Explain why and also how oligopolies existContrast collusion and competitionInterpret and also analyze the prisoner’s dilemma diagramEvaluate the tradeoffs of imperfect competition

Many purchase that people make at the sleeve level are produced in sectors that space neither perfect competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises as soon as a small number of large firms have all or many of the sales in an industry. Examples of oligopoly abound and also include the auto industry, cable television, and also commercial air travel. Oligopolistic this firm are prefer cats in a bag. They have the right to either scratch each other to pieces or cuddling up and also get comfortable v one another. If oligopolists compete hard, lock may finish up acting very much like perfect competitors, driving down costs and also leading to zero profits for all. If oligopolists collude through each other, they may properly act favor a syndicate and success in pushing up prices and earning consistently high levels of profit. Oligopolies room typically identified by shared interdependence where various decisions such together output, price, advertising, and so on, count on the decisions of the other firm(s). Evaluating the choices of oligopolistic firms around pricing and quantity developed involves considering the pros and cons that competition matches collusion at a given point in time.

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Why execute Oligopolies Exist?

A combination of the obstacles to entrance that develop monopolies and also the product differentiation the characterizes monopolistic compete can produce the setting for one oligopoly. Because that example, when a federal government grants a patent for an innovation to one firm, that may develop a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its very own drug for reducing high blood pressure, those 3 firms may end up being an oligopoly.

Similarly, a natural monopoly will certainly arise as soon as the quantity demanded in a sector is only large enough because that a solitary firm to run at the minimum that the long-run average expense curve. In such a setting, the market has actually room for just one firm, because no smaller sized firm have the right to operate in ~ a low enough average price to compete, and no bigger firm can sell what it produced given the quantity demanded in the market.

Quantity demanded in the sector may likewise be two or 3 times the quantity essential to produce at the minimum the the average cost curve—which method that the industry would have actually room for just two or three oligopoly this firm (and they require not produce differentiated products). Again, smaller sized firms would certainly have greater average costs and be unable to compete, if additional large firms would develop such a high amount that they would certainly not have the ability to sell it at a profitable price. This combination of economies of scale and also market demand creates the barrier to entry, which brought about the Boeing-Airbus oligopoly for big passenger aircraft.

The product differentiation at the heart of monopolistic competition can likewise play a function in producing oligopoly. For example, firms may need to with a specific minimum size prior to they space able come spend sufficient on advertising and also marketing to develop a recognizable brand name. The trouble in contending with, say, Coca-Cola or Pepsi is no that producing fizzy drink is technologically difficult, but rather that developing a brand name and also marketing effort to equal Coke or Pepsi is an huge task.

Collusion or Competition?

When oligopoly that company in a certain market decision what amount to produce and also what price come charge, they confront a temptation come act as if they to be a monopoly. By exhilaration together, oligopolistic firms have the right to hold down sector output, fee a higher price, and divide increase the profit amongst themselves. Once firms act together in this means to reduce output and keep prices high, the is referred to as collusion. A team of this firm that have actually a formal commitment to collude to produce the monopoly output and also sell in ~ the syndicate price is referred to as a cartel. Check out the adhering to Clear the Up feature for a more in-depth analysis of the difference in between the two.


Collusion matches cartels: How have the right to I phone call which is which?

In the united States, as well as many other countries, that is illegal for firms come collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust department of the justice Department and the Federal profession Commission have responsibilities for staying clear of collusion in the unified States.

The difficulty of enforcement is detect hard evidence of collusion. Cartels are formal agreements come collude. Because cartel agreements carry out evidence that collusion, they are rare in the joined States. Instead, most collusion is tacit, where firms implicitly reach an understanding that compete is bad for profits.


The desire that businesses come avoid competing so the they deserve to instead advanced the prices the they charge and earn higher profits has actually been well understood by economists. Adam Smith wrote in Wealth the Nations in 1776: “People the the exact same trade seldom meet together, even for merriment and also diversion, but the conversation ends in a conspiracy versus the public, or in part contrivance to raise prices.”

Even once oligopolists recognize that castle would advantage as a group by acting prefer a monopoly, each individual oligopoly faces a exclusive temptation to create just a slightly greater quantity and also earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep price high. If at least some oligopolists offer in to this temptation and start producing more, climate the industry price will certainly fall. Indeed, a little handful that oligopoly this firm may finish up completing so fiercely that they all finish up earning zero financial profits—as if they were perfect competitors.

