weapons was considered king of the world. But they also cost billions of dollars. If the US and Soviet stopped, they could've saved billions of dollars. However, they both didn't want to risk falling behind, and continued making them.

__**Society's view on Oligopoly**__

Arguing and self-interests are inherent parts of oligopolies. But also, they are good for the society in general. Because quantity is increased when oligopolists disagree, the quantity supplied gets closer to the socially optimal level.

But do oligopolists always disagree?

Not always. If Patrick and Patricia realize after a week that their profits decreased, then they could revert back to producing 30 gallons each, and $1,800 of profit each.

But just in case that oligopolies collude, there are certain policies made by the government.


 * Public Policy Toward Oligopolies**

Cooperation amonst oligopolists is bad for society becuase it creates monopoly situations. As a result, there are situations in which monopolies aren't allowed to be created, and where monopolies are broken.

These rules are called anti-trust laws and try to prevent too many monopolies. They prevent almost-monopolies (oligopolies, which will be discussed next chapter) from conspiring to raise prices. Also, it gives the government power to split up monopolies into smaller companies. For example, the government split up AT&T into 8 smaller companies in 1984.

But there are drawbacks and controversies associated with the Antitrust policy. Here's a few

Resale Price Maintenance - When some firm gives a store its product, it tells that firm to sell it at a certain resale price. This would set everyone on a certain same price, like a monopoly or a cartel, which breaks antitrust laws. However, it is controversial because it gets rid of free riders.

Predatory Pricing - when another smaller firm joins the market, a larger firm cuts down prices temporarily to drive smaller firm out of business. Then the large film raises its prices back to normal. However, people think its controversial because the larger firm will take losses in order to drive smaller firm out of business. Also, because of low prices, more people will ride the planes until the larger firm goes out of business. During this time, the smaller firm can just cut back on the number of flights until the larger firm starts to raise prices due to its losses.

Tying - when selling a good, another good is tied in with it, causing prices to rise, and price discrimination to increase profit. It's controversial because it's taking advantage of peoples' willingnesses to pay.


 * SUMMARY**

- oligopolists try to maximize profits by colluding and forming cartels and splitting profits - the more oligopolists per market means less profit - uneven balance between self-interest and collusion prevents oligopolies from cooperating properly - prisoners dilemma shows the difficulty in maintaining balance between self-interest and cooperation - laws such as anti-trust laws make it even harder for oligopolies to collude

__Questions__ 1. What is the concentration ratio? 2. What's the difference between an oligopoly and monopolistic competition? 3. According to the Nash equilibrium, if i formed a cartel in a duopoly and produced 40 gallons of water, and my partner suddenly increased his production to 50 gallons, what would I do? 4. If more people join the oligopoly, why is it bad for the existing oligopolists? 5. What is the Arms Race an example of? 6. Is a cartel good for consumers? For producers? 7. Which laws combat cartels?

__Answers__ 1. The ratio by the biggest 4 producers of a market. For example, if Peter's Smoothies, Smoothie King, Jamba Juice, and Fruit Smoothies were the 4 largest firms in smoothie-making, and controlled 70% of all smoothies in the market, the concentration ratio would be 70%. 2. Monopolistic competition has many sellers, while oligopoly has less. 3. Increase my production to 50 gallons so that we both make the same amount of profit. 4. If newer members joined an oligopolies, existing members' profits would decrease, and cooperation would be harder to maintain. 5. The prisoners' dilemma. 6. Bad for consumers because it creates monopoly-like prices and situations. For producers, it is good because it equals more profits. 7. Anti-trust laws.

Citations: http://media-2.web.britannica.com/eb-media/55/91955-004-AF92CB6A.gif