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Chapter 15

Economics 1021 Chapter 15 Notes

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Western University
Economics 1021A/B
Jeannie Gillmore

Chapter 15 Oligopoly  Oligopoly: A market structure in which: o Natural or legal barriers prevent the entry of new firms.  Natural oligopoly: A natural barrier stops firms due to mismatch in demand and price.  Legal monopoly: A legal barrier to entry protects the small number of firms in the market.  Duopoly: An oligopoly market with only two firms.  If there is 1 firm in the market, it makes an economic profit until a second firm enters.  If there are 3 firms in the market, all firms make an economic loss until a firm leaves. o A small number of firms compete.  Each firm’s actions influence the profits of all the other firms.  There is temptation to create a cartel (group of firms acting together to limit output, raise prices, and increase profit). o May produce identical products and compete on prices, or differentiate products and compete on price, product quality, and marketing. Oligopoly Games  Game theory: A set of tools for studying strategic behaviour that the expected behaviour of others and the recognition of mutual interdependence.  Game: All games share four common features: o Rules o Strategies (the possible actions of each player) o Payoffs o Outcomes  Prisoners’ Dilemma: o (A) and (B) have been caught for petty stealing and is to receive 2 years in prison, but the attorney believes that they may be responsible for a larger theft. He cannot charge them without confessions. o Rules:  Each prisoner is placed in separate rooms and is not allowed to communicate.  Each is told that he is suspected of a larger crime  If both of them confess to the larger crime, each will receive 3 years in prison.  If he alone confesses and his accomplice does not, he will receive 1 year in prison, while his accomplice will receive 10 years in prison. o Strategy: Since there are two prisoners, the possible outcomes are:  Both confess.  Both deny.  (A) confesses and (B) denies.  (B) confesses and (a) denies. o Payoffs:  Payoff matrix: A table that shows the payoffs for every possible action by each prison for every possible action by each other player.  Shown right. o Outcome: The combination of both prisoners’ choices  Nash equilibrium / Dominant-strategy equilibrium:  (A) takes the best possible action given the action of (B)  (B) takes the best possible action given the action of (A)  From (A)’s point of view,  If (B) confesses, (A)’s best action is to confess.  If (B) does not confess, (A)’s best action is to confess. (vice versa)  The best strategy of each prisoner is to confess regardless of the strategy of the other player.  For the prisoners, the equilibrium of the game is not the best outcome.  Oligopoly Price-Fixing Game: o Two firms (T) and (G) produce gears. They produce identical gear (perfect substitutes), and they have identical costs and market prices in a natural duopoly. o Suppose that (T) and (G) enter a collusive agreement (an agreement between firms to form a cartel to
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