short case study on oligopoly

Defining and measuring oligopoly

Concentration ratios

Example of a hypothetical concentration ratio, fixed broadband services, fuel retailing, further examples, the herfindahl – hirschman index (h-h index), key characteristics, interdependence.

• Whether to compete with rivals, or collude with them.
• Whether to raise or lower price, or keep price constant.
• Whether to be the first firm to implement a new strategy, or whether to wait and see what rivals do. The advantages of ‘going first’ or ‘going second’ are respectively called 1st and 2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-start profits. 2nd mover advantage occurs when it pays to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them.

Barriers to entry

Natural entry barriers include:, economies of large scale production., ownership or control of a key scarce resource, high set-up costs, high r&d costs, artificial barriers include:, predatory pricing, limit pricing, superior knowledge, predatory acquisition, advertising, a strong brand, loyalty schemes, exclusive contracts, patents and licences, vertical integration, collusive oligopolies, types of collusion, competitive oligopolies, pricing strategies of oligopolies.

• Oligopolists may use predatory pricing to force rivals out of the market. This means keeping price artificially low, and often below the full cost of production.
• They may also operate a limit-pricing strategy to deter entrants, which is also called entry forestalling price .
• Oligopolists may collude with rivals and raise price together, but this may attract new entrants.
• Cost-plus pricing is a straightforward pricing method, where a firm sets a price by calculating average production costs and then adding a fixed mark-up to achieve a desired profit level. Cost-plus pricing is also called rule of thumb pricing.There are different versions of cost-pus pricing, including  full cost pricing , where all costs - that is, fixed and variable costs - are calculated, plus a mark up for profits, and contribution pricing , where only variable costs are calculated with precision and the mark-up is a contribution to both fixed costs and profits.

Non-price strategies

• Trying to improve quality and after sales servicing, such as offering extended guarantees.
• Spending on advertising, sponsorship and product placement - also called hidden advertising – is very significant to many oligopolists. The UK's football Premiership has long been sponsored by firms in oligopolies, including Barclays Bank and Carling.
• Sales promotion, such as buy-one-get-one-free (BOGOF), is associated with the large supermarkets, which is a highly oligopolistic market, dominated by three or four large chains.
• Loyalty schemes, which are common in the supermarket sector, such as Sainsbury’s Nectar Card and Tesco’s Club Card .
• How successful is it likely to be?
• Will rivals be able to copy the strategy?
• Will the firms get a 1st - mover advantage?
• How expensive is it to introduce the strategy? If the cost of implementation is greater than the pay-off, clearly it will be rejected.
• How long will it take to work? A strategy that takes five years to generate a pay-off may be rejected in favour of a strategy with a quicker pay-off.

Price stickiness

Kinked demand curve.

Maximising profits

A game theory approach to price stickiness.

• Raise price
• Lower price
• Keep price constant

The Prisoner’s Dilemma

• Higher prices or hidden prices, such as the hidden charges in credit card transactions
• Lower output
• Restricted choice or other limiting conditions associated with the transaction

Examples of Oligopoly

Evaluation of oligopolies, the disadvantages of oligopolies.

• High concentration reduces consumer choice.
• Cartel-like behaviour reduces competition and can lead to higher prices and reduced output.
• Given the lack of competition, oligopolists may be free to engage in the manipulation of consumer decision making. By making decisions more complex - such as financial decisions about mortgages - individual consumers fall back on heuristics and rule of thumb processes, which can lead to decision making bias and irrational behaviour, including making purchases which add no utility or even harm the individual consumer.
• Firms can be prevented from entering a market because of deliberate barriers to entry .
• There is a potential loss of economic welfare.
• Oligopolists may be allocatively and productively inefficient .

The advantages of oligopolies

• Oligopolies may adopt a highly competitive strategy, in which case they can generate similar benefits to more competitive market structures , such as lower prices. Even though there are a few firms, making the market uncompetitive, their behaviour may be highly competitive.
• Oligopolists may be dynamically efficient in terms of innovation and new product and process development. The super-normal profits they generate may be used to innovate, in which case the consumer may gain.
• Price stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle.

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Game Theory

Monopolistic competition

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Chapter 10. Monopolistic Competition and Oligopoly

10.2 Oligopoly

Learning objectives.

• Explain why and how oligopolies exist
• Contrast collusion and competition
• Interpret and analyze the prisoner’s dilemma diagram
• Evaluate the tradeoffs of imperfect competition

Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. Oligopolies are typically characterized by mutual interdependence where various decisions such as output, price, advertising, and so on, depend on the decisions of the other firm(s). Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.

Why Do Oligopolies Exist?

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.

Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.

Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly for large passenger aircraft.

The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.

Collusion or Competition?

When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide up the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion . A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel . See the following Clear It Up feature for a more in-depth analysis of the difference between the two.

Collusion versus cartels: How can I tell which is which?

In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.

The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.

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

Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. Indeed, a small handful of oligopoly firms may end up competing so fiercely that they all end up earning zero economic profits—as if they were perfect competitors.

The Prisoner’s Dilemma

Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.

The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. The story behind the prisoner’s dilemma goes like this:

Two co-conspiratorial criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. So your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.

The game theory situation facing the two prisoners is shown in Table 3 . To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A ought to confess, too, so as to not get stuck with the eight years in prison. But if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. Confess is considered the dominant strategy or the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up doing a total of 10 years of jail time between them.

The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have had to serve a total of four years of jail time between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer jail terms.

The Oligopoly Version of the Prisoner’s Dilemma

The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits. Table 4 shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly . If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.

Can the two firms trust each other? Consider the situation of Firm A:

• If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in Table 4 ) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
• If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).

Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions.

The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits . The following Clear It Up feature discusses one cartel scandal in particular.

What is the Lysine cartel?

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

From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:

I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us … money. … And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.

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

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

How to Enforce Cooperation

How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.

Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC) , have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.

Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself.

Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.

One example of the pressure these firms can exert on one another is the kinked demand curve , in which competing oligopoly firms commit to match price cuts, but not price increases. This situation is shown in Figure 1 . Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.

If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price , and share a monopoly level of profits even without any legally enforceable agreement.

Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.

Tradeoffs of Imperfect Competition

Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.

Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffeted by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Monopoly and Antitrust Policy discusses the delicate judgments that go into this task.

The Temptation to Defy the Law

Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, which sometimes lasted more than four hours, complex pricing structures were established. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.

How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region; there were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.

Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

Key Concepts and Summary

An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.

The prisoner’s dilemma is an example of game theory. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.

Self-Check Questions

• Suppose the firms collude to form a cartel. What price will the cartel charge? What quantity will the cartel supply? How much profit will the cartel earn?
• Suppose now that the cartel breaks up and the oligopolistic firms compete as vigorously as possible by cutting the price and increasing sales. What will the industry quantity and price be? What will the collective profits be of all firms in the industry?
• Compare the equilibrium price, quantity, and profit for the cartel and cutthroat competition outcomes.

Review Questions

• Will the firms in an oligopoly act more like a monopoly or more like competitors? Briefly explain.
• Does each individual in a prisoner’s dilemma benefit more from cooperation or from pursuing self-interest? Explain briefly.
• What stops oligopolists from acting together as a monopolist and earning the highest possible level of profits?

Critical Thinking Questions

• Would you expect the kinked demand curve to be more extreme (like a right angle) or less extreme (like a normal demand curve) if each firm in the cartel produces a near-identical product like OPEC and petroleum? What if each firm produces a somewhat different product? Explain your reasoning.
• When OPEC raised the price of oil dramatically in the mid-1970s, experts said it was unlikely that the cartel could stay together over the long term—that the incentives for individual members to cheat would become too strong. More than forty years later, OPEC still exists. Why do you think OPEC has been able to beat the odds and continue to collude? Hint: You may wish to consider non-economic reasons.
• Mary and Raj are the only two growers who provide organically grown corn to a local grocery store. They know that if they cooperated and produced less corn, they could raise the price of the corn. If they work independently, they will each earn $100. If they decide to work together and both lower their output, they can each earn $150. If one person lowers output and the other does not, the person who lowers output will earn $0 and the other person will capture the entire market and will earn $200. Table 6 represents the choices available to Mary and Raj. What is the best choice for Raj if he is sure that Mary will cooperate? If Mary thinks Raj will cheat, what should Mary do and why? What is the prisoner’s dilemma result? What is the preferred choice if they could ensure cooperation? A = Work independently; B = Cooperate and Lower Output. (Each results entry lists Raj’s earnings first, and Mary’s earnings second.)

The United States Department of Justice. “Antitrust Division.” Accessed October 17, 2013. http://www.justice.gov/atr/.

eMarketer.com. 2014. “Total US Ad Spending to See Largest Increase Since 2004: Mobile advertising leads growth; will surpass radio, magazines and 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 Trade Commission.” Accessed October 17, 2013. http://www.ftc.gov/ftc/about.shtm.

Answers to Self-Check Questions

• Pc > Pcc. Qc < Qcc. Profit for the cartel is positive and large. Profit for cutthroat competition is zero.
• Firm B reasons that if it cheats and Firm A does not notice, it will double its money. Since Firm A’s profits will decline substantially, however, it is likely that Firm A will notice and if so, Firm A will cheat also, with the result that Firm B will lose 90% of what it gained by cheating. Firm A will reason that Firm B is unlikely to risk 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, since Firm B is so small. If both firms cheat, then Firm A loses at least 50% of what it could have earned. The possibility of a small gain ($50) is probably not enough to induce Firm A to cheat, so in this case it is likely that both firms will collude.

Principles of Economics Copyright © 2016 by Rice University is licensed under a Creative Commons Attribution 4.0 International License , except where otherwise noted.

18 Models of Oligopoly: Cournot, Bertrand, and Stackelberg

Cournot, Bertrand, and Stackelberg

The Policy Question How Should the Government Have Responded to Big Oil Company Mergers?

Exploring the policy question.

• How do oil companies compete—on quantities or prices?
• What policy solutions present themselves from this analysis?

Learning Objectives

18.1 cournot model of oligopoly: quantity setters.

Learning Objective 18.1 : Describe how oligopolist firms that choose quantities can be modeled using game theory.

18.2 Bertrand Model of Oligopoly: Price Setters

Learning Objective 18.2 : Describe how oligopolist firms that choose prices can be modeled using game theory.

18.3 Stackelberg Model of Oligopoly: First-Mover Advantage

Learning Objective 18.3 : Describe the different outcomes when oligopolist firms choose quantities sequentially.

18.4 Policy Example How Should the Government Have Responded to Big Oil Company Mergers?

Learning Objective 18.4 : Explain how models of oligopoly can help us understand how to respond to proposed mergers of oil companies that sell retail gas.

Oligopoly markets are markets in which only a few firms compete, where firms produce homogeneous or differentiated products, and where barriers to entry exist that may be natural or constructed. There are three main models of oligopoly markets, and each is considered a slightly different competitive environment. The Cournot model considers firms that make an identical product and make output decisions simultaneously. The Bertrand model considers firms that make an identical product but compete on price and make their pricing decisions simultaneously. The Stackelberg model considers quantity-setting firms with an identical product that make output decisions simultaneously. This chapter considers all three in order, beginning with the Cournot model.

Oligopolists face downward-sloping demand curves, which means that price is a function of the total quantity produced, which, in turn, implies that one firm’s output affects not only the price it receives for its output but the price its competitors receive as well. This creates a strategic environment where one firm’s profit maximizing output level is a function of its competitors’ output levels. The model we use to analyze this is one first introduced by French economist and mathematician Antoine Augustin Cournot in 1838. Interestingly, the solution to the Cournot model is the same as the more general Nash equilibrium concept introduced by John Nash in 1949 and the one used to solve for equilibrium in non-cooperative games in chapter 17 .

We will start by considering the simplest situation: two companies that make an identical product and that have the same cost function. Later we will explore what happens when we relax those assumptions and allow more firms, differentiated products, and different cost functions.

Let’s begin by considering a situation where there are two oil refineries located in the Denver, Colorado, area that are the only two providers of gasoline for the Rocky Mountain regional wholesale market. We’ll call them Federal Gas and National Gas. The gas they produce is identical, and they each decide independently—and without knowing the other’s choice—the quantity of gas to produce for the week at the beginning of each week. We will call Federal’s output choice [latex]q_F[/latex] and National’s output choice [latex]q_N[/latex], where [latex]q[/latex] represents liters of gasoline. The weekly demand for wholesale gas in the Rocky Mountain region is [latex]P=A—BQ[/latex], where [latex]Q[/latex] is the total quantity of gas supplied by the two firms, or [latex]Q=q_F+q_N[/latex]. Immediately, you can see the strategic component: the price they both receive for their gas is a function of each company’s output. We will assume that each liter of gas produced costs the company c, or that c is the marginal cost of producing a liter of gas for both companies and that there are no fixed costs.

If the profit function is [latex]\pi_F[/latex][latex]=[/latex] [latex]q_F(A-B(q_F+q_N)-c)[/latex] , then we can find the optimal output level by solving for the stationary point, or solving

[latex]\frac{\partial \pi_F}{\partial q_F}[/latex] [latex]=[/latex] [latex]_0[/latex]

If [latex]\pi_F=[/latex] [latex]q_F(A-B(q_F+q_N)-c)[/latex] , then we can expand to find

[latex]\pi_F[/latex] [latex]=[/latex][latex]Aq_F-Bq[/latex] [latex]\frac{F}{2}[/latex] [latex]-Bq_Fq_N-cq_F[/latex]

Taking the partial derivative of this expression with respect to [latex]q_F[/latex] ,

[latex]\frac{\partial \pi_F}{\partial q_F}[/latex] [latex]=[/latex][latex]A-2Bq_F-Bq_N-c[/latex] [latex]=[/latex] [latex]_0[/latex]

If we rearrange this, we can see that this is simply an expression of [latex]MR=MC[/latex] .

[latex]A-2Bq_F-Bq_N[/latex][latex]=[/latex][latex]c[/latex]

The marginal revenue looks the same as a monopolist’s [latex]MR[/latex] function but with one additional term, [latex]-[/latex] [latex]Bq_N[/latex] .

Solving for [latex]q_F[/latex] yields

[latex]q_F=[/latex] [latex]\frac{A-Bq_N-c}{2B}[/latex] ,

[latex]q^*_F=[/latex] [latex]\frac{A-c}{2B}-\frac{1}{2}[/latex] [latex]qN[/latex]

This is Federal Gas’s best response function, their profit maximizing output level given the output choice of their rivals. It is the same best response function as the ones in chapter 17 . By symmetry, National Gas has an identical best response function:

[latex]q^*_N=[/latex] [latex]\frac{A-c}{2B}-\frac{1}{2}[/latex] [latex]qF[/latex]

With these assumptions in place, we can express Federal’s profit function:

[latex]\pi_F=P \times q_F—c \times q_F = q_F (P-c)[/latex]

Substituting the inverse demand curve, we arrive at the expression

[latex]\pi_F=q_F(A-BQ-c)[/latex].

Substituting [latex]Q=q_A+q_B[/latex] yields

[latex]\pi_F=q_F(A-B(q_F+q_N)-c)[/latex].

The expression for National is symmetric:

[latex]\pi_N=q_N(A-B(q_N+q_F)-c)[/latex]

Note that we have now described a game complete with players, Federal and National; strategies, [latex]q_F[/latex] and [latex]q_N[/latex]; and payoffs, [latex]\pi_F[/latex] and [latex]\pi_N[/latex]. Now the task is to search for the equilibrium of the game. To do so, we have to begin with a best response function. In this case, the best response is the firm’s profit maximizing output. This will depend on both the firm’s own output and the competing firm’s output.

We know from chapter 15 that the monopolists’ marginal revenue curve when facing an inverse demand curve [latex]P=A-BQ[/latex] is [latex]MR(q)=A-2Bq[/latex]. This duopolistic example shows that the firms’ marginal revenue curves include one extra term:

[latex]MR_F(q_F)=A-2Bq_F-Bq_N[/latex] and [latex]MR_N(q_N)=A-2Bq_N-Bq_F[/latex]

The profit maximizing rule tells us that to find the profit maximizing output, we must set the marginal revenue to the marginal cost and solve. Doing so yields

[latex]q^*_F=\frac{A-c}{2B}-\frac{1}{2}qN[/latex]

for Federal Gas and

[latex]q^*_N=\frac{A-c}{2B}-\frac{1}{2}qF[/latex]

for National Gas. These are the firms’ best response functions, their profit maximizing output levels given the output choice of their rivals.

Now that we know the best response functions, solving for equilibrium in the model is relatively straightforward. We can begin by graphing the best response functions. These graphical illustrations of the best response functions are called reaction curves. A Nash equilibrium is a correspondence of best response functions, which is the same as a crossing of the reaction curves.

In figure 18.1 , we can see the Nash equilibrium of the Cournot duopoly model as the intersection of the reaction curves. Mathematically, this intersection is found by simultaneously solving

[latex]q^*_F=\frac{A-c}{2B}-\frac{1}{2}q_N[/latex] and [latex]q^*_F=\frac{A-c}{2B}-\frac{1}{2}q_F[/latex]

This is a system of two equations and two unknowns and therefore has a unique solution as long as the slopes are not equal. We can solve these by substituting one equation into the other, which yields a single equation with a single unknown:

[latex]q^*_F=\frac{A-c}{2B}-\frac{1}{2}[\frac{A-c}{2B}-\frac{1}{2}q_F][/latex]

Solving this by steps results in the following:

[latex]q^*_F=\frac{A-c}{2B}-\frac{A-c}{4B}+\frac{1}{4}q_F[/latex][latex]\frac{3}{4}q^*_F=\frac{A-c}{4B}[/latex] [latex]q^*_F=\frac{A-c}{3B}[/latex]

And by symmetry, we know that the two optimal quantities are the same:

[latex]q^*_N=\frac{A-c}{3B}[/latex]

The Nash equilibrium is

[latex](q^*_F,q^*_N)[/latex]

[latex](\frac{A-c}{3B}, \frac{A-c}{3B})[/latex].

Let’s consider a specific example. Suppose in the above example, the weekly demand curve for wholesale gas in the Rocky Mountain region is

[latex]p = 1,000 − 2Q[/latex], in thousands of gallons

Both firms have constant marginal costs of 400. In this case,

[latex]A = 1,000[/latex], [latex]B = 2[/latex] and [latex]C = 400[/latex].

[latex]q^*_F=\frac{A-c}{3B}=\frac{1,000 − 400}{(3)(2)}=\frac{600}{6}=100[/latex]

By symmetry, we know

[latex]q^*_N=100[/latex]

as well. So both Federal Gas and National Gas produce 100,000 gallons of gasoline a week. Total output is the sum of the two and is 200,000 gallons. The price is [latex]p= 1,000 − 2(200) = $600[/latex] for 1,000 gallons of gas, or $0.60 a gallon.

To analyze this from the beginning, we can set up the total revenue function for Federal Gas:

[latex]TR(q_F)=p×q_F[/latex] [latex]=(1,000 − 2Q)q_F[/latex] [latex]=(1,000 − 2q_F-2q_N)q_F[/latex] [latex]= 1,000 − 2q \frac{2}{F}-2q_Fq_N[/latex]

The marginal revenue function that is associated with this is

[latex]MR(q_F)=1,000 − 4q_F-2q_N[/latex].

We know marginal cost is 400, so setting marginal revenue equal to marginal cost results in the following expression:

[latex]1,000 − 4q_F-2q_N=400[/latex]

Solving for [latex]q_F[/latex] results in the following:

[latex]q_F=\frac{600 − 2q_N}{4}[/latex] [latex]q^*_F=150-\frac{q_F}{2}[/latex]

This is the best response function for Federal Gas. By symmetry, we know that National Gas has the same best response function:

[latex]q^*_N=150-\frac{q_F}{2}[/latex]

Solving for the Nash equilibrium, we get the following:

[latex]q^*_N=150-\frac{q_F}{2}[/latex] [latex]q^*_F=150 − 75+\frac{q_F}{4}[/latex] [latex]/frac{3}{4}q^*_F=25[/latex] [latex]q^*_F=100[/latex]

We can insert the solution for [latex]q_F[/latex] into [latex]q^*_N[/latex]:

[latex]q^*_N=150-\frac{(100)}{2}=100[/latex]

In the previous section, we studied oligopolists that make an identical good and who compete by setting quantities. The example we used in that section was wholesale gasoline, where the market sets a price that equates supply and demand and the strategic decision of the refiners was how much oil to refine into gasoline. In this section, we turn our attention to a different situation in which the oligopolists compete on price. The example here is the retail gas stations that bought the wholesale gas from the refiners and are now ready to sell it to consumers. We still have identical goods; for consumers, the gas that goes into their cars is all the same, and we will assume away any other differences like cleaner stations or the presence of a mini-mart.

Let’s imagine a simple situation where there are two gas stations, Fast Gas and Speedy Gas, on either side of a busy main street. Both stations have large signs that display the gas prices that each station is offering for the day. Consumers are assumed to be indifferent about the gas or the stations, so they will go to the station that is offering the lower price. So an individual gas station’s demand is conditional on its relative price with the other station.

Formally, we can express this with the following demand function for Fast Gas:

[latex]Q_F \left\{\begin{matrix} & & & \\ a-bP_F \text{ if }P_F P_F \end{matrix}\right.[/latex]

Speedy Gas has an equivalent demand curve:

[latex]Q_S \left\{\begin{matrix} & & & \\ a-bP_S \text{ if }P_S P_F \end{matrix}\right.[/latex]

In other words, these demand curves say that if a station has a lower price than the other, they will get all the demand at that price, and the other station will get no demand. If they have the same price, then each will get one-half of the demand at that price.

Let’s assume that Fast Gas and Speedy Gas both have the same constant marginal cost of [latex]c[/latex] and no fixed costs to keep the analysis simple. The question we now have to answer is, What are the best response functions for the two stations? Remember that best response functions are one player’s optimal strategy choice given the strategy choice of the other player. So what is Fast Gas’s best response to Speedy Gas’s price?

If Speedy Gas charges

[latex]P_S \gt c[/latex]

Fast Gas can set [latex]P_F \gt P_S[/latex] and they will get no customers at all and make a profit of zero. Fast Gas could instead set

[latex]P_F=P_S[/latex]

and get [latex]\frac{1}{2}[/latex] the demand at that price and make a positive profit. Or they could set

[latex]P_F=P_S −$0.01[/latex]

or set their price one cent below Speedy Gas’s price and get all the customers at a price that is one cent below the price, at which they would get [latex]\frac{1}{2}[/latex] the demand.

Clearly, this third option is the one that yields the most profit. Now we just have to consider the case where [latex]P_S=c[/latex]. In this case, undercutting the price by one cent is not optimal because Fast Gas would get all the demand but would lose money on every gallon of gas sold, yielding negative profits. Setting

[latex]P_F=P_S=c[/latex]

would give them half the demand at a break-even price and would yield exactly zero profits.

The best response function we just described for Fast Gas is the same best response function for Speedy Gas. So where are the correspondences of best response functions? As long as the prices are above [latex]c[/latex], there is always an incentive for both stations to undercut each other’s price, so there is no equilibrium. But at [latex]P_F=P_S=c[/latex], both stations are playing their best response to each other simultaneously. So the unique Nash equilibrium to this game is

[latex]P_F=P_S=c[/latex].

What is particularly interesting about this is the fact that this is the same outcome that would have occurred if they were in a perfectly competitive market because competition would have driven prices down to marginal cost. So in a situation where competition is based on price and the good is relatively homogeneous, as few as two firms can drive the market to an efficient outcome.

Both the Cournot model and the Bertrand model assume simultaneous move games. This makes sense when one firm has to make a strategic decision before knowing about the strategy choice of the other firm. But not all situations are like this. What happens when one firm makes its strategic decision first and the other firm chooses second? This is the situation described by the Stackelberg model, where the firms are quantity setters selling homogenous goods.

Let’s return to the example of two oil companies: Federal Gas and National Gas. The gas they produce is identical, but now they decide their output levels sequentially. We will assume that Federal Gas sets its output first, and then after observing Federal’s choice, National Gas decides on the quantity of gas they are going to produce for the week. We will again call Federal’s output choice [latex]q_F[/latex] and National’s output choice [latex]q_N[/latex], where [latex]q[/latex] represents liters of gasoline. The weekly demand for wholesale gas is still [latex]P = A—BQ[/latex], where [latex]Q[/latex] is the total quantity of gas supplied by the two firms, or

[latex]Q=q_F+q_N[/latex].

We have now turned the previous Cournot game into a sequential game, and the [latex]SPNE[/latex] solution to a sequential game is found through backward induction. So we have to start at the second move of the game: National’s output choice. When National makes this decision, Federal’s output choices are already made and known to National, so it is taken as given. Therefore, we can express Federal’s profit function as

[latex]\Pi _N=q_N(A-B(q_N+q_F)-c)[/latex].

This is the same as in the Cournot example, and for National, the best response function is also the same. This is because in the Cournot case, both firms took the other’s output as given.

[latex]q^*_N=\frac{A-c}{2B}-\frac{1}{2}q_F[/latex]

When it comes to Federal’s decision, we diverge from the Cournot model because instead of taking [latex]q_N[/latex] as a given, Federal knows exactly how National will respond because they know the best response function. Federal’s profit function,

[latex]\Pi _F=q_F(A-Bq_F-Bq_N-c)[/latex],

can be re-written, replacing [latex]q_N[/latex] with the best response function:

[latex]\Pi _F=q_F(A-Bq_F-B(\frac{A-C}{2B}-\frac{1}{2})-c)[/latex]

If the profit function is [latex]\Pi_F[/latex] [latex]=[/latex] [latex]q_F([/latex] [latex]\frac{A-C}{2}-[/latex] [latex]B[/latex] [latex]\frac{1}{2}[/latex] [latex]q_F)[/latex] , then we can find the optimal output level by solving for the stationary point, or solving

[latex]\frac{\partial \Pi _F}{\partial q_F}[/latex] [latex]=[/latex] [latex]_0[/latex]

If [latex]\Pi_F[/latex] [latex]=[/latex] [latex]q_F([/latex] [latex]\frac{A-c}{2}-[/latex] [latex]B[/latex] [latex]\frac{1}{2}[/latex] [latex]q_F)[/latex] , then we can expand to find

[latex]\Pi_F[/latex] [latex]=[/latex] [latex]q_F([/latex] [latex]\frac{A-c}{2}[/latex] [latex])q_F[/latex] [latex]-B[/latex] [latex]\frac{1}{2}[/latex] [latex]q_{F}^{2}[/latex]

Taking the partial derivative of this expression with respect to [latex]q_F[/latex], we get

[latex]\frac{\partial \Pi _F}{\partial q_F}[/latex] [latex]=([/latex] [latex]\frac{A-c}{2}[/latex] [latex])[/latex][latex]-[/latex] [latex]Bq_F=[/latex] [latex]_0[/latex]

[latex]q_F=[/latex] [latex]\frac{A-c}{2B}[/latex]

This is Federal Gas’s profit maximizing output level, given that they choose first and can anticipate National’s response.

We can see that Federal’s profits are determined only by their own output once we explicitly consider National’s response. Simplifying yields

[latex]\Pi _F=q_F(\frac{A-c}{2}-B\frac{1}{2}q_F)[/latex].

We know that the second mover’s best response is the same as in section 18.1 , and the solution to the profit optimization problem above yields the following best response function for Federal Gas:

[latex]q^*_F=\frac{A-c}{2B}[/latex],

substituting this into National’s best response function and solving the following:

[latex]q^*_N=\frac{A-c}{2B}-\frac{1}{2}\left [ \frac{A-c}{2B} \right ][/latex]

[latex]q^*_N=\frac{A-c}{2B}-\left [\frac{A-c}{4B} \right][/latex]

[latex]q^*_N=\frac{A-c}{4B}[/latex]

The subgame perfect Nash equilibrium is

([latex]q^*_F[/latex], [latex]q^*_F[/latex])

A few things are worth noting when comparing this outcome to the Nash equilibrium outcome of the Cournot game in section 18.1 . First, the individual output level for Federal, the first mover in the Stackelberg game, the Stackelberg leader , is higher than it is in the Cournot game. Second, the individual output level for National, the second mover in the Stackelberg game, the Stackelberg follower , is lower than it is in the Cournot game. Third, the total output is larger in the Stackelberg outcome than in the Cournot outcome. This means the price is lower because the demand curve is downward sloping. Since the Cournot outcome is one of the options for the Stackelberg leader—if it chooses the same output as in the Cournot case, the follower will as well—it must be true that profits are higher for the Stackelberg leader. And since both the quantity produced and the price received are lower for the Stackelberg follower compared to the Cournot outcome, the profits must be lower as well.

So from this we see the major differences in the Stackelberg model compared to the Cournot model. There is a considerable first-mover advantage . By being able to set its quantity first, Federal Gas is able to gain a larger share of the market for itself, and even though it leads to a lower price, it makes up for that lower price with the increase in quantity to achieve higher profits. The opposite is true for the second mover: by being forced to choose after the leader has set its output, the follower is forced to accept a lower price and lower output. From the consumer’s perspective, the Stackelberg outcome is preferable because overall, there is more quantity at a lower price.

The end of the twentieth century saw a number of mergers of massive oil companies. In 1999, BP Amoco acquired ARCO, followed soon thereafter by Exxon’s acquisition of Mobil. Then, in 2001, Chevron acquired Texaco for $38.7 billion. The newly combined company became the world’s fourth-largest producer of oil and natural gas. Whenever any such mergers and acquisitions are proposed, the US government has to approve the deal, and sometimes this approval comes with conditions designed to protect US consumers from undue harm that the consolidation might cause due to market concentration. In this case, the Federal Trade Commission (FTC) was the agency that provided oversight, and in the end, they approved the merger with the following condition: they had to sell their stake in two massive oil refineries. However, they were largely allowed to retain their retail gas operations, even though both companies had significant market presence and their merger would cause a drop in the competitiveness of the retail gas market, particularly in some areas where both companies had a significant market share.

On their face, these decisions seem to make little sense. How is it that the US government is worried about the impact of the merger on refining and the wholesale gas market but not on the retail gas market? The answer lies in the way these two markets fit into the economic models of oligopoly. Refining and wholesale gas operations are more akin to the Cournot model, where a few firms produce a homogenous product and compete on quantity and the sum total of all gas refined sets the wholesale market price. The insight of the Cournot model is that every merger produces fewer firms, and this constrains supply and increases price. Remember that this is a function not of capacity—that has not changed—but of the strategic environment, which makes it easier for all firms to constrict supply, which, in turn, raises prices and profits. The lower supply and higher prices do material harm to consumers, however, and it is for this reason that the FTC stepped in and demanded that the merged company sell off its interest in two big refining operations.

On the other hand, retail gas is more akin to the Bertrand model, where a bunch of retailers are selling a homogenous good but are competing mostly on price. A cursory examination of the retail gas industry confirms this: prices are posted prominently, and consumers show very strong responses to lower prices. The Bertrand model shows us that it takes very little competition to result in highly competitive pricing, so a merger that might reduce the number of competing gas station brands by one is unlikely to have much of a material effect on prices and therefore will be unlikely to harm consumers.

Viewed through the lens of the models of oligopoly studied in this chapter, the FTC’s decision to demand a divestment in oil refining and wholesale gas operations but mostly allow the retail side to consolidate makes sense. It is no surprise that these are the very same models the government uses to analyze such situations and devise a response.

• Do you think it is correct that wholesale gas looks more like the Cournot model and retail gas looks more like the Bertrand model?
• Do you think the government did the right thing in the case of the Chevron-Texaco merger?

Review: Topics and Related Learning Outcomes

Learn: key topics.

Oligopoly markets are markets in which only a few firms compete, where firms produce homogeneous or differentiated products, and where barriers to entry exist that may be natural or constructed.

The Cournot model considers firms that make an identical product and make output decisions simultaneously.

