Introduction to Microeconomics

Introduction to Microeconomics
Oligopoly

Peter Stoyanov

Sofia University “St. Kliment Ohridski”

Faculty of Economics & Business Administration
Lecture slides based on: Parkin, Microeconomics, 9th edition
http://wps.aw.com/aw_parkin_microecon_9/108/27656/7080048.cw/index.html

Fall semester, 2016-2017

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Introduction to Microeconomics
Oligopoly

Oligopoly: Table of Contents

1 Oligopoly

Monopolistic Competition: Definition and Identification

The Kinked Demand Curve Model of Oligopoly
The Dominant Firm Model of Oligopoly
Oligopoly Games
The Game of Chicken: R&D; Advertising
Repeated Games. Sequential Games.
Antitrust Regulation

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Introduction to Microeconomics
Oligopoly
Monopolistic Competition: Definition and Identification

Oligopoly: Definition

Oligopoly is a market structure in which:

Natural or legal barriers prevent the entry of new firms.

A small number of firms compete.

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Oligopoly
Monopolistic Competition: Definition and Identification

Barriers to entry

Either natural or legal barriers to

entry can create oligopoly.
The figure shows a natural
duopoly—a market with two firms
(market = 2x efficient scale).
A legal oligopoly might arise even
where the demand and costs leave
room for a larger number of firms.

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Oligopoly
Monopolistic Competition: Definition and Identification

Small number of firms

Because an oligopoly market has a small number of firms, the firms are
interdependent and face a temptation to cooperate.

Interdependence: With a small number of firms, each firm’s profit

depends on every firm’s actions.
Strategic behavior: Interdependence forces each firm to take into account
the reaction of others when considering its own actions.
Cartel: A cartel is a group of firms illegally acting together to
limit output, raise price, and increase profit. Firms in
oligopoly face the temptation to form a cartel, but aside
from being illegal, cartels often break down.

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Introduction to Microeconomics
Oligopoly
The Kinked Demand Curve Model of Oligopoly

The Kinked Demand Curve Model of Oligopoly (1)

In the kinked demand curve model

of oligopoly, each firm believes that:
If it raises its price, its
competitors will not follow,
If it lowers its price, all of its
competitors will follow.
The firm believes that the demand for
its product has a kink at the current
price and quantity.

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Introduction to Microeconomics
Oligopoly
The Kinked Demand Curve Model of Oligopoly

The Kinked Demand Curve Model of Oligopoly (2)

Above the kink, demand is

relatively elastic because all other
firm’s prices remain unchanged.
Below the kink, demand is
relatively inelastic because all
other firm’s prices change in line
with the price of the firm shown
in the figure.
The kink in the demand curve
means that the M R curve is
discontinuous at the current
quantity—shown by that gap AB
in the figure.

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Oligopoly
The Kinked Demand Curve Model of Oligopoly

The Kinked Demand Curve Model of Oligopoly (3)

Fluctuations in M C that remain

within the discontinuous portion
of the M R curve leave the
profit-maximizing quantity and
price unchanged.
The beliefs that generate the
kinked demand curve are not
always correct and firms can
figure out this fact.
If M C increases enough, all firms
raise their prices and the kink
vanishes.
A firm that bases its actions on
incorrect beliefs doesn’t maximize
profit.
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Introduction to Microeconomics
Oligopoly
The Dominant Firm Model of Oligopoly

The Dominant Firm Model of Oligopoly (1)

In a dominant firm oligopoly, there is one large firm that has a

significant cost advantage over many other, smaller competing firms.
The large firm operates as a monopoly, setting its price and output
to maximize its own profit.
The small firms act as perfect competitors, taking as given the
market price set by the dominant firm.

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Introduction to Microeconomics
Oligopoly
The Dominant Firm Model of Oligopoly

The Dominant Firm Model of Oligopoly (1)

The figure shows 10 small firms in part (a). The demand curve, D, is the
market demand and S10 is the supply curve of the 10 small firms.
At a price of $1.50, the 10 small firms produce the quantity demanded.
At this price, the large firm would sell nothing.

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Oligopoly
The Dominant Firm Model of Oligopoly

The Dominant Firm Model of Oligopoly (2)

But if the price was $1.00, the 10 small firms would supply only half the
market, leaving the rest to the large firm.
Therefore, the demand curve for the large firm’s output is the curve XD
in part (b).

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Introduction to Microeconomics
Oligopoly
The Dominant Firm Model of Oligopoly

The Dominant Firm Model of Oligopoly (3)

The large firm can set the price and receives a marginal revenue that is
less than price along the curve M R. It maximizes profit by setting
M R = M C. Let’s suppose that the marginal cost curve is M C in (b).
(Note M C is substantially lower than S10 due to the cost advantage.)

