OLIGOPOLY

1
OLIGOPOLY
Oligopoly is a market with few sellers selling
similar or identical products. Few means
more than one, but not so many that each firm
doesnt have a substantial influence over market
price.
2
OLIGOPOLY
The market demand for a product is given on the
left. The technology for producing the product
has zero fixed cost and constant marginal cost of
1. Then ATCAVCMC1 for any firm regardless of
size. We will consider three ways of organizing
production (perfect competition, monopoly,
and oligopoly), and examine the economic
Price Quantity (P) (Q) 10
0 9 1 8
2 7 3 6 4
5 5 4 6 3
7 2 8 1
9 0 10
3
OLIGOPOLY
efficiency of each.
Price Quantity (P) (Q) 10
0 9 1 8
2 7 3 6 4
5 5 4 6 3
7 2 8 1
9 0 10
4
PERFECT COMPETITION
Each perfectly competitive firm will produce
where PpcMC1, so that a total of Qpc9 units
will be produced. This is the socially optimal
level of output. Each firm will have zero
economic profit since ATCMCP, and (P-ATC) x Q
0.
Price Quantity (P) (Q) 10
0 9 1 8
2 7 3 6 4
5 5 4 6 3
7 2 8 1
9 0 10
5
MONOPOLY
P Q TR MR 10
0 0 - 9
1 9 9 8 2
16 7 7 3
21 5 6 4 24
3 5 5 25 1
4 6 24 -1 3
7 21 -3 2
8 16 -5 1 9
9 -7 0 10
0 -9
The monopolist will produce where PgtMRMC1,
which occurs at Qm5 units of output. Monopoly
price will be Pm5, and monopoly profits will
be (Pm-ATC) x Qm (5-1)x5 20.
6
MONOPOLY
P Q TR MR 10
0 0 - 9
1 9 9 8 2
16 7 7 3
21 5 6 4 24
3 5 5 25 1
4 6 24 -1 3
7 21 -3 2
8 16 -5 1 9
9 -7 0 10
0 -9

DEADWEIGHT LOSS
Pm5
ATCMC
Ppc1
D
Q
Qm 5
Qpc9
MR
The perfectly competitive industry is efficient
in allocating resources, while the
7
MONOPOLY
P Q TR MR 10
0 0 - 9
1 9 9 8 2
16 7 7 3
21 5 6 4 24
3 5 5 25 1
4 6 24 -1 3
7 21 -3 2
8 16 -5 1 9
9 -7 0 10
0 -9

DEADWEIGHT LOSS
Pm5
ATCMC
Ppc1
D
Q
Qm 5
Qpc9
MR
monopoly allocates too few resources producing a
deadweight loss of
8
MONOPOLY
P Q TR MR 10
0 0 - 9
1 9 9 8 2
16 7 7 3
21 5 6 4 24
3 5 5 25 1
4 6 24 -1 3
7 21 -3 2
8 16 -5 1 9
9 -7 0 10
0 -9

