A lack of cooperation by oligopolists trying to maintain monopoly profits

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CHAPTER

17 Oligopoly

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I

f you go to a store to buy tennis balls, you will probably come home with one of four brands: Wilson, Penn, Dunlop, or Spalding. These four companies make almost all the tennis balls sold in

the United States. Together these firms determine the quantity of tennis balls produced and, given the market demand curve, the price at which tennis balls are sold.

The market for tennis balls is an example of an oligopoly. The essence of an oligopolistic market is that there are only a few sellers. As a result, the actions of any one seller in the market can have a large impact on the profits of all the other sellers. Oligopolistic firms are interdependent in a way that competitive firms are not. Our goal in this chapter is to see how this interdependence shapes the firms' behavior and what problems it raises for public policy.

oligopoly a market structure in which only a few sellers offer similar or identical products

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The analysis of oligopoly offers an opportunity to introduce game theory, the study of how people behave in strategic situations. By “strategic” we mean a situation in which a person, when choosing among alternative courses of action, must consider how others might respond to the action she takes. Strategic thinking is crucial not only in checkers, chess, and tic-tac-toe but also in many business decisions. Because oligopolistic markets have only a small number of firms, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all the other firms in the market.

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game theory the study of how people behave in strategic situations

Game theory is not necessary for understanding competitive or monopoly markets. In a market that is either perfectly competitive or monopolistically competitive, each firm is so small compared to the market that strategic interactions with other firms are not important. In a monopolized market, strategic interactions are absent because the market has only one firm. But, as we will see, game theory is useful for understanding oligopolies and many other situations in which a small number of players interact with one another. Game theory helps explain the strategies that people choose, whether they are playing tennis or selling tennis balls.

17-1 Markets with Only a Few Sellers Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. The oligopolists are best off when they cooperate and act like a monopolist—producing a small quantity of output and charging a price above marginal cost. Yet because each oligopolist cares only about its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the cooperative outcome.

17-1a A Duopoly Example To understand the behavior of oligopolies, let's consider an oligopoly with only two members, called a duopoly. Duopoly is the simplest type of oligopoly. Oligopolies with three or more members face the same problems as duopolies, so we do not lose much by starting with the simpler case.

Imagine a town in which only two residents—Jack and Jill—own wells that produce water safe for drinking. Each Saturday, Jack and Jill decide how many gallons of water to pump, bring the water to town, and sell it for whatever price the market will bear. To keep things simple, suppose that Jack and Jill can pump as much water as they want without cost. That is, the marginal cost of water equals zero.

Table 1 shows the town's demand schedule for water. The first column shows the total quantity demanded, and the second column shows the price. If the two well owners sell a total of 10 gallons of water, water goes for $110 a gallon. If they sell a total of 20 gallons, the price falls to $100 a gallon. And so on. If you graphed these two columns of numbers, you would get a standard downward- sloping demand curve.

The last column in Table 1 shows the total revenue from the sale of water. It equals the quantity sold times the price. Because there is no cost to pumping water, the total revenue of the two producers equals their total profit.

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TABLE 1 The Demand Schedule for Water

Quantity Price Total Revenue (and total profit)

0 gallons $120 $ 0 10 110 1,100 20 100 2,000 30 90 2,700 40 80 3,200 50 70 3,500 60 60 3,600 70 50 3,500 80 40 3,200 90 30 2,700 100 20 2,000 110 10 1,100 120 0 0

Let's now consider how the organization of the town's water industry affects the price of water and the quantity of water sold.

17-1b Competition, Monopolies, and Cartels Before considering the price and quantity of water that would result from the duopoly of Jack and Jill, let's discuss briefly what the outcome would be if the water market were either perfectly competitive or monopolistic. These two polar cases are natural benchmarks.

If the market for water were perfectly competitive, the production decisions of each firm would drive price equal to marginal cost. Because we have assumed that the marginal cost of pumping additional water is zero, the equilibrium price of water under perfect competition would be zero as well. The equilibrium quantity would be 120 gallons. The price of water would reflect the cost of producing it, and the efficient quantity of water would be produced and consumed.

Now consider how a monopoly would behave. Table 1 shows that total profit is maximized at a quantity of 60 gallons and a price of $60 a gallon. A profit-maximizing monopolist, therefore, would produce this quantity and charge this price. As is standard for monopolies, price would exceed marginal cost. The result would be inefficient, because the quantity of water produced and consumed would fall short of the socially efficient level of 120 gallons.