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Oligopoly
The Dominant Firm Model of Oligopoly

The Dominant Firm Model of Oligopoly (4)

The profit-maximizing quantity for the large firm is 10 units, and it sets a
price of $1.00.
The small firms take this price and supply the rest of the quantity
demanded.

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Introduction to Microeconomics
Oligopoly
Oligopoly Games

Game Theory. The Prisoners’ Dilemma

Game theory is a tool for studying The Prisoners’ Dilemma

strategic behavior, which is behavior The prisoners’ dilemma game
that takes into account the expected illustrates the four features of a game:
behavior of others and the mutual Rules
recognition of interdependence.
Strategies
Payoffs
Outcome

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Oligopoly
Oligopoly Games

The four features of a game: Rules

The rules describe the setting of the Each prisoner is told that they both
game, the actions the players may are suspected of committing a more
take, and the consequences of those serious crime.
actions. If one of them confesses, he will
In the prisoners’ dilemma game, two get a 1-year sentence for
prisoners (Art and Bob) have been cooperating with the police while
caught committing a petty crime. his accomplice gets a 10-year
Each is held in a separate cell and they sentence for both crimes.
cannot communicate with each other.
If both confess to the more
serious crime, each receives 3
years in jail for both crimes.
If neither confesses, each receives
a 2-year sentence for the minor
crime only.

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Oligopoly
Oligopoly Games

The four features of a game: Strategies. Payoffs.

Strategies are all the possible Each prisoner can work out what
actions of each player. happens to him—can work out his
Art and Bob each have two possible payoff—in each of the four possible
actions: outcomes.
1 Confess to the larger crime. We can tabulate these outcomes in a
payoff matrix.
2 Deny having committed the larger
A payoff matrix is a table that
crime.
shows the payoffs for every possible
With two players and two actions for action by each player for every possible
each player, there are four possible action by the other player.
outcomes: The payoff matrix for this prisoners’
1 Both confess. dilemma game is given on the next
2 Both deny. slide.
3 Art confesses and Bob denies.
4 Bob confesses and Art denies.
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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma: The Payoff Matrix

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma: Outcome

Outcome
If a player makes a rational choice in pursuit of his own best interest, he
chooses the action that is best for him, given any action taken by the
other player.
If both players are rational and choose their actions in this way, the
outcome is an equilibrium called Nash equilibrium—first proposed by
John Nash.
Finding the Nash Equilibrium
The following slides show how to find the Nash equilibrium.

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma

Bob’s point
of view

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma

Bob’s point
of view

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma

Art’s point of
view

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma

Art’s point of
view

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma

Equilibrium

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Setup

A game like the prisoners’ dilemma is played in duopoly.

A duopoly is a market in which there are only two producers that
compete.
Duopoly captures the essence of oligopoly.
Cost and Demand Conditions:
The next slide describes the cost and demand situation in a natural
duopoly. Two firms can meet the market demand at the least cost. The
firms (called Trick and Gear) are assumed to be identical in every
relevant aspect.

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Cost curves

Part (a) shows each firm’s cost curves. Part (b) shows the market
demand curve. How does this market work? What is the price and
quantity produced in equilibrium?

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Collusion

Suppose that the two firms enter into The strategies that firms in a cartel
a collusive agreement. can pursue are to
A collusive agreement is an Comply
agreement between two (or more)
Cheat
firms to restrict output, raise the price,
and increase profits. Because each firm has two strategies,
Such agreements are illegal in most there are four possible combinations of
countries and are undertaken in secret. actions for the firms:
Firms in a collusive agreement operate 1 Both comply.
a cartel. 2 Both cheat.
NB: Countries may (and do) form
3 Trick complies and Gear cheats.
cartels! E.g. OPEC.
4 Gear complies and Trick cheats.

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Acting as a Monopoly (1)

Firms in a cartel act like a monopoly and maximize economic profit. To find
that profit, we set M C for the cartel equal to M R for the cartel.
The cartel’s marginal cost curve is the horizontal sum of the M C curves of the
two firms and the marginal revenue curve is like that of a monopoly.

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Acting as a Monopoly (2)

The firms maximize economic profit by producing the quantity at which
M CI = M R. Each firm agrees to produce 2,000 units and each firm shares
equally the maximum economic profit. HOWEVER: At Q = 2, 000 units
P > M C, so the firm can increase its profit by increasing output.

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: One Cheats

Suppose the cheater increases its output to 3,000 units. Industry output
increases to 5,000 and the price falls to $7.5.
For the complier: AT C now exceeds price, i.e. incurs economic loss.