The Prisoner’s Dilemma

Because the the intricacy of oligopoly, i m sorry is the an outcome of shared interdependence among firms, there is no single, generally-accepted theory of just how oligopolies behave, in the same way that we have actually theories for all the other sector structures. Instead, financial experts use game theory, a branch of mathematics that analyzes situations in i beg your pardon players have to make decisions and also then get payoffs based upon what other players decision to do. Video game theory has found widespread applications in the social sciences, and also in business, law, and military strategy.

The prisoner’s dilemma is a script in which the benefit from collaboration are bigger than the rewards from pursuing self-interest. It uses well to oligopoly. The story behind the prisoner’s dilemma goes prefer this:


Two co-conspiratorial criminals room arrested. When they room taken come the police station, castle refuse to say anything and also are put in different interrogation rooms. Eventually, a police officer beginning the room whereby Prisoner A is being held and also says: “You know what? Your companion in the other room is confessing. Therefore your companion is walking to obtain a light prison sentence of simply one year, and because you’re staying silent, the judge is going to stick you with eight year in prison. Why nothing you gain smart? If you confess, too, we’ll reduced your jail time down to five years, and also your partner will get five years, also.” end in the next room, an additional police officer is giving specifically the very same speech to prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence versus them is not especially strong, and the prisoners will end up with just two year in prison each.

The game theory situation facing the two prisoners is shown in Table 3. To recognize the dilemma, very first consider the options from sinner A’s point of view. If A believes the B will certainly confess, climate A need to confess, too, so regarding not obtain stuck with the eight year in prison. But if A believes that B will certainly not confess, climate A will certainly be tempted to act selfishly and confess, so as to serve only one year. The vital point is the A has an motivation to confess nevertheless of what choice B makes! B encounters the same set of choices, and thus will have an incentive to confess nevertheless of what an option A makes. Confess is taken into consideration the leading strategy or the strategy an individual (or firm) will go after regardless that the various other individual’s (or firm’s) decision. The an outcome is that if detainees pursue their very own self-interest, both are most likely to confess, and end up doing a complete of 10 years of jail time between them.

Prisoner B
Remain silent (cooperate with other prisoner)Confess (do no cooperate with other prisoner)
Prisoner ARemain quiet (cooperate with other prisoner)A it s okay 2 years, B it s okay 2 yearsA it s okay 8 years, B it s okay 1 year
Confess (do no cooperate with various other prisoner)A it s okay 1 year, B gets 8 yearsA gets 5 years B it s okay 5 years
Table 3. The Prisoner’s Dilemma Problem

The game is called a dilemma because if the two prisoners had actually cooperated by both continuing to be silent, lock would only have had actually to offer a full of 4 years of jail time between them. If the 2 prisoners have the right to work the end some way of cooperating so the neither one will confess, they will certainly both be better off 보다 if they each follow their own individual self-interest, i beg your pardon in this situation leads straight right into longer prison terms.

The Oligopoly variation of the Prisoner’s Dilemma

The members of one oligopoly can confront a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, climate high monopoly profits are possible. Every oligopolist, however, must issue that while it is holding down output, other firms space taking advantage of the high price by increasing output and earning greater profits. Table 4 reflects the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly. If that company A and B both agree to hold down output, they space acting with each other as a monopoly and will each knife $1,000 in profits. However, both firms’ leading strategy is to rise output, in which case each will certainly earn $400 in profits.

Firm B
Hold down Output (cooperate with various other firm)Increase calculation (do not cooperate with various other firm)
Firm AHold down Output (cooperate with various other firm)A gets $1,000, B gets $1,000A gets $200, B it s okay $1,500
Increase output (do no cooperate with various other firm)A gets $1,500, B gets $200A it s okay $400, B gets $400
Table 4. A Prisoner’s Dilemma because that Oligopolists

Can the two firms trust each other? consider the case of certain A:

If A thinks that B will certainly cooperate through holding under output, then A might seize the opportunity to earn greater profits by increasing output. After all, if B is walking to host down output, climate A have the right to earn $1,500 in revenues by expanding output (the bottom left-hand selection in the table) contrasted with just $1,000 by holding down output too (the upper left-hand an option in the table).

Thus, certain A will factor that it makes sense to broaden output if B holds under output and that it additionally makes feeling to broaden output if B raises output. Again, B encounters a parallel set of decisions.

The result of this prisoner’s dilemma is regularly that also though A and also B can make the highest linked profits by cooperating in producing a reduced level the output and acting prefer a monopolist, the 2 firms might well end up in a instance where they each increase output and earn only $400 each in profits. The adhering to Clear the Up feature discusses one cartel scandal in particular.


What is the Lysine cartel?

Lysine, a $600 million-a-year industry, is an amino acid offered by farmers as a feeding additive to ensure the proper growth the swine and also poultry. The major U.S. Producer of lysine is Archer Daniels Midland (ADM), however several other large European and Japanese firms are also in this market. For a time in the an initial half the the 1990s, the world’s major lysine producer met with each other in hotel conference rooms and also decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of examination (FBI), however, had learned of the cartel and placed wire taps ~ above a number of their phone call calls and also meetings.

From FBI monitoring tapes, adhering to is a comment that terry Wilson, chairman of the corn processing division at ADM, made to the other lysine producer at a 1994 meeting in Mona, Hawaii:


I wanna go earlier and ns wanna say something an extremely simple. If we’re walking to trust each other, okay, and also if i’m assured that I’m gonna get 67,000 lots by the year’s end, we’re gonna offer it at the prices us agreed to . . . The just thing we need to talk around there because we space gonna get manipulated by this buyers—they have the right to be smarter than united state if us let them be smarter. . . . Lock room not her friend. They room not my friend. And also we gotta have ‘em, yet they room not my friends. You are my friend. Ns wanna be closer come you 보다 I to be to any kind of customer. Cause you have the right to make us … money. … and all i wanna tell you again is let’s—let’s placed the prices on the board. Let’s all agree that’s what we’re gonna do and also then walk out of here and also do it.

The price that lysine doubled while the cartel was in effect. Challenged by the FBI tapes, Archer Daniels Midland pled guilty in 1996 and also paid a well of $100 million. A variety of top executives, both in ~ ADM and also other firms, later paid fines of up to $350,000 and also were sentenced come 24–30 months in prison.

In one more one of the FBI recordings, the chairman of Archer Daniels Midland told an executive from another competing firm that ADM had actually a slogan that, in his words, had “penetrated the totality company.” The agency president stated the slogan this way: “Our competitors are our friends. Our customers are the enemy.” that slogan can stand as the motto the cartels everywhere.


How to Enforce Cooperation

How have the right to parties who uncover themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate v each other? The method out of a prisoner’s dilemma is to discover a method to penalize those who perform not cooperate.

Perhaps the easiest method for colluding oligopolists, together you can imagine, would be to authorize a contract v each other that lock will organize output low and also keep price high. If a group of U.S. Companies signed together a contract, however, it would certainly be illegal. Certain international organizations, prefer the nations that space members of the Organization that Petroleum Exporting countries (OPEC), have signed worldwide agreements come act like a monopoly, hold down output, and also keep price high for this reason that every one of the countries can make high earnings from oil exports. Together agreements, however, since they loss in a gray area of worldwide law, space not legit enforceable. If Nigeria, for example, decides to begin cutting prices and selling much more oil, Saudi Arabia can not sue Nigeria in court and also force it to stop.


Visit the organization of the Petroleum Exporting countries website and learn an ext about its history and just how it defines itself.

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Because oligopolists cannot sign a legally enforceable contract to act choose a monopoly, the that company may rather keep near tabs on what various other firms space producing and also charging. Alternatively, oligopolists may choose to plot in a means that generates press on every firm to stick to its agreed quantity of output.

One example of the pressure these firms can exert ~ above one another is the kinked need curve, in which competing oligopoly that company commit to complement price cuts, however not price increases. This instance is presented in number 1. Say the an oligopoly airline has agreed v the rest of a cartel to administer a quantity of 10,000 seats on the new York to Los Angeles route, in ~ a price of $500. This selection defines the kink in the firm’s perceived demand curve. The reason that the firm deals with a kink in its need curve is since of how the various other oligopolists react to changes in the firm’s price. If the oligopoly decides come produce much more and cut its price, the other members that the cartel will automatically match any kind of price cuts—and therefore, a reduced price bring very tiny increase in amount sold.

If one firm cuts its price to $300, that will be able to sell only 11,000 seats. However, if the airline seeks to progressive prices, the various other oligopolists will certainly not raise their prices, and also so the firm that increased prices will lose a considerable share that sales. For example, if the certain raises the price come $550, the sales drop come 5,000 seat sold. Thus, if oligopolists always match price cut by other firms in the cartel, however do not match price increases, climate none that the oligopolists will have a solid incentive to change prices, due to the fact that the potential gains are minimal. This strategy have the right to work like a silent form of cooperation, in i beg your pardon the cartel effectively manages to organize down output, boost price, and also share a monopoly level of profits also without any type of legally enforceable agreement.