The Bertrand model considers firms that make an identical product but compete on price and make their pricing decisions simultaneously.

The Stackelberg model considers quantity-setting firms with an identical product that make output decisions simultaneously.

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13.2: Oligopoly in Practice

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Collusion and Competition

Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable.

learning objectives

• Assess the considerations involved in the oligopolist’s decision about whether to compete or cooperate

Oligopoly is a market structure in which there are a few firms producing a product. When there are few firms in the market, they may collude to set a price or output level for the market in order to maximize industry profits. As a result, price will be higher than the market-clearing price, and output is likely to be lower. At the extreme, the colluding firms may act as a monopoly, reducing their individual output so that their collective output would equal that of a monopolist, allowing them to earn higher profits.

OPEC : The oil-producing countries of OPEC have at times cooperated to raise world oil prices in order to secure a steady income for themselves.

If oligopolists individually pursued their own self-interest, then they would produce a total quantity greater than the monopoly quantity, and charge a lower price than the monopoly price, thus earning a smaller profit. The promise of bigger profits gives oligopolists an incentive to cooperate. However, collusive oligopoly is inherently unstable, because the most efficient firms will be tempted to break ranks by cutting prices in order to increase market share.

Several factors deter collusion. First, price-fixing is illegal in the United States, and antitrust laws exist to prevent collusion between firms. Second, coordination among firms is difficult, and becomes more so the greater the number of firms involved. Third, there is a threat of defection. A firm may agree to collude and then break the agreement, undercutting the profits of the firms still holding to the agreement. Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to effectively punish firms that may break the agreement.

In contrast to price-fixing, price leadership is a type of informal collusion which is generally legal. Price leadership, which is also sometimes called parallel pricing, occurs when the dominant competitor publishes its price ahead of other firms in the market, and the other firms then match the announced price. The leader will typically set the price to maximize its profits, which may not be the price that maximized other firms’ profits.

Game Theory Applications to Oligopoly

Game theory provides a framework for understanding how firms behave in an oligopoly.

• Explain how game theory applies to oligopolies

In an oligopoly, firms are interdependent; they are affected not only by their own decisions regarding how much to produce, but by the decisions of other firms in the market as well. Game theory offers a useful framework for thinking about how firms may act in the context of this interdependence. More specifically, game theory can be used to model situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.

For example, game theory can explain why oligopolies have trouble maintaining collusive arrangements to generate monopoly profits. While firms would be better off collectively if they cooperate, each individual firm has a strong incentive to cheat and undercut their competitors in order to increase market share. Because the incentive to defect is strong, firms may not even enter into a collusive agreement if they don’t perceive there to be a way to effectively punish defectors.

The prisoner’s dilemma is a specific type of game in game theory that illustrates why cooperation may be difficult to maintain for oligopolists even when it is mutually beneficial. In the game, two members of a criminal gang are arrested and imprisoned. The prisoners are separated and left to contemplate their options. If both prisoners confess, each will serve a two-year prison term. If one confesses, but the other denies the crime, the one that confessed will walk free, while the one that denied the crime would get a three-year sentence. If both deny the crime, they will both serve only a one year sentence. Betraying the partner by confessing is the dominant strategy; it is the better strategy for each player regardless of how the other plays. This is known as a Nash equilibrium. The result of the game is that both prisoners pursue individual logic and betray, when they would have collectively gotten a better outcome if they had both cooperated.

Prisoner’s Dilemma : In a prisoner’s dilemma game, the dominant strategy for each player is to betray the other, even though cooperation would have led to a better collective outcome.

The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy. If a player knew the strategies of the other players (and those strategies could not change), and could not benefit by changing his or her strategy, then that set of strategies represents a Nash equilibrium. If any player would benefit by changing his or her strategy, then that set of strategies is not a Nash equilibrium.

While game theory is important to understanding firm behavior in oligopolies, it is generally not needed to understand competitive or monopolized markets. In competitive markets, firms have such a small individual effect on the market, that taking other firms into account is simply not necessary. A monopolized market has only one firm, and thus strategic interactions do not occur.

The Prisoner’s Dilemma and Oligopoly

The prisoner’s dilemma shows why two individuals might not cooperate, even if it is collectively in their best interest to do so.

• Analyze the prisoner’s dilemma using the concepts of strategic dominance, Pareto optimality, and Nash equilibria

Sometimes firms fail to cooperate with each other, even when cooperation would bring about a better collective outcome. The prisoner’s dilemma is a canonical example of a game analyzed in game theory that shows why two individuals might not cooperate, even if it appears that it is in their best interest to do so.

In the game, two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of speaking to or exchanging messages with the other. The police offer each prisoner a bargain:

Prisoner’s Dilemma : Betrayal in the dominant strategy for both players, as it provides for a better individual outcome regardless of what the other player does. However, the resulting outcome is not Pareto-optimal. Both players would clearly have been better off if they had cooperated.

• If Prisoner A and Prisoner B both confess to the crime, each of them will serve two years in prison.
• If A confesses but B denies the crime, A will be set free, while B will serve three years in prison (and vice versa).
• If both A and B deny the crime, both of them will only serve one year in prison.

For both players, the choice to betray the partner by confessing has strategic dominance in this situation; it is the better strategy for each player regardless of what the other player does. This set of strategies is thus a Nash equilibrium in the game–no player would be better off by changing his or her strategy. As a result, all purely self-interested prisoners would betray each other, resulting in a two year prison sentence for both. This outcome is not Pareto optimal; it is clearly possible to improve the outcomes for both players through cooperation. If both players had denied the crime, they would each be serving only one year in prison.

Similarly to the prisoner’s dilemma scenario, cooperation is difficult to maintain in an oligopoly because cooperation is not in the best interest of the individual players. However, the collective outcome would be improved if firms cooperated, and were thus able to maintain low production, high prices, and monopoly profits.

One traditional example of game theory and the prisoner’s dilemma in practice involves soft drinks. Coca-Cola and Pepsi compete in an oligopoly, and thus are highly competitive against one another (as they have limited other competitive threats). Considering the similarity of their products in the soft drink industry (i.e. varying types of soda), any price deviation on part of one competitor is seen as an act of non-conformity or betrayal of an established status quo.

In such a scenario, there are a number of plausible reactions and outcomes. If Coca-Cola reduces their prices, Pepsi may follow to ensure they do not lose market share. In this situation, defection results in a lose-lose. Which is to say that, due to the initial price reduction by Coca-Cola (betrayal of status quo), both companies likely see reduced profit margins. On the other hand, Pepsi could uphold the price point despite Coca-Cola’s deviation, sacrificing market share to Coca-Cola but maintaining the established price point. Prisoner dilemma scenarios are difficult strategic choices, as any deviation from established competitive practice may result in less profits and/or market share.

Duopoly Example

The Cournot model, in which firms compete on output, and the Bertrand model, in which firms compete on price, describe duopoly dynamics.

• Discuss the characteristics of a duopoly

A true duopoly is a specific type of oligopoly where only two producers exist in a market. There are two principle duopoly models: Cournot duopoly and Bertrand duopoly.

Cournot Duopoly

Cournot duopoly is an economic model that describes an industry structure in which firms compete on output levels. The model makes the following assumptions:

• There are two firms, which produce a homogeneous product;
• The number of firms is fixed;
• Firms do not cooperate (there is no collusion);
• Firms have market power, and each firm’s output decision affects the good’s price;
• Firms are economically rational and act strategically, seeking to maximize profit given their competitor’s decisions; and
• Firms compete on quantity, and choose quantity simultaneously.

The Cournot model focuses on the production output decision of a single firm. The firm determines its rival’s output level, evaluates the residual market demand, and then changes its own output level to maximize profits. It is assumed that the firm’s output decision will not affect the output decision of its competitor.

For example, suppose that there are two firms in the market for toasters with a given demand function. Firm A will determine the output of Firm B, hold it constant, and then determine the remainder of the market demand for toasters. Firm A will then determine its profit-maximizing output for that residual demand as if it were the entire market, and produce accordingly. Firm B will be conducting similar calculations with respect to Firm A at the same time.

Bertrand Duopoly

The Bertrand model describes interactions among firms that compete on price. Firms set profit-maximizing prices in response to what they expect a competitor to charge. The model rests on the following assumptions:

• There are two firms producing homogeneous products;
• Firms do not cooperate;
• Firms compete by setting prices simultaneously; and
• Consumers buy everything from a firm with a lower price. If all firms charge the same price, consumers randomly select among them.

In the Bertrand model, Firm A’s optimum price depends on where it believes Firm B will set its price. Pricing just below the other firm will obtain full market demand, though this choice is not optimal if the other firm is pricing below marginal cost, as this would result in negative profits. If Firm B is setting the price below marginal cost, Firm A will set the price at marginal cost. If Firm B is setting the price above marginal cost but below monopoly price, then Firm A will set the price just below that of Firm B. If Firm B sets the price above monopoly price, Firm A will set the price at monopoly level.

Bertrand Duopoly : The diagram shows the reaction function of a firm competing on price. When P2 (the price set by Firm 2) is less than marginal cost, Firm 1 prices at marginal cost (P1=MC). When Firm 2 prices above MC but below monopoly prices, Firm 1 prices just below Firm 2. When Firm 2 prices above monopoly price (PM), Firm 1 prices at monopoly level (P1=PM).

Imagine if both firms set equal prices above marginal cost. Each firm would get half the market at a higher than marginal cost price. However, by lowering prices just slightly, a firm could gain the whole market. As a result, both firms are tempted to lower prices as much as they can. However, it would be irrational to price below marginal cost, because the firm would make a loss. Therefore, both firms will lower prices until they reach the marginal cost limit. According to this model, a duopoly will result in an outcome exactly equivalent to what prevails under perfect competition. The result of the firms’ strategies is a Nash equilibrium –a pair or strategies where neither firm can increase profits by unilaterally changing the price.

Colluding to charge the monopoly price and supplying one half of the market each is the best that the firms could do in this scenario. However, not colluding and charging the marginal cost, which is the non-cooperative outcome, is the only Nash equilibrium of this model.

The accuracy of the Cournot or Bertrand model will vary from industry to industry. If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. If output and capacity are difficult to adjust, then Cournot is generally a better model.

Cartel Example

A cartel is a formal collusive arrangement among firms with the goal of increasing profits.

• Assess the role of competition and collusion in the formation of cartels

A cartel is an agreement among competing firms to collude in order to attain higher profits. Cartels usually occur in an oligopolistic industry, where the number of sellers is small and the products being traded are homogeneous. Cartel members may agree on such matters are price fixing, total industry output, market share, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits.

Game theory suggests that cartels are inherently unstable, because the behavior of cartel members represents a prisoner’s dilemma. Each member of a cartel would be able to make a higher profit, at least in the short-run, by breaking the agreement (producing a greater quantity or selling at a lower price) than it would make by abiding by it. However, if the cartel collapses because of defections, the firms would revert to competing, profits would drop, and all would be worse off.

