Oligopoly

00:01 Hello, and welcome back to your online presentation in Microeconomics.

00:04 My name is James DeNicco.

00:06 This presentation is gonna be about Oligopolies. Fun word to say.

00:10 Alright, we're gonna learn about what an oligopoly is.

00:13 When you talk about oligopolies, you have to talk about game theories, so we'll learn about game theory.

00:20 We'll see how prices are determined in an oligopoly.

00:23 We'll see why cooperation is difficult when you only have a few firms so that leaves incentive for people to cooperate and become cartels but that's very difficult to do and I'll show you why.

00:35 And we're gonna look at the implications of the prisoners dilemma for economic well-being.

00:40 The prisoner's dilemma describes why cooperation is difficult.

00:45 So first, what is an oligopoly, alright? So now we've talked about perfect competition, a monopoly.

00:51 We talked about monopolistic competition.

00:53 This is gonna be the last type of market structure that we'll talk about, an oligopoly.

00:58 So an oligopoly is a market structure in which a few sellers offer similar or identical products.

01:04 So you're out of the credit card companies, right? There's just a few credit card companies that really control the line share of the market and they have very similar products, really identical products other than maybe small variations on interest rates or fees or different things like that.

01:21 Now we have a duopoly, alright, that's an oligopoly with only two firms.

01:26 You can think of Boeing and Airbus, right, they compete for each other, they have the line share of the market, you just have to two firms really going back and forth.

01:35 So when we have a small number of firms, it brings up some interesting issues, we talk about that on what's called the game theory, the study of how people behave in strategic situations.

01:47 We have such few firms combatting against each other for market share you're gonna see the strategic behavior, alright. So you could have collusion.

01:57 Collusion is an agreement among firms in the market about quantities to produce or the prices to charge, oftentimes, collusion is actually illegal so they try to stop that collusion because it's bad for the consumer, alright.

02:10 The cartel is a group of firms acting in unison or colluding together.

02:14 So these are terms that you should understand and I'm gonna be using as I go through the presentation and talk about oligopolies.

02:22 Alright, so now let's take a look at an example of an oligopoly.

02:25 Here I have it set up, we have 2 firms competing, one's Franky and one is Sammy.

02:30 They are actually the names of my nephews, alright, Franky and Sammy, they both own different water companies in this oligopoly and they're competing against each other.

02:38 So here I have a schedule of production for the market as a whole, both of them together, alright.

02:44 So what we're gonna see is quantity here and price here.

02:46 You're gonna notice that we have to lower our price to increase our quantity like we do in monopolistic competition and monopolies.

02:54 So at a price of $120 nobody is willing to buy your total revenue is gonna be zero.

02:59 We're gonna assume marginal cost equals zero here just to simplify, so our revenue is actually gonna equal our profit, so zero profit at the price of $120, but if we lower our price to $110 well say we'll said it'll sell 10 gallons so our profits at $1100 and on down the line, alright? So where are we gonna start? Well, let's use the starting point as Franky and Sammy are colluding, alright, they're a little cartel.

03:25 So when you collude, you're gonna wanna choose the profit maximizing quantity that a monopoly would choose so that gets you the most profits and then you can share those profits if you're colluding.

03:38 So here, we would start at a quantity of 60 in the price of $60 and the total revenue, the total profits would be $3600 split between the two of them, would be $1800.

03:50 Alright now, we started this monopoly quantity, right? But we're gonna see that it's difficult to cooperate, it's difficult to collude because there's gonna be an incentive to cheat because you can make more profit in the short run by cheating, right? So at first they're colluding, they chose to both produce 60 gallons at the price of $60 and they're making $1800 a piece.

04:13 However it's gonna be difficult to maintain that. Let's see why.

04:16 Because we know, Franky, right, Franky is sneaky.

04:19 Franky's gonna say, hey, if I go from producing 30 gallons to producing 40 gallons that's gonna lower the price a little bit, there's gonna be a total of 70 gallons being sold now.

