Oligopoly and Monopolistic Competition

Question 1

What is an oligopoly?

Answer 1

An industry in which only a small number of firms operate - 2, 3 or a handful. The word itself is Greek for ‘few sellers’.

examples: soft drinks industry (coke and pepsi vastly outsell other fizzy drinks), oil production (only 3 or 4 countries produce the majority of the world’s oil), video games industry (dominated by xbox and play station)

Question 2

What is Monopolistic competition?

Answer 2

This is the second type of intermediate industry - a sort of hybrid between perfect competition and monopoly.

The key thing that sets firms in this industry apart from firms in perfect competiton is prodcut differentiation: the fact that each firm produces a slightly different product than the others.

ex - the television industry.

Question 3

To explain how oligopoly firms interact strategically, describe what would happen if pepsi were to suddenly double its output.

Answer 3

If pepsi produces twice as much of its product and floods the market, the price of pepsi drops dramatically. but because most people aren’t 100% loyal to one brand or the other, if the price of pepsi drops dramatically, a lot of regualr Coke drinkers are going to switch brands and drink pepsi. In turn, the p of Coke drops too.

Question 4

Give an example of the situation Economists refer to as, strategic situations.

Answer 4

i.e. Pepsi and Coke are involved in a situation where each of their supply decisions affects not only their own sales, but alos those of their competitor.

This is known as a strategic situation because the firms involved have to decide what type of strategy to pursue.

Question 5

In our example, why might Pepsi and Coke have to decide whether to collude or compete with one another?

Answer 5

if they collude, they jointly cut back on production in order to drive up prices and increase their profits.

If they compete, they both try to increase production in order to undercut each other on price and capture as many customers as possible.

Question 6

How do the outcomes of competition and collusion differ for both producers and consumers?

Answer 6

For producers, collusion is always better than competition because it leads to profits that last as long as the firms keep colluding.

For consumers, collusion is worse than competition because it leads to higher prices and lower output.

Question 7

Does collusion occur much in the real world?

Answer 7

Actually, collusion doesn’t happen in a lot of industries where you’d expect it. Ex - coke and pepsi are fierce competitors that spend millions a year on advertising to steal each other’s customers.

Also, most territories only have a few competing mobile phone companies. But instead of colluding, they compete so ruthlessly that many of them are constantly flirting with bankrupcy.

other industries with few competitors that are fiercely competitive include low-cost airlines, where market shake outs have been common.

Question 8

What is a cartel?

Answer 8

A group of firms that colludes and acts as a single co-ordinated whole. Because a cartel acts essentially as one gigantic firm, it effectively turns a bunch of individual firms into a single big monopoly.

Question 9

What output level does a profit-maximising cartel choose to produce?

Answer 9

A profit-maximising cartel chooses to produce the MONOPOLY’S profit maximising output level of q^m units (previous chapter)

Question 10

To get the individual firms to co-operate and produce exactly q^m units of combined output, you have to get them to agree about two related things:

Answer 10

How to share the profits: obviously, every firm wants as large a share as possible.

How to set output quotas: the firms must agree, and abide by, how much of the total output q^m each firm produces. Each firm is constantly tempted to produce more than its quota because doing so would bring higher revenues.

Question 11

What is OPEC?

Answer 11

Organisation of the petroleum Exporting countries.

Including Saudi Arabia, Iraq, venezuela, Nigeria, Kuwait, Indonesia and several others.

Together, they control the vast majority of the worl’s oil reserves. They sell the right to extract oil to the major oil companies who in turn sell it to the consumer.

The importance of reserves means that they make up an oligopoly industry with only a few participants. Because there’s only a few key players, they have the oppurtunity to form a cartel and try to produce the monopoly output and make monopoly profits.

Question 12

Do the OPEC countries succeed in forming a successful cartel?

Answer 12

On the whole, no.

We say ‘on the whole’ because although they do negotiate agreements about oil production, these agreements are constantly broken.

