1.5.

Theory of the Firm: Oligopoly

Oligopoly is a market structure with a few dominant firms but no single firm has
monopoly power.

Assumptions of the Model

Definition of an oligopoly:
An oligopoly is a market dominated by a few producers, each of which has some control over
the market. It is an industry where there is a high level of market concentration. However,
oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its
market structure.

The concentration ratio measures the extent to which a market or industry is dominated by a
few leading firms. Normally an oligopoly exists when the top five firms in the market account
for more than 60% of total market demand/sales.

*** Colluding oligopoly: oligopolies working together to gain control of the market
The behavior of these oligopolies may sometimes behave like monopolies
Characteristics of an oligopoly
There is no single theory of how firms determine price and output under conditions of
oligopoly. If a price war breaks out, oligopolists will produce and price much as a perfectly
competitive industry would; at other times they act like a pure monopoly. But an oligopoly
exhibits the following features:

1. Few large dominant firms usually 3-10 but occasionally can be as large as 20
2. Product branding: Each firm in the market is selling a branded (differentiated)
product and thus has price-making ability
3. Entry barriers: Significant entry barriers into the market prevent the dilution of
competition in the long run, which maintains supernormal profits for the dominant
firms. It is perfectly possible for many smaller firms to operate on the periphery of an
oligopolistic market, but none of them is large enough to have any significant effect on
market prices and output.
4. Interdependent decision-making: Interdependence means that firms must take into
account likely reactions of their rivals to any change in price, output or forms of non-
price competition. In perfect competition and monopoly, the producers did not have to
consider a rivals response when choosing output and price. This leads to price rigidity.
5. Non-price competition: Non-price competition is a consistent feature of the
competitive strategies of oligopolistic firms. Examples of non-price competition
includes:
Free deliveries and installation
Extended warranties for consumers and credit facilities
Longer opening hours (e.g. supermarkets and petrol stations)
Branding of products and heavy spending on advertising and marketing
Extensive after-sales service
Expanding into new markets + diversification of the product range

6. Firms will profit maximize though their main objective is to gain market share

1
Oligopoly and Measures of Concentration

One method to gauge the extent of market power is the concentration ratio. Concentration
ratios give the portion of industry sales held by the 4, 8 or 20 largest firms in the industry. The
table below presents the 4, 8 and 20-firm concentration ratios for selected domestic industries
in the US for 1982.

Industry Number of 4-firm ratio (%) 8-firm ratio (%) 20-firm ratio
Companies (%)
Petroleum 282 28 48 76
refining
Motor vehicles 284 92 97 99
and car bodies
Electronic 1520 42 64 82
computing
equipment
Radio and TV 2083 22 35 57
equipment
Aircraft 139 64 81 98
Newspapers 7520 22 34 49
Pharmaceutical 584 26 42 60
preparations

Concentration ratios give some idea about market concentration but they say little about the
extent of competition or geographical factors. For example, even though the 4-firm
concentration ratio for newspapers is 22%, many towns in the US have only one paper. So
many local newspapers have virtual monopoly status. Another problem with concentration
ratios is that they say nothing about potential competition. Some industries with very high
concentration ratios behave much like competitive industries because of the threat of entry
into the industry prices are kept low to discourage entry. Finally, the information in the table
only represents domestic production. This explains why the 4-firm concentration ratio in
motor vehicles is 92% even though imported automobiles would make up approximately 33%
of domestic sales.

A more serious problem with concentration ratios is that they do not distinguish between an
industry in which one firm dominates and one where a small number of large firms share the
market. For example, if one firm had 57% of the market and the other 43 firms in the industry
each had 1%, the 4-firm concentration ratio would be 60%. This is the same concentration
ratio as an industry with 4 firms having 15% of the market apiece. Industry behaviour might
be similar in both cases, but it is also possible that the large firm would dominate the industry
in the first case, but it is also possible that the large firm would dominate the industry in the
first case, while the four firms in the second case would resort to cutthroat competition.