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Figure 1. A Kinked demand Curve. Take into consideration a member for sure in one oligopoly cartel that is an alleged to produce a quantity of 10,000 and sell at a price that $500. The other members that the cartel have the right to encourage this for sure to respect its commitments by acting so the the firm deals with a kinked demand curve. If the oligopolist attempts to broaden output and reduce price slightly, other firms additionally cut prices immediately—so if the firm increases output come 11,000, the price per unit falls dramatically, to $300. ~ above the other side, if the oligopoly attempts to raise its price, various other firms will not do so, so if the for sure raises that price come $550, its sales decline sharply come 5,000. Thus, the members the a cartel can technique each other to stick to the pre-agreed level of quantity and price v a strategy of equivalent all price cuts however not matching any kind of price increases.

Many real-world oligopolies, prodded by financial changes, legal and political pressures, and the egos the their optimal executives, go with episodes of cooperation and competition. If oligopolies could sustain cooperation with each various other on output and also pricing, they might earn earnings as if they were a solitary monopoly. However, every firm in one oligopoly has an impetus to produce an ext and seize a bigger re-superstructure of the all at once market; once firms begin behaving in this way, the market outcome in regards to prices and also quantity have the right to be similar to that of a highly competitive market.

Tradeoffs that Imperfect Competition

Monopolistic competition is most likely the single most typical market framework in the U.S. Economy. That provides an effective incentives because that innovation, as firms seek to earn earnings in the brief run, if entry assures the firms execute not earn financial profits in the lengthy run. However, monopolistically competitive firms do not create at the lowest point on your average expense curves. In addition, the endless search to impress consumers through product differentiation might lead to extreme social prices on advertising and marketing.

Oligopoly is most likely the 2nd most typical market structure. Once oligopolies result from patented innovations or native taking advantage of economic climates of range to develop at low median cost, lock may carry out considerable advantage to consumers. Oligopolies are frequently buffeted by far-reaching barriers to entry, which permit the oligopolists to knife sustained revenues over long periods that time. Oligopolists likewise do not typically produce at the minimum of their average expense curves. Once they lack colorful competition, castle may absence incentives to carry out innovative products and also high-quality service.

The job of public policy with regard to competition is to type through this multiple realities, attempting come encourage habits that is valuable to the broader society and to discourage habits that only adds to the revenues of a few large companies, with no corresponding advantage to consumers. Monopoly and Antitrust policy discusses the breakable judgments that enter this task.


The Temptation to Defy the Law

Oligopolistic firms have actually been referred to as “cats in a bag,” together this chapter mentioned. The French detergent makers chose to “cozy up” v each other. The result? one uneasy and also tenuous relationship. As soon as the Wall Street Journal reported on the matter, that wrote: “According come a declare a Henkel manager made to the commission, the detergent devices wanted ‘to limit the soot of the competition in between them and also clean increase the market.’ Nevertheless, by the beforehand 1990s, a price battle had broken out amongst them.” throughout the soap executives’ meetings, which occasionally lasted more than four hours, facility pricing structures were established. “One executive, management recalled ‘chaotic’ meetings together each next tried to occupational out how the other had actually bent the rules.” Like numerous cartels, the soap cartel broke down due come the very strong temptation because that each member come maximize its own individual profits.

How walk this soap opera end? after ~ an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and also Proctor & gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice cream is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. Nobody cares what label is on the bag. By agreeing to carve increase the ice market, control vast geographic swaths of territory, and collection prices, the icemakers relocated from perfect competition to a syndicate model. After ~ the agreements, each firm was the sole supplier of bagged ice cream to a region; over there were profits in both the long run and also the brief run. According to the courts: “These suppliers illegally conspired come manipulate the marketplace.” Fines totaled around $600,000—a steep well considering a bag of ice sells for under $3 in most parts of the joined States.

Even despite it is illegal in numerous parts that the civilization for firms to collection prices and also carve up a market, the temptation to earn greater profits renders it extremely tempting come defy the law.


Key Concepts and also Summary

An oligopoly is a situation where a few firms sell most or every one of the goods in a market. Oligopolists knife their highest possible profits if they deserve to band together as a cartel and act choose a monopolist by reduce output and raising price. Because each member the the oligopoly can advantage individually from widening output, such collusion regularly breaks down—especially due to the fact that explicit collusion is illegal.