Question 13

Give an example of how OPEC fails to form a successful cartel.

Answer 13

Suppose that the monopoly output level that maximises OPEC’s collective profit is 20 million barrels per day, and at that output level the price of oil is $60 per barrel.

To achieve that combined output, OPEC has to agree on each country’s production quota. For ex. Saudi Arabia may get to produce 4 million barrels per day while Venezuela may have a quota of only 2 million, leaving the other 14 million to be split up among the other members.

Question 14

Why is it difficult for OPEC to enforce these quotas?

Answer 14

because no way exists to stop Venezuela from pumping more than its 2 million barrels per day and selling the excess onto the world oil markets. Nearly all the OPEC countries cheat and overproduce.

Question 15

Why do nearly all OPEC countries cheat and overproduce?

Answer 15

Because the high price of oil is just too tempting. Ex - if all the countries obey the agreement and drive up the price of oil, venezuela finds it very tempting to produce more than its quota because each additional barrel it produces brings in lots of money.

Question 16

Explain the significance of the Saudi’s postion within the OPEC cartel.

Answer 16

Any occassional success of OPEC has largely been a result of the Saudi’s dominant position within the cartel - that is, when other members cheat on the arrangement, Saudi Arabia has been able to use its greater capacity to threaten to dump its output on the market, forcing the cheats back to the negotiating table.

Question 17

How are the behaviour of cartels and their incentive to cheat better understood?

Answer 17

Through a very famous game theory model known as the prisonner’s dilemma.

Question 18

What is game theory?

Answer 18

it is a branch of mathematics that studies how people behave in strategic situations - situations in which their actions or anticipated actions are taken account of by other people who then modify their own actions accordingly.

Question 19

Why is chess a strategic situation?

Answer 19

Because what you do on your move changes what your opponent does in subsequent moves.

Even more important, what you think your opponent is going to do in response to each of the moves that you may make right now helps you to choose the best thing to do.

Now think of cartels and how firms must take into account what it thinks all other firms are going to do before deciding what it needs to do.

Question 20

What is the Prisonner’s Dilemma?

Answer 20

The best way to understand each firm’s temptations within a cartel is to first study the Prisonner’s Dilemma - a game in which 2 criminal partners have to individually decide whether or not to cheat on an agreement they had previously made with each other or whether to remain silent and not talk to the police about their illicit activities.

Question 21

Give an example of the prisonner’s dilemma.

Answer 21

2 criminals - Reggie and ronnie have just robbed a bank.

The Police know this but they have no hard evidence against them.

Instead, the only way of getting a conviction is to get one or both of the robbers to confess to the crime and give evidence against the other.

Fortunately, the police have some leverage because they managed to catch reggie and ronnie commiting other unrelated, minor crimes.

These other crimes carry with them a 1 year jail sentence.

The Police are hoping to use the threat of a year in jail to get one or both robbers to implicate his partner in exchange for immunity from prosecution.

reggie and ronnie had previouly made a pact not to rat on each other, but the police are willing to find out what happens when push comes to shove.

Question 22

What stops reggie and ronnie from communicating?

Answer 22

Following standard procedures, the police seperate the pair, questioning them in seperate interrogation rooms, which prevents reggie and ronnie from communicating with one another, reduces their ability to renew their commitments and stops them from getting any idea about their partner in crime’s next move.

The Police offer each of them the chance to give evidence against the other in exchange for immunity.

Question 23

What problem does this standard procedure create for reggie and ronnie?

Answer 23

The problem for each man is that what happens to him depends not only on what he does, but also on what his partner does.

Each man can trade a confession for immunity, but he gets the deal only if his partner doesn’t confess at the same time in the other interrogation room.

Question 24

1) What are the 4 possible outcomes for Reggie and Ronnie?

Answer 24

If the men both keep their pact not to squeal and neither confesses to robbing banks, each man only gets a one year jail sentence for the minor offence.

