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Topic 10 - Oligopoly 1. Oligopoly ¨C Key Features 2. Monopoly profits for Oligopolists: Cartel 3. Firm cheats; Carte Breaks down; 4. Prisoner¡¯s Dilemma ¨C Pay-off Matrix 5. Application ¨C Ban on TV Advertising

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University of Toronto St. George
James Pesando

Topic 10 – Oligopoly (Week ten Nov 16 - Nov 24 ) th Outline: 1. Oligopoly – Key Features 2. Monopoly profits for Oligopolists: Cartel 3. Firm cheats; Carte Breaks down; 4. Prisoner’s 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 Price -- Profit Maximizing: MR=MC=0 PPrice P=60, Q=30; profit = 1800. ee -- Monopolist maximizes profit. 60 (* we know that atP=60,Q=30 MR=0 because at that point the total PPric e DD revenue stops increasing.) MC ee 30 Quantity MR 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
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