This problem can be eliminated by using a different measure of market concentration called
the Hirschmann-Herfindahl Index. The Hirschmann- Herfindahl Index is calculated by squaring
the percentage share of each firm. This puts extra weight on firms with a larger market share.

2
The formula for computing the Index is:

where Si is the market share of the ith firm. The Herfindahl Index can run from 100 for an
industry composed of identically sized firms to 10000 for a pure monopoly. For the two
examples above, the index would be:

H = 57 + 1 .. + 1 = 3249 + 43 = 3292

H = 15 + 15 +15 +15 +1 .. + 1 = 900 + 40 = 940

The Hisrchmann-Herfindahl Index is widely considered to be a superior measure of market

concentration because it can isolate the presence of a single or few dominant firms. However,
the Hirschmann- Herfindahl Index suffers from some of the same problems as concentration
ratios: it says nothing about potential competition or geographical concentration.
( )
Firm concentration ratio= %

The meaning of highly concentrated: sales of top 4 firms > 90% of industry sales

Price leadership tacit collusion

Another type of oligopolistic behaviour is price leadership. This is when one firm has a clear
dominant position in the market and the firms with lower market shares follow the pricing
changes prompted by the dominant firm. We see examples of this with the major mortgage
lenders and petrol retailers where most suppliers follow the pricing strategies of leading firms.
If most of the leading firms in a market are moving prices in the same direction, it can take
some time for relative price differences to emerge, which might cause consumers to switch
their demand. Firms who market to consumers that they are never knowingly undersold or
who claim to be monitoring and matching the cheapest price in a given geographical area are
essentially engaged in tacit collusion. Does the consumer really benefit from this?

Explicit collusion under oligopoly

It is often observed that when a market is dominated by a few large firms there is always the
potential for businesses to seek to reduce market uncertainty and engage in some form of
collusive behaviour. When this happens the existing firms decide to engage in price fixing
agreements or cartels. The aim of this is to maximize joint profits and act as if the market was a
pure monopoly. This behaviour is deemed illegal by the UK and European competition
authorities but it is hard to prove that a group of firms have deliberately joined together to
raise prices.
Oligopolistic markets
-Target different segments of the market
-The barriers for entry are of a natural barrier rather than on set up by the government set-
up costs: financial type of barrier

3
-Interdependent in decision-making: the firms would take the strategies of other firms into
account
-Price rigidity which refers to a price not changing easily
- Firms tend to compete using non-price determinants
Advertising in oligopolistic markets: e.g. Coke and Pepsi: the firms are competing against each
other to obtain a relatively inelastic demand for profit maximization

In the US, highly-concentrated firms are either:

- In manufacturing sector
- Hi-tech sector
Characteristics of highly-concentrated firms:
1. Inelastic since there are few substitutes
2. Mass-market necessities
3. Requires a lot of R&D investment to conduct innovation
4. Very high sunk costs (infrastructure)
5. Existence of patents (for production)
6. Brand loyalty due to historical entrenchment in the market place
7. Market diversification oligopolies have capability in thrive in multiple markets/
industries
8. Mergers and acquisitions (M+A) activity is prominent (might be banned if there is a
tendency towards monopoly)

Positive impacts:
- Action could lead to greater competition lower prices for some consumers
- More allocative efficiency increase output pushing market equilibrium to social
efficient level; smaller deadweight loss
- Productive efficiency could increase due to greater competition incentivizing firms to be
more cost-effective
- Diversification into new markets may lead to market dominance (for supermarkets) in
the long run
- Lower artificial barriers to entry encourage more market entrants
- Lowers both productive and allocative inefficiency with a greater competition
- May lower fond price inflation

Negative impacts:
- Doesnt focus on the actual collusive strategy amongst supermarkets
- May not result in a significant rise in competition; smaller retailers may still not be able
to compete effectively
- Construction of regulation has developed a fait-accompli: all firms will collude in future
to attain 25% at market share; non-competitive practice
- Reduce the incentive to innovate a less access to high abnormal profit due to lower
economies of scale
- Decrease in market share may lead to loss of employment
- Less opportunities to diversify may lead to loss of opportunities to compete in other
markets
- May lead to more strategic decision-making amongst the three firms negative feeling
amongst firms towards government

