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13 OTHER TYPES OF IMPERFECTCOMPETITION

LEARNING OBJECTIVES

In this chapter you will:

• Analyze competition among firms that sell differentiatedproducts

• Compare the outcome under monopolistic competitionand under perfect competition

• Consider the desirability of outcomes inmonopolistically competitive markets

• Examine what outcomes are possible when a market isan oligopoly

• Learn about the prisoners’ dilemma and how it applies tooligopoly and other issues

• Consider howcompetition laws try to foster competitionin oligopolistic markets

After reading this chapter you should be able to:

• Show the long-run adjustment that takes place in amonopolistically competitive market when a firmgenerates economic profits

• Show why monopolistically competitive firms produceat less-than-efficient scale in the long run

• Discuss the inefficiencies of monopolisticallycompetitive markets

• Describe the characteristics of oligopoly andmonopolistic competition

• Describe theconditionsunderwhichanoligopolisticmarketgenerates the same outcome as a monopolistic market

• Show why the outcome of the prisoners’ dilemma maychange if the game is repeated

• Showwhy some business practices that appear to reducecompetition may have a legitimate business purpose

301

INTRODUCTION

In Chapter 12 we looked at an extreme form of imperfect competition – monopoly. Wesaw how a firm’s behaviour might be different to that of a competitive market if it wasthe only supplier in the market.

In most markets we do not see the extremes described in perfect competition ormonopoly, instead there are often many firms competing with each other but withsome very much larger than others. The competition between firms might be very local-ized, for example, between a number of restaurants in a typical city centre, be based ondifferences in price, on differences in the product or the quality of the service provided,or through exploiting human psychology to make it appear there is some differencebetween the product or encouraging some sort of loyalty to a product.

These things and more are all characteristic of imperfect competition. In conditions ofimperfect competition, products are not homogenous. There might be many substitutes fora good in the market but in some way or another, the firm tries to make their productdifferent to rivals so that the degree of substitutability is reduced. In differentiating pro-ducts the firm is able to have some control over the price that they charge. The sellers inthis market are price makers rather than price takers and price will be above marginal cost.

Monopolistic Competition

Because these markets have some features of competition and some features of monop-oly it is called monopolistic competition. Monopolistic competition describes a marketwith the following attributes:

• Many sellers. There are many firms competing for the same group of customers witheach firm being small compared to the market as a whole.

• Product differentiation. Each firm produces a product that is at least slightly differentfrom those of other firms. The firm is able to have some control over the extent towhich it can differentiate its product from its rivals, thus reducing the degree of sub-stitutability and garnering an element of customer or brand loyalty. Therefore, ratherthan being a price taker, each firm faces a downward sloping demand curve.

• Free entry. Firms can enter (or exit) the market without restriction. Thus, the numberof firms in the market adjusts until economic profits are driven to zero.

Table 13.1 lists examples of the types of market with these attributes.

monopolistic competition amarket structure in which many firmssell products that are similar but notidentical

TABLE 13.1

Examples of Markets Which Have Characteristics of Monopolistic Competition

Computer games Vets

Restaurants Hotel accommodation

Conference organizers Air conditioning systems

Wedding planners Pest control

Plumbing Removal services

Coach hire Beauty consultants

Funeral directors Shop fitters

Fabric manufacturers Waste disposal

Tailors Dentists

Music teachers Children’s entertainers

Books Gas engineers

CDs/DVDs Steel fabricators

Landscape architects Driving schools

Environmental consultants Opticians

Furniture manufacturers Chimney sweeps

Four different toothpastes, one firm.How different are these products andhow does the consumer know theyare different?

ALAMY

302 Part 4 Microeconomics – The Economics of Firms in Markets

COMPETITION WITH DIFFERENTIATEDPRODUCTS

To understand monopolistically competitive markets, we first consider the decisions fac-ing an individual firm. We then examine what happens in the long run as firms enterand exit the industry. Next, we compare the equilibrium under monopolistic competitionto the equilibrium under perfect competition. Finally, we consider whether the outcomein a monopolistically competitive market is desirable from the standpoint of society as awhole.

The Monopolistically Competitive Firm in the Short Run

Each firm in a monopolistically competitive market is, in many ways, like a monopoly.Because its product is different from those offered by other firms, it faces a downwardsloping demand curve. If we assume that a monopolistically competitive firm aims forprofit maximization it chooses the quantity at which marginal revenue equals marginalcost and then uses its demand curve to find the price consistent with that quantity.

Figure 13.1 shows the cost, demand and marginal revenue curves for two typicalfirms, each in a different monopolistically competitive industry. In both panels of thisfigure, the profit-maximizing quantity is found at the intersection of the marginal reve-nue and marginal cost curves. The two panels in this figure show different outcomes forthe firm’s profit. In panel (a), price exceeds average total cost, so the firm makes a profit.In panel (b), price is below average total cost. In this case, the firm is unable to make apositive profit, so the best the firm can do is to minimize its losses.

All this should seem familiar. A monopolistically competitive firm chooses its quan-tity and price just as a monopoly does. In the short run, these two types of market struc-ture are similar.

FIGURE 13.1

Monopolistic Competitors in the Short Run

Monopolistic competitors maximize profit by producing the quantity at which marginal revenue equals marginal cost. The firm in panel(a) makes a profit because, at this quantity, price is above average total cost. The firm in panel (b) makes losses because, at this quantity,price is less than average total cost.

Price

Price

Average

total cost

Quantity

Demand

0

(a) Firm makes profits

Profit-

maximizing

quantity

Profit

ATC

MC

MR

Price

Price

Average

total cost

Quantity

Demand

0

(b) Firm makes losses

Loss-

minimizing

quantity

LossesATC

MC

MR

Chapter 13 Other Types of Imperfect Competition 303

The Long-Run Equilibrium

The situations depicted in Figure 13.1 do not last long. When firms are making profits,as in panel (a), new firms have an incentive to enter the market (remember that there isfree entry and exit into the market). This entry means that more firms are now offeringproducts for sale in the industry. The increase in supply causes the price received by allfirms in the industry to fall. If an existing firm wishes to sell more, then it must reduceits price. There are now more substitutes available in the market and so the effect forfirms is to shift the demand curve to the left. The effect is that there is an increase inthe number of products from which customers can now choose and, therefore, reducesthe demand faced by each firm already in the market. In other words, profit encouragesentry, and entry shifts the demand curves faced by the incumbent firms to the left. Asthe demand for incumbent firms’ products falls, these firms experience declining profit.

Conversely, when firms are making losses, as in panel (b), firms in the market have anincentive to exit. As firms exit, the supply will fall and price will rise. There are now fewersubstitutes and so customers have fewer products from which to choose. This decrease inthe number of firms effectively expands the demand faced by those firms that stay in themarket. In other words, losses encourage exit, and exit has the effect of shifting thedemand curves of the remaining firms to the right. As the demand for the remainingfirms’ products rises, these firms experience rising profit (that is, declining losses).

This process of entry and exit continues until the firms in the market are makingexactly zero economic profit. Figure 13.2 depicts the long-run equilibrium. Once themarket reaches this equilibrium, new firms have no incentive to enter, and existingfirms have no incentive to exit.

? what if…a firm operating in a very localized market making short-run abnormalprofit could erect some sort of barrier to entry – would it still be able to makeabnormal profits in the long run?

FIGURE 13.2

A Monopolistic Competitor in the Long Run

In a monopolistically competitive market, if firms are making profit, new firms enter and the demand curves for the incumbent firms shift tothe left. Similarly, if firms are making losses, old firms exit and the demand curves of the remaining firms shift to the right. Because ofthese shifts in demand, a monopolistically competitive firm eventually finds itself in the long-run equilibrium shown here. In this long-runequilibrium, price equals average total cost, and the firm earns zero profit.

0 Profit-maximizing

quantity

MR

MC

ATC

P 5 ATC

Demand

Price

Quantity


Notice that the demand curve in this figure just barely touches the average total costcurve. Mathematically, we say the two curves are tangent to each other. These two curvesmust be tangent once entry and exit have driven profit to zero. Because profit per unitsold is the difference between price (found on the demand curve) and average total cost,the maximum profit is zero only if these two curves touch each other without crossing.

To sum up, two characteristics describe the long-run equilibrium in a monopolisti-cally competitive market:

• As in a monopoly market, price exceeds marginal cost. This conclusion arises becauseprofit maximization requires marginal revenue to equal marginal cost and because thedownward sloping demand curve makes marginal revenue less than the price.

• As in a competitive market, price equals average total cost. This conclusion arisesbecause free entry and exit drive economic profit to zero.

The second characteristic shows how monopolistic competition differs from monop-oly. Because a monopoly is the sole seller of a product without close substitutes, it canearn positive economic profit, even in the long run. By contrast, because there is freeentry into a monopolistically competitive market, the economic profit of a firm in thistype of market is driven to zero.

Monopolistic versus Perfect Competition

Figure 13.3 compares the long-run equilibrium under monopolistic competition to thelong-run equilibrium under perfect competition. There are two noteworthy differencesbetween monopolistic and perfect competition – excess capacity and the mark-up.

