ECON101 Chapter Notes - Chapter 15: Nash Equilibrium, Normal-Form Game, Monopolistic Competition

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17 Feb 2016
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Dec 2 Lecture 23 1
Chapter 15: Oligopoly
Oligopoly: market structure in which
Natural or legal barriers prevent the entry of new firms
A small number of firms compete
Identical products
Price setters (some sort of market power)
Lies between perfect competition and monopoly
Note: number of firms that eliminate the economic profit of a monopoly (through rent seeking and
entering market) determine if it is a monopolistic competition or oligopoly
1. Barriers to Entry (natural or legal barriers to entry can create oligopoly)
Economies of scale and natural barriers to entry can create natural oligopoly, similar to natural
monopoly
Natural oligopoly: economies and scale and demand form a natural barrier to entry
A single firm can provide a product at lowest possible average cost (natural barrier)
Duopoly: oligopoly market with 2 firms
2 firms can supply product at lowest possible price because they have lowest
average cost of production
Ex. some cities only have 2 taxi companies, 2 car rental firms
Legal oligopoly: arises when legal barrier to entry protects small number of firms in the market
Ex. licenses
How does a duopoly maximize profit?
Natural oligopoly market with 3
firms
A legal oligopoly might arise
even where the demand and
costs leave room for a larger
number of firms
2. Small Number of Firms
Every firm has a sizable amount of market share (50/50, 70/30)
oCompeting at level of prices
oEx. cell phone industry, banking industry
Firms are interdependent
Interdependence: with a small number of firms, each firm's profit depends on every firm's actions
Since firms have identical products, competitors are always looking at what others are doing
because if a competitor reduces prices, they will go out of business
oMonopolistic competitive firms don't have interdependence so they look at average
price
There is a price war to a point where there is 0 economic profit
Temptation to cooperate
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Dec 2 Lecture 23 2
Since there are a small number of firms, there is a temptation to increase profits by forming a
cartel and acting like a monopoly
oCartel: a group of firms acting together to limit output, raise price, and increase profit.
Illegal but still operate in some markets
Oligopoly Games
Game theory: a tool for studying strategic behaviour; (behaviour that takes into account the expected
behaviour of others and the mutual recognition of independence)
Set price based on what I think other firms are going to do
Produce as much as I think other firms are going to produce
4 common features in game
Rules
Strategies
Payoffs
Outcome (what is the reward, what is the loser going home with)
Game: The Prisoner's Dilemma
2 prisoners, Art and Bob, have been caught breaking into someone's house
Rules (describe setting, actions the players may take, consequences of those results)
Each is held in a separate cell and cannot communicate with each other
Each is told that both are suspected of committing a more serious crime
oIf one of them confesses, he will get a 1 year sentence for cooperating while his
accomplice get a 10 year sentence of both comes
oIf both confess to the more serious crime, each receives 3 years in jail for both crimes
oIf neither confesses, each receives a 2 year sentence for the minor crime
Strategies (possible actions of each player)
Confess to the larger crime
Deny having committed the larger crime
With 2 players and 2 actions for each player, there were 4 possible outcomes
Both confess
Both deny
Art confesses and Bob denies
Bob confesses and art denies
Payoffs
Each prisoner can work out what happens to him (can work out his payoff) in each 4 possible
outcomes
Payoff matrix: table that shows the payoffs for every possible action by each player for each possible
action by the other player
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