ECMA04 – Week 10
Oligopoly is a market in which there are only a few sellers.
So few that they feel the effects of each other’s decisions. (cigarette companies, the banks, oil producers, steel producers, car
companies, insurance companies, cereal producers, electronics, etc)
When top four firms control large % of sales
Four-firm concentration ratio = share of sales in hands of top four firms in industry.
Four firm concentration ratio is over 50% for tobacco products, petroleum and coal products, transportation equipment, primary
metals, beverages, metal mining
x broadly defined industries
Suppose we have two firms competing in a given market, producing identical output (homogeneous, standardized product - just like
perfect competition). The decision each firm has to make is:
“How much output should I try to sell, given what I think the other producer might try to sell?”
Firm #1 decides on q1
Firm #2 decides on q2
Each firm has MC = AC = $2, no matter how much they produce (that is, TC1 = 2q1 andTC2 = 2q2)
The key to this problem is that each firm chooses its own output, but price depends on BOTH firms’ decisions
TC1 = 2q1 and TC2 = 2q2 and P = 14 - QT and QT = q1 + q2
For example, if firm #1 chooses q1 = 2
then if q2 = 2, P = 10
if q2 = 3, P = 9
if q2 = 4, P = 8
On the other hand, if firm #1 chooses q1 = 3
then if q2 = 2, P = 9
if q2 = 3, P = 8
if q2 = 4, P = 7
So, to repeat, the outcome (your profits, if you are one of the firms) depends not only on your decision but also on the other firm’s
How to model this kind of decision?
Economists use a concept known as “Prisoners’ Dilemma”
Story: A robbery is committed, and police catch two ex-cons whom they strongly suspect of the crime. There is some evidence, but
not enough to convict them of the robbery itself. Without more evidence, the best the prosecutor can do is convicting them of minor
things that will earn TWO YEARS in jail.
So police separate the two suspects and offer each of them the following offer: “If you will confess, and if your partner denies the
crime, we will let you off with 6 months in jail, and your partner will get 10 years in jail. If you both confess, you will both get 5
So, each prisoner has a problem (“a dilemma”).
You don’t know what your partner will do, but whatever he does, you are better off confessing:
x If your partner denies the crime, you can get off with 6 months (instead of 2 years) by confessing
x If your partner confesses, you are going to jail, but you end up with 5 years (instead of 10 years) by confessing
So you confess, as does your partner (he faces the same dilemma), and you end up with 5 years each (instead of 2 years if you both
deny the crime)
Economists think of the Prisoners’ Dilemma as a classic “Game Theory” situation – your payoff in the game depends on both your
decision and the other person’s decision. We treat this as a “game” and look at outcomes based on decisions.
Collective well-being vs. individual well-being
So let’s construct a “payoff matrix” representing outcomes based on decisions: