Chapter 17: Oligopoly

Welcome to Last Minute Lecture!

This free chapter overview is designed to help students review and understand key concepts.

These summaries supplement not replaced the original textbook and may not be redistributed or resold.

For complete coverage, always consult the official text.

Welcome back to The Deep Dive, where we sift through a stack of information to bring you the most potent insights.

Today we're embarking on a fascinating deep dive into a core concept in economics that really helps explain the world around us.

Everything from why you only see a few brands of tennis balls to, well, the complexities of international trade.

We're talking about oligopoly.

That's right.

For this deep dive, we've pulled a chapter from N.

Gregory Mankiw's Principles of Microeconomics to guide our conversation.

Our mission today is to unpack how markets with just a few dominant sellers operate, the unique challenges they face, and how their strategic decisions ripple through the economy.

It's a dynamic space where cooperation is tempting but often incredibly difficult for these firms to maintain.

And the way this complex dance plays out often reveals some surprising truths about human behavior, doesn't it?

You'll discover how a small number of players, whether they're selling water in a small town or making decisions that affect global markets, find themselves in a constant tug of war, you know, between working together and pursuing their own self -interest.

But how do these players truly navigate such intertwined fates?

That's where we bring in a powerful analytical lens, game theory, which is like a secret decoder ring for understanding these strategic situations.

So let's start with the basics then.

What exactly is an oligopoly?

Okay.

An oligopoly is a market structure characterized by just a few sellers offering similar or identical products.

They were the tennis ball market you mentioned, Penn, Wilson, Prince, and Dunlops -Lassinger.

These four firms produce almost all the tennis balls sold in the United States.

Their collective decisions, because there are so few of them, largely determine both the quantity produced and the market price.

Right.

And when there are only a handful of players like that, how profoundly does that interdependence shape their every move?

What's at stake if one firm miscalculates what the others might do?

Well, that interdependence is the very essence of an oligopoly.

It creates this fundamental tension.

These firms would collectively achieve the highest profits if they cooperated and acted like a single monopolist, you know, producing a smaller quantity and charging a higher price.

But the powerful pull of self -interest often hinders them from maintaining that cooperative outcome.

Each firm sees an individual gain in, well, deviating.

And that's precisely why game theory becomes so essential here, isn't it?

It's the study of how people behave in these strategic situations where your optimal choice fundamentally depends on what you expect others to do.

It's about anticipating moves and counter moves.

To really make this tangible, let's dive into a classic example from our source material, the duopoly of Jack and Jill.

They own the only two wells providing drinking water in a town.

Right.

The Jack and Jill example.

Imagine they can pump water at absolutely no cost.

So their marginal cost is zero.

Makes the math easier.

We have a demand schedule for water, illustrating how the price changes with the total quantity sold.

For instance, if they sell 10 gallons total, it's $110 a gallon.

If they sell 60 gallons total, the price drops to $60 a gallon.

And crucially, with no pumping cost, their total revenue directly equals their total profit.

Okay.

Now, to get a sense of the extremes, what would this market look like under perfect competition?

Under perfect competition, price equals marginal cost.

Since marginal cost here is zero, the price of water would be zero and 120 gallons would be sold.

That's the socially efficient quantity of the market producing as much as possible at the lowest possible price.

And on the other end, what if there was a pure monopoly?

Just one seller?

A profit maximizing monopolist would look at that demand schedule and find that total profit is maximized by producing 60 gallons and charging $60 a gallon.

This is an inefficient outcome from society's view, as the quantity is well below the competitive level and the price is significantly above marginal cost.

Okay.

So now we bring in Jack and Jill.

What if they decide to cooperate?

What if they form a cartel?

What would that look like?

Right.

They could collude, essentially agreeing to act as that single monopolist.

They would produce the monopoly quantity of 60 gallons and charge $60 a gallon.

This maximizes their joint profit.

If they split it evenly, each would produce 30 gallons and earn $1 ,800 profit.

But cooperation can be incredibly fragile in these situations, can it?

What happens when their individual self -interest kicks in, rather than sticking to the cooperative agreement?

This is where the dilemma truly surfaces.

Exactly.

Suppose Jack expects Jill to stick to her 30 gallons.

Jack thinks,

okay, if I also produce 30, my profit is $1 ,800.

But hmm, what if I secretly produce 40 gallons?

The total quantity rises to 70.

The price drops to $50 a gallon, but my profit jumps to $2 ,000.

That's more for me.

So Jack has a strong incentive to increase his own production.

And Jill, facing the exact same calculations and tempations, reasons identically.

So if they both individually act on that self -interest, they both decide to produce 40 gallons.

That brings the total output to 80 gallons, and the price drops even further to $40.

Each earns $1 ,600.