4
Task 1: Collusive oligopoly in the supermarket industry

5
ai. Collusive oligopoly refers to oligopolies merges to maximize joint profit and achieve effects
of an operational monopoly.
- small number of firms colluding in a market to gain a competitive advantage e.g. fixing prices
or output
- Higher prices for goods and services in Australia and comparable to other developed
countries
Aii. Abnormal profits happen when the total revenue is for the total cost to maintain the
production. (replicating a monopoly)
b. When the oligopolies combine, the demand would be more inelastic and thus there is a wider
difference between the ATC and AR, creating an abnormal profit after the cartel takes place.
c. SRAC1 SRAC2 (the LRAC takes place at where LRACmin= SRACmin, so that there would be
an achievement of a lower cost when the supermarkets increase their size.
d. The government may decide if they grant the supermarkets to merge or not to control the
market share of one owner. More elastic less abnormal profit and less allocative inefficiency
for a welfare loss

Task 2: While there are oligopolies present in goods market, these same companies use the
same principles in input markets (factors of production)

(a) If sellers who are oligopolies try to increase the price of goods they sell, what is the goal
of buyers who are oligopolists?
(b) Major league baseball team owners in the United States have an oligopoly in the market
for baseball players. What is the owners goal regarding players salaries? Why is this
goal difficult to achieve?
(c) Baseball players in the United States went on strike in 1994 because they would not
accept the salary cap that the owners wanted to impose. If the owners were already
colluding over salaries, why did the owners feel the need for a salary cap?
Owners are colluding over salaries but want a salary cap also. Teams have an incentive to
cheat

6
What is a cartel?

OPEC

The organization of petroleumexporting countries (OPEC) is perhaps the bestknown

example of an international cartel; OPEC members meet regularly to decide how much oil each
member of the cartel will be allowed to produce.

Oligopolistic firms join a cartel to increase their market power, and members work together to
determine jointly the level of output that each member will produce and/or the price that each
member will charge. By working together, the cartel members are able to behave like a
monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil,
the demand curve that each firm faces will be horizontal at the market price. If, however, the
oilproducing firms form a cartel like OPEC to determine their output and price, they will
jointly face a downwardsloping market demand curve, just like a monopolist. In fact, the
cartel's profitmaximizing decision is the same as that of a monopolist, as Figure below
reveals. The cartel members choose their combined output at the level where their combined
marginal revenue equals their combined marginal cost. The cartel price is determined by
market demand curve at the level of output chosen by the cartel. The cartel's profits are equal
to the area of the rectangular box labeled PmBAPc in Figure 1. Note that a cartel, like a
monopolist, will choose to produce less output and charge a higher price than would be found
in a perfectly competitive market

Industry
Price
Ideal Cartel (B)
Competition (C) MC

B
Pm

C
Pc A

Cartel Deadweight
Loss (A)
D

Qm Qc
Quantity

MR

Incentives to cheat

7
 Once established, cartels are difficult to maintain. The problem is that cartel members will be
tempted to cheat on their agreement to limit production. By producing more output than it has
agreed to produce, a cartel member can increase its share of the cartel's profits. Hence, there is
a builtin incentive for each cartel member to cheat. Of course, if all members cheated, the
cartel would cease to earn monopoly profits, and there would no longer be any incentive for
firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as
other cartels and perhaps explains why so few cartels exist.
Firm
Industry
Price Competitive
Price
Profit (A) MC AC
Ideal Cartel (E)
Cheater (C)
Competition (F) MC

E
Pm C
Pm MR'
(15) (15) A
F B
D Pc
Pc D=AR=MR
(12) (12)
Cartel Deadweight
Loss (D)
Incentive to
Cheat Cheat (B)

Qm Qc Qm Qc Qm' Quantity
Quantity
(400) (500) (20) (25) (30)
Quota
MR
(B)
(A)