Question 25

2)What are the 4 possible outcomes for Reggie and Ronnie?

Answer 25

if Reggis confesses and agrees to give evidence against Ronnie while ronnie remains silent, Reggie goes free because he co-operated with the police, but ronnie gets 10 years for bank robbery.

Question 26

3)What are the 4 possible outcomes for Reggie and Ronnie?

Answer 26

If Ronnie confesses and gives evidence while Reggie remains silent, Ronnie goes free and reggie goes to jail for ten years.

Question 27

4)What are the 4 possible outcomes for Reggie and Ronnie?

Answer 27

if both men admit to the crime, they each get 5 years in jail. Why 5? If both confess, the police don’t need to make such a generous deal; they don’t need to give either man immunity in order to get evidence against the other.

On the other hand, the police want to give each criminal an incentive to confess, so they send each man to jail for only 5 years rather than the 10 years he’d get if he remaied silent while his partner gave evidence.

Question 28

What does the pay-off matrix of jail times facing ronnie and reggie look like?

Answer 28

Question 29

What is the dominant strategy for each prisoner?

Answer 29

The prisoner’s dilemma is famous because the way the police have set up the potential pay-offs means that each criminal has an incentive to confess, no matter what the other criminal does.

Question 30

using Ronnie as an example, why is confessing always his dominant strategy?

Answer 30

Because if ronnie confesses when reggie confesses, ronnie gets 5 years rather than 10. And if ronnie confesses when reggie stays silent, he gets 0 years rather than 1. So ronnie should always confess no matter what reggie is saying or not saying next door.

And vice versa.

Question 31

Why is the dominant strategy actually a pretty lousy outcome for both players?

Answer 31

Because the logic of the dominant strategy (confession) is so strong that they each break their agreement (not to squeal on one another) and end up going to jail for 5 years rather than 1.

Question 32

How has organised crime found a solution to the prisonner’s dilemma?

Answer 32

The system is called Omerta: which is Sicilian for silence.

the mafia changes the pay-offs to the PD so that the dominant strategy switches from confessing to remaining silent.

The mob does this by explaining to their criminal members that if anybody squeals they will die.

Question 33

Using the matrix, show how the dominant strategy in the PD changes when death becomes the pay-off to confessing.

Answer 33

Paradoxically, the death threat benefits the 2 criminals. Even though the threat is scary for both, it actually serves their individual interests because it means that they go to jail for only one year rather than 5.

Question 34

Give an example of a PD applied to a cartel.

Answer 34

Imagine a duopoly - an industry where only 2 firms compete (Jazzy Drops vs Fruity rock).

Each firms profit depends not only on its own pricing decision but also on that of the other firm.

Question 35

what is the dominant strategy chosen by Fruity rock and Jazzy drops?

Answer 35

Charging £2 per bag is the dominant strategy of both firms - and in doing so they both lose out on their chance to join forces, reduce output, drive up prices and earn monopoly profits.

Question 36

How much per day would each firm earn if they figured out a way to commit to selling at £3 per bag?

Answer 36

Both would earn £1000 per day in profits. But without a way to commit, they’re each going to follow their dominant strategy, charge £2 per bag and end up only earning £800 per day in profits. By failing to work together, they each lose £200 per day in profits

Question 37

Who benefits from jazzy drops and fruity rocks dominant strategy of charging £2 per bag?

Answer 37

The dominant strategy of charging the lower price works toward the benefit of consumers and society at large. This fact is why society often doesn’t have to bother regulating oligopoly industries. Thanks to the PD, cartels very often fail to raise prices.

Question 38

Why does the OPEC cartel not work very well?

Answer 38

Because each country faces the same temptation to overproduce its quota, the OPEC cartel doesn’t typically work very well. Overproducing is a dominant strategy and is simply too tempting to resist given the pay-offs.

Question 39

what is the Omerta equivalent of OPEC?

Answer 39

Economic threats - in the form of super-low oil prices.