What does this outcome tell us about the power of individual self -interest versus collective gain in a market like this?

It's quite revealing, isn't it?

This outcome, where each produces 40 gallons, is a Nash equilibrium.

It means that, given what the other person is doing, neither Jack nor Jill has an incentive to unilaterally change their strategy.

If Jack is producing 40, Jill's best move is 40.

And if Jill is producing 40, Jack's best move is 40.

They're sort of stuck.

And what's crucial is that their combined profit, $3 ,200,

is significantly less than the $3 ,600 they could have achieved if they had truly cooperated.

Their individual pursuit of profit, even when they know better, leads them to a worse collective outcome.

So that's the dynamic with the duopoly.

Just two players.

Does that fundamental tension between cooperation and self -interest change much if the market grows, say, to four or five players or even more?

It absolutely does.

It gets much harder if they try to form a cartel.

It would become exponentially harder to reach and, crucially, to enforce an agreement as the group grows larger.

More firms mean more incentives to cheat and, frankly, just more members to monitor.

It makes collusion much more prone to break down.

Okay, so if they don't form a cartel, how do individual firms decide how much to produce when there are more of them?

Is it still the same logic?

Pretty much, yes.

Each well owner still weighs two opposing forces when deciding whether to increase production.

First, there's the output effect.

Because the price is above marginal cost, selling one more gallon at the current price will raise profit.

Simple enough.

But then there's the price effect.

Increasing production will increase the total quantity sold in the market, which inevitably lowers the overall market price for all gallons sold, reducing profit on the other units.

They will increase production until these two effects roughly balance out, taking the other firm's production as given.

And as an oligopoly gets really, really big, what happens to that price effect?

Does it just sort of vanish entirely?

It diminishes significantly.

The more sellers there are, the less impact each individual seller's production has on the overall market price.

In a very large oligopoly, the price effect essentially disappears.

At that point, the production decision of an individual firm hardly affects the market price anymore.

Each firm takes the market prices given, much like a competitive firm would, and therefore, it increases production as long as price exceeds marginal cost.

This means that a large oligopoly starts to look a lot like a perfectly competitive market.

The price approaches marginal cost, and the quantity produced moves closer to the socially efficient level.

And this analysis provides a powerful economic argument for why free international trade, by increasing the number of consumers, it fosters competition and drives prices down.

We've seen the struggle for cooperation with Jack and Jill, but there's a classic thought experiment that brings this tension into even sharper focus, one that really makes you question rational self -interest.

The Prisoner's Dilemma.

Tell us about Bonnie and Clyde.

Ah yes, The Prisoner's Dilemma.

It's a fascinating game theory scenario.

Imagine two criminals, Bonnie and Clyde, captured by the police.

The police have enough evidence to convict them of a minor crime, maybe carrying an unregistered gun, for which each would get one year in jail.

Standard stuff.

But the police suspect them of a bigger crime, say, a bank robbery.

And they question them separately.

They offer each the following deal.

If you confess to the bank robbery and implicate your partner, we'll give you immunity.

You go free.

Your partner gets 20 years.

If your partner confesses and implicates you, you get 20 years and they go free.

If both of you confess, you each get an intermediate sentence, let's say eight years.

But if both of you remain silent, you each get only one year for that minor crime.

Okay, so Bonnie is in that room, can't talk to Clyde.

How does she rationally decide what to do?

What's going through her head?

Bonnie would reason something like this.

Okay, what could Clyde do?

If Clyde remains silent, my best strategy is definitely to confess, because then I'll go free, which is way better than one year.

Now, what if Clyde confesses?

Well, then my best strategy is still to confess, because then I'll get eight years, which is much, much better than 20 years if I stay silent and he rats me out.

So you see, regardless of what Clyde does, confessing is Bonnie's dominant strategy.

It's the best move for her, no matter what the other player chooses.

And Clyde, of course, faces the exact same incentives and comes to the exact same conclusion.

So they both confess, they both end up with eight years.

It's a Nash equilibrium, sure, but it's a terrible outcome for both of them.

They would have been far better off if they had both just kept quiet, getting only one year each.

It's such a powerful illustration of self -interest overriding their collective well -being, just like Jack and Jill, really.

Absolutely.

The Oligopolists face this exact same dilemma.

Even if Jack and Jill agree to low production to achieve monopoly profits, each has that individual incentive to cheat by producing more.

This ultimately leads to a worse outcome for both, because from an individual standpoint, defecting from the agreement is always the better choice, regardless of what the other does.

This fundamental tension makes cooperation incredibly difficult to maintain.

And we even see this play out in the real world, don't we, with powerful cartels like OPEC?

Indeed.

OPEC, the Organization of Petroleum Exporting Countries, they attempt to coordinate oil production among its members to keep prices high.

