Lecture Principles of Microeconomics: Chapter 11 - James D. Miller

Chapter 11

Challenge To Market
Effectiveness 2:
Oligopolies

McGraw­Hill/Irwin

Copyright © 2009 by The McGraw­Hill Companies, Inc. All Rights Reserved.


Learning Objectives
• What is oligopoly?
• What is the Prisoners’ Dilemma?
• How do oligopolistic firms find themselves in the
pricing Prisoners’ Dilemma?
• How do oligopolists escape the pricing
Prisoners’ Dilemma?
• How do colluding oligopolists harm a society?
• Why do oligopolists have incentives to innovate?
• How do antitrust laws affect the society?
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Oligopoly
• Oligopolistic markets are in between a monopoly (where
there is just one firm) and perfect competition (where
there are a large number of firms).
Industry

% of U.S. market controlled by
four largest firms in the industry

Breweries

90.5

Cigarette manufacturing

95.3

Electric lamp bulb and part
manufacturing

89.6

Light truck and utility vehicle
manufacturing

96.7

Guided missile and space
vehicle manufacturing

95.3
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In The Quest Of An Oligopoly
• Antitrust laws prevent firms colluding on price as well as
monopolies from forming.
• An implicit agreement to raise prices: sending a clear but
legal signal through consecutive change of price.
• The challenge of maintaining high prices: each firm has
an incentive to cheat by undercutting the implicit
agreement.
• The challenge of international competition.
• The attempts of product differentiation and complicated
pricing.
• Incompatibility and lock-in.
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Oligopoly
• Economists are not sure when oligopolistic
firms will compete and when they will
cooperate.
• There is no reliable theory that tells when
oligopolists will succeed cooperation.
• Prisoners’ Dilemma refers to forces that
thwart oligopolists’ efforts at cooperation.

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Prisoners’ Dilemma
• Two criminals are arrested.
• The only way to know they’re serious is to
establish at least one of them has
confessed.
• By separating them, the police create
incentives for the prisoners to turn on each
other.

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Prisoners’ Dilemma
• Adam and Ben both
simultaneously decide
whether to confess or
stay silent. The two
prisoners end up in the
box corresponding to
their choices.

Ben
Confess

Confess

• In the Prisoners’
Dilemma game, each
person is individually Adam
better off confessing.
So if both Ben and
Adam are rational
Stay Silent
and self-interested,
they will both confess
and spend their lives
in prison.

Stay Silent

Adam gets life
in prison.

Adam goes free.

Ben gets life in
prison.

Ben is executed.

Adam and Ben will
end up here.

Adam is executed.
Ben goes free.

Adam gets one
year in prison.
Ben gets one
year in prison.
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Prisoners’ Dilemma
• Prisoners’ Dilemma
applies to many more
groups.
• Generally, those stuck in
the Prisoners’ Dilemma
take an action that is
either selfish or altruistic.
• Individually, each player is
better off being selfish.
• Yet all players are better
off if everyone is altruistic.
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Athlete's Steroid Dilemma
If winning is more important than
avoiding health problems then
both athletes will individually

always be better off using
steroids. Yet the athletes are in
a Prisoners’ Dilemma game
because they are both better off
if neither uses steroids than if
both use steroids.

Athlete Two
Use Steroids
Both athletes have an
equal chance of winning.

Use Steroids
Both athletes suffer
health problems.

Don’t Use Steroids
Athlete One wins.
Athlete One suffers health
problems.

Athlete One
Athlete Two wins.

Don’t Use Steroids

Both athletes have an
equal chance of winning.

Athlete Two suffers health

problems.

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The Pricing Prisoners’ Dilemma
• Oligopolists are often in
a Prisoners' Dilemma
with respect to pricing.
• Each firm’s pricing
actions affect the other
firm.
• If the two firms play the
game just once, they
each have an incentive
to charge low prices.

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Escaping the Prisoners’ Dilemma
Through Collusion
• If a Prisoners’ Dilemma is played repeatedly, the
participants can sometimes successfully collude.

Cartels:

• These are organizations of producers who
explicitly collude to charge high prices.
• Organization of Petroleum Exporting Countries
(OPEC)
• Criminal cartels
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Antitrust Laws and Collusion
• Explicit agreements to charge high prices is a
violation of antitrust laws.
• A major purpose of antitrust laws is to keep firms
in a pricing Prisoners’ Dilemma.
• Firms often have difficulty using implicit collusion
to escape a pricing Prisoners’ Dilemma.
• Mistrust and greed can easily destroy implicit
agreements to maintain high prices.

