Unit 4: Monopolies, Monopolistic Competition, and Oligopolies



Unit 4: Monopolies, Monopolistic Competition, and Oligopolies4.3 OligopolyMain Topics: Structural Characteristics, Industry Concentration, Prisoners’ Dilemma, Collusion Oligopoly markets are typically farther from perfect competition than the monopolistic market structure, although there is no one model of oligopoly. A couple of oligopoly models are presented; but keep in mind that if one little assumption is relaxed, the predictions of the model can be radically different. For the AP exam you will likely face only these basics.Structural CharacteristicsYou can see from these characteristics that oligopoly shares more common ground with monopoly, but these are flexible enough to describe many different and diverse industries.A few large producers. Can it get more vague than this? Think of the American auto industry, with the “Big 3” producers, or the tobacco industry, also dominated by three huge firms. If the distribution of market share in an industry is top heavy with a few large firms, the industry is described as oligopolistic.Differentiated or standardized product. Oligopoly industries can come in both flavors.Crude oil is a fairly standard product, but it is very much an oligopoly of large producers. Automobiles, beer, and soft drinks are also oligopoly markets, but with more differentiated products.Entry barriers. If these industries were fairly easy to enter, we would not see themdominated by a few huge producers.Mutual interdependence. Because a few large producers control these industries, the action of one firm (price setting or advertising) is likely to affect the others and prompt a response. A good example of this is your local gasoline market. This is very much an oligopoly; when one gas station lowers prices by one cent per gallon, the others usually quickly follow.Industry ConcentrationHow does an industry become classified as an oligopoly? Economists have tried to get more specific than a “few large producers” by developing ways to measure how much market share is held by, or concentrated in, the largest of the firms. One way to gauge how powerful the largest of firms might be is to sum up the market share of the top four, or eight or 12 firms and create a concentration ratio. If the top four firms in the breakfast cereal industry have a combined market share of 85 percent we say that the four-firm concentration ratio is 85. Some economists use a four-firm concentration ratio of 40 percent as a rough guideline for identifying an oligopolistic industry. We predict that as this concentration ratio increases, the degree of monopoly price-setting power increases.Game Theory and The Prisoners’ DilemmaImagine a case where a two-firm oligopoly (a duopoly) engages in a daily pricing decision. Each firm knows that if it sets a price higher than the rival’s, it loses sales. Likewise, if it sets a price below the rival’s, it steals sales. This non-collusive model of pricing, called the prisoners’ dilemma, emerges from the following scenario that any fan of Law and Order quickly recognizes.Example:A college professor suspects two students (Jack and Diane) of cheating on a take- home final exam, but cannot prove guilt with enough certainty to fail both students in the course, or expel them from the school. Without a confession, she will give each student a D in the course. With a confession from one student but not the other, she can reward the confessor with a B. The professor brings both students, one at a time, into her office and gives each the following deal:If you remain silent and do not confess, and your classmate implicates you, I will expel you from school and give your friend a B.If you confess to cheating and implicate your silent classmate, I will pass you with a Band expel your friend from school.These options can be depicted in the following matrix.JACK’S CHOICESConfessStay SilentDIANE’S CHOICESConfessD: Fail the course J: Fail the courseD: Gets a BJ: Expelled from schoolStay SilentD: Expelled from school J: Gets a BD: Gets a D J: Gets a DDiane doesn’t know what Jack is going to do when he is in the professor’s office. But whatever Jack’s decision, Diane should confess. She might be thinking that Jack is going to confess. If so, she confesses because staying silent will get her expelled from school. Maybe she thinks that Jack is going to stay silent. If true, the choice is between a B and a D in the course. Diane would be wise to confess. For Diane, confessing is a dominant strategy because no matter what Jack does, confession is always better than staying silent. Likewise for Jack, the dominant strategy is to confess.This is certainly a dilemma, because if Jack and Diane could only agree to give the pro- fessor the silent treatment, they would both walk away with a D, which is much better than failing the course or expulsion from school. Without such a binding agreement, cheating on the pact would be quite tempting, maybe even fairly predictable.Example:The owners of two gas stations operate on opposite corners of a busy intersection.Each morning each owner goes out to the sign and sets the price of gasoline, either high or low. Consumers are concerned only about the lowest price of gas. The matrix below summarizes the daily revenues for each station.STATION XPrice HighPrice LowSTATION YPrice HighX: $2000 Y: $2000X: $3000 Y: $500Price LowX: $500 Y: $3000X: $1000 Y: $1000Can you see the dilemma? Both stations would love to set a high price of gas so that they could earn $2000 in daily revenue. But if the rival were to set the low price, the high price station would be stuck with $500 while the other station cleans up with $3000.Since both firms recognize that pricing low is the dominant strategy, both earn only $1000 every day. A collusive agreement might emerge.Use of the previous game matrices assumes that both players in the game make simultaneous choices. Many games involve a series of stages where one player moves first. The second player observes the choice made by the first, and then reacts to it. These sequential games are typically seen as a game tree rather than a game matrix. Let’s convert the previous game to a sequential game where gas station X gets to move first. Station Y sees the choice of station X, and then sets the price high or low. Payoffs are given at the end of the tree.Can you see how this game will play out? Gas station X knows that its rival, station Y, still has a dominant strategy of setting a low price. No matter what the initial decision of station X, station Y would always see that a low price beats a high price. Because station X knows this about its rival, it will select a low price at the beginning of the game. In 2007, the AP Microeconomics exam included simple game theory on the free-response section for the very first time. You should expect this area of microeconomics to be tested again in the future and, in my experience, I predict that the degree of difficulty will gradually increase.Collusive PricingExplicit collusive behavior between direct competitors is an illegal business practice, but it does happen (surprise!) from time to time. More common is a kind of tacit, or understood, collusion. Two competitors over time figure out that repeated attempts to undercut the price of their rivals is counterproductive. Eventually they understand that if both set the price high, both firms win. When one cheats on this “understanding,” the other inflicts punishment with a retaliatory price cut.Cartels are more organized forms of collusive oligopoly behavior. Cartels are groups offirms that create a formal agreement not to compete with each other on the basis of price, production, or other competitive dimensions. The general idea of the cartel is that rather than act independently to maximize individual profits, they collectively operate as a monopolist to maximize their joint profits. Each cartel member agrees to a limited level of output and this results in a higher cartel price. Joint profits are maximized and distributed to each member.In addition to the pesky illegality of forming cartels, these entities face three challenges that are completely unrelated to the Attorney General.Difficulty in arriving at a mutually acceptable agreement to restrict output. Have you ever tried to order pizza or rent a movie with more than two other friends? If so, you get the idea.Punishment mechanism. If the cartel can restrict output and increase the price above the current competitive level, cartel members have an incentive to cheat by producing more than their allotment. There must be some kind of deterrent to cheating.Entry of new firms. If the cartel members are successful in creating monopoly profits, they are faced with new firms eager to enter. If entry occurs, the cartel loses monopoly power and profi ................
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