What outcome should we expect from our duopolists? One possibility is that Jack and Jill get

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together and agree on the quantity of water to produce and the price to charge for it. Such an agreement among firms over production and price is called collusion, and the group of firms acting in unison is called a cartel. Once a cartel is formed, the market is in effect served by a monopoly and we can apply our analysis from Chapter 15. That is, if Jack and Jill were to collude, they would agree on the monopoly outcome because that outcome maximizes the total profit that they can get from the market. Our two producers would produce

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a total of 60 gallons, which would be sold at a price of $60 a gallon. Once again, price exceeds marginal cost, and the outcome is socially inefficient.

collusion an agreement among firms in a market about quantities to produce or prices to charge cartel a group of firms acting in unison

A cartel must agree not only on the total level of production but also on the amount produced by each member. In our case, Jack and Jill must agree on how to split the monopoly production of 60 gallons. Each member of the cartel will want a larger share of the market because a larger market share means larger profit. If Jack and Jill agreed to split the market equally, each would produce 30 gallons, the price would be $60 a gallon, and each would get a profit of $1,800.

IN THE NEWS Public Price Fixing

If a group of producers coordinates their prices in secret meetings, they can be sent to jail for criminal violations of antitrust laws. But what if they discuss the same topic in public? Market Talk By Alistair Lindsay

ost companies have antitrust compliance policies. They typically—and quite rightly— identify a number of things that officers and employees should not do, on pain of criminal

liability, eye-watering fines and unlimited damages actions. All make clear that companies must not agree with their competitors to fix prices. This is a bright-line rule. But it raises an important question: Can companies coordinate price increases without infringing the cartel rules?

In markets where competitors need to publish their prices to win business—for example, many retail markets—it is perfectly lawful to shadow a rival's increases, so long as each seller acts entirely independently in setting its charges. The very definition of an oligopoly is a market involving a small number of suppliers that set their own commercial strategies but take account of their competitors. One competitor may emerge as a leader, with others taking their cue on when to raise

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prices and by how much. When prices are privately negotiated—as in many industrials markets—it is common for a

customer to volunteer information about a rival's prices to obtain leverage: “You've quoted £100 per ton, but X is offering £95 and I'm going to them unless you can do better.”A company that receives this information obtains valuable intelligence about what its rivals are charging, but it does not infringe cartel rules….

Companies also sometimes signal to one another in their communications with investors, whether deliberately or not. A competitor which informs the markets, say, that it expects a price war to end in February is providing relevant information to actual and potential owners of its stock. But of course its rivals read the same reports and can change their strategies accordingly. So a statement to the market can serve as just as much of a signal to competitors as a statement made during a cartel meeting….

Signaling through investor communications raises difficult questions for cartel enforcement. The enforcers want to protect consumers from the adverse effects of blatant signaling, but not at the price of losing transparency in financial markets. For example, it is highly relevant to an investor to know an airline's predicted growth of per-mile passenger revenue for the next quarter. But a rival airline might use the announced figure as a benchmark when setting its own fares for the next quarter.

As things stand, cartel authorities have focused their efforts in such situations on blocking mergers in markets where signaling is prevalent, arguing that consolidation in such markets can further dampen competition by making coordination easier or more successful. However, they have not taken high-profile action alleging cartel infringements against companies for announcements made to investors.

If there is no justification for a particular announcement other than to signal to competitors, cartel authorities should seek to intervene. For in this case the public announcement is analytically the same as a private discussion directly with the rivals, and there is scope for consumers to be seriously harmed. But most announcements do serve legitimate purposes, such as keeping investors informed. In these cases, intervention by the cartel authorities seems too complex, given the disparate policy objectives in play.

Source: Reprinted with permission of The Wall Street Journal, Copyright © 2007 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

17-1c The Equilibrium for an Oligopoly

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Oligopolists would like to form cartels and earn monopoly profits, but that is often impossible. Squabbling among cartel members over how to divide the profit in the market can make agreement among members difficult. In addition, antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy. Even talking about pricing and production restrictions with competitors can be a criminal offense. Let's therefore consider what happens if Jack and Jill decide separately how much water to produce.

