Oligopoly

Oligopoly
Oligopoly
• A small number of firms

• Barriers to entry

• Similar to monopoly, but with a twist

• The profits of one firm depend on the actions of other firms

A two-firm example of natural duopoly
Firm A Firm B

ATC
ATC

demand

Efficient scale of Firm A= 30 Efficient scale of firm B = 30 units

units
At price of efficient scale
Demand = 60 units
A natural oligopoly
• Can have 3 or 4 firms

• Each firm producing at its minimum average cost

• The sum of these firms’ output equals the quantity the market
demands at the price corresponding to minimum average cost.
“Non-natural” oligopolies
• Can collude to make excess profits

• A simple introduction to game theory

• The prisoners’ dilemma

The prisoners’ dilemma
• The police hold 2 suspects, but have insufficient evidence against
either.

• They separate the 2 prisoners and offer each prisoner the same deal:
The proposed deal
• If you testify against your “accomplice” (and your accomplice remains
silent) you go free, and your accomplice gets 10 years in jail.

• If you both remain silent, each of you gets 6 months in jail.

• If you both betray, each of you gets 5 years in jail.

The Prisoners’ Dilemma

The payoff matrix

Assume
• 1. each prisoner prefers a shorter prison sentence to a longer
sentence

• 2. each player is selfish: he doesn’t care about the other’s prison

sentence

• 3. the prisoners cannot communicate

Prisoner A

10 yrs (B betrays)

• A silent 0.5 yrs (B silent)

5 years (B betrays)

0 years (B silent)
• A betrays

• It is strictly better for A to betray, whatever B does.

Prisoner B
• Same payoff.

• It is strictly better for B to betray

The Prisoners’ Dilemma

The payoff matrix

(Pareto optimum)

(Actual equilibrium)
The prisoners’ dilemma
• The optimal outcome (6 months each) is avoided because the
prisoners cannot co-ordinate their actions.

• Or do not believe that the other will do as he says.

However
• If the game is repeated
• And each can monitor the other’s actions
• And punish the other for cheating

• Then an optimal outcome can be achieved.

2 identical firms
Each firm will produce 3000 if no collusion
The 2 firms collude to restrict output: each
firm produces only 2000
However
• If one firm cheats and the other does not cheat, the cheater will make
an excess profit while the complier makes a loss

• This is illustrated in the next slide.

But each firm has an incentive to cheat in
order to increase its market share
If both firms cheat
• Each firm has an incentive to produce more
• Lowering the price until price equals marginal cost

• And the output and price will be the same as in a competitive

industry
The 2 firms face a dilemma
• Like the prisoners’ dilemma

• The Payoff Matrix is shown in the next slide

Duopoly Payoff Matrix