CHAPTER
Oligopoly
13B
After studying this chapter you will be able to
Define and identify oligopoly
Explain two traditional oligopoly models
Use game theory to explain how price and output are
determined in oligopoly
Use game theory to explain other strategic decisions
PC War Games
In some markets there are only two firms. Computer chips
are an example.
The chips that drive most PCs are made by Intel and
Advanced Micro Devices.
How does competition between just two chip makers work?
Do they operate in the social interest, like the firms in
perfect competition?
Or do they restrict output to increase profit, like a
monopoly?
What Is Oligopoly?
The distinguishing features of oligopoly are
 Natural or legal barriers that prevent entry of new firms
 A small number of firms compete
What is Oligopoly?
Barriers to Entry
Either natural or legal
barriers to entry can
create oligopoly.
Figure 13.9 shows two
oligopoly situations.
In part (a), there is a
natural duopoly—a
market with two firms.
What is Oligopoly?
In part (b), there is a
natural oligopoly market
with three firms.
A legal oligopoly might
arise even where the
demand and costs leave
room for a larger number
of firms.
What is Oligopoly?
Small Number of Firms
Because an oligopoly market has a small number of firms,
the firms are interdependent and face a temptation to
cooperate.
Interdependence: With a small number of firms, each
firm’s profit depends on every firm’s actions.
Cartel: A cartel and is an illegal group of firms acting
together to limit output, raise price, and increase profit.
Firms in oligopoly face the temptation to form a cartel, but
aside from being illegal, cartels often break down.
What is Oligopoly?
Examples of Oligopoly
Figure 13.10 shows some
examples of oligopoly.
 Four largest firms
 Next four largest firms
 Next 12 largest firms
An HHI that exceeds 1,000
is usually an oligopoly.
An HHI below 1,000 is
usually monopolistic
competition.
Two Traditional Oligopoly Models
The Kinked Demand Curve Model
In the kinked demand curve model of oligopoly, each firm
believes that if it raises its price, its competitors will not
follow, but if it lowers its price all of its competitors will
follow.
Two Traditional Oligopoly Models
Figure 13.11 shows the
kinked demand curve
model.
The firm believes that the
demand for its product has
a kink at the current price
and quantity.
Two Traditional Oligopoly Models
Above the kink, demand is
relatively elastic because
all other firm’s prices
remain unchanged.
Below the kink, demand is
relatively inelastic because
all other firm’s prices
change in line with the
price of the firm shown in
the figure.
Two Traditional Oligopoly Models
The kink in the demand
curve means that the MR
curve is discontinuous at
the current quantity—shown
by that gap AB in the figure.
Two Traditional Oligopoly Models
Fluctuations in MC that
remain within the
discontinuous portion of the
MR curve leave the profitmaximizing quantity and
price unchanged.
For example, if costs
increased so that the MC
curve shifted upward from
MC0 to MC1, the profitmaximizing price and
quantity would not change.
Two Traditional Oligopoly Models
The beliefs that generate
the kinked demand curve
are not always correct and
firms can figure out this
fact.
If MC increases enough,
all firms raise their prices
and the kink vanishes.
A firm that bases its
actions on wrong beliefs
doesn’t maximize profit.
Two Traditional Oligopoly Models
Dominant Firm Oligopoly
In a dominant firm oligopoly, there is one large firm that
has a significant cost advantage over many other, smaller
competing firms.
The large firm operates as a monopoly, setting its price
and output to maximize its profit.
The small firms act as perfect competitors, taking as given
the market price set by the dominant firm.
Two Traditional Oligopoly Models
Figure 13.12 shows10 small firms in part (a). The
demand curve, D, is the market demand and the supply
curve S10 is the supply of the 10 small firms.
Two Traditional Oligopoly Models
At a price of $1.50, the 10 small firms produce the quantity
demanded. At this price, the large firm would sell nothing.
Two Traditional Oligopoly Models
But if the price was $1.00, the 10 small firms would supply
only half the market, leaving the rest to the large firm.
Two Traditional Oligopoly Models
The demand curve for the large firm’s output is the curve
XD on the right.
Two Traditional Oligopoly Models
The large firm can set the price and receives a marginal
revenue that is less than price along the curve MR.
Two Traditional Oligopoly Models
The large firm maximizes profit by setting MR = MC. Let’s
suppose that the marginal cost curve is MC in the figure.
