Krugman AP Section 12 Notes

Econ: 64
Introduction to Oligopoly
Margaret Ray and David Anderson
What you will learn
in this Module:
• Why oligopolists have an incentive to act
in ways that reduce their combined profit.
• Why oligopolies can benefit from
I. Understanding Oligopoly
A. “Few” producers
• Remember HHI
• Page 573-74
B. InterdependenceActions of one firm
have an impact on
another firm and vice
II. Collusion and Competition
A. Oligopoly firms can
increase their profits by
colluding to restrict output
or raise price.
B. Maintaining collusive
agreements is difficult
because there is an
incentive to cheat
C. Collusion is illegal
Price versus Quantity Competition
• Bertrand
• Price competition- undercut prices of
• Competitive outcome
• Cournot
• Quantity competition
• Economic profits
Oligopoly is a market structure that is
characterized by a ______ number of ______
firms that produce ______ products.
A) large; relatively small, independent; identical
B) Small; independent; identical or differentiated
C) Large; relatively small, independent;
D) Small; independent; differentiated
E) Small; interdependent; identical or
Answer: E
An extreme case of oligopoly in which firms
collude to raise joint profits is known as a:
A) Duopoly
B) Cartel
C) Dominant producer
D) Price war
E) Price leadership
Answer: B
Econ: 65
Game Theory
Margaret Ray and David Anderson
What you will learn
in this Module:
• How oligopoly can be analyzed using
game theory.
• The concept of the prisoners’ dilemma.
• How repeated interactions among
oligopolists can result in collusion in the
absence of any formal agreement.
I. Game Theory
A. Game Theory: study of
how interdependent
decision makers make
B. When two firms are
close rivals, the choices
of each affect the
outcomes for each.
II. Non-Cooperative Games
A. Each player competes
to maximize individual
payoffs and ignores
the effects of his/her
action on the payoffs
received by the rival.
Oligopoly Video
Game Theory Practice
Golden Balls
B. Terms to Know
1. Payoff matrix- is a diagram showing how the payoffs to
each player in a game depend on the actions of both.
2. Dominant strategy- is an action that is a player’s best
action regardless of what the other player does.
3. Nash equilibrium- occurs when the game ends, and
each player is happy with the outcome, given the
choice made by the rival.
C. Prisoner’s Dilemma
1. Each player has an
incentive to choose
an action that
benefits his/herself
at the other player’s
2. Both players are
then worse off than
if they had acted
The payoff matrix below summarizes the
strategies and outcomes. The payoffs are
measured as years in prison, so smaller
numbers are preferred.
Crook 2
Crook 1 Confess
#1: 5 years
#2: 5 years
#1: 1 year
#2: 20 years
#1: 20 years #1: 2 years
#2: 1 year
#2: 2 years
D. Repeated Interaction and
Tacit Collusion
1. Strategic Behavior: taking account of the effects of an
action today on the future actions of other players in the
2. Repeated interaction can lead to strategic behavior
• Tit for tat strategy
3. Tacit Collusion- cooperation among producers, without a
formal agreement, to limit production and raise prices so
as to raise profits.
Econ: 66
Oligopoly in Practice
Margaret Ray and David Anderson
What you will learn
in this Module:
• The legal constraints of antitrust policy.
• The factors that limit tacit collusion.
• The causes and effects of price wars,
product differentiation, price leadership,
and nonprice competition.
• The importance of oligopoly in the real
I. Antitrust Legislation
A. Laws including the
Sherman Act and the
Clayton Act make
cartels, collusion, and
certain anticompetitive business
practices illegal
B. Prevents Overt
II. Factors Limiting Tacit Collusion
(gentleman’s agreement)
A. Large numbers
• The more firms in the industry, the less likely tacit collusion will be
B. Complex products and pricing schemes
• It is easier to tacitly agree to keep a price high if the product is simple
and there are few ways price can be set.
C. Differences in interests
• If firms have diverse characteristics and interests, it will be more
difficult to establish and maintain tacit agreements.
D. Bargaining powers of buyers
• If the buyers of a product have bargaining power, or they operate in
a competitive retail environment, tacit agreements to keep prices
high are unlikely to succeed.
III. Product Differentiation
and Tacit Collusion
A. Product differentiation is the attempt by firms to convince
buyers that their products are different from those of other firms
in the industry (either by making them different or just
convincing buyers that they are). If firms can convince buyers,
they can charge a higher price.
B. A price leader is a firm that sets a price and the rival firms
follow it. By following the leader, a tacit agreement is created.
C. Non-Price competition occurs when firms compete without
lowering prices; non-price competition.
D. For example: Offer a warranty or better service than their
rivals, offer longer hours, a charge card with rewards program,
personal shoppers, or amenities like a café in the store.
How Important is Oligopoly?
• Prevalence in the “real world”
• Difficulty of modeling oligopoly firm
Econ: 67
Introduction to
Monopolistic Competition
What you will learn
in this Module:
• How prices and profits are determined in
monopolistic competition, both in the
short run and in the long run.
• How monopolistic competition can lead
to inefficiency and excess capacity.
I. Monopolistic Competition
A.Characteristics in common with perfect comp.:
1. Many firms exist in the market, but not as
many as perfect competition.
2. There are no barriers to entry or exit.
B.Characteristics in common with monopoly:
1. The product is differentiated.
2. Each firm has some ability to set the price
of their product.
Ex. Local restaurants, clothing stores
II. Monopolistic Competition
in the Short Run
A. In the short run,
competitors set price
and quantity in the
same way a monopoly
B. Monopolistic
competitors can earn
a profit in the short
Monopolistic Competition in
the Short Run
C. Monopolistic
competitors can also
earn a loss in the
short run.
III. Monopolistic competition
in the Long Run
A. Entry and exit occur
in response to shortrun profits or losses
causing demand to
B. In the long run,
competitors earn a
normal profit
Comparing Monopolistic Competition
with Perfect Competition
• Economic profit = 0 (normal profit), so ATC=P in both
due to entry and exit
• MR = MC in both (profit maximization rule)
• In perfect competition, ATC = P = MR = MC
• In monopolistic competition ATC = P > MR = MC
• Perfect competition achieves productive efficiency by
producing at the minimum ATC
• Monopolistic competition results in excess capacity
IV. Is Monopolistic
Competition efficient?
A. No, P > MC so there is
B. BUT, variety
products) provides a
benefit to consumers.
Econ: 68
Product Differentiation
and Advertising
What you will learn
in this Module:
• How and why oligopolists and
monopolistic competitors differentiate
their products.
• The economic significance of advertising
and brand names.
I. Product Differentiation
A. Product
differentiation is the
attempt by firms to
convince buyers that
their products are
different from those of
other firms in the
II. Differentiation by Style or
As long as consumers have different
tastes, producers will be able to increase
profits by differentiating their products to suit
those tastes.
III. Differentiation by
Many monopolistically competitive firms
differentiate their product by location –
particularly in service industries
IV. Differentiation by Quality
Even if quality differences are mostly
perceived, consumers are often willing to
pay a higher price for a product they
perceive to be of higher quality.
V. Is Product Differentiation
A. Product differentiation can increase product
variety and advertising can provide useful
information, both of which can benefit
B. Product differentiation can be a waste of
resources and advertising can mislead
consumers, both of which can be an inefficient
use of resources.

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