Excess Capacity As we have just seen, entry and exit drive each firm in a monop-olistically competitive market to a point of tangency between its demand and average

FIGURE 13.3

Monopolistic versus Perfect Competition

Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in aperfectly competitive market. Two differences are notable. (1) The perfectly competitive firm produces at the efficient scale, where averagetotal cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. (2) Price equalsmarginal cost under perfect competition, but price is above marginal cost under monopolistic competition.

Price

QuantityEfficient

scale

Quantity

produced

Excess capacity

P

MR

MCATC

0

Marginal

cost

Demand

(a) Monopolistically competitive firm

Mark-up

Price

QuantityQuantity produced 5efficient scale

P 5 MC

MCATC

0

P 5 MR (demand

curve)

(b) Perfectly competitive firm


total cost curves. Panel (a) of Figure 13.3 shows that the quantity of output at this pointis smaller than the quantity that minimizes average total cost. Thus, under monopolisticcompetition, firms produce on the downward sloping portion of their average total costcurves. In this way, monopolistic competition contrasts starkly with perfect competition.As panel (b) of Figure 13.3 shows, free entry in competitive markets drives firms to pro-duce at the minimum of average total cost.

The quantity that minimizes average total cost is called the efficient scale of the firm.In the long run, perfectly competitive firms produce at the efficient scale, whereasmonopolistically competitive firms produce below this level. Firms are said to have excesscapacity under monopolistic competition. In other words, a monopolistically competitivefirm, unlike a perfectly competitive firm, could increase the quantity it produces andlower the average total cost of production.

Mark-Up Over Marginal Cost A second difference between perfect competitionand monopolistic competition is the relationship between price and marginal cost. For acompetitive firm, such as that shown in panel (b) of Figure 13.3, price equals marginalcost. For a monopolistically competitive firm, such as that shown in panel (a), priceexceeds marginal cost, because the firm always has some market power.

How is this mark-up over marginal cost consistent with free entry and zero profit?The zero-profit condition ensures only that price equals average total cost. It does notensure that price equals marginal cost. Indeed, in the long-run equilibrium, monopolisti-cally competitive firms operate on the declining portion of their average total cost curves,so marginal cost is below average total cost. Thus, for price to equal average total cost,price must be above marginal cost. Because of this a monopolistically competitive firm isalways eager to get another customer. Because its price exceeds marginal cost, an extraunit sold at the posted price means more profit.

One characteristic of monopolistic competition is the use of advertising and establish-ment of brand names. We looked at advertising and branding in Chapter 7 and suffice tosay that these are important in understanding the behaviour of firms in imperfectcompetition.

Summary

• A monopolistically competitive market is characterized by three attributes: manyfirms, differentiated products and free entry.

• The equilibrium in a monopolistically competitive market differs from that in a perfectlycompetitive market in two related ways. First, each firm in a monopolistically competi-tive market has excess capacity. That is, it operates on the downward sloping portion ofthe average total cost curve. Secondly, each firm charges a price above marginal cost.

• Monopolistic competition does not have all the desirable properties of perfect compe-tition. There is the standard deadweight loss of monopoly caused by the mark-up ofprice over marginal cost. In addition, the number of firms (and thus the variety ofproducts) can be too large or too small. In practice, the ability of policy makers tocorrect these inefficiencies is limited.

• The product differentiation inherent in monopolistic competition leads to the use ofadvertising and brand names.

Table 13.2 summarizes the differences between monopolistic competition, perfect com-petition and monopoly.

Quick Quiz List the three key attributes of monopolistic competition.

• Draw and explain a diagram to show the long-run equilibrium in a

monopolistically competitive market. How does this equilibrium differ from

that in a perfectly competitive market?


TABLE 13.2

Monopolistic Competition: Between Perfect Competition and Monopoly Market Structure

Market Structure

Perfect competition

Monopolistic

competition Monopoly

Features that all three market structures share

Goal of firms Maximize profits Maximize profits Maximize profits

Rule for maximizing MR = MC MR = MC MR = MC

Can earn economic profits in the short run? Yes Yes Yes

Features that monopoly and monopolistic competition share

Price taker? Yes No No

Price P = MC P > MC P > MC

Produces welfare-maximizing level of output? Yes No No

Features that perfect competition and monopolistic competition share

Number of firms Many Many One

Entry in long run? Yes Yes No

Can earn economic profits in long run? No No Yes

FYI

Contestable Markets

Most economics textbooks up to the late1970s covered market structures rangingfrom perfect competition at one extremeto monopoly at the other. Changes in theway businesses actually operated inthe real world meant that there weresome gaps between the theory and theobserved behaviour of firms. This led tothe development of a new theory whichwas incorporated into the explanation ofmarket structures. The theory of contest-able markets was developed by WilliamJ. Baumol, John Panzar and RobertWillig in 1982.

The key characteristic of a perfectlycontestable market (the benchmark toexplain firms’ behaviours) was thatfirms were influenced by the threat ofnew entrants into a market. We haveseen how, in monopolistically competi-tive markets, despite the fact that eachfirm has some monopoly control over itsproduct, the ease of entry and exitmeans that in the long run profits can

be competed away as new firms enterthe market. This threat of new entrantsmay make firms behave in a way thatdeparts from what was assumed to bethe traditional goal of firms – to maxi-mize profits. The suggestion by Baumoland colleagues was that firms maydeliberately limit profits made to dis-courage new entrants. The other char-acteristics of a perfectly contestablemarket are that there are no barriersto entry or exit and no sunk costs. Prof-its might be limited by what was termedentry limit pricing. This refers to a situ-ation where a firm will keep priceslower than they could be in order todeter new entrants. Similarly, firmsmay also practise predatory ordestroyer pricing whereby the price isheld below average cost for a period totry and force out competitors or preventnew firms from entering the market.Incumbent firms may be in a positionto do this because they may have

been able to gain some advantages ofeconomies of scale which new entrantsmay not be able to exploit.

In a contestable market firms mayalso erect other artificial barriers toprevent entry into the industry by newfirms. Such barriers might include oper-ating at over-capacity, which providesthe opportunity to flood the market anddrive down price in the event of a threatof entry. Firms will also carry outaggressive marketing and brandingstrategies to ‘tighten’ up the market orfind ways of reducing costs andincreasing efficiency to gain competi-tive advantage. Searching out sourcesof competitive advantage was a topicwritten on extensively by MichaelPorter, who defined competitive advan-tage as being the advantages firms cangain over another which are both dis-tinctive and defensible. These sourcesare not simply to be found in terms ofnew product development but through


OLIGOPOLY

The Europeans love chocolate. The average German eats about 180 62-gram bars ofchocolate a year. The Belgians are not far behind at 177 bars, the Swiss around 173 andthe British eat around 164 bars per year. There are many firms producing chocolatein Europe including Anthon Berg in Denmark, Camille Bloch, Lindt and Favarger inSwitzerland, Guylian and Godiva in Belgium, and Hachez in Germany. However,Europeans are likely to find that what they are eating has probably been made by oneof three companies: Cadbury (now owned by US firm Kraft), Mars or Nestlé. Thesefirms dominate the chocolate industry in the European Union. Being so large and domi-nant they are able to influence the quantity of chocolate bars produced and, given themarket demand curve, the price at which chocolate bars are sold.

The European market for chocolate bars fits a model of imperfect competition calledoligopoly – literally, competition amongst the few. The essence of an oligopolistic marketis that there are a few sellers which dominate the market and where the products they sellare identical or near identical. In this situation, competition between these large firms mightbe focused on strategic interactions among them. As a result, the actions of any one seller inthe market can have a large impact on the profits of all the other sellers. That is, oligopolis-tic firms are interdependent in a way that competitive firms are not.

There is no magic number that defines ‘few’ from ‘many’ when counting the numberof firms. Do the approximately dozen companies that now sell cars in Europe make thismarket an oligopoly or more competitive? The answer is open to debate. Similarly, thereis no sure way to determine when products are differentiated and when they are identi-cal. Are different brands of milk really the same? Again, the answer is debatable. Whenanalyzing actual markets, economists have to keep in mind the lessons learned fromstudying all types of market structure and then apply each lesson as it seemsappropriate.

Our goal is to see how the interdependence that characterizes oligopolistic marketsshapes the firms’ behaviour and what problems it raises for public policy.

MARKETS WITH ONLY A FEWDOMINANT SELLERS

If a market is dominated by a relatively small number of sellers it is said to be concen-trated. The concentration ratio refers to the proportion of the total market shareaccounted for by the top x number of firms in the industry. For example, a five-firmconcentration ratio of 80 per cent means that five firms account for 80 per cent of mar-ket share; a three-firm concentration ratio of 72 per cent would indicate that three firmsaccount for 72 per cent of total market sales and so on.

close investigation and analysis of thesupply chain, where little changesmight make a difference to the costbase of a firm which it can then exploitto its advantage.

Hit-and-run tactics might be evidentin a contestable market where firmsenter the industry, take the profit andget out quickly (possible because of the

freedom of entry and exit). In other casesfirms may indulge in what is termedcream-skimming – identifying parts ofthe market that are high in value addedand exploiting those markets.