Restrict output to 400: each firm is issued with an individual quota/limit 20 firms in the
industry 20X20=400
Incentive to Cheat (Put the production at MC=MR): Diagram A represents the industry and
diagram B represents the firms in the industry. There are 20 firms; the competitive quantity
produced by each firm is 25 units so the competitive industry quantity is 500 units at $12.
After the cartel forms, each firm agree to restrict output to 20 units so the industry quantity
reduces to 400 units at $15. When the cartel successfully raises the price, firms in the industry
have an incentive to cheat. If a single firm increases output to 30 units while the rest of the
firms are producing 20 units, the single firm will earn larger profits. The incentive to cheat is
illustrated by the yellow shaded area B in part B of the diagram. Profit is maximized when the
cheating firm produces 30 units at point C while receiving the cartel price. Point C is where the
marginal cost (MC) curve intersects the new marginal revenue (MR) curve after the cartel
successfully raises price. The competitive firms profit is equal to the blue shaded area A.
lead a loss of trust
more importantly market price will fall (oversupply)

Collusion (tacit or explicit) in a market or industry is easier to achieve when: related

to the oligopolists dilemma

8
Collusion: cooperating/ conspire with others to deceive
Implicit collusion: informal agreement qnd working together to gain a competitive advantage
Epxlicit collusion: formal agreement (legal contracts) to cooperate to influence price or output
1. There are only a small number of firms in the industry and barriers to entry protect the
monopoly power of existing firms in the long run
2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not
subject to violent fluctuations which may lead to excess demand or excess supply
3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the
total revenue to suppliers in the market this is clearly easier when the product is viewed as a
necessity by the majority of final consumers
4. Each firms output can be easily monitored (this is important) this enables the cartel more
easily to control total supply and identify firms who are cheating on output quotas.

Possible breakdowns of cartels

Most cartel arrangements experience difficulties and tensions and some producer cartels
collapse completely. Several factors can create problems within a collusive agreement between
suppliers:
1. Enforcement problems: The cartel aims to restrict total production to maximize total
profits of members. But each individual member of the cartel finds it profitable to raise its own
production. It may become difficult for the cartel to enforce its output quotas. There may be
disputes about how to share out the profits. Other firms not members of the cartel may opt
to take a free ride by producing close to but just under the cartel price.
2. Falling market demand during a slowdown or recession creates excess capacity in the
industry and puts pressure on individual firms to cut prices to maintain their revenue. There
are good recent examples of this in international commodity markets including the collapse of
the coffee export cartel and some of the problems that have faced OPEC in recent years
3. The successful entry of non-cartel firms into the industry undermines a cartels control
of the market e.g. the emergence of online retailers in the book industry in the mid 1990s.
4. The exposure of illegal price fixing by market regulators e.g. the severe fines imposed
on vitamin producers by the European Commission in the autumn of 2001 and recent
investigations of price-fixing by the UK Office of Fair Trading.

9
 AN EFFECTIVE cartel requires three things: discipline, a dominant market position and
barriers to entry. The Organisation of the Petroleum Exporting Countries lacks all three. Its
members cheat on their quotas. It supplies only 30% of the worlds oiltoo little to
exercise control. New producers abound.

That is the backdrop to OPECs decision last month to make no attempt to bolster the oil
price, sending it below $70 a barrela near 40% drop since June. Saudi Arabia, its most
influential member, could have sent the price up single-handedly by deciding to pump less.
Unlike cash-strapped oil exporters such as Venezuela, the kingdom can afford self-denial: it
has savings of $900 billion.

But Saudi Arabia can also weather a low price: its production costs are $5-$6 a barrelthe
lowest in the world. Moreover, history suggests most of the gains from any cut in its output
would go to other producers, who would sell their oil for more while increasing their
market share. Saudi Arabia did try the tactic in the early 1980s, cutting its output by three-
quarters from 10m b/d in 1980 to under 2.5m in 1985-6. The result was higher prices, but
also a boom in investment, and then production, in places such as Britain and Norway.