04:30 So in order to sell more we have to lower that price to $50 but now I'm selling 40, 40 times $50 that gives me $2000 in profit, I'm doing better than I was before making $1800 in profits.

04:44 But Sammy however, he's gonna be worse off, he's still only producing 30 gallons but he had to sell it at a lower price cuz the overall quantity went up, so now he's only selling 30 gallons at $50, he's only making $1500 in profits.

04:59 So Sammy's gonna say, hey, no, that's not happening, alright.

05:04 You wanna play this game, I can play that game, too.

05:06 So Sammy's gonna increase his production to 40 as well, you're gonna see that now were gonna have a total of 80 gallons that's gonna bring the price down even further to $40.

05:16 However, 40 gallons times $40, he's now gonna be making a profit of $1600 that was worth it for him, right, he's only making $1500 before now he's making $1600.

05:27 So where do we go from here? Well, this is gonna be our Nash Equilibrium point, this is where we're gonna stop.

05:33 They're both gonna produce 40 gallons for a total of 80 gallons of water at a price of $40.

05:39 And you'll see, they're not gonna deviate from this point because then they'll lose profits.

05:44 So if they increase to 50 gallons that would lower the price again, right, it'll lower the price to $30 and they'll only make $1500 instead of $1600.

05:54 Now, they could also decrease the 30 gallons that would get the price up, but 30 gallons to $50, again that's only $1500, so our equilibrium is gonna end up being here 80 gallons of water at $40 for $3200 in total revenue or total profit, that's not as good as if they were in the monopoly situation splitting $3600 making $1800 a piece, right, now they're making a thousand dollars less a piece.

06:24 So it'll be better in the long run to be at that monopoly quantity but that's difficult because the short run incentive is to cheat.

06:32 So now again, the result here is gonna be a lower price and a higher quantity than the monopoly but a higher price and a lower quantity than perfect competition.

06:42 So here as I said before, our Nash Equilibrium is gonna be 40 gallons, that's a situation in which economic actors interacting with one another choose their best strategy given the strategies that all the other actors have chosen, so they're not gonna deviate from that 40 gallons because it will decrease their profits, alright? So we have two effects here, right, when they're making their decisions about increase in the quantity.

07:08 It's our output effect and our price effect that we've looked at before.

07:12 So that affects our total revenue here, our total profits.

07:16 So the output effect says, if I increase my output that tends the one increase my total revenue, I'm selling more so I can make more.

07:25 However, in order to do that, we have to lower our price, that's the price effect.

07:29 So raising production increases the amount sold but that lowers the price and profits on all other unit sold so that has the effect of wanting to bring down total revenue.

07:40 So the output effect wants to bring up total revenue and the price effect that wants to bring down total revenue, so you only wanna increase your production if that output effect dominates and it increases your overall revenue or your profits here, alright.

07:55 Now, let's shift gears a little bit and talk about the prisoner's dilemma.

07:58 So this is another example of why coordination is difficult, why it's difficult to cooperate using some fun examples, alright.

08:07 So the prisoner's dilemma that's a particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even though it's mutually beneficial.

08:17 Alright, now let's take a look at an example of this prisoner's dilemma using the Bonnie and Clyde decision, alright.

08:23 Bonnie and Clyde are robbers, they're out there robbing banks, they get arrested by the police and they get taken into the station, alright, and the police they put them in two different rooms and they're working on them trying to get them to confess, they're making deals, hey, if you confess on the other guy, we'll let you go free.

08:39 Alright, so there's four possibilities here. Let's take a look at it, alright.

08:43 So we have Bonnie's decisions up here to confess or remain silent.

08:47 Clyde's decision is to either confess or remain silent.

08:50 Before they go to the station they know that if they both remained silence that's gonna be the best mutually beneficial outcome.

08:57 They will both get one year, they get a slap on the wrist, alright.

09:01 So if Bonnie remains silent and Clyde remains silent, they both get one year.

09:05 Now, if they both confess, they'll both end up getting eight years.

