AP Micro 4-4 Oligopolies

Unit 4: Imperfect Competition
Oligopoly
FOUR MARKET MODELS

Perfect Competition Monopolistic Competition Oligopoly
Pure Monopoly
Characteristics of Oligopolies:
A Few Large Producers (Less than 10) Identical or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms use Strategic Pricing Examples: OPEC, Cereal Companies, Car Producers
HOW DO OLIGOPOLIES OCCUR?
Oligopolies occur when only a few large firms start to control an industry. High barriers to entry keep others from entering.
Types of Barriers to Entry

1. Economies of Scale Ex: The car industry is difficult to enter because only large firms can make cars at the lowest cost 2. High Start-up Costs 3. Ownership of Raw Materials
Game Theory
The study of how people behave in strategic situations
An understanding of game theory helps firms in an oligopoly maximize profit.
Game theory helps predict human behavior

THE ICE CREAM MAN SIMULATION
1. You are a ice cream salesmen at the beach 2. You have identical prices as another salesmen. 3. Beachgoers will purchase from the closest salesmen 4. People are evenly distributed along the beach. 5. Each morning the two firms pick locations on the beach
Where is the best location?
Where should you put your firm?

B A
Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the real-world?
Where should you put your firm?

A
*Note to teachers* (delete) B Assign one student firm A and another student firm B. Ask firm A to put their ice cream anywhere along the beach. (the best place is right in the middle) Ask firm B to put theirs in the most profitable location. (the best place is right next to firm A) Explain that if firm B puts theirs anywhere other than right next to firm A they will be less profitable Repeat with firm B choosing first. Students learn that game theory explain why fast food restaurants and gas stations are often located near each other
Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day? How is this observed in the real-world?
Why learn about game theory?

Oligopolies are interdependent since they compete with only a few other firms. Their pricing and output decisions must be strategic as to avoid economic losses. Game theory helps us analyze their strategies.
SIMULATION!
The Prisoners Dilemma

Charged with a crime, each prisoner has one of two choices: Deny or Confess
Prisoner 2
Deny
Both Deny = 5 Deny Years in jail each
Confess
Confess = Free
Deny =20 Years
Prisoner 1
Confess = Free
Confess
Deny = 20 Years
Both Confess= 10 Years in jail each
Game Theory Matrix

You and your partner are competing firms. You have one of two choices: Price High or Price Low. Without talking, write down your choice
Firm 2
High High Low
Both High = $20 Each

High = 0 Low = $30
Low = $30 High = 0

Both Low= $10 each
Firm 1
Low
Game Theory Matrix

Notice that you have an incentive to collude but also an incentive to cheat on your agreement
Firm 2
High High Low
Both High = $20 Each

High = 0 Low = $30
Low = $30 High = 0

Both Low= $10 each
Firm 1
Low
Dominant Strategy
The Dominant Strategy is the best move to make regardless of what your opponent does What is each firms dominate strategy?
Firm 2
High High
No Dominant Low Strategy
$100, $50
$50, $90
Firm 1
Low
$80, $40
$20, $10
Video: Split or Steal

What is each players dominate strategy?
Firm 2
Split Split Steal
Half, Half
None, All
Firm 1
Steal
All, None
None, None
What did we learn?

1. Oligopolies must use strategic pricing (they have to worry about the other guy) 2. Oligopolies have a tendency to collude to gain profit.
(Collusion is the act of cooperating with rivals in order to rig a situation)
3. Collusion results in the incentive to cheat. 4. Firms make informed decisions based on their dominant strategies
2007 FRQ #3
Payoff matrix for two competing bus companies
2009 FRQB #3
Payoff matrix for two competing bus companies
Oligopoly Graphs
Because firms are interdependent
There are 3 types of Oligopolies 1. Price Leadership (no graph) 2. Colluding Oligopoly 3. Non Colluding Oligopoly
#1. Price Leadership
Example: Small Town Gas Stations To maximize profit what will they do?
OPEC does this with OIL
Price Leadership
Collusion is ILLEGAL. Firms CANNOT set prices. Price leadership is a strategy used by firms to coordinate prices without outright collusion
General Process: 1. Dominant firm initiates a price change 2. Other firms follow the leader
Price Leadership
Breakdowns in Price Leadership Temporary Price Wars may occur if other firms dont follow price increases of dominant firm. Each firm tries to undercut each other. Example: Employee Pricing for Ford
#2. Colluding Oligopolies
Cartel = Colluding Oligopoly