They try to act as a unified monopolist.

But individual members are always tempted to increase their output beyond the agreed -upon quotas to gain a larger share of the profit.

Get a bit more revenue for themselves.

This self -interest frequently leads to breakdowns in cooperation and volatile oil prices, as we saw pretty vividly in the mid -1980s, when internal disagreements about production levels caused crude oil prices to fall significantly.

Even with new technologies like fracking expanding global supply, the fundamental challenge of maintaining cartel cooperation because of this prisoner's dilemma dynamic remains.

It's incredible how this dilemma extends beyond just markets, isn't it?

Thinking about our source material, it also touches on things like arms races between countries, or the overuse of common resources like a shared oil pool.

In these situations, self -interest also leads to an inferior outcome for all parties involved, right?

That's right.

In an arms race, like between the US and the Soviet Union during the Cold War, each country might feel it's better off arming regardless of what the other does,

to maintain influence or prevent being vulnerable.

The dominant strategy for both ends up being armed, leading to a world where both are arguably at greater risk instead of a safer world where both are disarmed.

Similarly, with a common oil pool, if two companies share it, each has an incentive to drill more wells to get a larger share for themselves, even if it means both drilling extra -costly wells that ultimately reduce their joint profits.

What's fascinating here, though, is that the societal implications of this non -cooperation depend heavily on the situation.

In arms races or common resources, non -cooperation is generally bad for society.

It leads to greater risk or wasted resources.

But for oligopolists, their failure to cooperate and act like a monopoly is actually desirable for society, because it pushes prices closer to marginal costs and quantities closer to the socially efficient level.

The invisible hand needs competition to work effectively,

and the oligopolists' self -interest, paradoxically, helps bring about some of that competition.

So, given these powerful incentives against cooperation, what does this all mean?

Is it ever truly possible to escape these suboptimal Nash equilibria?

Can cooperation sometimes win out?

It can be, yes, especially in repeated games.

If players know they will interact many times, the threat of future retaliation like a tit -for -tat strategy, where you cooperate unless the other person defects, then you defect too until they cooperate again, can help maintain cooperation.

Robert Axelrod's famous Prisoner's Dilemma Tournament, where computer programs played against each other repeatedly, demonstrated just how effective this simple strategy can be at fostering cooperation over time.

The long -term relationship changes the calculation.

Okay, given everything we've discussed, it makes perfect sense that governments would step in.

One of the ten principles of economics is that governments can sometimes improve market outcomes.

How do policymakers specifically try to encourage competition in oligopolies?

What tools do they use?

They primarily use antitrust laws.

Cooperation among oligopolists is generally seen as undesirable from society's perspective because it leads to low production and high prices, much like a monopoly.

So, policies are designed to induce competition rather than cooperation, to push markets closer to the socially optimal outcome.

So, are agreements between firms to fix prices just straight up illegal?

Absolutely.

Historically, such agreements were deemed contrary to the public good.

The Sherman Antitrust Act of 1890 made contracts in restraint of trade criminal conspiracies.

It's a foundational piece of U .S.

law.

Later, the Clayton Act of 1914 strengthened this by allowing private parties to sue for triple damages.

That provides a significant incentive to encourage enforcement against conspiring oligopolists because if you can prove you were harmed by their collusion, you can recover three times your losses.

That gets people's attention.

And our sources share a really vivid, real -world example of this, that illegal phone call between airline executives Robert Crandall of American Airlines and Howard Putnam of Braniff Airways, where Crandall explicitly suggested raising fares together.

Yes, it's a classic case.

Crandall directly proposed to Putnam,

raise your expletive fares 20 percent, I'll raise mine the next morning.

Pretty blatant.

Putnam correctly identified that they absolutely could not talk about pricing as such conversations are explicitly prohibited under the Sherman Antitrust Act.

He even recorded the call, apparently.

The Justice Department later filed suit against Crandall.

It truly illustrates Adam Smith's old observation, you know, that people of the same trade seldom meet together, but the conversation ends in a conspiracy against the public.

But not all antitrust issues are so clear -cut, are they?

The chapter highlights some areas that are pretty controversial.

For instance, resale price maintenance, where a manufacturer requires retailers to charge a specific price.

On the surface, that sounds anti -competitive, but why do some economists argue it might actually be beneficial?

Right, this is where it gets tricky.

It raises the important question.

When is government intervention truly beneficial?

For resale price maintenance, while it prevents price competition among retailers, some economists argue it can prevent retailers from free riding on others' customer service.

Imagine a high -service retailer that invests in knowledgeable staff, nice showrooms, you know, the whole experience.

A discount retailer nearby could benefit from customers checking out the product at the high -service store and then just buying it cheaper from the discounter down the street.