Trying to save OPEC with such tactics could be even more dangerous now. Keeping the
price up would be good news for frackers, speeding the spread of that technology from
America to other countries. Costly oil spurs thrift too, hastening the shift away from oil in
transport. Every hybrid or electric car spells lost business for oil producers. Why encourage
them?

Cheap oil also has its consolations. Russia and Iran, two countries with which Saudi Arabia
has its differences, are suffering much more. Better still, if low prices stem investment in
other sources of oil, such as Canadas tar sands or Americas shale, that means more
demand for low-cost Saudi oil in future.

Source: http://www.economist.com/news/finance-and-economics/21635510-what-oil-
cartel-up-making-best-low-price

Questions on Cartels
Task 3: The New York Times (Nov 30, 1993) reported that the inability of OPEC to agree last
week to cut production has sent the oil market into turmoil leading to the lowest price for
domestic crude oil since July 1990

(a) Why were the members of OPEC trying to agree to cut production?
(b) Why do you suppose OPEC was unable to agree on cutting production? Why did the oil
market go into turmoil as a result?
(c) The newspaper also noted OPECs view that producing nations outside the
organisation, like Britain and Norway, should do their share and cut production. What
does the phrase do their share suggest about OPECs desired relationship with
Norway and Britain?

Task 4: A large share of the world supply of Diamonds comes from Russia and South Africa.
Suppose the marginal cost of mining diamonds is constant at 1000 per diamond, and the
demand for diamonds is described by the following schedule:

10
 Price Quantity
8000 5000
7000 6000
6000 7000
5000 8000
4000 9000
3000 10000
2000 11000
1000 12000

(a) If there were many suppliers of diamonds, what would be the price and quantity?
(b) If there were only one supplier of diamonds, what would be the price and quantity?
(c) If Russia and South Africa formed a cartel, what would be the price and quantity? If the
countries split the market evenly, what would be South Africas production and profit?
What would happen to South Africas profit if it increased 1000 units while Russia stuck
to the cartel agreement?

Task 5: Evaluating commodity cartels

11
12
13
Non-collusive oligopoly

In this case, each firm will embark upon a particular strategy without colluding with its rivals,
although there will of course still exist a state of interdependence, as possible reactions of
rivals will have to be considered.

There are three broad approaches that might be adopted by firms in a situation of competitive
oligopoly:
1. Observe the behaviour of rival firms but make no attempt to predict their possible
strategies on the basis that they will not develop counter strategies. This was the
essence of the earliest model of oligopoly developed by Cournot as far back as 1838:
each firm acts independently on the assumption that its decision will not provoke any
response from rivals; this is not generally accepted nowadays as providing a useful
framework in which to analyze contemporary oligopoly behaviour.
2. Make the assumption that a given strategy will provoke a response from competitor
firms, and assess the nature of the response using past experience. This is the basis of
the kinked demand curve model, described below, in which it is assumed that any price
cut by one oligopolist will induce all others to do likewise, whilst a similar price
increase would not be matched.
3. Formulate a strategy and try to anticipate how rivals are most likely to react, and be
prepared with suitable counter measures.

The kinked demand curve model

See:
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/kinkeddcurve.
html

The kinked demand curve model assumes that a business might face a dual demand curve for
its product based on the likely reactions of other firms in the market to a change in its price or
another variable. The common assumption of the theory is that firms in an oligopoly are
looking to protect and maintain their market share and that rival firms are unlikely to match
anothers price increase but may match a price fall. I.e. rival firms within an oligopoly react
asymmetrically to a change in the price of another firm.

If firm A raises price and others leave their prices constant, then we can expect quite a large
substitution effect away from firm A making demand relatively price elastic. Firm A would lose
market share and expect to see a fall in its total revenue. If firm A reduces price but other firms
follow suit, the relative price change is much smaller and demand would be inelastic in respect
of the price change. Cutting prices when demand is inelastic also leads to a fall in total revenue
with little or no effect on market share.