Whether members of a cartel choose to cheat on the agreement depends on whether the short-term returns to cheating outweigh the long-term losses from the possible breakdown of the cartel. It also partly depends on how difficult it is for firms to monitor whether the agreement is being adhered to by other firms. If monitoring is difficult, a member is likely to get away with cheating for longer; members would then be more likely to cheat, and the cartel will be more unstable.

Perhaps the most globally recognizable and effective cartel is OPEC, the Organization of Petroleum Exporting Countries. In 1973 members of OPEC reduced their production of oil. Because crude oil from the Middle East was known to have few substitutes, OPEC member’s profits skyrocketed. From 1973 to 1979, the price of oil increased by $70 per barrel, an unprecedented number at the time. In the mid 1980s, however, OPEC started to weaken. Discovery of new oil fields in Alaska and Canada introduced new alternatives to Middle Eastern oil, causing OPEC’s prices and profits to fall. Around the same time OPEC members also started cheating to try to increase individual profits.

OPEC : In the 1970s, OPEC members successfully colluded to reduce the global production of oil, leading to higher profits for member countries.

• Firms in an oligopoly may collude to set a price or output level for a market in order to maximize industry profits. At an extreme, the colluding firms can act as a monopoly.
• Oligopolists pursuing their individual self-interest would produce a greater quantity than a monopolist, and charge a lower price.
• Collusive arrangements are generally illegal. Moreover, it is difficult for firms to coordinate actions, and there is a threat that firms may defect and undermine the others in the arrangement.
• Price leadership, which occurs when a dominant competitor sets the industry price and others follow suit, is an informal type of collusion which is generally legal.
• In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well. Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.
• The prisoner’s dilemma is a type of game that illustrates why cooperation is difficult to maintain for oligopolists even when it is mutually beneficial. In this game, the dominant strategy of each actor is to defect. However, acting in self-interest leads to a sub-optimal collective outcome.
• The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy.
• Game theory is generally not needed to understand competitive or monopolized markets.
• In the game, two criminals are arrested and imprisoned. Each criminal must decide whether he will cooperate with or betray his partner. The criminals cannot communicate to coordinate their actions.
• Betrayal is the dominant strategy for both players in the game. Betrayal leads to best individual outcome regardless of what the other person does.
• Both players choosing betrayal is the Nash equilibrium of the game. However, this outcome is not Pareto-optimal. Both players would have clearly been better off if they had cooperated.
• Cooperation by firms in oligopolies is difficult to achieve because defection is in the best interest of each individual firm.
• The Cournot model focuses on the production output decision of a single firm. A firm determines its competitor’s output level and the residual market demand. It then determines its profit -maximizing output for that residual demand as if it were the entire market, and produces accordingly.
• In the Bertrand model, firms set profit-maximizing prices in response to what they expect the competitor to charge. The model predicts that both firms will lower prices until they reach the marginal cost limit, arriving at an outcome equivalent to what prevails under perfect competition.
• The accuracy of the Cournot or Bertrand model will vary from industry to industry, depending on how easy it is to adjust output levels in the industry.
• Cartel members cooperate to set industry price and output.
• Game theory indicates that cartels are inherently unstable. Each individual member has an incentive to cheat in order to make higher profits in the short run.
• Cheating may lead to the collapse of a cartel. With the collapse, firms would revert to competing, which would lead to decreased profits.
• OPEC, the Organization of Petroleum Exporting Countries, provides an example of a historically effective cartel.
• Price leadership : Occurs when one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following.
• collusion : A secret agreement for an illegal purpose; conspiracy.
• price fixing : An agreement between sellers to sell a product only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply.
• Prisoner’s dilemma : A game that shows why two individuals might not cooperate, even if it appears that it is in their best interests to do so.
• game theory : A branch of applied mathematics that studies strategic situations in which individuals or organisations choose various actions in an attempt to maximize their returns.
• Nash equilibrium : The set of players’ strategies for which no player can benefit by changing his or her strategy, assuming that the other players keep theirs unchanged.
• Pareto optimal : Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.
• Strategic dominance : Occurs when one strategy is better than another strategy for one player, no matter how that player’s opponents may play.
• Cournot duopoly : An economic model describing an industry in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time.
• Bertrand duopoly : A model that describes interactions among firms competing on price.
• Cartel : A group of businesses or nations that collude to limit competition within an industry or market.

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11.2 Oligopoly: Competition Among the Few

Learning objectives.

• Explain the main characteristics of an oligopoly, differentiating it from other types of market structures.
• Explain the measures that are used to determine the degree of concentration in an industry.
• Explain and illustrate the collusion model of oligopoly.
• Discuss how game theory can be used to understand the behavior of firms in an oligopoly.

In July, 2005, General Motors Corporation (GMC) offered “employee discount pricing” to virtually all GMC customers, not just employees and their relatives. This new marketing strategy introduced by GMC obviously affected Ford, Chrysler, Toyota and other automobile and truck manufacturers; Ford matched GMC’s employee-discount plan by offering up to $1,000 to its own employees who convinced friends to purchase its cars and trucks. Ford also offered its customers the same prices paid by its employees. By mid-July, Chrysler indicated that it was looking at many alternatives, but was waiting for GMC to make its next move. Ultimately, Chrysler also offered employee discount pricing.

Toyota had to respond. It quickly developed a new marketing strategy of its own, which included lowering the prices of its cars and offering new financing terms. The responses of Ford, Chrysler, and Toyota to GMC’s pricing strategy obviously affected the outcome of that strategy. Similarly, a decision by Procter & Gamble to lower the price of Crest toothpaste may elicit a response from Colgate-Palmolive, and that response will affect the sales of Crest. In an oligopoly , the fourth and final market structure that we will study, the market is dominated by a few firms, each of which recognizes that its own actions will produce a response from its rivals and that those responses will affect it.

The firms that dominate an oligopoly recognize that they are interdependent: What one firm does affects each of the others. This interdependence stands in sharp contrast to the models of perfect competition and monopolistic competition, where we assume that each firm is so small that it assumes the rest of the market will, in effect, ignore what it does. A perfectly competitive firm responds to the market, not to the actions of any other firm. A monopolistically competitive firm responds to its own demand, not to the actions of specific rivals. These presumptions greatly simplify the analysis of perfect competition and monopolistic competition. We do not have that luxury in oligopoly, where the interdependence of firms is the defining characteristic of the market.

Some oligopoly industries make standardized products: steel, aluminum, wire, and industrial tools. Others make differentiated products: cigarettes, automobiles, computers, ready-to-eat breakfast cereal, and soft drinks.

Measuring Concentration in Oligopoly

Oligopoly means that a few firms dominate an industry. But how many is “a few,” and how large a share of industry output does it take to “dominate” the industry?

Compare, for example, the ready-to-eat breakfast cereal industry and the ice cream industry. The cereal market is dominated by two firms, Kellogg’s and General Mills, which together hold more than half the cereal market. This oligopoly operates in a highly concentrated market. The market for ice cream, where the four largest firms account for just less than a third of output, is much less concentrated.

One way to measure the degree to which output in an industry is concentrated among a few firms is to use a concentration ratio , which reports the percentage of output accounted for by the largest firms in an industry. The higher the concentration ratio, the more the firms in the industry take account of their rivals’ behavior. The lower the concentration ratio, the more the industry reflects the characteristics of monopolistic competition or perfect competition.

The U.S. Census Bureau, based on surveys it conducts of manufacturing firms every five years, reports concentration ratios. These surveys show concentration ratios for the largest 4, 8, 20, and 50 firms in each industry category. Some concentration ratios from the 2002 survey, the latest available, are reported in Table 11.1 “Concentration Ratios and Herfindahl–Hirschman Indexes” . Notice that the four-firm concentration ratio for breakfast cereals is 78%; for ice cream it is 48%.

Table 11.1 Concentration Ratios and Herfindahl–Hirschman Indexes

Two measures of industry concentration are reported by the Census Bureau: concentration ratios and the Herfindahl–Hirschman Index (HHI).

Source: Selected statistics from Sector 31: Manufacturing: Subject Series—Concentration Ratios: Share of Value of Shipments Accounted for by the 4, 8, 20, and 50 Largest Companies for Industries: 2002 at http://www.census.gov/epcd/www/concentration.html .

An alternative measure of concentration is found by squaring the percentage share (stated as a whole number) of each firm in an industry, then summing these squared market shares to derive a Herfindahl–Hirschman Index (HHI) . The largest HHI possible is the case of monopoly, where one firm has 100% of the market; the index is 100 2 , or 10,000. An industry with two firms, each with 50% of total output, has an HHI of 5,000 (50 2 + 50 2 ). In an industry with 10,000 firms that have 0.01% of the market each, the HHI is 1. Herfindahl–Hirschman Indexes reported by the Census Bureau are also given in Table 11.1 “Concentration Ratios and Herfindahl–Hirschman Indexes” . Notice that the HHI is 2,521 for breakfast cereals and only 736 for ice cream, suggesting that the ice cream industry is more competitive than the breakfast cereal industry.

In some cases, the census data understate the degree to which a few firms dominate the market. One problem is that industry categories may be too broad to capture significant cases of industry dominance. The sporting goods industry, for example, appears to be highly competitive if we look just at measures of concentration, but markets for individual goods, such as golf clubs, running shoes, and tennis rackets, tend to be dominated by a few firms. Further, the data reflect shares of the national market. A tendency for regional domination does not show up. For example, the concrete industry appears to be highly competitive. But concrete is produced in local markets—it is too expensive to ship it very far—and many of these local markets are dominated by a handful of firms.

The census data can also overstate the degree of actual concentration. The “automobiles” category, for example, has a four-firm concentration ratio that suggests the industry is strongly dominated by four large firms (in fact, U.S. production is dominated by three: General Motors, Ford, and Chrysler). Those firms hardly account for all car sales in the United States, however, as other foreign producers have captured a large portion of the domestic market. Including those foreign competitors suggests a far less concentrated industry than the census data imply.

The Collusion Model

There is no single model of profit-maximizing oligopoly behavior that corresponds to economists’ models of perfect competition, monopoly, and monopolistic competition. Uncertainty about the interaction of rival firms makes specification of a single model of oligopoly impossible. Instead, economists have devised a variety of models that deal with the uncertain nature of rivals’ responses in different ways. In this section we review one type of oligopoly model, the collusion model. After examining this traditional approach to the analysis of oligopoly behavior, we shall turn to another method of examining oligopolistic interaction: game theory.

Firms in any industry could achieve the maximum profit attainable if they all agreed to select the monopoly price and output and to share the profits. One approach to the analysis of oligopoly is to assume that firms in the industry collude, selecting the monopoly solution.

