E201 Chap 17 Notes - jkhjkh PDF

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ECON 201 CHAPTER 17 – OLIGOPOLY Recall the definition of Oligopoly: Oligopoly is a market structure where there are a few large firms competing in a market. The key difference between this and the 3 previous market structures we discussed (perfect competition, monopoly, and monopolistic competition) is that here the decisions of one firm depend on the actions of other firms. In other words, strategic interaction is important in oligopoly. Game Theory is the study of how agents behave in strategic situations: how an agent chooses among alternative courses of action and he must consider how others might respond to the action he takes. Markets with Only a Few Sellers Duopoly is an oligopoly with only two members. They decide what quantity to sell and the price is determined on the market by the demand. In a market that is perfectly competitive each firm is a price taker. The price is equal to marginal cost and the total quantity of output produced and consumed is efficient. In a monopoly the monopolist is not a price taker. The price is greater than the marginal cost and the quantity produced and consumed is less than the efficient level (there is a deadweight loss). Two firms collude if they reach an agreement about the quantity and price to charge. All firms acting uniformly according to a collusive agreement form a cartel. For oligopolists it is difficult to obtain monopoly profits for two reasons: self-interest and antitrust laws. If each duopolist pursues his self interest he will produce more than the agreed quantity. In the example presented in Table 1 for simplicity there are no costs. The equilibrium quantity and price in perfect competition are 120 gallons and $0 respectively. If the supplier of water is instead a monopolist, the profits are at maximum for a quantity of 60 gallons at a price of $60 per gallon.

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Assume that there are only two firms supplying water in this market and that they are called Jill and Jack. If these two firms are allowed to collude, they could agree to produce a total of 60 gallons and sell at a price of $60 in order to maximize profits. If they agreed to produce each 30 gallons, then the price would be $60 and each would earn $1,800. If one firm stands by the agreement (therefore producing 30 gallons) but the other “cheats” producing more, then the firm that cheats can earn higher profits at the expenses of the other firm. In the example in Table 1 if one firm cheats and produces 50 gallons while the other produces the agreed 30 gallons, the total output is 80 gallons. The price corresponding to 80 gallons on the demand curve is $40. Therefore, the “cheater” could have profits equal to $2,000 ($40*50gallons) and the other firm would only get $1,200 ($40*30gallons). However, if each firm is a “cheater” and produces 50 gallons, then the total production is 100 gallons and the price is $20. In this case each firm earns only $1,000 ($20*50gallons). Note that if instead one firm (the “cheater”) was producing 40 gallons and the other was producing 30, the “cheater” would earn $2,000 ($50*40gallons), while the “non cheater” would only earn $1,500 ($50*30gallons). If both firms were cheating and producing 40 gallons each, the price would be $40 and each would make $1,600, which is greater than the profits that they would earn if they “cheated” producing 50 gallons each.

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The Economics of Cooperation and Game Theory A game is a situation where agents interact and recognize that their well being depends on their own actions as well as actions of others (strategic interdependence). A game is defined by players, payoffs, and strategies. The players are the agents making decisions. The payoffs are the profits or utility realized by the agents when the game is played out. A strategy is a rule that tells the player which action to choose at a given point in the game. (Note that this is a complete contingent set of actions. An action for each possible situation.) The normal form representation of a game indicates the players in the game, the possible strategies of the players and the payoff to the players resulting from alternative strategies (it is the matrix form in the figures of your book). A dominant strategy is a strategy that results in the highest payoff to a player regardless of the opponent’s action. An equilibrium to a game is a strategy combination such that each player is playing her “best strategy” given the strategy of her rival.

The Nash equilibrium is the most common equilibrium concept. A Nash Equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen. A strategy combination is a Nash equilibrium if no player has an incentive to deviate from her strategy. In other words, each player’s strategy is a best response to the other player’s strategy.

The Prisoners’ Dilemma (Example 1) Consider the Prisoner’s Dilemma: Two prisoners are being interrogated in separate rooms. They have two choices: Confess (C) - implicate the other prisoner Remain Silent (S) - deny any wrong doing

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The payoffs (player 1, player2) are as follows:

Player 1

C S

Player 2 C (-8,-8) (-20,0)

S (0,-20) (-1,-1)

The payoffs to the two players are given by the entries in each cell of the matrix (left entry for Player 1 and right entry for Player 2). The police explain the rules to the prisoners. If one prisoner implicates his partner but the partner doesn’t, then the prisoner who implicated the other gets no jail time. If both prisoners deny any wrong doing then they each get a short jail sentence. If they both implicate the other they get a medium jail sentence (8 years). The longest jail sentence results if one does not implicate the partner but the partner implicates him. How should the players play the game? Note that C is a dominant strategy for each player (regardless of the action of the other player, a choice of C results in the highest payoff). Therefore, each player will play his dominant strategy and the Nash equilibrium is (C,C). This result is called dilemma because the Nash equilibrium outcome is inferior (each stays 8 years in jail) to the situation where the two players agree to deny any wrong doing (only 1 year in jail).