09:09 If Bonnie remains silent and Clyde confesses they're gonna let Clyde go, they make that deal with him, you tell on her, she doesn't tell on you, you get to go, so he gets to walk out and Bonnie gets 20 years.

09:21 Now, if Bonnie confesses and Clyde remains silence, it's just the opposite, right, Bonnie gets to go free, they made that deal with her, and Clyde, he gets 20 years in prison.

09:30 So, again, this is the best for both of them together, if they both remain silent and they make that agreement going into the station, however, it's hard to maintain that cooperation and let's look why.

09:42 So, let's start with Bonnie's decision first.

09:45 So if Bonnie's decision is to confess, alright, let's start with the remain silent cuz they said they're both gonna remain silent, so if Bonnie remain silent, what's the best thing Clyde can do? Well, let's take a look, Bonnie remains silent here.

10:00 Now, if Clyde confesses, he goes free and Bonnie gets twenty years, alright? If he remains silent, well then he only gets one year and Bonnie gets one year, that's what they decided upon in the beginning, but what dominates there? What dominates is for Clyde to confess because he knows he'll go free instead of getting one year, so if he thinks Bonnie's gonna remain silent, he's gonna confess cuz it's a better deal for him.

10:28 Now, what if he doesn't trust Bonnie? He says, well, she thinks the way I do.

10:31 I think she's gonna confess, so we go over here and look at Bonnies decision to confess, what's Clyde's best strategy if she confesses? Well, if she confesses and he confesses he gets eight years.

10:44 If she confesses and he doesn't confess, he remains silent, he gets 20 years.

10:50 So if she confesses, his best strategy is to confess as well.

10:54 So we take a look no matter what her decision, if she decide to remain silent, it's better for him to confess, he goes free instead of getting one year.

11:02 If she confesses, it's better for him to confess, he gets eight years instead of twenty years.

11:07 Now, we'll go over to Clyde's decisions and how Bonnie should react.

11:11 So they both decided to remain silent that was their agreement so if Bonnie thinks that Clyde's gonna remain silent what's the best thing she can do? Well, if she remains silent as well, she gets one year. But if she confesses she goes free.

11:27 So if Clyde remains silent it's in her best interest for her to confess to go free.

11:32 So now what if she doesn't trust Clyde, right, she doesn't trust Clyde, she thinks he's gonna confess what's her best strategy? Well, if Clyde confesses and Bonnie confesses she gets eight years.

11:43 If Clyde confesses and Bonnie remains silent she gets 20 years.

11:47 So her dominant strategy is to confess.

11:50 His dominant strategy is to confess, so they both went in there, wanting to both remain silent but then when the decision was in front of them, they had to react to the other player's strategy, they both will decide to confess and they'll both gets eight years.

12:04 It's difficult to cooperate. So now we can play this game in a number of ways, alright.

12:09 So let's go back to our oligopoly example and see the prisoner's dilemma for an oligopoly.

12:14 So we have Franky and Sammy again, these water producers.

12:17 So we know when they collude they go to the monopoly profits, right? That's the best mutually beneficial outcome for them, they're both gonna get $1800, alright.

12:28 But however, it's difficult to maintain that collusion and let's take a look why.

12:33 First, go with Franky's decisions and how Sammy should react.

12:37 Well, Sammy and Franky decided both to go low, right? So Franky's going low, what's the best thing for Sammy to do? It's actually to go high now because he'll get $2000 instead of $1800.

12:50 What if he doesn't trust Franky? He think Franky's gonna go high, he's gonna produce too much? Well, if Franky produces 40 galloons then let's look.

12:58 If Sammy produces 40 he gets $1600, if Sammy produces only 30, he only gets $1500, so again, no matter what Franky does, the dominant strategy for Sammy is to produce 40 gallons, it's to produce more.

13:13 For Sammy, it's gonna be the same thing when he makes the decisions and Franky reacts.