The prisoner’s dilemma is an instance of video game theory. It reflects how, in specific situations, all sides can advantage from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to uncover ways come encourage cooperative behavior.


Self-Check Questions

Consider the curve displayed in figure 2, which shows the market demand, marginal cost, and marginal revenue curve because that firms in an oligopolistic industry. In this example, we assume firms have actually zero solved costs.
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Figure 2.Suppose the this firm collude to type a cartel. What price will certainly the cartel charge? What quantity will the cartel supply? how much profit will certainly the cartel earn?Suppose currently that the cartel division up and also the oligopolistic firms complete as strongly as feasible by cut the price and also increasing sales. What will certainly the industry quantity and price be? What will the cumulative profits it is in of all firms in the industry?Compare the equilibrium price, quantity, and also profit because that the cartel and also cutthroat compete outcomes.

Review Questions

Will the this firm in one oligopoly act much more like a monopoly or more like competitors? summary explain.Does every individual in a prisoner’s dilemma benefit an ext from participation or from follow self-interest? describe briefly.What stops oligopolists from acting with each other as a monopolist and earning the highest feasible level the profits?

Critical thinking Questions

Would you intend the kinked need curve to be much more extreme (like a appropriate angle) or less extreme (like a normal demand curve) if every firm in the cartel produce a near-identical product choose OPEC and petroleum? What if each firm to produce a somewhat various product? define your reasoning.When OPEC increased the price the oil significantly in the mid-1970s, professionals said it to be unlikely the the cartel could stay with each other over the lengthy term—that the incentives for individual members come cheat would end up being too strong. An ext than forty years later, OPEC tho exists. Why execute you think OPEC has been able come beat the odds and continue come collude? Hint: You may wish to consider non-economic reasons.
References

The United claims Department that Justice. “Antitrust Division.” Accessed October 17, 2013. Http://www.justice.gov/atr/.

eMarketer.com. 2014. “Total US advertisement Spending come See biggest Increase due to the fact that 2004: Mobile advertising leads growth; will certainly surpass radio, magazines and also newspapers this year. Accessed march 12, 2015. Http://www.emarketer.com/Article/Total-US-Ad-Spending-See-Largest-Increase-Since-2004/1010982.

Federal trade Commission. “About the Federal profession Commission.” Accessed October 17, 2013. Http://www.ftc.gov/ftc/about.shtm.


Glossary

cartela team of firms that collude to develop the monopoly output and sell at the monopoly pricecollusionwhen firms act with each other to minimize output and keep price highduopolyan oligopoly with just two firmsgame theorya branch the mathematics frequently used by financial experts that analyzes cases in which players should make decisions and also then receive payoffs based on what decision the various other players makekinked demand curvea perceived demand curve the arises when completing oligopoly that company commit to complement price cuts, yet not price increasesprisoner’s dilemmaa game in i beg your pardon the gains from collaboration are larger than the rewards from pursuing self-interest

Solutions

Answers to Self-Check Questions

If the firms form a cartel, they will certainly act prefer a monopoly, picking the amount of output where MR = MC. Illustration a heat from the monopoly quantity approximately the demand curve shows the syndicate price. Assuming that fixed costs are zero, and with an understanding of cost and also profit, we have the right to infer that when the marginal price curve is horizontal, average price is the exact same as marginal cost. Thus, the cartel will certainly earn positive financial profits same to the area the the rectangle, with a base equal to the syndicate quantity and also a elevation equal come the difference between price (on the demand over the monopoly quantity) and average cost, as shown in the complying with figure.
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Figure 3.The that company will increase output and cut price as long as there are profits remaining. The long-run equilibrium will happen at the suggest where average cost equals demand. As a result, the oligopoly will earn zero financial profits because of “cutthroat competition,” as displayed in the next figure.
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Figure 4.

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Pc > Pcc. Qc for sure B reasons that if that cheats and Firm A does no notice, the will double its money. Since Firm A’s revenues will decrease substantially, however, the is most likely that for sure A will notice and if so, firm A will cheat also, through the result that firm B will lose 90% the what it acquired by cheating. Firm A will reason that for sure B is i can not qualify to threat cheating. If neither firm cheats, firm A earns $1000. If firm A cheats, assuming firm B does not cheat, A can boost its profits only a little, because Firm B is so small. If both firms cheat, then Firm A loser at the very least 50% that what it could have earned. The possibility of a tiny gain ($50) is more than likely not enough to induce firm A come cheat, so in this instance it is likely that both firms will collude.