The theory of contestable marketshas been widely adopted as a benefi-cial addition to the theory of the firmand there has been extensive research

into its application. There are numerousexamples of markets exhibiting contest-ability characteristics including finan-cial services; airlines, especiallyflights on domestic routes; the IT indus-try and in particular internet serviceproviders (ISPs), software and webdevelopers; energy supplies and thepostal service.

oligopoly competition amongst thefew – a market structure in which onlya few sellers offer similar or identicalproducts and dominate the market

WIKIM

EDIA


There are a number of examples of oligopolistic market structures including brewing,banking, mobile phone networks, the chemical and oil industries, the grocery/supermar-ket industry, detergents, and entertainment. Note that in each of these industries theremight be many sellers in the industry (there are thousands of small independent brewer-ies across Europe, for example) but sales are dominated by a relatively small number offirms. In brewing, the industry is dominated by A-BInBev, Heineken, Carlsberg andSABMiller.

A key feature of oligopoly is the tension that exists between the firms of cooperation andself-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 becauseeach oligopolist cares about only its own profit, there are powerful incentives at work thathinder a group of firms from maintaining the monopoly outcome.

A Duopoly Example

To understand the behaviour of oligopolies, let’s consider an oligopoly with only twomembers, called a duopoly. Duopoly is the simplest type of oligopoly. Oligopolies withthree or more members face the same problems as oligopolies with only two members,so we do not lose much by starting with the case of duopoly.

Imagine a town in which only two residents – Ishaq and Coralie – own wells thatproduce water safe for drinking. Each Saturday, Ishaq and Coralie decide how manylitres of water to pump, bring the water to town, and sell it for whatever price the marketwill bear. To keep things simple, suppose that Ishaq and Coralie can pump as muchwater as they want without cost. That is, the marginal cost of water equals zero.

Table 13.3 shows the town’s demand schedule for water. The first column shows thetotal quantity demanded, and the second column shows the price. If the two well ownerssell a total of 10 litres of water, water goes for €110 a litre. If they sell a total of 20 litres,the price falls to €100 a litre. And so on. If you graphed these two columns of numbers,you would get a standard downward sloping demand curve.

The last column in Table 13.3 shows the total revenue from the sale of water. Itequals the quantity sold times the price. Because there is no cost to pumping water, thetotal revenue of the two producers equals their total profit.

Let’s now consider how the organization of the town’s water industry affects the priceof water and the quantity of water sold.

A duopoly sees two dominantfirms competing against eachother – will it always be a fight?

TABLE 13.3

The Demand Schedule for Water

Quantity (in litres) Price € Total revenue (and total profit) €

0 120 0

10 110 1100

20 100 2000

30 90 2700

40 80 3200

50 70 3500

60 60 3600

70 50 3500

80 40 3200

90 30 2700

100 20 2000

110 10 1100

120 0 0

ALAMY


Competition, Monopolies and Cartels

Consider what would happen if the market for water were perfectly competitive. In acompetitive market, the production decisions of each firm drive price equal to marginalcost. In the market for water, marginal cost is zero. Thus, under competition, the equi-librium price of water would be zero, and the equilibrium quantity would be 120 litres.The price of water would reflect the cost of producing it, and the efficient quantity ofwater would be produced and consumed.

Now consider how a monopoly would behave. Table 13.3 shows that total profit ismaximized at a quantity of 60 litres and a price of €60 a litre. A profit-maximizingmonopolist, therefore, would produce this quantity and charge this price. As is standardfor monopolies, price would exceed marginal cost. The result would be inefficient, for thequantity of water produced and consumed would fall short of the socially efficient levelof 120 litres.

What outcome should we expect from our duopolists? One possibility is that Ishaqand Coralie get together and agree on the quantity of water to produce and the priceto charge for it. Such an agreement among firms over production and price is calledcollusion, and the group of firms acting in unison is called a cartel. Once a cartel isformed, the market is in effect served by a monopoly, and we can apply our analysisfrom Chapter 12. That is, if Ishaq and Coralie were to collude, they would agree on themonopoly outcome because that outcome maximizes the total profit that the producerscan get from the market. Our two producers would produce a total of 60 litres, whichwould be sold at a price of €60 a litre. Once again, price exceeds marginal cost, and theoutcome is socially inefficient.

? what if…one of the firms entering into a cartel had much more market powerthan the other firms in the agreement – would this mean the cartel is more likelyto succeed or not?

A cartel must agree not only on the total level of production but also on the amountproduced by each member. In our case, Ishaq and Coralie must agree how to splitbetween themselves the monopoly production of 60 litres. Each member of the cartelwill want a larger share of the market because a larger market share means larger profit.If Ishaq and Coralie agreed to split the market equally, each would produce 30 litres, theprice would be €60 a litre and each would get a profit of €1800.

C A S E S T U D YOPEC and the World Oil Market

Our story about the town’s market for water is fictional, but if we change water tocrude oil, and Ishaq and Coralie to Iran and Iraq, the story is close to being true.Much of the world’s oil is produced by a few countries, mostly in the Middle East.These countries together make up an oligopoly. Their decisions about how muchoil to pump are much the same as Ishaq and Coralie’s decisions about how muchwater to pump.

The countries that produce most of the world’s oil have formed a cartel, called theOrganization of Petroleum Exporting Countries (OPEC). As originally formed in1960, OPEC included Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. By 1973,eight other nations had joined: Qatar, Indonesia, Libya, the United Arab Emirates,Algeria, Nigeria, Ecuador and Gabon. These countries control about three-fourths ofthe world’s oil reserves. Like any cartel, OPEC tries to raise the price of its product

collusion an agreement amongstfirms in a market about quantities toproduce or prices to charge

cartel a group of firms acting in unison


through a coordinated reduction in quantity produced. OPEC tries to set productionlevels for each of the member countries.

The problem that OPEC faces is much the same as the problem that Ishaq andCoralie face in our story. The OPEC countries would like to maintain a high pricefor oil. But each member of the cartel is tempted to increase its production to get alarger share of the total profit. OPEC members frequently agree to reduce produc-tion but then cheat on their agreements.

OPEC was most successful at maintaining cooperation and high prices in theperiod from 1973 to 1985. The price of crude oil rose from $3 a barrel in 1972 to$11 in 1974 and then to $35 in 1981. But in the mid-1980s, member countriesbegan arguing about production levels, and OPEC became ineffective at maintain-ing cooperation. By 1986 the price of crude oil had fallen back to $13 a barrel.

In recent years, the members of OPEC have continued to meet regularly, butthe cartel has been less successful at reaching and enforcing agreements. Althoughthe price of oil rose significantly in 2007 and 2008, the primary cause wasincreased demand in the world oil market, in part from a booming Chinese econ-omy, rather than restricted supply. While this lack of cooperation among OPECnations has reduced the profits of the oil-producing nations below what theymight have been, it has benefited consumers around the world.

The Equilibrium For an Oligopoly

Although oligopolists would like to form cartels and earn monopoly profits, often that isnot possible. Competition laws prohibit explicit agreements among oligopolists as a matterof public policy. In addition, squabbling among cartel members over how to divide theprofit in the market sometimes makes agreement among them impossible. Let’s thereforeconsider what happens if Ishaq and Coralie decide separately how much water to produce.

At first, one might expect Ishaq and Coralie to reach the monopoly outcome on theirown, for this outcome maximizes their joint profit. In the absence of a binding agreement,however, the monopoly outcome is unlikely. To see why, imagine that Ishaq expects Coralieto produce only 30 litres (half of the monopoly quantity). Ishaq might reason as follows:

I could produce 30 litres as well. In this case, a total of 60 litres of water would be soldat a price of €60 a litre. My profit would be €1800 (30 litres × €60 a litre). Alterna-tively, I could produce 40 litres. In this case, a total of 70 litres of water would be soldat a price of €50 a litre. My profit would be €2000 (40 litres × €50 a litre). Even thoughtotal profit in the market would fall, my profit would be higher, because I would have alarger share of the market.

Of course, Coralie might reason the same way. If so, Ishaq and Coralie would each bring40 litres to town. Total sales would be 80 litres, and the price would fall to €40. Thus, if theduopolists individually pursue their own self-interest when deciding how much to produce,they produce a total quantity greater than the monopoly quantity, charge a price lower thanthe monopoly price and earn total profit less than the monopoly profit.

Although the logic of self-interest increases the duopoly’s output above the monopolylevel, it does not push the duopolists to reach the competitive allocation. Consider what hap-pens when each duopolist is producing 40 litres. The price is €40, and each duopolist makesa profit of €1600. In this case, Ishaq’s self-interested logic leads to a different conclusion:

Right now my profit is €1600. Suppose I increase my production to 50 litres. In thiscase, a total of 90 litres of water would be sold, and the price would be €30 a litre.Then my profit would be only €1500. Rather than increasing production and drivingdown the price, I am better off keeping my production at 40 litres.


The outcome in which Ishaq and Coralie each produce 40 litres looks like some sortof equilibrium. In fact, this outcome is called a Nash equilibrium (named after eco-nomic theorist John Nash, whose life was portrayed in the book, A Beautiful Mind, andthe film of the same name). A Nash equilibrium is a situation in which economic actorsinteracting with one another each choose their best strategy given the strategies theothers have chosen. In this case, given that Coralie is producing 40 litres, the best strat-egy for Ishaq is to produce 40 litres. Similarly, given that Ishaq is producing 40 litres, thebest strategy for Coralie is to produce 40 litres. Once they reach this Nash equilibrium,neither Ishaq nor Coralie has an incentive to make a different decision.