A cartel is a group of producers that create an agreement to fix prices high. 1. Cartels set price and output at an agreed upon level 2. Firms require identical or highly similar demand and costs 3. Cartel must have a way to punish cheaters 4. Together they act as a monopoly
Firms in a colluding oligopoly act as a monopoly and share the profit

P
MC
ATC
MR Q
#3. NonColluding Oligopolies
Kinked Demand Curve Model

The kinked demand curve model shows how noncollusive firms are interdependent If firms are NOT colluding they are likely to react to competitors pricing in two ways: 1. Match price-If one firm cuts its prices, then the other firms follow suit causing inelastic demand 2. Ignore change-If one firm raises prices, others maintain same price causing elastic demand
If this firm increases its price, other firms will ignore it and keep prices the same
As the only firm with high prices, Qd for this firm will decrease a lot P
P1 Pe
Q1
Qe
D Q
If this firm decreases its price, other firms will match it and lower their prices
Since all firms have lower prices, Qd for this firm P will increase only a little
P1 Pe P2
Q1
Qe Q2
D Q
Where is Marginal Revenue?

MR has a vertical gap at the kink. The result is that MC can move and Qe wont change. Price is sticky.
P
MC Pe
MR Q
D Q
Market Structures Venn Diagram
Perfect Competition
Monopolistic Competition
No Similarities
Oligopoly
Monopoly
Name the market structure(s) that it is associated with each concept

1. Price Maker (Demand > MR) 2. Collusion/Cartels 3. Identical Products 4. Price Taker (Demand = MR) 5. Excess Capacity 6. Low Barriers to Entry 7. Game Theory 8. Differentiated Products 9. Long-run Profits 10.Efficiency 11.Normal Profit 12.Dead Weight Loss 13.High Barriers to Entry 14.Firm = Industry 15. MR=MC Rule
Perfect Competition
No Similarities
Oligopoly
Monopoly
Perfect Competition
Identical Products No advantage D=MR=AR=P Both efficiencies Price-Taker 1000s
Low barriers to entry No Long-Run Profit Price = ATC
Excess Advertising Differentiated Products Excess Capacity More Elastic Demand than Monopoly 100s
No Similarities
MR = MC Shut-Down Point Cost Curves Motivation for Profit
Price Maker (D>MR) Some Non-Price Competition Inefficient
Collusion Strategic Pricing (Interdependence) Game Theory 10 or less

Oligopoly
Price Maker (D>MR) High Barriers Ability to Make LR Profit Inefficient
Unique Good Price Discrimination 1
Monopoly

AP Micro 4-4 Oligopolies

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Unit 4: Imperfect Competition

FOUR MARKET MODELS

HOW DO OLIGOPOLIES OCCUR?

Types of Barriers to Entry

An understanding of game theory helps firms in an oligopoly maximize profit.

Game theory helps predict human behavior

Where is the best location?

Where should you put your firm?

Where should you put your firm?

Why learn about game theory?

The Prisoners Dilemma

Both Confess= 10 Years in jail each

Game Theory Matrix

Both High = $20 Each

Low = $30 High = 0

Game Theory Matrix

Both High = $20 Each

Low = $30 High = 0

No Dominant Low Strategy

Video: Split or Steal

What did we learn?

Because firms are interdependent

#1. Price Leadership

OPEC does this with OIL

#2. Colluding Oligopolies

Cartel = Colluding Oligopoly

Firms in a colluding oligopoly act as a monopoly and share the profit

#3. NonColluding Oligopolies

Kinked Demand Curve Model

Where is Marginal Revenue?

Market Structures Venn Diagram

Name the market structure(s) that it is associated with each concept

Identical Products No advantage D=MR=AR=P Both efficiencies Price-Taker 1000s

Low barriers to entry No Long-Run Profit Price = ATC

MR = MC Shut-Down Point Cost Curves Motivation for Profit

Price Maker (D>MR) Some Non-Price Competition Inefficient

Collusion Strategic Pricing (Interdependence) Game Theory 10 or less

Price Maker (D>MR) High Barriers Ability to Make LR Profit Inefficient

Unique Good Price Discrimination 1

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