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Oligopoly

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In competitive market, each firm is so small compared to the market that it cannot influence the price of its product and, therefore, takes the price as given by market conditions. In a monopolized market, a single firm supplies the entire market for a good, and that firm can choose any price an quantity on the market demand curve. Competition and monopoly are extreme forms of market structure. Yet many industries have competitors but, at the same time, do not face so much competition that they are price takers. Economists call this situation imperfect competition. A particular type of it is called oligopoly. The essence of an oligopolistic market is that there are only few sellers. As a result, the actions of any one seller in the market xan have a large impact on the profits of all the other sellers. That is, oligopolistic firms are interdependent in a way that competitive firms are not.

Between monopoly and perfect competition[edit | edit source]

The typical firm in our economy is the imperfectly competitive. There are two types of imperfectly competitive markets. An oligopoly is a market with only a few sellers, each offering a product similar or identical to the others. Monopolistic competition describes a market structure in which there are many firms selling products that are similar but not identical. (CD, Books, Games) In a monopolistically competitive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers.

Markets with only a few sellers[edit | edit source]

Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. The group of oligopolists is best off cooperating and acting like a monopolist – producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares about only its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the monopoly outcome.

A duopoly example[edit | edit source]

To understand the behavior of oligopolies, let’s consider an oligopoly with only two members, called a duopoly. Duopoly is the simplest type of oligopoly.

Competition, Monopolies and Cartels[edit | edit source]

An agreement among firms over production and price is called a collusion and the group of firms acting in unison is called a cartel. Once a cartel is formed, the market is in effect served by a monopoly.

The equilibrium for an oligopoly[edit | edit source]

Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. If the duopolsits individually pursue their own self-interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge price lower than the monopoly price and earn total profit less than the monopoly profit.

Although the logic of self-interest increases the duopoly’s output above the monopoly level, it does not push the duopolists to reach the competitive allocation.

A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen.

When firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price.

How the size of an oligopoly affects the market outcome[edit | edit source]

If the oligopolists do not form a cartel they must each decide on their own how much to produce. To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each firm owner has the option to raise production by 1. In making this decision, the well owner weights two effects:

 The output effect:

Because price is above marginal cost, selling one unit more at the going price will raise profit

 The price effect:

Raising production will increase the total amount sold, which will lower the price and lower the profit on all the other units sold.

If the output effect is larger than the price effect, the firm owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. Each oligopolist continues to increase production until these two marginal effects exactly balance, taking the other firms’ production as given.

Now consider how the number of firms in the industry affects the marginal analysis of each oligopolist. The larger the number of sellers, the less concerned each seller is about its own impact on the market price. That is, as the oligopoly grows in size the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether, leaving only the output effect. In this extreme case, each firm in the oligopoly increases production as long as price is above marginal cost.

We can now see that a large oligopoly is essentially a group of competitive firms. Thus, as the number of seller in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Game theory and the economics of cooperation[edit | edit source]

As we have seen, oligopolies would like to reach the monopoly outcome, but doing so requires cooperation, which at times is difficult to maintain. In this section we look more closely at the problems people face when cooperation is desirable but difficult. To analyze the economics of cooperation, we need to learn a little about game theory. Game theory is the study of how people behave in strategic situations. By “strategic” we mean a situation in which each person, when deciding what actions to take, must consider how others might respond to that action. A particularly important “game” is called the prisoners’ dilemma. This game provides insight into the difficulty of maintaining cooperation.

The prisoners’ dilemma[edit | edit source]

Two suspects, A and B, are arrested for a crime. The local prosecutor has little evidence in the case and is anxious to extract a confession. She separates the suspects and tells each if they confess and his partner doesn’t she can reduce the sentence (one year) and on the basis of his confess

his partner will get ten years. If both confess, both get three years. Each suspect knows, that if neither of them confesses, the lack of evidence will cause them to be tried for a lesser crime for which they will receive two-year sentences.

B A

Confess

Silent

Confess

-3 -3

-1 -10

Silent

-10 -1

-2 -2

In the language of game theory a strategy is called a

dominant strategy if it is the best strategy for a player to follow regardless of the strategy pursued by other players. In the case of prisoners it would be to confess.

Oligopolies as a prisoners’ Dilemma[edit | edit source]

It turns out that the game oligopolists play in trying to reach the monopoly outcome is similar to the game that the two prisoners play in the prisoners’ dilemma.

The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopoly to maintain the cooperative outcome with low production, high prices and monopoly profits.

The prisoners’ dilemma and the welfare of society[edit | edit source]

The prisoners’ dilemma describes many of lifes’s situations, and it shows that cooperation can be difficult to maintain, even when cooperation would make both players better off. Clearly, this lack of cooperation is a problem for those involved in these situations. But is lack of cooperation a problem from the standpoint of society as a whole? The answer depends on the circumstances. In some cases, the non- cooperative equilibrium is bad for society as well as the players. In the case of oligopolists trying to maintain monopoly profits, lack of cooperation is desirable from the standpoint of society as a whole. The monopoly outcome is good for the oligopolist, but is bad for the consumers of the product. When oligopolists fail to cooperate, the quantity they produce is closer to the maximum total surplus.

Why people sometimes cooperate[edit | edit source]

Cartels sometimes do manage to maintain collusive arrangements, despite the incentive members to defect. Very often, the reason that players can solve the prisoners’ dilemma is that they play the game not once but many times.

Public policy toward oligopolies[edit | edit source]

As we have seen, cooperation among oligopolists is undesirable from the standpoint of society as a whole, because it leads to production that is too low and prices that are too high. To move the allocation of resources closer to the social optimum, policy makers should try to induce firms in an oligopoly to compete rather than to cooperate.

Restraint of trade and competition law[edit | edit source]

One way that policy discourages cooperation is through the common law. Normally, freedom of contract is an essential part of a market economy. Yet, for many centuries, courts in Europe and North America have deemed agreements among competitors to reduce quantities and raise prices to be contrary to the public interest. They have therefore, refused to enforce such agreements.

Controversies over competition policy[edit | edit source]

Over time, much controversy has centred on the question of what kinds of behavior competition law should prohibit. Most commentators agree that price-fixing agreements among competing firms should be illegal. Yet competition law has been used to condemn some business practices whose effects are not obvious.

References[edit | edit source]