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Using “Pro-Consumer” Policies to
Promote Collusion
“Most favored customer” promise:
• Under this promise, the seller legally promises
that the price the customer is paying is not

higher than the price for any other customer.
Price matching:
• The seller promises to match all its rival’s prices.
• “Most favored customer” and price matching can
prevent firms from lowering prices.
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The Social Harm of Collusion
• By the Law of Demand, when oligopolists
maintain high prices, they reduce sales.
• When oligopolists collude, they raise
prices above marginal costs.
• As a result, some consumers go without
buying the good even when they value it
higher than marginal costs.
• Colluding oligopolists reduce wealth of
society.
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Escaping the Prisoners’ Dilemma
Product differentiation:
• Firms resort to product differentiation when they cannot
escape a pricing Prisoners’ Dilemma through collusion.
• When consumers base their choice on more than just

price, oligopolists do not have the pressure to sell for the
lowest price.
• Oligopolists sometimes use style rather than quality to
differentiate their products.
Advertising and brand names:
• Firms also have to inform consumers about the
differences between their product and rivals’ products.
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Escaping the Prisoners’ Dilemma
Using confusing prices:
• Complication reduces the damage of price
competition.
• With complicated pricing, customers cannot
easily discern which firm is charging less.
• Complicated pricing reduces the incentive for
firms to cut prices as well as the harm to one
firm of its rival’s price cut, e.g. long distance
phone services, frequent-flyer programs of
airlines.
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Oligopolies and Innovation
• Oligopolies have greater incentives to

innovate than any other type of firm.
• Firms in oligopoly face direct competition
and so must innovate to survive.
• Oligopolies primarily engage in disruptive
innovations.

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Disruptive Innovation in Oligopolies
• Disruptive innovation reduces the value of
existing products or services.
• Firms are willing to develop innovations that
harm rival firms but not themselves.
• Though disruptive innovation can reduce the
value of individual firms, it usually increases the
wealth of society by giving it better products.
• Example firms are Bell Telephone, Black &
Decker, Charles Schwab, Dell computer, eBay,
Expedia, Kodak, Linux.
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Prisoners’ Dilemma
and Disruptive Innovation
• Oligopolists sometimes collude to avoid

disruptive innovation.
• Oligopoly firms benefit from colluding to
reduce innovation expenditure.
• However, colluding to suppress innovation
is far more dangerous than colluding to set
high prices.
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Antitrust Laws
• Antitrust laws prohibit firms from colluding
or attempting to acquire monopolies.
• They can reduce the deadweight loss
caused by monopolies and oligopolies.
• However, antitrust laws are enacted and
interpreted by imperfect government agent
and hence can destroy society’s wealth.

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Antitrust Laws
Beneficial antitrust enforcement:
• The United States v. Addyston Pipe and Steel
Corporation,1899
• National Society of Professional Engineers v. The United

States,1978
• The courts ruled against eliminating price competition.
Harmful antitrust rulings:
• The United States v. IBM Corporation, 1969 : The
government dropped the case in 1982 but IBM had spent
valuable resources fighting the government that it soon
lost its dominance of the computer market.
• Predatory pricing
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Antitrust Laws and Predatory Pricing
• Antitrust laws prevent predatory pricing.
• Predatory pricing litigation always seeks to punish firms
when they charge low prices.
• According to predatory pricing theory, firms initially
charge low prices to drive other firms out of their market.
Then, when the predatory firm becomes a monopolist it
raises prices, thereby damaging consumers.
• However, economists have never found any successful
examples of predatory pricing.
• Some firms can be expected to return to the market
when the predatory firm starts charging high prices.
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Do You Know?
• How do both criminals confess in the Prisoners’
Dilemma?
Each person is individually better off confessing
regardless of what the person does. So, each
criminal confesses for his own good.
• How can oligopolistic collusion destroy wealth?
When oligopolists collude, they maintain prices
higher than marginal costs and reduce sales.
Since some consumers go without buying the
good, it destroys society’s wealth.
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Do You Know?
• Why do oligopolistic firms often try to differentiate their
products?
When consumers base their choice on more than just
price, oligopolists do not have the pressure to sell for the
lowest price. Hence, oligopolists try to convince
consumers that their product is different from their rivals.
• Why do oligopolies have tremendous incentives to
innovate?
Oligopolistic firms face direct competition, so they must
innovate to survive. They have greater incentive to
innovate to differentiate their products from their rivals.
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Summary
• Oligopolistic markets are in between a monopoly and
perfect competition.
• Through cooperation and collusion, oligopolists maintain
high prices and increase profits.
• Oligopolists are often in a Prisoners' Dilemma with
respect to pricing. where each firm’s pricing actions
affect the other firms.
• Generally, those stuck in Prisoners’ Dilemma take an
action that is either selfish or altruistic.
• Though each player is individually better off being
selfish, all players are better off if everyone is altruistic.
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