Suppose an industry is a duopoly , an industry with two firms. Figure 11.5 “Monopoly Through Collusion” shows a case in which the two firms are identical. They sell identical products and face identical demand and cost conditions. To simplify the analysis, we will assume that each has a horizontal marginal cost curve, MC. The demand and marginal revenue curves are the same for both firms. We find the combined demand curve for the two firms, D combined , by adding the individual demand curves together. Because one firm’s demand curve, D firm , represents one-half of market demand, it is the same as the combined marginal revenue curve for the two firms. If these two firms act as a monopoly, together they produce Q m and charge a price P m . This result is achieved if each firm selects its profit-maximizing output, which equals 1/2 Q m . This solution is inefficient; the efficient solution is price P c and output Q c , found where the combined market demand curve D combined and the marginal cost curve MC intersect.

Figure 11.5 Monopoly Through Collusion

Two identical firms have the same horizontal marginal cost curve MC. Their demand curves D firm and marginal revenue curves MR firm are also identical. The combined demand curve is D combined ; the combined marginal revenue curve is MR combined . The profits of the two firms are maximized if each produces 1/2 Q m at point A. Industry output at point B is thus Q m and the price is P m . At point C, the efficient solution output would be Q c , and the price would equal MC .

In the simplest form of collusion, overt collusion , firms openly agree on price, output, and other decisions aimed at achieving monopoly profits. Firms that coordinate their activities through overt collusion and by forming collusive coordinating mechanisms make up a cartel .

Firms form a cartel to gain monopoly power. A successful cartel can earn large profits, but there are several problems with forming and maintaining one. First, in many countries, including the United States, cartels are generally illegal 1 . They are banned, because their purpose is to raise prices and restrict output. Second, the cartel may not succeed in inducing all firms in the industry to join. Firms that remain outside the cartel can compete by lowering price, and thus they prevent the cartel from achieving the monopoly solution. Third, there is always an incentive for individual members to cheat on cartel agreements. Suppose the members of a cartel have agreed to impose the monopoly price in their market and to limit their output accordingly. Any one firm might calculate that it could charge slightly less than the cartel price and thus capture a larger share of the market for itself. Cheating firms expand output and drive prices down below the level originally chosen.

The Organization of Petroleum Exporting Countries (OPEC), perhaps the best-known cartel, is made up of 13 oil-producing countries. In the 1970s, OPEC successfully acted like a monopoly by restricting output and raising prices. By the mid-1980s, however, the monopoly power of the cartel had been weakened by expansion of output by nonmember producers such as Mexico and Norway and by cheating among the cartel members.

An alternative to overt collusion is tacit collusion , an unwritten, unspoken understanding through which firms agree to limit their competition. Firms may, for example, begin following the price leadership of a particular firm, raising or lowering their prices when the leader makes such a change. The price leader may be the largest firm in the industry, or it may be a firm that has been particularly good at assessing changes in demand or cost. At various times, tacit collusion has been alleged to occur in a wide range of industries, including steel, cars, and breakfast cereals.

It is difficult to know how common tacit collusion is. The fact that one firm changes its price shortly after another one does cannot prove that a tacit conspiracy exists. After all, we expect to see the prices of all firms in a perfectly competitive industry moving together in response to changes in demand or production costs.

Game Theory and Oligopoly Behavior

Oligopoly presents a problem in which decision makers must select strategies by taking into account the responses of their rivals, which they cannot know for sure in advance. The Start Up feature at the beginning of this chapter suggested the uncertainty eBay faces as it considers the possibility of competition from Google. A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes these possible actions into account is called a strategic choice . Game theory is an analytical approach through which strategic choices can be assessed.

Among the strategic choices available to an oligopoly firm are pricing choices, marketing strategies, and product-development efforts. An airline’s decision to raise or lower its fares—or to leave them unchanged—is a strategic choice. The other airlines’ decision to match or ignore their rival’s price decision is also a strategic choice. IBM boosted its share in the highly competitive personal computer market in large part because a strategic product-development strategy accelerated the firm’s introduction of new products.

Once a firm implements a strategic decision, there will be an outcome. The outcome of a strategic decision is called a payoff . In general, the payoff in an oligopoly game is the change in economic profit to each firm. The firm’s payoff depends partly on the strategic choice it makes and partly on the strategic choices of its rivals. Some firms in the airline industry, for example, raised their fares in 2005, expecting to enjoy increased profits as a result. They changed their strategic choices when other airlines chose to slash their fares, and all firms ended up with a payoff of lower profits—many went into bankruptcy.

We shall use two applications to examine the basic concepts of game theory. The first examines a classic game theory problem called the prisoners’ dilemma. The second deals with strategic choices by two firms in a duopoly.

The Prisoners’ Dilemma

Suppose a local district attorney (DA) is certain that two individuals, Frankie and Johnny, have committed a burglary, but she has no evidence that would be admissible in court.

The DA arrests the two. On being searched, each is discovered to have a small amount of cocaine. The DA now has a sure conviction on a possession of cocaine charge, but she will get a conviction on the burglary charge only if at least one of the prisoners confesses and implicates the other.

The DA decides on a strategy designed to elicit confessions. She separates the two prisoners and then offers each the following deal: “If you confess and your partner doesn’t, you will get the minimum sentence of one year in jail on the possession and burglary charges. If you both confess, your sentence will be three years in jail. If your partner confesses and you do not, the plea bargain is off and you will get six years in prison. If neither of you confesses, you will each get two years in prison on the drug charge.”

The two prisoners each face a dilemma; they can choose to confess or not confess. Because the prisoners are separated, they cannot plot a joint strategy. Each must make a strategic choice in isolation.

The outcomes of these strategic choices, as outlined by the DA, depend on the strategic choice made by the other prisoner. The payoff matrix for this game is given in Figure 11.6 “Payoff Matrix for the Prisoners’ Dilemma” . The two rows represent Frankie’s strategic choices; she may confess or not confess. The two columns represent Johnny’s strategic choices; he may confess or not confess. There are four possible outcomes: Frankie and Johnny both confess (cell A), Frankie confesses but Johnny does not (cell B), Frankie does not confess but Johnny does (cell C), and neither Frankie nor Johnny confesses (cell D). The portion at the lower left in each cell shows Frankie’s payoff; the shaded portion at the upper right shows Johnny’s payoff.

Figure 11.6 Payoff Matrix for the Prisoners’ Dilemma

The four cells represent each of the possible outcomes of the prisoners’ game.

If Johnny confesses, Frankie’s best choice is to confess—she will get a three-year sentence rather than the six-year sentence she would get if she did not confess. If Johnny does not confess, Frankie’s best strategy is still to confess—she will get a one-year rather than a two-year sentence. In this game, Frankie’s best strategy is to confess, regardless of what Johnny does. When a player’s best strategy is the same regardless of the action of the other player, that strategy is said to be a dominant strategy . Frankie’s dominant strategy is to confess to the burglary.

For Johnny, the best strategy to follow, if Frankie confesses, is to confess. The best strategy to follow if Frankie does not confess is also to confess. Confessing is a dominant strategy for Johnny as well. A game in which there is a dominant strategy for each player is called a dominant strategy equilibrium . Here, the dominant strategy equilibrium is for both prisoners to confess; the payoff will be given by cell A in the payoff matrix.

From the point of view of the two prisoners together, a payoff in cell D would have been preferable. Had they both denied participation in the robbery, their combined sentence would have been four years in prison—two years each. Indeed, cell D offers the lowest combined prison time of any of the outcomes in the payoff matrix. But because the prisoners cannot communicate, each is likely to make a strategic choice that results in a more costly outcome. Of course, the outcome of the game depends on the way the payoff matrix is structured.

Repeated Oligopoly Games

The prisoners’ dilemma was played once, by two players. The players were given a payoff matrix; each could make one choice, and the game ended after the first round of choices.

The real world of oligopoly has as many players as there are firms in the industry. They play round after round: a firm raises its price, another firm introduces a new product, the first firm cuts its price, a third firm introduces a new marketing strategy, and so on. An oligopoly game is a bit like a baseball game with an unlimited number of innings—one firm may come out ahead after one round, but another will emerge on top another day. In the computer industry game, the introduction of personal computers changed the rules. IBM, which had won the mainframe game quite handily, struggles to keep up in a world in which rivals continue to slash prices and improve quality.

Oligopoly games may have more than two players, so the games are more complex, but this does not change their basic structure. The fact that the games are repeated introduces new strategic considerations. A player must consider not just the ways in which its choices will affect its rivals now, but how its choices will affect them in the future as well.

We will keep the game simple, however, and consider a duopoly game. The two firms have colluded, either tacitly or overtly, to create a monopoly solution. As long as each player upholds the agreement, the two firms will earn the maximum economic profit possible in the enterprise.

There will, however, be a powerful incentive for each firm to cheat. The monopoly solution may generate the maximum economic profit possible for the two firms combined, but what if one firm captures some of the other firm’s profit? Suppose, for example, that two equipment rental firms, Quick Rent and Speedy Rent, operate in a community. Given the economies of scale in the business and the size of the community, it is not likely that another firm will enter. Each firm has about half the market, and they have agreed to charge the prices that would be chosen if the two combined as a single firm. Each earns economic profits of $20,000 per month.

Quick and Speedy could cheat on their arrangement in several ways. One of the firms could slash prices, introduce a new line of rental products, or launch an advertising blitz. This approach would not be likely to increase the total profitability of the two firms, but if one firm could take the other by surprise, it might profit at the expense of its rival, at least for a while.

We will focus on the strategy of cutting prices, which we will call a strategy of cheating on the duopoly agreement. The alternative is not to cheat on the agreement. Cheating increases a firm’s profits if its rival does not respond. Figure 11.7 “To Cheat or Not to Cheat: Game Theory in Oligopoly” shows the payoff matrix facing the two firms at a particular time. As in the prisoners’ dilemma matrix, the four cells list the payoffs for the two firms. If neither firm cheats (cell D), profits remain unchanged.

Figure 11.7 To Cheat or Not to Cheat: Game Theory in Oligopoly

Two rental firms, Quick Rent and Speedy Rent, operate in a duopoly market. They have colluded in the past, achieving a monopoly solution. Cutting prices means cheating on the arrangement; not cheating means maintaining current prices. The payoffs are changes in monthly profits, in thousands of dollars. If neither firm cheats, then neither firm’s profits will change. In this game, cheating is a dominant strategy equilibrium.

This game has a dominant strategy equilibrium. Quick’s preferred strategy, regardless of what Speedy does, is to cheat. Speedy’s best strategy, regardless of what Quick does, is to cheat. The result is that the two firms will select a strategy that lowers their combined profits!