For the cheater: Price exceeds AT C, i.e. makes an increased economic profit.

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Oligopoly Games

Duopoly price-fixing game: Both Cheat (1)

Suppose that both increase their output to 3,000 units.
Industry output is now 6,000 units, the price falls to $6, and both firms
make zero economic profit—the same as in perfect competition.

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Oligopoly Games

Duopoly price-fixing game: Both Cheat (2)

Summary of outcomes:

If both comply, each firm makes $2 million economic profit (per

week).
If both cheat, each firm makes zero economic profit.
If Trick complies and Gear cheats, Trick incurs an economic loss of
$1 million and Gear makes an economic profit of $4.5 million.
If Gear complies and Trick cheats, Gear incurs an economic loss of
$1 million and Trick makes an economic profit of $4.5 million.

The next slides show the payoff matrix for this duopoly game and
reaching the equilibrium.

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: The Payoff matrix

Payoff matrix

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Oligopoly Games

Duopoly price-fixing game: Trick’s point of view 1

Trick’s point
of view

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Oligopoly Games

Duopoly price-fixing game: Trick’s point of view 2

Trick’s point
of view

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Payoff matrix

Gear’s point
of view

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Payoff matrix

Gear’s point
of view

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Oligopoly
Oligopoly Games

Duopoly price-fixing game: Payoff matrix

The Nash
equilibrium
is that both
firms cheat.
The quantity
and price are
those of a
competitive
market, and
the firms
make zero
economic
profit.

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Oligopoly
Oligopoly Games

The Prisoners’ Dilemma Example 2: An R&D game

Procter &
Gamble and
Kimberley
Clark play an
R&D game
in the market
for disposable
diapers.

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Oligopoly Games

The Prisoners’ Dilemma: Conclusion

The Disappearing Invisible Hand

In all the versions of the prisoners’ dilemma that we’ve examined, the
players end up worse off than they would have been if they were able to
cooperate.
That is, the pursuit of self-interest does not promote the social
interest in these games.
Q: What about the other economic agents? What is the effect on them?

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Oligopoly
The Game of Chicken: R&D; Advertising

Other Oligopoly Games: The Game of Chicken

In the prisoners’ dilemma game, the Nash equilibrium is a dominant

strategy equilibrium, by which we mean the best strategy for each
player is independent of what the other player does.
Not all games have such an equilibrium. One that doesn’t is the game of
“chicken.”

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Oligopoly
The Game of Chicken: R&D; Advertising

The Game of Chicken: Definition

Two cars race against each other. The first driver to swerve and avoid a
crash is “chicken”. The payoffs are a big loss for both if no one
“chickens”, zero for the chicken and a gain for the player who hangs
tough.

Source of picture: http://hubpages.com/hub/What-is-Game-Theory

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The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

R&D that
creates a new
technology
results in
information that
cannot be kept
secret or
patented, so
both firms
benefit from the
R&D of either
firm. The
chicken in this
case is the firm
that does the
R&D. The other
company copies.
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The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

KC’s PoV:
If P&G does the
R&D, then No
R&D is better
($10m > $5m).
More profit just
by copying.

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The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

KC’s PoV:
If P&G does not
do the R&D,
then R&D better
($1m > $0m).
P&G copies
(and makes a
big profit).

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The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

P&G’s PoV:

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Oligopoly
The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

P&G’s PoV

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Oligopoly
The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

Equilibrium:
No unique
equilibrium
exists.

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Oligopoly
The Game of Chicken: R&D; Advertising

The Game of Chicken: The R&D Version

The two firms calculate their best strategies.

Each firm is better off doing R&D if the other firm does not do it.
Each firm is better off just copying if the other firm does it.
The top-left and bottom-right corners are not Nash equilibria, as
one firm will want to choose the other strategy.
There are two equilibria: where one firm does the R&D and the
other does not. We cannot say which will do the R&D, however.
Solution: Use a ‘randomizing device’ (i.e. flip a coin).

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Repeated Games. Sequential Games.

A Repeated Duopoly Game (1)

If a game is played repeatedly, it is possible for the duopolists to

successfully collude and make a monopoly profit.
If the players take turns and move sequentially (rather than
simultaneously as in the prisoner’s dilemma), many outcomes are possible.
In a repeated prisoners’ dilemma duopoly game, additional punishment
strategies enable the firms to comply and achieve a cooperative
equilibrium, in which the firms make and share the monopoly profit.

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Repeated Games. Sequential Games.

A Repeated Duopoly Game (2)

One possible punishment strategy is a tit-for-tat strategy.

