Chapter 11

Challenge To Market Effectiveness 2:

Oligopolies

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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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

Stay SilentBen

Confess

Adam goes free.

Ben is executed.

Adam gets one year in prison.

Ben gets one year in prison.

Adam gets life in prison.

Ben gets life in prison.

Adam and Ben will end up here.

Adam is executed.

Ben goes free.

Confess

Stay Silent

Adam

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

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

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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

Athlete One

Athlete Two

Don’t Use Steroids

Don’t Use Steroids

Use Steroids

Use Steroids

Athlete One wins.

Athlete One suffers health problems.

Athlete Two wins.

Athlete Two suffers health problems.

Both athletes have an equal chance of winning.

Both athletes suffer health problems.

Both athletes have an equal chance of winning.

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.

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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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Summary

• Firms can cooperate and escape the pricing Prisoners' Dilemma by “most favored customer” and price matching.

• Product differentiation, advertising and brand names, and complicated pricing are the other ways to escape the pricing Prisoners' Dilemma.

• Colluding oligopolists reduce wealth of society.• Oligopolies have greater incentives to innovate

and primarily engage in disruptive innovations.• Antitrust laws prohibit firms from colluding or

attempting to acquire monopolies.11-26

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Coming Up

What are government imperfections?

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