13:19 So the dominant strategy both of them are gonna come to is to produce high, is to go for 40 gallons, so that they're gonna end up in the top left here.

13:28 So even though the best mutually beneficial outcome was for them to split the monopoly profits, they both have an incentive to cheat, and they both end up cheating and producing 40 gallons and making $16000 a piece instead of $1800 a piece, alright.

13:44 We can look at it from an arms raise.

13:46 So let's go back to the 80s, the Soviet Union versus the United States in the arm race, what's the best possible outcome for everybody? For everybody to disarm and both countries are safe.

13:57 So let's say you come to that agreement, they go in, say we're gonna cooperate and we're gonna both disarm and we're both gonna be safe.

14:04 Well, that's nice but it's difficult to maintain.

14:08 So let's look at the United States decision.

14:10 So they knew the Soviet Union, they had that agreement, they're gonna disarm but if so, if the US disarms what's in the best interest of the Soviet Union? Well, if they disarm we'll be safe, but if they keep armed and the United States disarmed, then they'll be safe and powerful.

14:27 That's better than just being safe, so they're gonna wanna arm, if the United States disarms.

14:32 Well, what if they don't trust the United States, they think they're gonna arm, what's their best strategy? Well, if the United States arms, the Soviet Union arms, then they're at risk, right? But if the United States stays armed and the Soviet Union disarms, then they're at risk and weak, because the United States has arms and the Soviet Union, USSR, does not have arms, alright? So no matter what the United States does, whether they disarmed or they armed, the dominant strategy for the Soviet Union is to arm.

15:03 And it's gonna be the same for the United States responding to the Russia's possible decisions, so what you're gonna see is they're both gonna arm themselves even though it's most mutually beneficial for both of them to disarm, their dominant strategy is gonna be to arm in order to react to the other players choices.

15:22 So we see that it's difficult to cooperate.

15:25 That can sometimes be good, it can sometimes be bad.

15:28 In the case of the oligopoly it's good for the competitor, right? They're gonna both product more and we're gonna have lower prices.

15:34 Lower prices we can buy more stuff.

15:36 In terms of the suspects, Bonnie and Clyde, that's good for society as well, right? We both want them to confess so we can get them both off the streets.

15:45 But in terms of the arms race it's bad, right? It'd be better to have a world where you didn't need nukes, where you could disarm, however we end up in the situation where both countries armed themselves so we're all at risk.

15:56 So it could be good, it could be bad.

15:58 Sometimes it's okay that we can't cooperate, sometimes it makes things more difficult or makes us less well-off.

16:04 So people can learn from these games.

16:07 These repeated -- you can have these games repeated over and over and sometimes that makes cooperation more difficult, alright, so not all suspects "rat" on each other.

16:17 Maybe that happens a few times but sometimes there's dire consequences for people that rat on each other, tell on each other, confess on each other.

16:25 Right, Mafioso, the mafias are famous for not ratting because they're strong incentives not to, right, they punish people that confess on each other, they punish them very heavily, alright, so people can learn, they can see that other people did not cooperate, they confess and then they see the dire consequences of that, they learn, so they keep their mouth shut, right, they don't tell on each other.

16:47 In the case of Franky and Sammy, with the oligopoly, they found out, okay, we had this Monopoly profits, we didn't cooperate, we had these incentives to cheat, now instead of having $1800 a piece, they both have $1600 apiece.

17:01 So maybe they can learn from that and then say, hey, let's stop this war, let's stop this pricing war, let's go back to our monopoly profits cuz we're better off then, as you can learn from these games.

17:12 Alright, so now what have we learned here in this presentation? We know how to define an oligopoly and we understand game theory and collusion.

17:20 We know our pricing is determined in an oligopoly.

17:23 We understand why cooperation is difficult through the lens of the prisoner's dilemma, and we understand the implication of the prisoner's dilemma for economic well-being.

17:32 Sometimes its good people can't cooperate, sometimes it's bad for economic well-being that they can't cooperate.

17:37 That's your presentation on oligopolies. Thank you very much.