This example illustrates the tension between cooperation and self-interest. Oligopolistswould be better off cooperating and reaching the monopoly outcome. Yet because theypursue their own self-interest, they do not end up reaching the monopoly outcome andmaximizing their joint profit. Each oligopolist is tempted to raise production and capture alarger share of the market. As each of them tries to do this, total production rises, and theprice falls.

At the same time, self-interest does not drive the market all the way to the competi-tive outcome. Like monopolists, oligopolists are aware that increases in the amount theyproduce reduce the price of their product. Therefore, they stop short of following thecompetitive firm’s rule of producing up to the point where price equals marginal cost.

In summary, when firms in an oligopoly individually choose production to maximizeprofit, they produce a quantity of output greater than the level produced by monopolyand less than the level produced by competition. The oligopoly price is less than themonopoly price but greater than the competitive price (which equals marginal cost).

JEOPARDY PROBLEMAn oligopolistic market consists of a four-firm concentration ratio of 80 per cent.An economist does some research on this market and finds that prices haveremained stable in the market for the last five years. What might the explanationbe for this behaviour?

Nash equilibrium a situation inwhich economic actors interacting withone another each choose their beststrategy given the strategies that all theother actors have chosen

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How the Size of an Oligopoly Affects the Market Outcome

We can use the insights from this analysis of duopoly to discuss how the size of an oli-gopoly is likely to affect the outcome in a market. Suppose, for instance, that Jean andPatrice suddenly discover water sources on their property and join Ishaq and Coralie inthe water oligopoly. The demand schedule in Table 13.3 remains the same, but nowmore producers are available to satisfy this demand. How would an increase in the num-ber of sellers from two to four affect the price and quantity of water in the town?

If the sellers of water could form a cartel, they would once again try to maximize totalprofit by producing the monopoly quantity and charging the monopoly price. Just aswhen there were only two sellers, the members of the cartel would need to agree on pro-duction levels for each member and find some way to enforce the agreement. As the car-tel grows larger, however, this outcome is less likely. Reaching and enforcing anagreement becomes more difficult as the size of the group increases.

If the oligopolists do not form a cartel – perhaps because competition laws prohibit it –they must each decide on their own how much water to produce. To see how the increasein the number of sellers affects the outcome, consider the decision facing each seller. Atany time, each well owner has the option to raise production by 1 litre. In making thisdecision, the well owner weighs two effects:

• The output effect. Because price is above marginal cost, selling 1 more litre of water atthe going price will raise profit.

• The price effect. Raising production will increase the total amount sold, which willlower the price of water and lower the profit on all the other litres sold.

If the output effect is larger than the price effect, the well owner will increase produc-tion. If the price effect is larger than the output effect, the owner will not raise produc-tion. (In fact, in this case, it is profitable to reduce production.) Each oligopolistcontinues to increase production until these two marginal effects exactly balance, takingthe other firms’ production as given.

Now consider how the number of firms in the industry affects the marginal analysisof each oligopolist. The larger the number of sellers, the less concerned each seller isabout its own impact on the market price. That is, as the oligopoly grows in size, themagnitude of the price effect falls. When the oligopoly grows very large, the price effectdisappears altogether, leaving only the output effect. In this extreme case, each firm inthe 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. Acompetitive firm considers only the output effect when deciding how much to produce:because a competitive firm is a price taker, the price effect is absent. Thus, as the numberof sellers in an oligopoly grows larger, an oligopolistic market looks more and more likea competitive market. The price approaches marginal cost, and the quantity producedapproaches the socially efficient level.

Pitfall Prevention Remember that in an oligopolistic market structure there canbe many hundreds, and in some cases, thousands of firms but the crucial thing toremember is that the market is dominated by a small number of very large firms.

This analysis of oligopoly offers a new perspective on the effects of international trade.Imagine that Toyota and Honda are the only car manufacturers in Japan, Volkswagen andBMW are the only car manufacturers in Germany, and Citroën and Peugeot are the onlycar manufacturers in France. If these nations prohibited international trade in cars, eachwould have a motorcar oligopoly with only two members, and the market outcomewould likely depart substantially from the competitive ideal. With international trade, how-ever, the car market is a world market, and the oligopoly in this example has six members.Allowing free trade increases the number of producers from whom each consumer can


choose, and this increased competition keeps prices closer to marginal cost. Thus, the the-ory of oligopoly provides another reason why all countries can benefit from free trade.

Quick Quiz If the members of an oligopoly could agree on a total quan-

tity to produce, what quantity would they choose? • If the oligopolists do

not act together but instead make production decisions individually, do

they produce a total quantity more or less than in your answer to the pre-

vious question? Why?

GAME THEORY AND THE ECONOMICSOF COMPETITION

As we have seen, oligopolies would like to reach the monopoly outcome, but doing sorequires cooperation, which at times is difficult to maintain. In this section we lookmore closely at the problems people face when cooperation is desirable but difficult. Toanalyze 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, mustconsider how others might respond to that action. Because the number of firms in anoligopolistic market is small, each firm must act strategically. Each firm knows that itsprofit depends not only on how much it produces but also on how much the otherfirms produce. In making its production decision, each firm in an oligopoly should con-sider how its decision might affect the production decisions of all the other firms. Gametheory is quite useful for understanding the behaviour of oligopolies.

A particularly important ‘game’ is called the prisoners’ dilemma. This game providesinsight into the difficulty of maintaining cooperation. Many times in life, people fail tocooperate with one another even when cooperation would make them all better off. Anoligopoly is just one example. The story of the prisoners’ dilemma contains a generallesson that applies to any group trying to maintain cooperation among its members.

The Prisoners’ Dilemma

The prisoners’ dilemma is a story about two criminals who have been captured by thepolice. Let’s call them Mr Green and Mr Blue. The police have enough evidence to con-vict Mr Green and Mr Blue of a relatively minor crime, possessing stolen property, sothat each would spend a year in jail. The police also suspect that the two criminalshave committed an armed jewellery robbery together, but they lack hard evidence toconvict them of this major crime. The police question Mr Green and Mr Blue in separaterooms, and they offer each of them the following deal:

Right now we can lock you up for 1 year. If you confess to the jewellery robbery andimplicate your partner, however, we’ll give you immunity and you can go free. Yourpartner will get 20 years in jail. But if you both confess to the crime, we won’t needyour testimony and we can avoid the cost of a trial, so you will each get an intermedi-ate sentence of 8 years.

If Mr Green and Mr Blue, heartless criminals that they are, care only about theirown sentences, what would you expect them to do? Would they confess or remainsilent? Figure 13.4 shows their choices. Each prisoner has two strategies: confess orremain silent. The sentence each prisoner gets depends on the strategy he choosesand the strategy chosen by his partner in crime.

game theory the study of howpeople behave in strategic situations

prisoners’ dilemma a particular‘game’ between two captured prisonersthat illustrates why cooperation isdifficult to maintain even when it ismutually beneficial


Consider first Mr Green’s decision. He reasons as follows:

I don’t know what Mr Blue is going to do. If he remains silent, my best strategy is toconfess, since then I’ll go free rather than spending a year in jail. If he confesses, mybest strategy is still to confess, since then I’ll spend 8 years in jail rather than 20. So,regardless of what Mr Blue does, I am better off confessing.

In the language of game theory, a strategy is called a dominant strategy if it is thebest strategy for a player to follow regardless of the strategies pursued by other players.In this case, confessing is a dominant strategy for Mr Green. He spends less time in jail ifhe confesses, regardless of whether Mr Blue confesses or remains silent.

Now consider Mr Blue’s decision. He faces exactly the same choices as Mr Green, andhe reasons in much the same way. Regardless of what Mr Green does, Mr Blue canreduce his time in jail by confessing. In other words, confessing is also a dominant strat-egy for Mr Blue.

In the end, both Mr Green and Mr Blue confess, and both spend 8 years in jail. Yet,from their standpoint, this is a terrible outcome. If they had both remained silent, bothof them would have been better off, spending only 1 year in jail on the possessioncharge. By each pursuing his own interests, the two prisoners together reach an outcomethat is worse for each of them.

To see how difficult it is to maintain cooperation, imagine that, before the police cap-tured Mr Green and Mr Blue, the two criminals had made a pact not to confess. Clearly,this agreement would make them both better off if they both live up to it, because theywould each spend only 1 year in jail. But would the two criminals in fact remain silent,simply because they had agreed to? Once they are being questioned separately, the logicof self-interest takes over and leads them to confess. Cooperation between the two pris-oners is difficult to maintain, because cooperation is individually irrational.

Oligopolies as a Prisoner’s Dilemma

What does the prisoners’ dilemma have to do with markets and imperfect competition?It turns out that the game oligopolists play in trying to reach the monopoly outcome issimilar to the game that the two prisoners play in the prisoners’ dilemma.

FIGURE 13.4

The Prisoners’ Dilemma

In this game between two criminals suspected of committing a crime, the sentence that each receives depends both on his decisionwhether to confess or remain silent and on the decision made by the other.