At first, one might expect Jack and Jill to reach the monopoly outcome on their own, because this outcome maximizes their joint profit. In the absence of a binding agreement, however, the monopoly outcome is unlikely. To see why, imagine that Jack expects Jill to produce only 30 gallons (half of the monopoly quantity). Jack would reason as follows:

“I could produce 30 gallons as well. In this case, a total of 60 gallons of water would be sold at a price of $60 a gallon. My profit would be $1,800 (30 gallons × $60 a gallon). Alternatively, I could produce 40 gallons. In this case, a total of 70 gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000 (40 gallons × $50 a gallon). Even though total profit in the market would fall, my profit would be higher, because I would have a larger share of the market.”

Of course, Jill might reason the same way. If so, Jack and Jill would each bring 40 gallons to town. Total sales would be 80 gallons, and the price would fall to $40. Thus, if the duopolists individually pursue their own self-interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge a price lower than the monopoly price, and earn total profit less than the monopoly profit.

Although the logic of self-interest increases the duopoly's output above the monopoly level, it does not push the duopolists all the way to the competitive allocation. Consider what happens when each duopolist produces 40 gallons. The price is $40, and each duopolist makes a profit of $1,600. In this case, Jack's self-interested logic leads to a different conclusion:

“Right now, my profit is $1,600. Suppose I increase my production to 50 gallons. In this case, a total of 90 gallons of water would be sold, and the price would be $30 a gallon. Then my profit would be only $1,500. Rather than increasing production and driving down the price, I am better off keeping my production at 40 gallons.”

The outcome in which Jack and Jill each produce 40 gallons looks like some sort of equilibrium. In fact, this outcome is called a Nash equilibrium. (It is named after economic theorist John Nash, whose life was portrayed in the book and movie A Beautiful Mind.) A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies the others have chosen. In this case, given that Jill is producing 40 gallons, the best strategy for Jack is to produce 40 gallons. Similarly, given that Jack is producing 40 gallons, the best strategy for Jill is to produce 40 gallons. Once they reach this Nash equilibrium, neither Jack nor Jill has an incentive to make a different decision.

Nash equilibrium a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the other actors have chosen

This example illustrates the tension between cooperation and self-interest. Oligopolists would be

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better off cooperating and reaching the monopoly outcome. Yet because they pursue their own self- interest, they do not end up reaching the monopoly outcome and maximizing their joint profit. Each oligopolist is tempted to raise production and capture a larger share of the market. As each of them tries to do this, total production rises, and the price falls.

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At the same time, self-interest does not drive the market all the way to the competitive outcome. Like monopolists, oligopolists are aware that increasing the amount they produce reduces the price of their product, which in turn affects profits. Therefore, they stop short of following the competitive firm's rule of producing up to the point where price equals marginal cost.

In summary, when firms in an oligopoly individually choose production to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by perfect competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

17-1d How the Size of an Oligopoly Affects the Market Outcome We can use the insights from this analysis of duopoly to discuss how the size of an oligopoly is likely to affect the outcome in a market. Suppose, for instance, that John and Joan suddenly discover water sources on their property and join Jack and Jill in the water oligopoly. The demand schedule in Table 1 remains the same, but now more producers are available to satisfy this demand. How would an increase in the number of sellers from two to four affect the price and quantity of water in the town?

If the sellers of water could form a cartel, they would once again try to maximize total profit by producing the monopoly quantity and charging the monopoly price. Just as when there were only two sellers, the members of the cartel would need to agree on production levels for each member and find some way to enforce the agreement. As the cartel grows larger, however, this outcome is less likely. Reaching and enforcing an agreement becomes more difficult as the size of the group increases.

If the oligopolists do not form a cartel—perhaps because the antitrust laws prohibit it—they must each decide on their own how much water to produce. To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each well owner has the option to raise production by one gallon. In making this decision, the well owner weighs the following two effects:

The output effect: Because price is above marginal cost, selling one more gallon of water at the going price will raise profit. The price effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold.

If the output effect is larger than the price effect, the well owner will increase production. If the price effect is larger than the output effect, the owner will not raise production. (In fact, in this case, it is profitable to reduce production.) Each oligopolist continues to increase production until these two marginal effects exactly balance, taking the other firms' production as given.

Now consider how the number of firms in the industry affects the marginal analysis of each oligopolist. The larger the number of sellers, the less each seller is concerned about her own impact on the market price. That is, as the oligopoly grows in size, the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether. That is, the production decision of an individual firm no longer affects the market price. In this extreme case, each firm takes the market price as given when deciding how much to produce. It increases production as long as price is above marginal cost.