Two Traditional Oligopoly Models
The profit-maximizing quantity for the large firm is 10 units.
The price charged is $1.00.
Two Traditional Oligopoly Models
The small firms take this price and supply the rest of the
quantity demanded.
Two Traditional Oligopoly Models
In the long run, such an industry might become a monopoly
as the large firm buys up the small firms and cuts costs.
Oligopoly Games
Game theory is a tool for studying strategic behavior,
which is behavior that takes into account the expected
behavior of others and the mutual recognition of
interdependence.
The Prisoners’ Dilemma
The prisoners’ dilemma game illustrates the four features
of a game.
 Rules
 Strategies
 Payoffs
 Outcome
Oligopoly Games
Rules
The rules describe the setting of the game, the actions the
players may take, and the consequences of those actions.
In the prisoners’ dilemma game, two prisoners (Art and
Bob) have been caught committing a petty crime.
Each is held in a separate cell and cannot communicate
with each other.
Oligopoly Games
Each is told that both are suspected of committing a more
serious crime.
If one of them confesses, he will get a 1-year sentence for
cooperating while his accomplice get a 10-year sentence for
both crimes.
If both confess to the more serious crime, each receives 3
years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for the
minor crime only.
Oligopoly Games
Strategies
Strategies are all the possible actions of each player.
Art and Bob each have two possible actions:
1. Confess to the larger crime.
2. Deny having committed the larger crime.
With two players and two actions for each player, there are
four possible outcomes:
1. Both confess.
2. Both deny.
3. Art confesses and Bob denies.
4. Bob confesses and Art denies.
Oligopoly Games
Payoffs
Each prisoner can work out what happens to him—can work
out his payoff—in each of the four possible outcomes.
We can tabulate these outcomes in a payoff matrix.
A payoff matrix is a table that shows the payoffs for every
possible action by each player for every possible action by
the other player.
The next slide shows the payoff matrix for this prisoners’
dilemma game.
Oligopoly Games
Oligopoly Games
Outcome
If a player makes a rational choice in pursuit of his own
best interest, he chooses the action that is best for him,
given any action taken by the other player.
If both players are rational and choose their actions in this
way, the outcome is an equilibrium called Nash
equilibrium—first proposed by John Nash.
The following slides show how to find the Nash
equilibrium.
Bob’s
view
of the
world
Bob’s
view
of the
world
Art’s
view
of the
world
Art’s
view
of the
world
Equilibrium
Oligopoly Games
An Oligopoly Price-Fixing Game
A game like the prisoners’ dilemma is played in duopoly.
A duopoly is a market in which there are only two
producers that compete.
Duopoly captures the essence of oligopoly.
Figure 13.13 on the next slide describes the demand and
cost situation in a natural duopoly.
Oligopoly Games
Part (a) shows each firm’s cost curves.
Part (b) shows the market demand curve.
Oligopoly Games
This industry is a natural duopoly.
Two firms can meet the market demand at the least cost.
Oligopoly Games
How does this market work?
What is the price and quantity produced in equilibrium?
Oligopoly Games
Collusion
Suppose that the two firms enter into a collusive
agreement.
A collusive agreement is an agreement between two (or
more) firms to restrict output, raise the price, and increase
profits.
Such agreements are illegal in the United States and are
undertaken in secret.
Firms in a collusive agreement operate a cartel.
Oligopoly Games
The strategies that firms in a cartel can pursue are to
 Comply
 Cheat
Because each firm has two strategies, there are four
possible combinations of actions for the firms:
1. Both comply.
2. Both cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.
Oligopoly Games
Colluding to Maximize Profits
Firms in a cartel act like a monopoly and maximum
economic profit.
Oligopoly Games
To find that profit, we set marginal cost for the cartel equal to
marginal revenue for the cartel.
Oligopoly Games
The cartel’s marginal cost curve is the horizontal sum of the
MC curves of the two firms and the marginal revenue curve
is like that of a monopoly.
Oligopoly Games
The firm’s maximize economic profit by producing the
quantity at which MCI = MR.
Oligopoly Games
Each firm agrees to produce 2,000 units and each firm
shares the maximum economic profit. The blue rectangle
shows each firm’s economic profit.
Oligopoly Games
When each firm produces 2,000 units, the price is greater
than the firm’s marginal cost, so if one firm increased
output, its profit would increase.
Oligopoly Games
One Firm Cheats on a Collusive Agreement
Suppose the cheat increases its output to 3,000 units.