The kinked demand curve model therefore makes a prediction that a business might reach a
stable profit-maximizing equilibrium at price P1 and output Q1 and have little incentive to
alter prices. The kinked demand curve model predicts periods of relative price stability under
an oligopoly with businesses focusing on non-price competition as a means of reinforcing their
market position and increasing their supernormal profits. Short-lived price wars between rival

14
firms can still happen under the kinked demand curve model. During a price war, firms in the
market are seeking to snatch a short-term advantage and win over some extra market share.

Change in costs -
http://web.sis.edu.hk/Departments/EcoBus/microeconomics_11/media/kinkeddcurve
change.html

Criticisms of the kinked demand curve theory

The theory assumes that oligoplists perceive a kink at the current market price i.e. at
point X, but it does not explain how or why the original price was chosen. As a theory, it
is therefore incomplete as it does not deal with price determination.
Price stickiness or rigidity in oligopolistic markets might, in practice, be more apparent
than real; for example, in the market for new cars, published catalogue prices may
remain constant over relatively long periods, but the common practices of offering
discounts, and items such as free insurance, cash- back deals and interest -free credit all
amount to ways of reducing price. In fact, the theory takes no account of the various
forms of non-price competition, which characterize most oligopolistic markets.
There is little empirical evidence from firms operating in oligopolistic markets to
substantiate the kinked demand curve hypothesis that a change in price by one firm will
always evoke a predictable and uniform response from its rivals. In practice, a very
wide range of possible reactions is probable.
Any perceived stability in prices in oligopolistic markets may not be due to the
existence of a kinked demand curve, but may occur for other reasons such as the
administrative expense and inconvenience of altering prices too regularly.

15
Cut-price competition (predatory pricing)

Although oligopolistic markets tend to be characterized by relative price stability in the longer
term, occasionally short bursts of price warfare break out. This typically occurs when the
dominant players attempt to defend and/or raise their market shares because the total level of
demand in the market is insufficient to enable all to achieve their intended level of sales, and
overcapacity results. Price cutting has the effect of reducing the profits of all the combatants in
the short run, with consumers gaining the temporary benefit of lower prices.

However, the likely outcome is that the weakest firms, i.e. those with the highest costs, will be
driven into bankruptcy, with a new era of relative price stability eventually emerging. If too
many casualties are caused, consumers are likely to face greater monopoly power and possibly
higher prices. Price wars have been experienced between supermarket chains in many
countries. In the UK such wars have also featured in petrol station forecourts.

Game Theory

The term game theory does not mean that we are really going to be playing games, but it is
appropriate because each game involves players, strategies and payoffs. To play a game, each
player different firms, labour unions, management or policy-makers must consider the
costs and benefits of alternative strategies as well as the possible strategies that might be
adopted by other players. The purpose of each game is to win the payoff market share, wages,
profits, achievement of policy goals, or whatever. To be successful, a player must adopt a
strategy that correctly anticipates the response of its opponent. For example, if a firm in an
oligopoly industry is considering the introduction of anew product, it must consider not only
the costs of product development and the likely response of consumers, but also whether its
rival firms will also introduce new products. If only one firm introduces a new product, it may
be able to capture a large market share and pay for development costs, but if all firms
introduce new products, the development costs may exceed the increased sales revenue.

The Prisoners Dilemma

Suppose that two criminals, Art and Betty, are held as suspects in a bank robbery. The evidence
is convincing, but without a confession, the most that the police can pin on each of them is a
one-year jail sentence for a known previous petty crime. If they both confess, each will get a
five-year jail term. Thus the best strategy is for both suspects to hold out and spend only a year
in jail but the police want a confession to the bank robbery. To coax a confession out of the
prisoners, the police can use a simple application of game theory. Put Art and Betty in separate
rooms so they cannot communicate, and offer each a suspended sentence (zero years) for
confessing and naming the other as an accomplice. The accomplice will then go to jail for 10
years. This offer is made to each suspect. Betty knows that if she and Art both clam up, they get
only a year in jail, but if Art confesses and she does not confess, she will go to jail for 10 years.
Art knows the same thing. What should the suspects do?