Oligopolies and the Prisoners’ Dilemma The example of Jill and Jack in the water market can be represented in an Oligopoly Game in matrix form. In conclusion, Jack and Jill can agree to keep production low (30 gallons) so the price stays high and they will earn together the maximum total profit. However, each can choose to comply with the agreement and produce 30 gallons, or alternatively “cheat” and produce instead 40 gallons. The matrix in Figure 2 shows the profits that each player obtains from the combination of his and the other player’s decision. Note that each player makes a decision contemporaneously with the other. We can simplify Figure 2 as follows:

Jill

High (40gal) Low (30gal)

Jack High (40gal) ($1600, $1600) ($1500, $2000)

Low (30gal) ($2000, $1500) ($1800, $1800)

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Producing 40 gallons is a dominant strategy for both Jack and Jill. The Nash equilibrium is (High, High). This result has lower profits for each than if they had cooperated.

OPEC and the World Oil Market Organization of Petroleum Exporting Countries (OPEC) is a cartel. It was formed in 1960 by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. By 1973 it also included Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, Gabon. OPEC controls about three-fourths of the world’s oil reserves. OPEC tries to raise the price of oil through a coordinated reduction in quantity produced. The problem for OPEC is that each member of the cartel is tempted to cheat on agreement, increase its production and get a larger share of the total profit. OPEC was successful at maintaining cooperation and high prices from 1973 to 1985. Mid-1980s member countries began arguing about production levels and OPEC was ineffective at maintaining cooperation. By 1986 price had decreased. Note that the increase in more recent years was not the result of the ability by OPEC to maintain cooperation, but rather the result of increased world demand of oil (partially due to the booming Chinese economy). Other two examples: Arms-Race Game

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Common-Resources Game

Conditions for Cooperation Players will choose to cooperate (therefore resolving the prisoner dilemma) if they can play the game repeatedly. An infinitely repeated game is a game that is played over and over again and in which players receive payoffs during each play of the game. Consider Jack and Jill’s game:

Jill

High (40gal) Low (30gal)

Jack High (40gal) ($1600, $1600) ($1500, $2000)

Low (30gal) ($2000, $1500) ($1800, $1800)

We have seen that if this was a one-shot game it would be similar to the Prisoner’s Dilemma: High is a dominant strategy for each player and (H,H) is a Nash equilibrium. However here the two players will continue to play (and experience payoffs). Therefore it is possible to collude without fear of being cheated on. In fact, both players can use trigger strategies: 

If Jack, “cheats” by producing 40 gallons instead of the agreed upon 30, Jill will never trust Jack again and will always produce 40. In this case Jack gets $2,000 only the first period of the game. Thereafter he knows that he will earn only $1,600 each period.

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If Jack never cheats and Jill never cheats, they both earn $1,800 in each period forever. Assuming no interest rates and no present value calculations, this means 6

that Jack and Jill play the game forever, they will have an incentive to collude and both produce Low. Players will cooperate if the present value of the profits from cooperating are greater than the present value of the profits from cheating. Public Policy Toward Oligopolies Policymakers try to induce firms in an oligopoly to compete rather than cooperate in order to move the allocation of resources closer to the social optimum. •

Antitrust laws – The Sherman Antitrust Act, 1890 • Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy – The Clayton Act, 1914 • Further strengthened the antitrust laws These laws are used to prevent mergers and to prevent oligopolists from colluding Price-fixing agreements among competing firms should be illegal. However antitrust laws have also been used to condemn business practices like resale price maintenance, predatory pricing and tying. Resale price maintenance According to this practice, retailers are required to charge customers a given price. This practice might seem anticompetitive because it prevents the retailers from competing on price. Defenders of this practice claim that it is not aimed at reducing competition and that it has the legitimate goal to ensure that retailers offer good service to the buyers of the good. Predatory pricing Some claim that charging prices that are too low may be intended to drive other firms out of the market. However skeptics argue that predatory pricing is not a profitable strategy because in order to drive out a rival, prices have to reach a level below cost. Tying According to this practice a producer offers two goods together “tied” in a bundle. Some claim that in some cases this is aimed at obtaining market power. However, rather than a tool to expand market power, tying might simply be a form of price discrimination.

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