Mr Green gets 8 years

Mr Blue gets 8 years

Confess

Mr Green’s decision

Mr Blue’s

decision

Mr Green gets 20 years

Mr Blue goes free

Remain silent

Confess

Mr Green goes free

Mr Blue gets 20 years

Mr Green gets 1 year

Mr Blue gets 1 year

Remain

silent

dominant strategy a strategy thatis best for a player in a game regardlessof the strategies chosen by the otherplayers


Consider an oligopoly with two firms, BP and Shell. Both firms refine crude oil. Afterprolonged negotiation, the two firms agree to keep refined oil production low in order tokeep the world price of refined oil high. After they agree on production levels, each firmmust decide whether to cooperate and live up to this agreement or to ignore it and pro-duce at a higher level. Figure 13.5 shows how the profits of the two firms depend on thestrategies they choose.

Suppose you are the CEO of BP. You might reason as follows:

I could keep production low as we agreed, or I could raise my production and sell morerefined oil on world markets. If Shell lives up to the agreement and keeps its productionlow, then my firm earns profit of $6 billion with high production and $5 billion withlow production. In this case, BP is better off with high production. If Shell fails to liveup to the agreement and produces at a high level, then my firm earns $4 billion withhigh production and $3 billion with low production. Once again, BP is better off withhigh production. So, regardless of what Shell chooses to do, my firm is better off reneg-ing on our agreement and producing at a high level.

Producing at a high level is a dominant strategy for BP. Of course, Shell reasons inexactly the same way, and so both countries produce at a high level. The result is theinferior outcome (from BP and Shell’s standpoint) with low profits for each firm.

This example illustrates why oligopolies have trouble maintaining monopoly profits.The monopoly outcome is jointly rational for the oligopoly, but each oligopolist has anincentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma toconfess, self-interest makes it difficult for the oligopoly to maintain the cooperative out-come with low production, high prices and monopoly profits.

Other Examples of the Prisoners’ Dilemma

We have seen how the prisoners’ dilemma can be used to understand the problem facingoligopolies. The same logic applies to many other situations as well. Here we considertwo examples in which self-interest prevents cooperation and leads to an inferior out-come for the parties involved.

FIGURE 13.5

An Oligopoly Game

In this game between members of an oligopoly, the profit that each earns depends on both its production decision and the productiondecision of the other oligopolist.

BP gets $4 billion

Shell gets $4 billion

High production

BP’s decision

Shell’s

decision

BP gets $3 billion


Low production

High

production

BP gets $6 billion


BP gets $5 billion


Low

production


Advertising When two firms advertise to attract the same customers, they face aproblem similar to the prisoners’ dilemma. For example, consider the decisions facingtwo cigarette companies, Marlboro and Camel. If neither company advertises, the twocompanies split the market. If both advertise, they again split the market, but profits arelower, since each company must bear the cost of advertising. Yet if one company adver-tises while the other does not, the one that advertises attracts customers from the other.

Figure 13.6 shows how the profits of the two companies depend on their actions. Youcan see that advertising is a dominant strategy for each firm. Thus, both firms choose toadvertise, even though both firms would be better off if neither firm advertised.

A test of this theory of advertising occurred in many countries during the 1970s and1980s, when laws were passed in Europe and North America banning cigarette advertise-ments on television. To the surprise of many observers, cigarette companies did not usetheir political influence to oppose these bans. When the laws went into effect, cigaretteadvertising fell and the profits of cigarette companies rose. The television advertisingbans did for the cigarette companies what they could not do on their own: they solvedthe prisoners’ dilemma by enforcing the cooperative outcome with low advertising andhigh profit.

Common Resources Common resources tend to be subject to overuse becausethey are rival in consumption but not excludable, for example, fish in the sea. One canview this problem as an example of the prisoners’ dilemma.

Imagine that two mining companies – Kazakhmys and Vedanta – own adjacent cop-per mines. The mines have a common pool of copper worth €12 million. Drilling a shaft

P.J

CURRIER/M

EDIA

SELECTIN

TERNATIO

NAL


to mine the copper costs €1 million. If each company drills one shaft, each will get half ofthe copper and earn a €5 million profit (€6 million in revenue minus €1 million in costs).

Because the pool of copper is a common resource, the companies will not use it effi-ciently. Suppose that either company could drill a second shaft. If one company has twoof the three shafts, that company gets two-thirds of the copper, which yields a profit of€6 million. The other company gets one-third of the copper, for a profit of €3 million.Yet if each company drills a second shaft, the two companies again split the copper. Inthis case, each bears the cost of a second shaft, so profit is only €4 million for eachcompany.

Figure 13.7 shows the game. Drilling two wells is a dominant strategy for each com-pany. Once again, the self-interest of the two players leads them to an inferior outcome.

FIGURE 13.6

An Advertising Game

In this game between firms selling similar products, the profit that each earns depends on both its own advertising decision and theadvertising decision of the other firm.

Marlboro gets €3

billion profit

Camel gets €3

billion profit

Advertise

Marlboro’s decision

Camel’s

decision

Marlboro gets €2

billion profit

Camel gets €5

billion profit

Don’t advertise

Advertise

Marlboro gets €5

billion profit

Camel gets €2

billion profit

Marlboro gets €4

billion profit

Camel gets €4

billion profit

Don’t

advertise

FIGURE 13.7

A Common Resources Game

In this game between firms mining copper from a common pool, the profit that each earns depends on both the number of shafts it drillsand the number of shafts drilled by the other firm.

Vedanta gets €4 million profit

Kazakhmys gets €4 million profit

Drill two shafts

Vedanta’s decision

Kazakhmy’s

decision



Drill one shaft

Drill two

shafts





Drill one

shaft


Why Firms Sometimes Cooperate

The prisoners’ dilemma shows that cooperation is difficult. But is it impossible? Not allprisoners, when questioned by the police, decide to turn in their partners in crime. Car-tels sometimes do manage to maintain collusive arrangements, despite the incentive forindividual 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.

To see why cooperation is easier to enforce in repeated games, let’s return to our duo-polists, Ishaq and Coralie. Recall that Ishaq and Coralie would like to maintain themonopoly outcome in which each produces 30 litres, but self-interest drives them to anequilibrium in which each produces 40 litres. Figure 13.8 shows the game they play. Pro-ducing 40 litres is a dominant strategy for each player in this game.

Imagine that Ishaq and Coralie try to form a cartel. To maximize total profit theywould agree to the cooperative outcome in which each produces 30 litres. Yet, if Ishaqand Coralie are to play this game only once, neither has any incentive to live up to thisagreement. Self-interest drives each of them to renege and produce 40 litres.

Now suppose that Ishaq and Coralie know that they will play the same game everyweek. When they make their initial agreement to keep production low, they can alsospecify what happens if one party reneges. They might agree, for instance, that onceone of them reneges and produces 40 litres, both of them will produce 40 litres foreverafter. This penalty is easy to enforce, for if one party is producing at a high level, theother has every reason to do the same.

The threat of this penalty may be all that is needed to maintain cooperation. Eachperson knows that defecting would raise his or her profit from €1800 to €2000. But thisbenefit would last for only one week. Thereafter, profit would fall to €1600 and staythere. As long as the players care enough about future profits, they will choose to forgothe one-time gain from defection. Thus, in a game of repeated prisoners’ dilemma, thetwo players may well be able to reach the cooperative outcome.

Quick Quiz Tell the story of the prisoners’ dilemma. Write down a table

showing the prisoners’ choices and explain what outcome is likely. • What

does the prisoners’ dilemma teach us about oligopolies?

FIGURE 13.8

Ishaq and Coralie’s Oligopoly Game

In this game between Ishaq and Coralie, the profit that each earns from selling water depends on both the quantity he or she chooses tosell and the quantity the other chooses to sell.

Ishaq gets €1600 profit

Coralie gets €1600 profit

Sell 40 litres

Ishaq’s decision

Coralie’s

decision



Sell 30 litres

Sell 40

litres





Sell 30

litres


Models of Oligopoly

Earlier we noted that firms are interdependent. Most firms will have a reasonable idea ofthe size of the market in which they operate and what position they hold in that market.Let us assume a duopoly again to illustrate how firms might behave.

Assume that Firm A has conducted research and that the size of the market it oper-ates in is 1 million units or a value of €1 million a year. We will also assume that themarginal cost is constant. Figure 13.9 illustrates this situation. If Firm A were the onlyproducer in the market it would produce where the MR curve cuts the MC curve andsupply the whole 1 million units at Q1. However, Firm A knows that Firm B also oper-ates in the market and supplies 20 per cent of the market. The demand curve it faces isthus not D1 but D2 which is referred to as a residual demand curve. D2 has an associatedmarginal revenue curve MR2. Firm A’s profit-maximizing output is now Q2 where MR2

cuts the MC curve. Residual demand is defined as the difference between the marketdemand curve and the amount supplied by other firms in the market. The residualdemand curve depends on the output decision of the other firms in the market. Firm Amight expend some time and effort trying to find out or at the very least estimate whatthis output level might be. In other words, Firm A needs to have some idea of the resid-ual demand curve it faces or risk producing an output which would drive down the mar-ket price it faced. If, for example, it produced 1 million units and Firm B produced200 000 units then there would be excess supply and the price it faces would fall. Know-ing what your rival is planning to do is important in adopting the right strategy toensure profit-maximizing output.

If Firm B supplied 40 per cent of the market then Firm A would face a different resid-ual demand curve D3 and would set output at Q3 where MR3 cuts the MC curve. Itwould be possible to conceptualize a situation where Firm A could map all possible out-puts by Firm B and thus how it would react to these output levels.