Resale price maintenance, the argument goes, ensures all retailers can afford to provide that valuable customer service, which ultimately might benefit the product's reputation and the consumer experience.

It's not a universally accepted argument, but it's out there.

Another contentious practice mentioned is predatory pricing.

This is where a large firm supposedly slashes prices way down low, specifically to drive out a smaller competitor.

So on the surface, that sounds undeniably bad competition, but economists often raise an eyebrow at these claims.

Why is there so much skepticism?

Well, economists are indeed often skeptical of predatory pricing claims.

They argue it's rarely a profitable strategy in the long run.

Because the predator typically suffers more losses in the short term than the smaller prey it's trying to eliminate.

Think about it.

If a large airline slashes prices on a route to drive out a small regional carrier, the large airline might have to fly many more planes at a loss on that route.

The regional carrier, meanwhile, could just cut flights or even temporarily cease operations, waiting for the larger firm to bleed money and eventually give up.

It's simply very tough for courts to distinguish between aggressive, healthy price competition, which is good for consumers, and genuine predatory behavior designed solely to create a monopoly later on.

Right.

The line can be blurry.

And then there's selling two products together as a bundle, like the example of make -money movies offering superheroes and Hamlet together.

What's the economic debate around this practice?

Yeah, tying.

The Supreme Court once banned it, fearing it was a way for a firm with market power in one product to extend that power into another market.

However, many economists are skeptical of that view, too.

They suggest it can sometimes be a form of price discrimination, allowing firms to more total willingness to pay from diverse customers.

For example, if two movie theaters value superheroes and Hamlet differently—one loves action, the other loves drama bundling them—might allow the studio to charge a combined price closer to each theater's total willingness to pay for both films together.

This could extract more value for the studio without necessarily harming competition in other ways.

It's about capturing existing value, not necessarily extending market power inappropriately.

And these complexities were absolutely central to that famous Microsoft antitrust case, weren't they?

Where the government accused Microsoft of bundling its Internet Explorer browser with Windows specifically to extend its operating system market power into the browser market, Microsoft of course argued it was just natural technological progress, adding features.

Exactly.

Microsoft argued that adding new features to operating systems is a natural part of technological evolution,

making products more reliable and easier to use for consumers.

Critics, however, pointed to Microsoft's substantial market share in operating systems as evidence of monopoly power being leveraged unfairly.

The government and Microsoft eventually reached a settlement, but the case really highlighted the immense difficulty of applying traditional antitrust laws in fast -evolving tech industries.

And the recent discussions around companies like Amazon show this debate persists.

While critics worry about Amazon's enormous scale and reach,

antitrust law usually punishes anticompetitive conduct, specific actions, not simply bigness itself.

Justice Scalia famously wrote that the mere possession of monopoly power is not unlawful.

It's an important element of the free market system because the prospect of monopoly profits induces innovation.

This is a very difficult line for policymakers to walk, especially as modern tech companies become incredibly large and diversified.

Wow.

That was an incredibly insightful journey through the world of oligopolies.

To bring it all together for you listening, here are the key takeaways from today's deep dive.

Okay.

First, oligopolies exist where a few sellers offer similar products and their decisions are fundamentally interdependent.

What one does affects the others.

Second, while oligopolists would prefer to act like a single monopolist and earn maximum profits,

self -interest usually pushes them towards producing more and charging less than a pure monopoly, but still less quantity and a higher price than you'd see in perfect competition.

They land somewhere in the middle.

Right.

Third, the more firms there are in an oligopoly, the closer the market outcome gets to a competitive one, pushing prices down and quantities up, which is generally good for consumers.

And finally, the prisoner's dilemma powerfully illustrates why cooperation is so difficult to maintain, even when it's mutually beneficial for the players involved, whether it's our friends, Jack and Jill, or nations engaged in an arms race.

But critically, for society as a whole, this very failure of oligopolists to cooperate and act like a monopoly is actually a good thing.

It fosters competition.

Remember,

policymakers use antitrust laws to try and encourage that competition, but applying these laws can be really controversial.

Business practices that might appear anticompetitive on the surface, like resale price maintenance or tying, can sometimes have legitimate, even subtle, economic purposes.

It's a constant challenge for society to strike the right balance between encouraging robust competition and allowing for beneficial business innovation.

Indeed.

So as you go about your day, maybe observe the markets around you.

What oligopolies can you spot?

Perhaps in industries you regularly interact with, like, I don't know, airlines or cell phone providers.

And how do you think their internal struggles between cooperation and self -interest are shaping the prices and choices you see?

Something to think about.

Thank you for joining us on this deep dive into oligopoly.

We hope you're now feeling well informed and maybe a bit more ready to back all those strategic situations you might encounter.