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ch 15 oligopoly.docx

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University of Waterloo
ECON 102
Eva Lau

15 – oligopoly Chapter 15: Oligopoly What is Oligopoly?  oligopoly: a market structure in which  natural/legal barriers prevent the entry of new firms  a small number of firms compete Barriersto Entry  if the minimum ATC is $10, and the quantity is 30... compare the quantity demanded for this price, say 60;  then (60/30 = 2) 2 firms can satisfy the market demand  this natural oligopoly has 2 firms, aka natural duopoly  duopoly: an oligopoly market with two firms Small Number of Firms  because of barriers, oligopoly consists of a small number of firms and each has a large market share  these firms are interdependent, and face a temptation to cooperate to increase their joint economic profit  interdependence: each firm’s actions influence the profits of all the other firms  there may be too much competition and smaller/weaker firms may go out of business  the firms can increase their profits by working together, acting like a monopoly  cartel: a small group of firms acting together to limit output, raise prices, and increase economic profit  cartels tend to break down because not all firms want to work together (selfish ones) TwoTraditional OligopolyModels The Kinked Demand Curve Model  based on the assumption that each firm believes that if it raises its price, others will not follow, but if it cuts its price, other firms will cut theirs  the demand curve has a kink (corner) at the current price and quantity  @ prices above the kink, a small price increase brings a big decrease in quantity  if a firm raises its prices, other firms will not change their prices  the firm which raised its price will lose market share  @ prices below the kink, a large price cut will only bring a small increase in quantity sold  if one firm cuts its price, other firms will match the price cut  the firm that cuts its price will get no price advantage over its competitors  the kink causes a break in the MR curve  to maximize profits, a firm produces the quantity where MC= MR  the quantity is where the marginal cost curve passes through the gap in MR  if marginal cost increases by enough to cause the firm to increase its price and if all firms experience the same increase in marginal cost, they all increase their prices together  firms usually believe that other firms will not follow them in a price increase  a firm that basis its action on beliefs that are wrong does not maximize profit and might even end up incurring an economic loss Dominant Firm Oligopoly  one firm has a big cost advantage over the other firms  the dominant firm sets the market price and the other firms are price takers  if the dominant firm sets a price that is lower than the equilibrium of the other smaller firms, the quantity demanded is higher than the quantity supplied (shortage)  to maximize profit, the dominant firm operates like a monopoly and sells extra to eliminate the shortage page 1 of 6 15 – oligopoly  the small firms behave like firms in a perfect competition page 2 of 6 15 – oligopoly Oligopoly Games The Prisoners’ Dilemma  rules: each player is placed in a separate room and cannot communicate with the other player and told that he is suspected of having carried out the bank robbery  if both confess, each will receive a sentence of 3 years  if one confesses and the other does not, he will receive a sentence of 1 year and the other 10 years  strategies: the possible actions of each player  confess to the bank robbery  deny having committed the bank robbery  possible outcomes:  both confess  both deny  one confesses and the other does not  payoffs  payoff matrix: a table that shows the payoffs for every possible action by each player for every possible action by the other player Player 2 Confess Deny Confess 3 10 Player 1 3 1 Deny 1 2 10 2  outcome: choices made my players determine the outcome  Nash equilibrium: the first player takes the best possible action given the action of player 2, and same with player 2  in the above example, player 2 would confess (because if player 1 confesses, it is better to confess, and if player 1 denies, it is better for player 2 to confess); same with player 1  therefore the Nash equilibrium is for both to confess and go to jail for 3 years  dilemma: both players have the dilemma to deny and possibly get only 2 or 10 years depending on the other player  bad outcome: the Nash equilibrium is not the best outcome... is there a way to achieve a better outcome?  Each player can put himself in the other player’s place and figure out that there is a best strategy for each  firms in an oligopoly are in a similar situation An Oligopoly Price-Fixing Game  cost and demand conditions: if 2 firms have identical costs and produce the exact same product, and the market price for each product is the same, then this is a natural duopoly  two firms can produce a good at a lower cost than either one firm  collusion agreement: an agreement between 2 or more producers to form a cartel to restrict output, increase prices and profits (cartels are illegal in Canada)  firms in a cartel can either comply or cheat  both cheat  both comply  one cheats, and the other complies  if both firms comply to make the max profit for the cartel, then they act like a monopoly  the calculations are exactly the same as a monopoly except that each firm has to agree on how much each will produce  to maximize industry profits, the firms in the duopoly agree to restrict output to the rate that makes the industry MR = MC, and the market price depends on the demand curve page 3 of 6 15 – oligopoly  the 2 firms then decide on how to split the output (half-half usually if the firms are identical)  and look at the cost curves to determine profit of each firm  each fi
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