FIGURE 13.9

Residual Demand

If Firm A supplied the whole market (i.e. it assumes Firm B produces nothing) then the profit-maximizing output would be Q1. If Firm Aassumes Firm B produces 20 per cent of the market (shown by demand curve D2) then its new profit-maximizing output will be Q2 wherethe MR curve associated with the residual demand curve D2. If Firm B was assumed to produce 40 per cent of the market output then FirmA would produce where MR3 associated with residual demand D3 cuts the MC curve at output Q3.

Price

Quantity

MR3 D2 D2 D1MR2 MRQ1Q2Q3

MC

residual demand the differencebetween the market demand curve andthe amount supplied by other firms inthe market


The result of this analysis by Firm A would give it its reaction function. The reactionfunction outlines the profit-maximizing output for a firm given the simultaneous outputdecisions of its rivals. Firm B will also have a reaction function derived from its analysis ofhow it would react to the output decisions of FirmA. The respective reaction functions showhow FirmAwould react if Firm B changed its output decisions and vice versa. This model ofoligopoly was developed by Augustin Cournot in 1838. Cournot assumed that given twofirms in a duopoly, each firm determines its profit-maximizing output on the assumption ofthe output of the other firm and that the decision of the other firm will not change in a giventime period. In a given time period, therefore, Firm A, for example, could alter its outputdecision and its rival would not react. However, Firm B makes its decision under the sameassumptions. This simultaneous decision making whereby each firm is trying to increase itsprofits but assuming its rivals will not react over different time periods eventually leads to anequilibrium position.

We can represent this equilibrium in Figure 13.10. Firm A’s output is on the vertical axisand Firm B’s output on the horizontal axis. If Firm A assumed Firm B would produce zerothen it would supply the whole market and the vertical intercept would be given by pointC1. If Firm B produced all the market output then Firm A would produce nothing indicatedby point C2. All other points in between show combinations of output for Firm A given acorresponding output decision by Firm B. The red line is Firm A’s reaction function.

Equally we can graph Firm B’s reaction function which will be the symmetrical oppo-site of Firm A’s. If Firm A produces all the market output Firm B will produce nothing(point T1) and if Firm A produced nothing Firm B would produce all the market output(point T2). Connecting these points gives Firm B’s reaction function indicated by theblue line.

FIGURE 13.10

Reaction Functions

The reaction functions given by the red and blue lines show combinations of output produced by Firm A and Firm B respectively givensimultaneous decisions on output. If Firm A assumed Firm B will produce all the output in the market it produces zero shown by thehorizontal intercept C1. If Firm B produced nothing, Firm A will act as a monopolist and produce all the output shown by the verticalintercept C2. The points in between show the various combinations of output Firm A would produce given Firm B’s reaction and give FirmA’s reaction function shown by the red line.

Equally, if Firm A produced nothing, Firm B would act as the monopolist and produce all the output shown by the horizontal interceptT1. If Firm A produced all the output Firm B would produce nothing shown by the vertical intercept T2. The points in between give Firm B’sreaction function shown by the blue line. If either firm produced off its reaction function at different time periods there would be anincentive for the other to change its output in subsequent time periods until equilibrium was reached at Q1, Q2. This represents a Nashequilibrium because both firms make optimum decisions based on what its rivals are doing and a change in strategy by either firm wouldresult in a less than optimum outcome.

C1

C2

T1

T2

Nash

equilibrium

Q1

Q2Output

Firm B

Output Firm A

reaction function the profit-maximizing output for a firm given thesimultaneous output decisions of itsrivals


The point where the two reaction functions cross is a Nash equilibrium. At this pointneither firm has any incentive to change its output – both firms maximize profit given itsown decision and the decision of its rival.

An alternative model is the Bertrand model. In this model firms assume that the pricefixed by its rivals is given. If Firm B, for example, sets price, Firm A will select a price andoutput level which maximizes this profit.

Assume that Firm B sets a price which is above MC. Firm A has the incentive to setits price slightly below that of Firm B and capture market share. In such a situation howwould Firm B react? It would react by cutting its price. In turn Firm A would cut itsprice and the process will continue until P = MC and there is no incentive for either tochange. What the Bertrand model predicts, therefore, is that the equilibrium in an oli-gopoly will give an outcome the same as that in perfect competition with P = MC. Insuch a situation each firm will be making its own pricing decision based on its own opti-mal outcome given the optimal behaviour of its rivals. Once again, this is a Nashequilibrium.

In reality, of course, firms do not make simultaneous decisions and game theory tellsus that a firm will look to make decisions based on what it thinks its rivals will do inresponse and that it will learn from repeated instances of this ‘game’. The Stackelbergmodel takes these new assumptions into account. This model looks at what equilibriumoutput would be for the two firms if one firm was the leader taking decisions first butconsidering what the other firm would do in response. If Firm A announces that it isgoing to produce output Q1, it has to think about what Firm B will do in response.Firm A will have to consider a range of outputs and the response of Firm B to determinewhat its optimal output and profit level will be.

The Stackelberg model describes the advantages a firm can gain through movingbefore that of its rivals – so called first mover advantage. If Firm A is the leader andFirm B the follower then there may be an advantage to A in making a move to changeoutput having estimated the response by Firm B. What is crucial in this model is that thedecision made by Firm A is seen as being serious and credible by Firm B.

Assume that Firm A sets its output level at Q1, and thus is the first mover. Firm B,the follower, will observe this and make its output decision based on Firm A’s decision.Firm A knows this and so will have to take into consideration what Firm B’s reaction isgoing to be. It is in Firm A’s interest to set output at a higher level to generate moreprofits but Firm B must also be sure that this is what Firm A is going to do, hence theimportance of Firm A’s announcement being serious and credible. If Firm A announcesthat it intends to build a new plant and production facility to enable it to produce 70 percent of the market output then Firm B must set its output to produce 30 per cent. IfFirm B knows that Firm A is serious (and the investment announcement is an indicatorof this) then if it produced any more that 30 per cent of the market output price wouldbe driven down due to excess supply and it would be worse off as a result.

In addition, moving first in the market could mean that Firm A is able to exploit theprofits that accrue from its investment first and use these profits to reinvest in expandingthe firm further in the future. The risk for Firm A is that in making the move first itmight experience considerable costs in so doing – costs which Firm B will also have topay but possibly at lower levels because it can learn from the mistakes of the first mover.

PUBLIC POLICIES TOWARD OLIGOPOLIES

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 theallocation of resources closer to the social optimum, policy makers try to induce firms inan oligopoly to compete rather than cooperate. Let’s consider how policy makers do thisand then examine the controversies that arise in this area of public policy.


Restraint of Trade and Competition Law

One way that policy discourages cooperation is through the common law. Normally, free-dom of contract is an essential part of a market economy. Businesses and households usecontracts to arrange mutually advantageous trades. In doing this, they rely on the courtsystem to enforce contracts. Yet, for many centuries, courts in Europe and North Americahave deemed agreements among competitors to reduce quantities and raise prices to becontrary to the public interest. They have therefore refused to enforce such agreements.

Given the long experience of many European countries in tackling abuses of marketpower, it is perhaps not surprising that competition law is one of the few areas in whichthe European Union has been able to agree on a common policy. The European Com-mission can refer directly to the Treaty of Rome to prohibit price-fixing and otherrestrictive practices such as production limitation, and is especially likely to do sowhere a restrictive practice affects trade between EU member countries. The EU Compe-tition Commission sets out its role as follows:

The antitrust area covers two prohibition rules set out in the Treaty on the Functioningof the European Union.

• First, agreements between two or more firms which restrict competition are prohib-ited by Article 101 of the Treaty, subject to some limited exceptions. This provisioncovers a wide variety of behaviours. The most obvious example of illegal conductinfringing [the Article] is a cartel between competitors (which may involve price-fixing or market sharing).

• Second, firms in a dominant position may not abuse that position (Article 102 of theTreaty). This is for example the case for predatory pricing aiming at eliminatingcompetitors from the market.

The Commission is empowered by the Treaty to apply these prohibition rules and enjoys anumber of investigative powers to that end (e.g. inspection in business and non-businesspremises, written requests for information, etc). It may also impose fines on undertakingswhich violate EU antitrust rules. Since 1 May 2004, all national competition authoritiesare also empowered to apply fully the provisions of the Treaty in order to ensure thatcompetition is not distorted or restricted. National courts may also apply these prohibi-tions so as to protect the individual rights conferred to citizens by the Treaty.

(Source: http://ec.europa.eu/competition/antitrust/overview_en.html)

Controversies Over Competition Policy

Over time, much controversy has centred on the question of what kinds of behaviour com-petition law should prohibit. Most commentators agree that price-fixing agreementsamong competing firms should be illegal. Yet competition law has been used to condemnsome business practices whose effects are not obvious. Here we consider three examples.

Resale Price Maintenance One example of a controversial business practice isresale price maintenance, also called fair trade. Imagine that Superduper Electronicssells DVD players to retail stores for €300. If Superduper requires the retailers to chargecustomers €350, it is said to engage in resale price maintenance. Any retailer thatcharged less than €350 would have violated its contract with Superduper.