DEADWEIGHT LOSS
Pm5
ATCMC
Ppc1
D
Q
Qm 5
Qpc9
MR
(1/2) x (Qpc-Qm) x (Pm-Ppc) (1/2)(9-5)(4-1)8.
9
DUOPOLY
The special case of oligopoly, where there are
only two firms, is called duopoly. Assume that
the two firms are identical. Then they
can maximize their combined profits by together
producing the monopoly output of 5 and charging
the monopoly price
P Q TR MR 10
0 0 - 9
1 9 9 8 2
16 7 7 3
21 5 6 4 24
3 5 5 25 1
4 6 24 -1 3
7 21 -3 2
8 16 -5 1 9
9 -7 0 10
0 -9
10
DUOPOLY
of 5. If each of the duopolists produce 2.5
units of output, they will each have a profit
of (P-ATC) x Q (5-1) x 2.510. Then their
combined profit will be 20 -- the same as
a monopolists profit. When firms enter into an
agreement about their production levels
P Q TR MR 10
0 0 - 9
1 9 9 8 2
16 7 7 3
21 5 6 4 24
3 5 5 25 1
4 6 24 -1 3
7 21 -3 2
8 16 -5 1 9
9 -7 0 10
0 -9
11
DUOPOLY
and price to charge, this is called collusion,
and the group of firms in the agreement is a
cartel. Then a cartel may allocate resources in
the same way as a monopoly. However there are
often strong incentives for duopolists
(oligopolists) to jointly produce a larger output
than a monopolist. When duopoly firm A sees its
competitor, firm B, producing 2.5 units of
output, A can increase its profit by producing
more than 2.5 units.
12
DUOPOLY
QB QA Q P TRA MRA
TCA PROFIT 2.5 0.5 3 7
3.5 - 0.5 3 2.5
1.5 4 6 9 5.5
1.5 7.5 2.5 2.5 5
5 12.5 3.5 2.5 10 2.5
3.5 6 4 14 1.5
3.5 10.5 2.5 4.5 7
3 13.5 -0.5 4.5 9 2.5
5.5 8 2 11 -1.5
5.5 5.5 2.5 6.5 9
1 6.5 -4.5 6.5 0 2.5
7.5 10 0 0 -6.5
7.5 -7.5
If B continues to produce and sell 2.5 units, A
can increase profits to 10.5 by selling
3.5 units of output. Price will fall to 4 so
that Bs profit will now be (P-ATC)xQ(4-1)x2.57.
5, a decrease of 2.5. Therefore, when A
increases its sales, Bs profit is affected.
Similarly, if B changes
13
DUOPOLY
the quantity that it sells, As profit will
change. Therefore the two firms are
interdependent. When each firm believes that the
other will produce and sell 2.5 units, each has
the incentive to produce and sell 3.5 units to
increase their profit. However, when each firm
produces 3.5 units, total output is 7 and market
price is 3. Then each firms profit is
(P-ATC)xQ(3-1)X3.57. Each firm does worse than
when they each produce 2.5.
14
DUOPOLY
The table at the left summarizes the results
of the two duopolists actions. As profits for
each output pair is given in the upper right of
each cell Bs profit
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
for each output pair is in the lower left of each
cell. When B sells 2.5 and A sells 3.5, As
profit is 10.5 and Bs profit is 7.5.
15
GAME THEORY
Since the duopolists actions affect each other,
they must develop strategies for deciding how
much output to produce. Strategic decision
making can be conveniently analyzed using game
theory. An elementary game is known as the
prisoners dilemma.
16
PRISONERS DILEMMA
Each prisoner will get a 5 year sentence if they
both remain silent. However, each has an

Butch Remain
Silent
Confess Remain Sundance
Silent Confess
5 years 0 years
5 years 20 years
20 years 10 years
0 years 10 years
incentive to confess and have their sentence
reduced to 0 years. But if both confess, they
will
17
PRISONERS DILEMMA
both be worse off than if they both
remain silent. The actions of each will have not
only an effect

Butch Remain
Silent
Confess Remain Sundance
Silent Confess
5 years 0 years
5 years 20 years
20 years 10 years
0 years 10 years
on themselves, but also on the other. The
results of their actions are interdependent. If
Butch
18
PRISONERS DILEMMA
confesses and Sundance remains silent, Sundances
sentence will increase from 5 to 20 years.

Butch Remain
Silent
Confess Remain Sundance
Silent Confess
5 years 0 years
5 years 20 years
20 years 10 years
0 years 10 years
19
DUOPOLY
The duopolists game is similar to the
prisoners dilemma. Each has an incentive to
choose an action that is not jointly optimal.
The actions of
Firm A
2.5 3.5
2.5 Firm B 3.5
10 10.5
10 7.5
7.5 7
10.5 7
each duopolist has an effect on the profits of
the other.
20
OPEC
Founded in 1960, the Organization of Petroleum
Exporting Countries (OPEC) is a cartel of 11
countries that collectively produce about 75 of
the worlds oil. Periodically, the cartel
assigns production quotas to each of its members
to limit production in order to increase price
and profits of its members. The cartel has no
legal means of enforcing the production quotas.
They are simply accepted by mutual consent.
When price is high,
21
OPEC
each country has an incentive to increase
its production to increase its own profits. But
when a number of countries increase production,
price will fall and so will the OPEC members
profits. In fact the history of OPEC has seen
output quotas raise petroleum (and gasoline)
prices, only to have some members eventually
cheat on the agreement. Saudi Arabia (which is an
OPEC member) has attempted to penalize the
cheaters by flooding the
22
OPEC
world market with oil, and driving down
world price and the profits of oil producers.
The idea that Saudi Arabia is attempting to
convey is that countries who cheat will be
punished with low prices and profits when they
do not follow their production quotas.
Repeatedly playing this game OPEC members should
eventually learn that the best strategy to play
is to adhere to their production quotas.