16
The payoff matrix in the following table illustrates the dilemma faced by the two prisoners.

Art (A)

Actions Dont Confess Confess

Betty (B)
Dont Confess A:1 B: 1 A:0 B: 10
Confess A: 10 B: 0 A:5 B: 5

Interpreting the payoff matrix is straightforward. The entry (A:1, B:1) in the northwest corner
shows what happens if both Art and Betty hold out both go to jail for one year. The entry
(A:0, B:10) in the northeast corner shows what happens if Art confesses and Betty holds out
Art gets the suspended sentence and Betty goes to jail for 10 years.

What is the most likely outcome of the game? To make the most advantageous decision, each
player needs to consider the action of the other. Consider the situation from Arts standpoint.
Suppose that Betty confesses. If Art also confesses, he gets 5 years; if he holds out, he will get
10 years. The best strategy is to confess. But what if Betty holds out? If Art also holds out, he
will get 1 year. If he confesses, he will get a suspended sentence. Again the right choice is to
confess. You get the same situation if you look at it from Bettys standpoint.

Confessing is the dominant strategy because it gives each player the best payoff regardless of
the strategy chosen by the other player. A dominant strategy is the only likely outcome of a
prisoners dilemma game. When both players adopt their dominant strategies, the game rests
in dominant strategy equilibrium. However, it should be noted that in the above example, the
equilibrium is not the most beneficial equilibrium to both players.

Cartel Behaviour

The prisoners dilemma has been applied to several areas in economics, most notably,
oligopoly behaviour. One can apply it to the classic case of cartel cheating.

Suppose that two firms share a market and must decide whether to produce high quantity (H)
or low quantity (L). If the firms form a cartel and agree to restrict production, they can charge
high prices and earn $6 million in profits each. This is represented in the northwest corner
(A:6, B:6) of the table below :

Firm A
Actions Low Output High Output
Firm B Low Output A:6 B: 6 A:9 B: 2
High Output A: 2 B: 9 A:3 B: 3

If there is no cartel agreement and both firms produce high output, price will fall and bring
profits down to $3 million per firm. This is represented by the (A:3, B:3) entry in the southeast
corner of the table. The other entries in the table show what happens if one firm cheats on the
cartel while the other maintains low production. The cheater will increase sales at the expense
of the rival, and profits rise to $9 million for the cheater and fall to $2 million for the rival.

17
What is the most likely outcome to this game? Look at this situation from the perspective of
Firm A. If Firm B keeps to the cartel agreement, then Firm A can increase its profits from $6
million to $9 million by cheating. And if Firm B cheats, Firm A should still cheat; otherwise its
profits will fall to $2 million. Firm B faces the same choices, so the dominant strategy for both
firms is to cheat on the cartel.

Result: Both firms choose high

choosing dominant strategy
not in cartel agreement

If in cartel agreement, both at low output as each doubles profit. However , both have incentive
to cheat. Dominant strategy again

Questions on Game Theory

Task 6: The payoff matrix below shows the profit two firms earn if both advertise, neither
advertise, or one advertises and the other does not. Profits are reported in millions of dollars.
Does either firm have a dominant strategy?

Firm A
Actions Advertise Dont advertise
Firm B
Advertise A:100 B: 20 A:50 B: 70
Dont advertise A: 0 B: 10 A:20 B: 60

Task 7: Bud and Wise are the only two makers of aniseed beer, a new-age product designed to
displace root beer. Bud and Wise are trying to figure out how much of this new beer to
produce.

They each know that if they both limit production to 10,000 gallons a day, they will
make the maximum attainable joint profit of $200,000 a day - $100,000 a day each.
They also know that if either of them produces 20,000 gallons a day while the other
produces 10,000 gallons a day, economic profit will be $150,000 for the one that
produces 20,000 gallons and an economic loss of $50,000 for the one that sticks with
10,000 gallons.
They know also that if they both increase production to 20,000 gallons a day, they will
both earn zero economic profit.

(a) Construct a payoff matrix for the game that Bud and Wise must play
(b) Find the Nash equilibrium
(c) What is the equilibrium if this game is played repeatedly?

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