A tit-for-tat strategy is one in which one player cooperates this
period if the other player cooperated in the previous period but cheats in
the current period if the other player cheated in the previous period.
A more severe punishment strategy is a trigger strategy.
A trigger strategy is one in which a player cooperates if the other
player cooperates but plays the Nash equilibrium strategy forever
thereafter if the other player cheats.

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Repeated Games. Sequential Games.

A Repeated Duopoly Game (3)

A payoff matrix
for a sequential
game.
Applies for each
period.
Both companies
maximize
long-term
profits, not
per-period
profits!

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Oligopoly
Repeated Games. Sequential Games.

A Repeated Duopoly Game (4)

Trick contemplates to
cheat in Period 1. Earns
$4.5m profit but knows
Gear will play tit-for-tat.
If both cheat in LR, no
profit ($0m) for both.
So, Trick wants to go
back to colluding in LR
(must play Comply and
accept punishment).
The max profit a cheater
can earn for any two
periods is $3.5m,
compared to $4m if not
cheating…

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Oligopoly
Repeated Games. Sequential Games.

A Repeated Duopoly Game (5)

Price wars might result from a tit-for-tat strategy where there is an

additional complication – uncertainty about changes in demand.
A fall in demand might lower the price and bring forth a round of
tit-for-tat punishment. As the firm cannot easily determine whether the
drop in price was due to cheating of the other party or due to change in
demand conditions, it is easier to assume cheating...

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Oligopoly
Repeated Games. Sequential Games.

A Sequential Entry Game in a Contestable Market (1)

A contestable market is a market in which firms can enter and

leave so easily that firms in the market face competition from potential
entrants.
In a contestable market firms play a sequential entry game.

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Introduction to Microeconomics
Oligopoly
Repeated Games. Sequential Games.

A Sequential Entry Game in a Contestable Market (2)

Example: Agile Air is the only firm operating on a particular route.

Demand and cost conditions are such that there is room for only one
airline to operate. Wanabe, Inc., is another airline that could offer
services on the route. The two companies play a two-stage sequential
game.

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Introduction to Microeconomics
Oligopoly
Repeated Games. Sequential Games.

A Sequential Entry Game in a Contestable Market (3)

First Stage: Agile decides whether to charge the monopoly price, or to

charge the competitive price. Once set, the price cannot be changed.
Customers buy from the lowest-price seller, i.e. there is no customer
loyalty. There are fixed costs to be covered even if nobody uses your
airline (plane flies empty).

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Oligopoly
Repeated Games. Sequential Games.

A Sequential Entry Game in a Contestable Market (4)

Second stage: Wanabe decides whether to enter the market or stay out.
If Wanabe enters, it can capture the whole market by setting a price just
below the price set by Agile. Agile will be driven out of business (there’s
room for only one).

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Oligopoly
Repeated Games. Sequential Games.

A Sequential Entry Game in a Contestable Market (5)

The equilibrium of this sequential entry game: Agile sets the

competitive price and makes zero economic profit to keep Wanabe out.
A less costly strategy: Limit pricing: Set the price at the highest level
that is consistent with keeping the potential entrant out.
Agile does not have to set the price all the way down at the competitive
price (where Wanabe loses $10m). Any price higher than the competitive
price but making Wanabe incur a loss should be sufficient to deter them
from entering, while guaranteeing Agile a positive economic profit (but
lower than under monopoly price).

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Oligopoly
Antitrust Regulation

Antitrust Regulation: Competition limiting practices

Price fixing is illegal, if proven.

Resale price maintenance
Tying arrangements
Predatory pricing

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Oligopoly
Antitrust Regulation

Resale price maintenance

Most manufacturers sell their product to the final consumer through a

wholesale and retail distribution chain.
Resale price maintenance occurs when a manufacturer agrees with
a distributor on the price at which the product will be resold.
Resale price maintenance is inefficient if it promotes monopoly pricing.
But resale price maintenance can be efficient if it provides retailers with
an incentive to provide an efficient level of retail service in selling a
product.

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Antitrust Regulation

Tying (bundling) arrangements

A tying arrangement is an agreement to sell one product only if the

buyer agrees to buy another different product as well.
Some people argue that by tying, a firm can make a larger profit.
Where buyers have a differing willingness to pay for the separate items, a
firm can price discriminate and take a larger amount of the consumer
surplus by tying.

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Antitrust Regulation

Predatory pricing

Predatory pricing is setting a low price with the intention to drive

competitors out of business and then set the monopoly price.
Economists are skeptical that predatory pricing actually occurs.
A high, certain, and immediate loss is a poor exchange for a temporary,
uncertain, and future gain.

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