Saudi Arabia is in one of the best positions to make such a threat for 2 reasons:

1) it’s the second largest oil producer in the world (marginally behin Russia)
2) it’s the lowest cost producer of oil in the world (roughly 8$ per barrel) and so it can produce profitably even if the price of oil falls to a very low price per barrel.

Question 40

Why does the Saudi Arabian threat not work that well in real life?

Answer 40

Because the Saudi’s have a limited pumping capacity. Although S.A. may be able to produce an extra 10 or 20% more oil per day than it normally does, that much of an increase wouldn’t be enough to drive the price of oil down (to say £3 per barrel = very cheap) and bankrupt other OPEC nations.

Question 41

Is the S.A threat strong enough to switch the dominant strategy of OPEC nations?

Answer 41

No. The S.A. threat isn’t nearly strong enough to switch the dominant strategy from cheating on the quota to obeying the quota. And because OPEC has never figured out a way to threaten quota violators effectively, the cartel doesn’t work very well.

Question 42

Does product differentiation eliminate price competition?

Answer 42

No. Product differentiation lessens, but doesn’t eliminate, price competition.

i.e. all the restaurants in your neighborhood have to worry abouot what the other restaurants are charging, even if others specialise in completely different cuisines.

Although you may be willing to pay 20% more for something exotic, you are unlikely to pay 90% more.

Question 43

Why do monopolistically competitive firms face profit limitations?

Answer 43

Because of product differentiation, this firm faces a downward sloping d curve. Why? Because, like a monopoly, it has control over its price. Product differentioation means it can choose whether to set a higher or lower price.

At a higher price, the q demanded of its product falls because some customers don’t think the firms products are worth the extra money.

At a lower price, the q demanded increases because the lower price steals customers away from the firm’s competitors.

Question 44

What is the difference between the d curve facing an individual competitive firm and a monopolistically competitive firm?

Answer 44

Individually competitive firm = D curve is horizontal line which equals market price.

Monopolistically competitive firm = D curve is downward sloping.

Remember: because individual competitive firms sell identical products, the only thing that matters to consumers when choosing among them is who offers the lowest price.

Question 45

What is an important consequence of a downward sloping d curve?

Answer 45

That the MR curve is also downward sloping = the MR that the firm gets from selling an additional unit of output is less than the MR it gets from selling the previous unit.

This is because, the only way to get consumers to buy more of your product is to entice them with a lower price, the MR you get has to fall with every additional unit you sell.

Question 46

What happens when profits attract new entrants to the monopolistically competitive industry?

Answer 46

A monopolistically competitive firm makes zero profits after entry (or exit) shifts the demand curve left to D₂ until it is tangent with the ATC curve at point B. This also shifts the MR curve to the left to MR₂. And so, where MR = MC, the firm now produces at q₂.

Question 47

Given the new demand curve D₂ and output level q₂, how much profit is the monopolistically competitive firm earning?

Answer 47

At this output level, profits are zero. Use the graph and see how the ATC per unit of produicing output level q₂ is equal to the price per unit that the firm can get selling those units.

Question 48

What happens if firms in a monopolistically competitive industry are making losses?

Answer 48

Some firms exit the industry.

As each of them exits, the remaining firms gain more business, and the d curves for firms still in the industry shift up and to the right.

Exit continues until an equilibrium is reached where all firms are making zero profits.

Question 49

Do Monopolistically competitive firms produce efficiently?

Answer 49

No. to see this fact compare the Monopolistically competitive firm’s output level q₂* with the output level produced by a firm witht the same cost curves in a fully competitive industry in which all frims sell an identical product. This output level = q^comp

Question 50

What is one consequence of monopolistically competitive firms producing inefficiently?

Answer 50

Some people look at this result and conculde that society may be better off transforming monopolistically competitive industries into competitive industries. But the cost savings may not be worth the loss of product differentiation.

After all, variety is the spice of life.