Quick Rent and Speedy Rent face an unpleasant dilemma. They want to maximize profit, yet each is likely to choose a strategy inconsistent with that goal. If they continue the game as it now exists, each will continue to cut prices, eventually driving prices down to the point where price equals average total cost (presumably, the price-cutting will stop there). But that would leave the two firms with zero economic profits.

Both firms have an interest in maintaining the status quo of their collusive agreement. Overt collusion is one device through which the monopoly outcome may be maintained, but that is illegal. One way for the firms to encourage each other not to cheat is to use a tit-for-tat strategy. In a tit-for-tat strategy a firm responds to cheating by cheating, and it responds to cooperative behavior by cooperating. As each firm learns that its rival will respond to cheating by cheating, and to cooperation by cooperating, cheating on agreements becomes less and less likely.

Still another way firms may seek to force rivals to behave cooperatively rather than competitively is to use a trigger strategy , in which a firm makes clear that it is willing and able to respond to cheating by permanently revoking an agreement. A firm might, for example, make a credible threat to cut prices down to the level of average total cost—and leave them there—in response to any price-cutting by a rival. A trigger strategy is calculated to impose huge costs on any firm that cheats—and on the firm that threatens to invoke the trigger. A firm might threaten to invoke a trigger in hopes that the threat will forestall any cheating by its rivals.

Game theory has proved to be an enormously fruitful approach to the analysis of a wide range of problems. Corporations use it to map out strategies and to anticipate rivals’ responses. Governments use it in developing foreign-policy strategies. Military leaders play war games on computers using the basic ideas of game theory. Any situation in which rivals make strategic choices to which competitors will respond can be assessed using game theory analysis.

One rather chilly application of game theory analysis can be found in the period of the Cold War when the United States and the former Soviet Union maintained a nuclear weapons policy that was described by the acronym MAD, which stood for m utually a ssured d estruction. Both countries had enough nuclear weapons to destroy the other several times over, and each threatened to launch sufficient nuclear weapons to destroy the other country if the other country launched a nuclear attack against it or any of its allies. On its face, the MAD doctrine seems, well, mad. It was, after all, a commitment by each nation to respond to any nuclear attack with a counterattack that many scientists expected would end human life on earth. As crazy as it seemed, however, it worked. For 40 years, the two nations did not go to war. While the collapse of the Soviet Union in 1991 ended the need for a MAD doctrine, during the time that the two countries were rivals, MAD was a very effective trigger indeed.

Of course, the ending of the Cold War has not produced the ending of a nuclear threat. Several nations now have nuclear weapons. The threat that Iran will introduce nuclear weapons, given its stated commitment to destroy the state of Israel, suggests that the possibility of nuclear war still haunts the world community.

Key Takeaways

• The key characteristics of oligopoly are a recognition that the actions of one firm will produce a response from rivals and that these responses will affect it. Each firm is uncertain what its rivals’ responses might be.
• The degree to which a few firms dominate an industry can be measured using a concentration ratio or a Herfindahl–Hirschman Index.
• One way to avoid the uncertainty firms face in oligopoly is through collusion. Collusion may be overt, as in the case of a cartel, or tacit, as in the case of price leadership.
• Game theory is a tool that can be used to understand strategic choices by firms.
• Firms can use tit-for-tat and trigger strategies to encourage cooperative behavior by rivals.

Which model of oligopoly would seem to be most appropriate for analyzing firms’ behavior in each of the situations given below?

• When South Airlines lowers its fare between Miami and New York City, North Airlines lowers its fare between the two cities. When South Airlines raises its fare, North Airlines does too.
• Whenever Bank A raises interest rates on car loans, other banks in the area do too.
• In 1986, Saudi Arabia intentionally flooded the market with oil in order to punish fellow OPEC members for cheating on their production quotas.
• In July 1998, Saudi Arabia floated a proposal in which a group of eight or nine major oil-exporting countries (including OPEC members and some nonmembers, such as Mexico) would manage world oil prices by adjusting their production.

Case in Point: Memory Chip Makers Caught in Global Price-Fixing Scheme

Figure 11.8

Tristendomusic – Chips array – CC BY-SA 2.0.

It may have been the remark by T.L. Chang, vice president of the Taiwan-based memory chip manufacturer Mosel-Vitelic that sparked the investigation by the U.S. Department of Justice Antitrust Division. Mr. Chang was quoted in Taiwan’s Commercial Times in May 2002 as admitting to price-fixing meetings held in Asia among the major producers of DRAM, or dynamic random access memory. DRAM is the most common semi-conductor main memory format for storage and retrieval of information that is used in personal computers, mobile phones, digital cameras, MP3 music players, and other electronics products. At those meetings, as well as through emails and telephone conferences, the main manufacturers of DRAM decided not only what prices to charge and how much to make available, but also exchanged information on DRAM sales for the purpose of monitoring and enforcing adherence to the agreed prices. The collusion lasted for three years—from 1999 to 2002. In December 2001, DRAM prices were less than $1.00. By May of 2002, price had risen to the $4 to $5 range.

The companies that were directly injured by the higher chip prices included Dell, Compaq, Hewlett-Packard, Apple, IBM, and Gateway. In the end, though, the purchasers of their products paid in the form of higher prices or less memory.

In December 2003, a Micron Technology sales manager pled guilty to obstruction of justice and served six months of home detention. The first chipmaker to plead guilty a year later was Germany-based Infineon Technologies, which was fined $160 million. As of September 2007, five companies, Samsung being the largest, had been charged fines of more than $732 million, and over 3,000 days of jail time had been meted out to eighteen corporate executives.

The sharp reduction in the number of DRAM makers in the late 1990s undoubtedly made it easier to collude. The industry is still quite concentrated with Samsung holding 27.7% of the market and Hynix 21.3%. The price, however, has fallen quite sharply in recent years.

Sources: Department of Justice, “Sixth Samsung Executive Agrees to Plead Guilty to Participating in DRAM Price-Fixing Cartel,” Press Release April 19, 2007; Stephen Labaton, “Infineon To Pay a Fine in the Fixing of Chip Prices,” The New York Times , September 16, 2004; George Leopold and David Lammers, “DRAMs Under Gun in Antitrust Probe”, Electronic Engineering Times , 1124 (June 24, 2002):1, 102; Lee Sun-Young, “Samsung Cements DRAM Leadership,” Korea Herald , online, March 31, 2008.

Answers to Try It! Problems

• North Airlines seems to be practicing a price strategy known in game theory as tit-for-tat.
• The banks could be engaged in tacit collusion, with Bank A as the price leader.
• Saudi Arabia appears to have used a trigger strategy, another aspect of game theory. In general, of course, participants hope they will never have to “pull” the trigger, because doing so harms all participants. After years of cheating by other OPEC members, Saudi Arabia did undertake a policy that hurt all members of OPEC, including itself; OPEC has never since regained the prominent role it played in oil markets.
• Saudi Arabia seems to be trying to create another oil cartel, a form of overt collusion.

1 One legal cartel is the NCAA, which many economists regard as a successful device through which member firms (colleges and universities) collude on a wide range of rules through which they produce sports.

Principles of Economics Copyright © 2016 by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License , except where otherwise noted.

9 Monopoly, Monopolistic Competition, and Oligopoly

Introduction.

Chapter Objectives

In this chapter, you will learn about:

How Monopolies Form: Barriers to Entry

How a profit-maximizing monopoly chooses output and price, monopolistic competition, who controls our power.

In 2022, conversations began within Louisiana state government to reconsider the limitations on which companies can sell electricity within the state. Historically, only Cleco and Entergy have been allowed to provide electrical services to business and residents. Many argue that this creates a monopoly, because the market is fully controlled by only two companies and all others are barred from access. Is this a problem or a safety net?

Those against the barring of allowing other companies to provide services think that this is a monopoly and serves to protect only Cleco and Entergy. Some cite what they feel are uncontrolled service rates and point out that recent natural disasters were not well handled by the two companies. The most recent hurricanes demonstrated a lack of ability to reestablish service in what is considered a reasonable time frame.

Cleco, Entergy, and their supporters argue that allowing competition to enter the market would hinder the ability to regulate costs. Further, the introduction of competition would impact Cleco’s and Entergy’s ability to fund improvements to facilities and infrastructures due to loss of income.

https://www.theadvocate.com/baton_rouge/news/politics/could-louisiana-open-its-power-market-to-competition-utilities-hope-not/article_b2552154-2aff-11ed-8a05-f719c2b6cbed.html

Many believe that top executives at firms are the strongest supporters of market competition, but this belief is far from the truth. Think about it this way: If you very much wanted to win an Olympic gold medal, would you rather be far better than everyone else, or locked in competition with many athletes just as good as you? Similarly, if you would like to attain a very high level of profits, would you rather manage a business with little or no competition, or struggle against many tough competitors who are trying to sell to your customers?

In the case of monopoly , one firm produces all of the output in a market. Since a monopoly faces no significant competition, it can charge any price it wishes, subject to the demand curve. While a monopoly, by definition, refers to a single firm, in practice people often use the term to describe a market in which one firm merely has a very high market share. This tends to be the definition that the U.S. Department of Justice uses.

Even though there are very few true monopolies in existence, we do deal with some of those few every day, often without realizing it: The U.S. Postal Service and your electric and garbage-collection companies are a few examples. Some new drugs are produced by only one pharmaceutical firm—and no close substitutes for that drug may exist.

From the mid-1990s until 2004, the U.S. Department of Justice prosecuted the Microsoft Corporation for including Internet Explorer as the default web browser with its operating system. The Justice Department’s argument was that, since Microsoft possessed an extremely high market share in the industry for operating systems, the inclusion of a free web browser constituted unfair competition to other browsers, such as Netscape Navigator. Since nearly everyone was using Windows, including Internet Explorer eliminated the incentive for consumers to explore other browsers and made it impossible for competitors to gain a foothold in the market. In 2013, the Windows system ran on more than 90% of the most commonly sold personal computers. In 2015, a U.S. federal court tossed out antitrust charges that Google had an agreement with mobile device makers to set Google as the default search engine.

One type of imperfectly competitive market is monopolistic competition. Monopolistically competitive markets feature a large number of competing firms, but the products that they sell are not identical. Most of the markets that consumers encounter at the retail level are monopolistically competitive.

The other type of imperfectly competitive market is oligopoly. Oligopolistic markets are those which a small number of firms dominate. Commercial aircraft provides a good example: Boeing and Airbus each produce slightly less than 50% of the large commercial aircraft in the world. Another example is the U.S. soft drink industry, which Coca-Cola and Pepsi dominate. We characterize oligopolies by high barriers to entry with firms choosing output, pricing, and other decisions strategically based on the decisions of the other firms in the market.