Industry output increases to 5,000 and the price falls.
Oligopoly Games
For the complier, ATC now exceeds price.
For the cheat, price exceeds ATC.
Oligopoly Games
The complier incurs an economic loss.
The cheat makes an increased economic profit.
Oligopoly Games
Both Firms Cheat
Suppose that both increase their output to 3,000 units.
Oligopoly Games
Industry output is 6,000 units, the price falls, and both
firms make zero economic profit—the same as in perfect
competition.
Oligopoly Games
Possible Outcomes
 If both comply, each firm makes $2 million a week.
 If both cheat, each firm makes zero economic profit.
 If Trick complies and Gear cheats, Trick incurs an
economic loss of $1 million and Gear makes an
economic profit of $4.5 million.
 If Gear complies and Trick cheats, Gear incurs an
economic loss of $1 million and Trick makes an
economic profit of $4.5 million.
The next slide shows the payoff matrix for the duopoly
game.
Payoff
Matrix
Trick’s
view
of the
world
Trick’s
view
of the
world
Gear’s
view
of the
world
Gear’s
view
of the
world
Equilibrium
Oligopoly Games
Nash Equilibrium
The Nash equilibrium is that both firms cheat.
The quantity and price are those of a competitive market,
and the firms make zero economic profit.
Other Oligopoly Games
Advertising and R&D games are also prisoners’ dilemmas.
An R&D Game
Procter & Gamble and Kimberley Clark play an R&D game
in the market for disposable diapers.
Oligopoly Games
Here is the payoff matrix for the Pampers Versus Huggies
game.
Oligopoly Games
The Disappearing Invisible Hand
In all the versions of the prisoners’ dilemma that we’ve
examined, the players end up worse off than they would if
they were able to cooperate.
The pursuit of self-interest does not promote the social
interest in these games.
Oligopoly Games
A Game of Chicken
In the prisoners’ dilemma game, the Nash equilibrium is a
dominant strategy equilibrium, by which we mean the
best strategy for each player is independent of what the
other player does.
Not all games have such an equilibrium.
One that doesn’t is the game of “chicken.”
Payoff
Matrix
KC’s
view
of the
world
KC’s
view
of the
world
P&G’s
view
of the
world
P&G’s
view
of the
world
Equilibrium
Repeated Games and Sequential Games
A Repeated Duopoly Game
If a game is played repeatedly, it is possible for duopolists
to successfully collude and make a monopoly profit.
If the players take turns and move sequentially (rather
than simultaneously as in the prisoner’s dilemma), many
outcomes are possible.
In a repeated prisoners’ dilemma duopoly game, additional
punishment strategies enable the firms to comply and
achieve a cooperative equilibrium, in which the firms
make and share the monopoly profit.
Repeated Games and Sequential Games
One possible punishment strategy is a tit-for-tat strategy.
A tit-for-tat strategy is one in which one player cooperates
this period if the other player cooperated in the previous
period but cheats in the current period if the other player
cheated in the previous period.
A more severe punishment strategy is a trigger strategy.
A trigger strategy is one in which a player cooperates if the
other player cooperates but plays the Nash equilibrium
strategy forever thereafter if the other player cheats.
Repeated Games and Sequential Games
Table 13.5 shows that a tit-for-tat strategy is sufficient to
produce a cooperative equilibrium in a repeated duopoly
game.
Price wars might result from a tit-for-tat strategy where
there is an additional complication—uncertainty about
changes in demand.
A fall in demand might lower the price and bring forth a
round of tit-for-tat punishment.
Repeated Games and Sequential Games
A Sequential Entry Game in a Contestable Market
In a contestable market—a market in which firms can
enter and leave so easily that firms in the market face
competition from potential entrants—firms play a
sequential entry game.
Repeated Games and Sequential Games
Figure 13.17 shows the game tree for a sequential entry
game in a contestable market.
Repeated Games and Sequential Games
In the first stage, Agile decides whether to set the
monopoly price or the competitive price.
Repeated Games and Sequential Games
In the second stage, Wanabe decides whether to enter or
stay out.
Repeated Games and Sequential Games
In the equilibrium of this entry game,
Agile sets a competitive price and makes zero economic
profit to keep Wanabe out.
A less costly strategy is limit pricing, which sets the price
at the highest level that is consistent with keeping the
potential entrant out.
THE END