At first, resale price maintenance might seem anti-competitive and, therefore, detri-mental to society. Like an agreement among members of a cartel, it prevents the retailersfrom competing on price. For this reason, the courts have often viewed resale pricemaintenance as a violation of competition law.

Yet some economists defend resale price maintenance on two grounds. First, they denythat it is aimed at reducing competition. To the extent that Superduper Electronics hasany market power, it can exert that power through the wholesale price, rather than


through resale price maintenance. Moreover, Superduper has no incentive to discouragecompetition among its retailers. Indeed, because a cartel of retailers sells less than a groupof competitive retailers, Superduper would be worse off if its retailers were a cartel.

Secondly, economists believe that resale price maintenance has a legitimate goal.Superduper may want its retailers to provide customers with a pleasant showroom anda knowledgeable salesforce. Yet, without resale price maintenance, some customerswould take advantage of one store’s service to learn about the DVD player’s special fea-tures and then buy the item at a discount retailer that does not provide this service. Tosome extent, good service is a public good among the retailers that sell Superduper pro-ducts. As we saw in Chapter 8, when one person provides a public good, others are ableto enjoy it without paying for it. In this case, discount retailers would free ride on theservice provided by other retailers, leading to less service than is desirable. Resale pricemaintenance is one way for Superduper to solve this free-rider problem.

The example of resale price maintenance illustrates an important principle: businesspractices that appear to reduce competition may in fact have legitimate purposes. Thisprinciple makes the application of competition law all the more difficult. The competi-tion authorities in each EU nation under the European Competition Network are incharge of enforcing these laws and must determine what kinds of behaviour public policyshould prohibit as impeding competition and reducing economic well-being. Often thatjob is not easy.

Predatory Pricing Firms with market power normally use that power to raiseprices above the competitive level. But should policy makers ever be concerned thatfirms with market power might charge prices that are too low? This question is at theheart of a second debate over competition policy.

Imagine that a large airline, call it National Airlines, has a monopoly on some route.Then Fly Express enters and takes 20 per cent of the market, leaving National with 80per cent. In response to this competition, National starts slashing its fares. Some anti-trust analysts argue that National’s move could be anti-competitive: the price cuts maybe intended to drive Fly out of the market so National can recapture its monopoly andraise prices again. Such behaviour is called predatory pricing.

Although it is common for companies to complain to the relevant authorities that acompetitor is pursuing predatory pricing, some economists are sceptical of this argumentand believe that predatory pricing is rarely, and perhaps never, a profitable businessstrategy. Why? For a price war to drive out a rival, prices have to be driven below cost.Yet if National starts selling cheap tickets at a loss, it had better be ready to fly moreplanes, because low fares will attract more customers. Fly Express, meanwhile, canrespond to National’s predatory move by cutting back on flights. As a result, Nationalends up bearing more than 80 per cent of the losses, putting Fly Express in a good posi-tion to survive the price war. In such cases, the predator can suffer more than the prey.

Economists continue to debate whether predatory pricing should be a concern forcompetition policy makers. Various questions remain unresolved. Is predatory pricingever a profitable business strategy? If so, when? Are the authorities capable of tellingwhich price cuts are competitive and thus good for consumers and which are predatory?There are no simple answers.

Tying A third example of a controversial business practice is tying. Suppose thatMakemoney Movies produces two new films – Spiderman and Hamlet. If Makemoneyoffers cinemas the two films together at a single price, rather than separately, the studiois said to be tying its two products.

Some economists have argued that the practice of tying should be banned. Their rea-soning is as follows: imagine that Spiderman is a blockbuster, whereas Hamlet is anunprofitable art film. Then the studio could use the high demand for Spiderman toforce cinemas to buy Hamlet. It seemed that the studio could use tying as a mechanismfor expanding its market power.


Other economists are sceptical of this argument. Imagine that cinemas are willing topay €20 000 for Spiderman and nothing for Hamlet. Then the most that a cinema wouldpay for the two films together is €20 000 – the same as it would pay for Spiderman byitself. Forcing the cinema to accept a worthless film as part of the deal does not increasethe cinema’s willingness to pay. Makemoney cannot increase its market power simply bybundling the two films together.

Why, then, does tying exist? One possibility is that it is a form of price discrimina-tion. Suppose there are two cinemas. City Cinema is willing to pay €15 000 for Spider-man and €5000 for Hamlet. Country Cinema is just the opposite: it is willing to pay€5000 for Spiderman and €15 000 for Hamlet. If Makemoney charges separate prices forthe two films, its best strategy is to charge €15 000 for each film, and each cinemachooses to show only one film. Yet if Makemoney offers the two films as a bundle, itcan charge each cinema €20 000 for the films. Thus, if different cinemas value the filmsdifferently, tying may allow the studio to increase profit by charging a combined pricecloser to the buyers’ total willingness to pay.

Tying remains a controversial business practice. We saw in Chapter 12 how Microsofthad been investigated for ‘tying’ its internet browser and other software like its WindowsMedia Player with its Windows operating system and the arguments that the companyhad put forward in its defence. The argument that tying allows a firm to extend its mar-ket power to other goods is not well founded, at least in its simplest form. Yet econo-mists have proposed more elaborate theories for how tying can impede competition.Given our current economic knowledge, it is unclear whether tying has adverse effectsfor society as a whole.

All the analysis is based on an assumption that rivals may have sufficient informationto be able to make a decision and that the decision will be a rational one based on thisinformation. In reality firms do not have perfect information and do not behave ratio-nally. Most firms in oligopolistic markets work very hard to protect sensitive informationand only give out what they have to by law. Some information may be given to deliber-ately obfuscate the situation and hide what their true motives/strategies/tactics are. Econ-omists have tried to include these imperfections into theories. Behavioural economics hasbecome more popular in recent years because it offers some greater insights into theobserved behaviour of the real world which often does not conform to the assumptionsimplied by the assumption of rationality.

Quick Quiz What kind of agreement is illegal for businesses to make?

• Why is competition law controversial?

CONCLUSION

Oligopolies would like to act like monopolies, but self-interest drives them closer to com-petition. Thus, oligopolies can end up looking either more like monopolies or more likecompetitive markets, depending on the number of firms in the oligopoly and how coop-erative the firms are. The story of the prisoners’ dilemma shows why oligopolies can failto maintain cooperation, even when cooperation is in their best interest.

Policy makers regulate the behaviour of oligopolists through competition law. Theproper scope of these laws is the subject of ongoing controversy. Although price fixingamong competing firms clearly reduces economic welfare and should be illegal, somebusiness practices that appear to reduce competition may have legitimate if subtle pur-poses. As a result, policy makers need to be careful when they use the substantial powersof competition law to place limits on firm behaviour.


IN THE NEWS

Anti-Competitive BehaviourOne aspect of anti-trust or anti-competitive behaviour is price-fixing where a group of firms acttogether to set prices at a level which is above the market clearing price. The cement industry ina number of countries has been subject to investigation by competition authorities and in thisarticle, the industry in Egypt has come under scrutiny.

Accusations of Price Fixing in

Egypt’s Cement Sector

The Egyptian Competition Authority(ECA) referred 11 cement companies –

essentially every major producer in thesector – to the public prosecutor lastmonth (October 2007). All the 11 compa-nies were accused of violating antitrustlaws after a 14-month investigation intothe sector. The final report of the inves-tigation alleged widespread anticom-petitive practices, particularly relatedto price fixing efforts in the localmarket.

In statements following the an-nouncement, Minister of Trade and In-dustry Rachid Mohamed Rachid saidthat competing in a free market involvescomplying with laws and regulations,and that such laws exist to ensure thatall competitors play on an even field. Theminister stressed that antitrust investi-gations by the ECA (also known by itsofficial title of the Authority for theProtection of Competition and the Pro-hibition of Monopolistic Practices) will

not be exclusive to the steel and cementsectors.

Samiha Fawzy, an assistant to theminister, said that fines will start atLE 30 000 and could go up to a cripplingLE 10 million, and that Rachid onlydecided to act when it was demon-strated that the companies were mak-ing profits from illegal collusion.

Reactions from cement sector lea-ders were predictably hostile. AbdelMeguid Mahmoud, an exporter andinvestor in the sector, confirmed thatthere was a ‘verbal’ agreementbetween cement companies to raiseprices from US$58 to US$75 per ton,noting that production was set toincrease from the current 35 milliontons to 49 million tons in 2008. Mah-moud justified such an agreementbased on the fact that cement demandis not flexible, and that any shortage insupply will cause direct price hikes.According to Mahmoud, by informallyagreeing to a price target, producerswere attempting to keep demand andprices in check.

Medhat Stefano, commercial headof the Egyptian arm of France-basedglobal cement company Lafarge, toldlocal reporters that the decision willnegatively impact the investment envi-ronment, and that there may have beenpolitical influence on the court’s finaldecision.

In support of the charges, Ahmed El-Zieny, deputy of the construction mate-rial division in the Chamber of Trade,said that several cement companiestried to pressure the minister not to

go ahead with the charges, attributingrecent price rises to increasing trans-portation costs.

Hassan Rateb, head of the BuildingMaterial Exporting Board and headof Sinai Cement Group, said thatfree market mechanisms must berespected and followed, but he criti-cized Rachid for indicting the entiresector, including state-owned compa-nies, saying that the move will give theimpression that the state can’t controlthe actions of its own companies.Rateb defended the sector, claimingthat given export market prices aresignificantly higher than local ones,there is little incentive to game thedomestic market.

