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Lecture

# ECO101H1 Lecture Notes - Monopoly Price, Blackberry Limited, Demand Curve

Department
Economics
Course Code
ECO101H1
Professor
James Pesando

Page:
of 4
Topic 10 Oligopoly
(Week ten Nov 16th - Nov 24th)
Outline:
1. Oligopoly Key Features
2. Monopoly profits for Oligopolists: Cartel
3. Firm cheats; Carte Breaks down;
4. Prisoners Dilemma Pay-off Matrix
5. Application Ban on TV Advertising
Opening Example: Research In Motion
RIM plans to introduce a new kind of tablet called PlayBook.
Questions: -- What price should it set?
-- What features should it have (i.e. size, color);
-- What date to introduce?
These answers depend upon what RIM believes Apple Inc. will do with its iPad, in response.
RIM is an oligopolist. Its strategic decisions reflect anticipated response of its rivals.
Oligopoly Key Features:
a) No single theory about Oligopoly;
b) Economic profits can range from nil to monopoly level;
c) Mutual Interdependence among firms is central to analysis:
-- Oligopolistic firms within an industry are aware that the behavior of one firm will influence others.
Examples Monopoly VS Oligopolists
Assume (for simplicity): MC=0=ATC (e.g. town wells)
Market Demand Schedule
Total Revenue (=profit)
P
Q
80
20
1600
70
25
1750
60
30
1800
50
35
1750
40
40
1600
30
45
1350
1. Monopoly
-- Profit Maximizing: MR=MC=0
P=60, Q=30; profit = 1800.
-- Monopolist maximizes profit.
(* we know that atP=60,Q=30 MR=0 because at that point the total
revenue stops increasing.)
Price
PPrice
ee
MC
MR
DD
60
PPric
e
ee
2. Duopolist - (for simplicity assume there are only two firms in the industry);
Possible Outcome:
a) Collude (form Cartel)
-- replicate monopoly outcome: Q=30,P=60; Profit=1800;
-- must allocate market share
e.g. 50:50; then each firm produces Q=15
* How do Oligopolists collude?
-- by fixing prices (at monopoly level, if joint profits are maximized).
-- fixing price is illegal (so arrangements cannot be enforced by the courts)
b) Incentive to Cheat: Cartel may break down.
Firm Cheats, Cartel Breaks down
Firm: To Cheat or Not To Cheat
-- if firm does not cheat, each firm will produce Q=15; market quantity=30, P=60, so each firm will earn
profit =900;
-- if one firm cheats and increases its Q=20; then market quantity=15+20=35; P decreases to 50;
So the firm that cheats get a profit of 1,000 and the firm that does not cheat get a profit of 750.
-- As a result of cheating, one firm increases its profit and the other one decreases; the cartel breaks down.
Insight: incentive to cheat? (How do firms know when to cheat?)
-- If firm increases Q from 15 to 20,
-- MR is 1000 900 = 100
-- MC still equals to 0;
-- MR>MC => firm has incentive to cheat.
Cheat Continued:
-- The firm that did not cheat will eventually cheat as well due to the decrease of the profit:
-- Now both firms produce Q=20. Market Quantity=20+20=40; P decreases to 40.
-- Now both firms earn a profit of 800.
-- For the second firm, MR from Q=15 to Q=20 is 800-750 = 50;
MC = 0; MR>MC therefore it has incentive to cheat (increase the quantity to 20);
Note: lower profit for either firm compared to the Cartel profit.
-- If one firm continues to cheat, raising quantity from 20 to 25;
-- Market Quantity = 25+20 = 45; P = 30;
-- The firm that cheats gets profit of 750, lower than previously when it did not cheat (20);
-- look at it from MR/MC perspective:
from 20-25, MR= -50, MC=0, MR<MC, therefore no incentive to cheat.
Note: No incentive for further cheating for both of the firms, since further increase in quantity will bring
decrease in profit for both of the firms.
Observation:
1. Firms want to collude (resist output to achieve monopoly & price);
2. But each firm has incentive to increase output and thus to cheat cartel if MR>MC;
3. Difficulty in co-operating (maintaining cartel) leads to:
-- Higher output, lower price than monopoly;
-- lower profits for each firm than in carte
Conclusion:
1. If Oligopolists collude to form cartel (illegal), industry may earn monopoly profits;
2. if one firm has MR>MC, the firm may cheat by increasing output and cartel may break down.
3. The point may be made using the Prisoners Dilemma.
Prisoners Dilemma Pay-off Matrix
-- As we know, 3 situations could happen to Oligopolists:
1. Firms might collude;
2. One firm might cheat;
3. Both firms might cheat.
-- Assume Duopolists form cartel and agree to divide market output (hence profit) 50:50;
-- Conditions are as such:
1. If each produce 1/2 of monopoly output (as stated in the cartel), each has profit of 20;
2. If both cheat and increase production to 2/3 of monopoly output, each has profit of 17;
3. If one of them cheats and increases production to 2/3 of monopoly output, the one that cheats has
profit of 22, while the one that does not cheat has profit of 15.
-- Each firm faces two strategies: produce 1/2 of monopoly output, or produce 2/3 of monopoly output.
-- Given the above information, we can construct the pay-off matrix:
As output
Bs output
1/2
2/3
1/2
As profit: 20;
Bs profit: 20
As profit: 22;
Bs profit: 15
2/3
As profit: 15
Bs profit: 22
As profit:17;
Bs profit:17
Insight:
1. If each firm acts rationally, each firm will produce 2/3;
2. 2/3 ---- dominant strategy (i.e. regardless of what the opponent does, you are better off by adopting the
dominant strategy);
3. Cartel breaks down (e.g. OPEC).
4. In repeat game, punishment strategies may lead to more co-operations.
Application on Prisoners Dilemma:
-- Does Ban on TV Advertising help Cigarette Producers?
-- Philip Morris and RJR are the two largest cigarette producers (consider a duopoly)
-- TV Advertising shifts brand loyalty, but does not necessarily add more consumers.
(20/20 --- 35/5) therefore no ethics issues are involved.
-- Information is given by the pay-off matrix:
Philip Morris
RJR