Accusations of price fixing in theconstruction materials sector havebeen made in countries throughoutthe world in recent years, after a20-year wave of consolidation left theindustry dominated by a small group oflarge global players. In 2003, the Ger-man Federal Cartel Office (a nationalcompetition watchdog) levied almostUS$650 million in antitrust fines againstthe country’s leading cement produ-cers. Bertrand Collomb, then CEO ofLafarge, later acknowledged that hiscompany had engaged in ‘unaccept-able practices’ in the German market.

Antitrust investigations into thecement sector, most ending in chargesbeing made, have recently taken placein France, Poland, Argentina, Hungary,Ukraine, Romania and Taiwan.

Richard Whish, an expert on cartelsand Professor of Law at Kings College,

Allegations of price fixing in the

cement industry have been made

across the world – not just in Egypt.

TAW

FIK

DAJANI/SHUTTERSTOCK


SUMMARY• A monopolistically competitive market is characterized by

three attributes: many firms, differentiated products andfree entry.

• The equilibrium in a monopolistically competitive market dif-fers from that in a perfectly competitive market in two relatedways. First, each firm in a monopolistically competitive mar-ket has excess capacity. That is, it operates on the down-ward sloping portion of the average total cost curve.Secondly, each firm charges a price above marginal cost.

• Monopolistic competition does not have all the desirableproperties of perfect competition. There is the standarddeadweight loss of monopoly caused by the mark-up ofprice over marginal cost. In addition, the number of firms(and thus the variety of products) can be too large or toosmall. In practice, the ability of policy makers to correctthese inefficiencies is limited.

• Oligopolists maximize their total profits by forming a carteland acting like a monopolist. Yet, if oligopolists make deci-sions about production levels individually, the result is agreater quantity and a lower price than under the monopolyoutcome. The larger the number of firms in the oligopoly, thecloser the quantity and price will be to the levels that wouldprevail under competition.

• The prisoners’ dilemma shows that self-interest can preventpeople from maintaining cooperation, even when coopera-tion is in their mutual interest.

• Policy makers use competition law to prevent oligopoliesfrom engaging in behaviour that reduces competition. Theapplication of these laws can be controversial, becausesome behaviour that may seem to reduce competition mayin fact have legitimate business purposes.

KEY CONCEPTS

monopolistic competition, p. 302oligopoly, p. 308collusion, p. 310cartel, p. 310

nash equilibrium, p. 312game theory, p. 314prisoners’ dilemma, p. 314dominant strategy, p. 315

residual demand, p. 320reaction function, p. 321

QUEST IONS FOR REVIEW1. Describe the three attributes of monopolistic competition.

How is monopolistic competition like monopoly? How is itlike perfect competition?

2. Draw a diagram depicting a firm in a monopolistically com-petitive market that is making profits in the short run.a. Now show what happens to this firm as new firms enter

the industry.b. Now draw the diagram of the long-run equilibrium in a

monopolistically competitive market. How is price related

to average total cost? How is price related to marginalcost?

3. Does a monopolistic competitor produce too much or toolittle output compared to the most efficient level? Whatpractical considerations make it difficult for policy makers tosolve this problem?

4. If a group of sellers could form a cartel, what quantity andprice would they try to set?

London, told a group of UK competitionauthority officials in 2001 that ‘everysystem of competition law will dealwith cartels and the first thing for anyregulator to do is to go out and find thecement cartel. The only countries inwhich I have been unable to find thecement cartel is where there is anational state-owned monopoly,’ hesaid.

Questions1. Explain why price-fixing is seen as

being ‘anti-competitive’.2. Outline the argument put forward by

cement sector leaders to counterthe accusations by the authorities.Do you agree with their argument?

3. Why might there be little incentiveto ‘game the domestic market’because of high export prices?

4. Does the article suggest that theauthorities in countries around theworld have been successful in pre-venting anti-competitive practicesin the cement industry? Explain youranswer.

5. Why is it difficult to prove that car-tels actually exist in practice?

Source: http://www.bi-me.com/main.php?id=15015&t=1 November 2007, accessed11 March 2011.


5. How does the number of firms in an oligopoly affect theoutcome in its market?

6. What is the prisoners’ dilemma, and what does it have to dowith oligopoly?

7. Give two examples other than oligopoly to show how theprisoners’ dilemma helps to explain behaviour.

8. What kinds of behaviour do the competition laws prohibit?

9. What is resale price maintenance, and why is itcontroversial?

10. Why might predatory pricing not be a useful tactic for anoligopolistic firm to pursue?

PROBLEMS AND APPL ICAT IONS1. Classify the following markets as perfectly competitive,

monopolistic or monopolistically competitive, and explainyour answers.a. wooden HB pencilsb. bottled waterc. copperd. local telephone servicee. strawberry jamf. lipstick

2. Sparkle is one firm of many in the market for toothpaste,which is in long-run equilibrium.a. Draw a diagram showing Sparkle’s demand curve, mar-

ginal revenue curve, average total cost curve, and mar-ginal cost curve. Label Sparkle’s profit-maximizing outputand price.

b. What is Sparkle’s profit? Explain.c. On your diagram, show the consumer surplus derived

from the purchase of Sparkle toothpaste. Also show thedeadweight loss relative to the efficient level of output.

d. If the government forced Sparkle to produce the efficientlevel of output, what would happen to the firm? Whatwould happen to Sparkle’s customers?

3. If you were thinking of entering the ice cream business,would you try to make ice cream that is just like one of theexisting (successful) brands? Explain your decision usingthe ideas of this chapter.

4. The Economist (15 November 2001) reported that ‘OPEC hasfailed to agree immediate production cuts to shore up oilprices. Afraid of losing market share, it wants nonmembers,who would also benefit from any price support, to cut outputas well. So far, they have refused to agree. If oil prices con-tinue to fall, that would provide relief to the beleaguered worldeconomy, but it might wreak havoc on the finances of OPECmembers.’a. Why do you suppose OPEC was unable to agree on

cutting production?b. Why do you think oil-producing non-members refused to

cut output?

5. A large share of the world supply of diamonds comes fromRussia and South Africa. Suppose that the marginal cost ofmining diamonds is constant at €1000 per diamond, and thedemand for diamonds is described by the followingschedule:

Price (€)Quantity

8000 5000

7000 6000

6000 7000

5000 8000

4000 9000

3000 10 000

2000 11 000

1000 12 000

a. If there were many suppliers of diamonds, what wouldbe the price and quantity?

b. If there was only one supplier of diamonds, what wouldbe the price and quantity?

c. If Russia and South Africa formed a cartel, what wouldbe the price and quantity? If the countries split the mar-ket evenly, what would be South Africa’s production andprofit? What would happen to South Africa’s profit if itincreased its production by 1000 while Russia stuck tothe cartel agreement?

d. Use your answer to part (c) to explain why cartelagreements are often not successful.

6. This chapter discusses companies that are oligopolists inthe market for the goods they sell. Many of the same ideasapply to companies that are oligopolists in the market forthe inputs they buy. If sellers who are oligopolists try toincrease the price of goods they sell, what is the goal ofbuyers who are oligopolists?

7. The chapter states that the ban on cigarette advertising ontelevision which many countries imposed in the 1970sincreased the profits of cigarette companies. Could the banstill be good public policy? Explain your answer.

8. Assume that two airline companies decide to engage incollusive behaviour.Let’s analyze the game between two such companies.Suppose that each company can charge either a high pricefor tickets or a low price. If one company charges €100, itearns low profits if the other company charges €100 also,and high profits if the other company charges €200. On theother hand, if the company charges €200, it earns very lowprofits if the other company charges €100, and mediumprofits if the other company charges €200 also.a. Draw the decision box for this game.b. What is the Nash equilibrium in this game? Explain.


c. Is there an outcome that would be better than the Nashequilibrium for both airlines? How could it be achieved?Who would lose if it were achieved?

9. Farmer Jones and Farmer MacDonald graze their cattle onthe same field. If there are 20 cows grazing in the field, eachcow produces €4000 of milk over its lifetime. If there aremore cows in the field, then each cow can eat less grass,and its milk production falls. With 30 cows on the field, eachproduces €3000 of milk; with 40 cows, each produces €2000of milk. Cows are priced at €1000 apiece.a. Assume that Farmer Jones and Farmer MacDonald can

each purchase either 10 or 20 cows, but that neitherknows how many the other is buying when he makeshis purchase. Calculate the pay-offs of each outcome.

b. What is the likely outcome of this game? What would bethe best outcome? Explain.

c. There used to be more common fields than there aretoday. Why?

10. Little Kona is a small coffee company that is consideringentering a market dominated by Big Brew. Each company’sprofit depends on whether Little Kona enters and whetherBig Brew sets a high price or a low price:Big Brew threatens Little Kona by saying, ‘If you enter,we’re going to set a low price, so you had better stay out’.Do you think Little Kona should believe the threat? Why orwhy not? What do you think Little Kona should do?

Brew makes €3 million

Kona makes €2 million

High price

Big brew

Little

kona


Kona loses €1 million

Low price

Enter


Kona makes zero


Kona makes zero

Don’t

enter


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