Learning Objectives

By the end of this section, you will be able to:

• Distinguish between a natural monopoly and a legal monopoly.
• Explain how economies of scale and the control of natural resources led to the necessary formation of legal monopolies
• Analyze the importance of trademarks and patents in promoting innovation
• Identify examples of predatory pricing

Because of the lack of competition, monopolies tend to earn significant economic profits. These profits should attract vigorous competition, as we described in Perfect Competition , and yet because of one particular characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that discourage or prevent potential competitors from entering a market. Barriers to entry can range from the simple and easily surmountable, such as the cost of renting retail space, to the extremely restrictive. For example, there are a finite number of radio frequencies available for broadcasting. Once an entrepreneur or firm has purchased the rights to all of them, no new competitors can enter the market.

In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in markets with significant barriers to entry, it is not necessarily true that abnormally high profits will attract new firms, and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a normal level of profit in the long run.

There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural monopoly, where the barriers to entry are something other than legal prohibition. The other is legal monopoly, where laws prohibit (or severely limit) competition.

Natural Monopoly

Economies of scale can combine with the size of the market to limit competition. (We introduced this theme in Production, Cost and Industry Structure.) Figure 9.2 presents a long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000 planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year.

Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC) curve at an output level of 5,000 planes per year and at a price P1, which is higher than P0. In this situation, the market has room for only one producer. If a second firm attempts to enter the market at a smaller size, say by producing a quantity of 4,000 planes, then its average costs will be higher than those of the existing firm, and it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000 planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it produced because of insufficient demand in the market.

Economists call this situation, when economies of scale are large relative to the quantity demanded in the market, a natural monopoly. Natural monopolies often arise in industries where the marginal cost of adding an additional customer is very low, once the fixed costs of the overall system are in place. This results in situations where there are substantial economies of scale. For example, once a water company lays the main water pipes through a neighborhood, the marginal cost of providing water service to another home is fairly low. Once the electric company installs lines in a new subdivision, the marginal cost of providing additional electrical service to one more home is minimal. It would be costly and duplicative for a second water company to enter the market and invest in a whole second set of main water pipes, or for a second electricity company to enter the market and invest in a whole new set of electrical wires. These industries offer an example where, because of economies of scale, one producer can serve the entire market more efficiently than a number of smaller producers that would need to make duplicate physical capital investments.

A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For example, cement production exhibits economies of scale, and the quantity of cement demanded in a local area may not be much larger than what a single plant can produce. Moreover, the costs of transporting cement over land are high, and so a cement plant in an area without access to water transportation may be a natural monopoly.

Control of a Physical Resource

Another type of monopoly occurs when a company has control of a scarce physical resource. In the U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the 1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough aluminum to compete.

As another example, the majority of global diamond production is controlled by DeBeers, a multi-national company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It also has exploration activities on four continents, while directing a worldwide distribution network of rough cut diamonds. Although in recent years they have experienced growing competition, their impact on the rough diamond market is still considerable.

Legal Monopoly

For some products, the government erects barriers to entry by prohibiting or limiting competition. Under U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states or cities have laws or regulations that allow households a choice of only one electric company, one water company, and one company to pick up the garbage. Most legal monopolies are utilities—products necessary for everyday life—that are socially beneficial. As a consequence, the government allows producers to become regulated monopolies, to ensure that customers have access to an appropriate amount of these products or services. Additionally, legal monopolies are often subject to economies of scale, so it makes sense to allow only one provider.

Promoting Innovation

Innovation takes time and resources to achieve. Suppose a company invests in research and development and finds the cure for the common cold. In this world of near ubiquitous information, other companies could take the formula, produce the drug, and because they did not incur the costs of research and development (R&D), undercut the price of the company that discovered the drug. Given this possibility, many firms would choose not to invest in research and development, and as a result, the world would have less innovation. To prevent this from happening, the Constitution of the United States specifies in Article I, Section 8: “The Congress shall have Power . . . to Promote the Progress of Science and Useful Arts, by securing for limited Times to Authors and Inventors the Exclusive Right to their Writings and Discoveries.” Congress used this power to create the U.S. Patent and Trademark Office, as well as the U.S. Copyright Office. A patent gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time. In the United States, exclusive patent rights last for 20 years. The idea is to provide limited monopoly power so that innovative firms can recoup their investment in R&D, but then to allow other firms to produce the product more cheaply once the patent expires.

A trademark is an identifying symbol or name for a particular good, like Chiquita bananas, Chevrolet cars, or the Nike “swoosh” that appears on shoes and athletic gear. Between 2003 and 2019, roughly 6.8 million trademarks were registered with the U.S. government. A firm can renew a trademark repeatedly, as long as it remains in active use.

A copyright , according to the U.S. Copyright Office, “is a form of protection provided by the laws of the United States for ‘original works of authorship’ including literary, dramatic, musical, architectural, cartographic, choreographic, pantomimic, pictorial, graphic, sculptural, and audiovisual creations.” No one can reproduce, display, or perform a copyrighted work without the author’s permission. Copyright protection ordinarily lasts for the life of the author plus 70 years.

Roughly speaking, patent law covers inventions and copyright protects books, songs, and art. However, in certain areas, like the invention of new software, it has been unclear whether patent or copyright protection should apply. There is also a body of law known as trade secrets . Even if a company does not have a patent on an invention, competing firms are not allowed to steal their secrets. One famous trade secret is the formula for Coca-Cola, which is not protected under copyright or patent law, but is simply kept secret by the company.

Taken together, we call this combination of patents, trademarks, copyrights, and trade secret law intellectual property , because it implies ownership over an idea, concept, or image, not a physical piece of property like a house or a car. Countries around the world have enacted laws to protect intellectual property, although the time periods and exact provisions of such laws vary across countries. There are ongoing negotiations, both through the World Intellectual Property Organization (WIPO) and through international treaties, to bring greater harmony to the intellectual property laws of different countries to determine the extent to which those in other countries will respect patents and copyrights of those in other countries.

Government limitations on competition used to be more common in the United States. For most of the twentieth century, only one phone company—AT&T—was legally allowed to provide local and long-distance service. From the 1930s to the 1970s, one set of federal regulations limited which destinations airlines could choose to fly to and what fares they could charge. Another set of regulations limited the interest rates that banks could pay to depositors; yet another specified how much trucking firms could charge customers.

What products we consider utilities depends, in part, on the available technology. Fifty years ago, telephone companies provided local and long-distance service over wires. It did not make much sense to have many companies building multiple wiring systems across towns and the entire country. AT&T lost its monopoly on long-distance service when the technology for providing phone service changed from wires to microwave and satellite transmission, so that multiple firms could use the same transmission mechanism. The same thing happened to local service, especially in recent years, with the growth in cellular phone systems.

The combination of improvements in production technologies and a general sense that the markets could provide services adequately led to a wave of deregulation , starting in the late 1970s and continuing into the 1990s. This wave eliminated or reduced government restrictions on the firms that could enter, the prices that they could charge, and the quantities that many industries could produce, including telecommunications, airlines, trucking, banking, and electricity.

Around the world, from Europe to Latin America to Africa and Asia, many governments continue to control and limit competition in what those governments perceive to be key industries, including airlines, banks, steel companies, oil companies, and telephone companies.

Visit this website for examples of some pretty bizarre patents.

Intimidating Potential Competition

Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors from entering the market. One method is known as predatory pricing , in which a firm uses the threat of sharp price cuts to discourage competition. Predatory pricing is a violation of U.S. antitrust law, but it is difficult to prove.

Consider a large airline that provides most of the flights between two particular cities. A new, small start-up airline decides to offer service between these two cities. The large airline immediately slashes prices on this route to the bone, so that the new entrant cannot make any money. After the new entrant has gone out of business, the incumbent firm can raise prices again.

After the company repeats this pattern once or twice, potential new entrants may decide that it is not wise to try to compete. Small airlines often accuse larger airlines of predatory pricing: in the early 2000s, for example, ValuJet accused Delta of predatory pricing, Frontier accused United, and Reno Air accused Northwest. In 2015, the Justice Department ruled against American Express and Mastercard for imposing restrictions on retailers that encouraged customers to use lower swipe fees on credit transactions.

In some cases, large advertising budgets can also act as a way of discouraging the competition. If the only way to launch a successful new national cola drink is to spend more than the promotional budgets of Coca-Cola and Pepsi Cola, not too many companies will try. A firmly established brand name can be difficult to dislodge.

Summing Up Barriers to Entry

Table 9.1 lists the barriers to entry that we have discussed. This list is not exhaustive, since firms have proved to be highly creative in inventing business practices that discourage competition. When barriers to entry exist, perfect competition is no longer a reasonable description of how an industry works. When barriers to entry are high enough, monopoly can result.

• Explain the perceived demand curve for a perfect competitor and a monopoly
• Analyze a demand curve for a monopoly and determine the output that maximizes profit and revenue
• Calculate marginal revenue and marginal cost
• Explain allocative efficiency as it pertains to the efficiency of a monopoly

Consider a monopoly firm, comfortably surrounded by barriers to entry so that it need not fear competition from other producers. How will this monopoly choose its profit-maximizing quantity of output, and what price will it charge? Profits for the monopolist, like any firm, will be equal to total revenues minus total costs. We can analyze the pattern of costs for the monopoly within the same framework as the costs of a perfectly competitive firm —that is, by using total cost, fixed cost, variable cost, marginal cost, average cost, and average variable cost. However, because a monopoly faces no competition, its situation and its decision process will differ from that of a perfectly competitive firm. (The Clear It Up feature discusses how hard it is sometimes to define “market” in a monopoly situation.)

Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly

A perfectly competitive firm acts as a price taker, so we calculate total revenue by taking the given market price and multiplying it by the quantity of output that the firm chooses. The demand curve as it is perceived by a perfectly competitive firm appears in Figure 9.3 (a). The flat perceived demand curve means that, from the viewpoint of the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively high quantity like Qh at the market price P.

Clear It Up

What defines the market.

A monopoly is a firm that sells all or nearly all of the goods and services in a given market. However, what defines the “market”?

In a famous 1947 case, the federal government accused the DuPont company of having a monopoly in the cellophane market, pointing out that DuPont produced 75% of the cellophane in the United States. DuPont countered that even though it had a 75% market share in cellophane, it had less than a 20% share of the “flexible packaging materials,” which includes all other moisture-proof papers, films, and foils. In 1956, after years of legal appeals, the U.S. Supreme Court held that the broader market definition was more appropriate, and it dismissed the case against DuPont.

Questions over how to define the market continue today. True, Microsoft in the 1990s had a dominant share of the software for computer operating systems, but in the total market for all computer software and services, including everything from games to scientific programs, the Microsoft share was only about 14% in 2014. The Greyhound bus company may have a near-monopoly on the market for intercity bus transportation, but it is only a small share of the market for intercity transportation if that market includes private cars, airplanes, and railroad service. DeBeers has a monopoly in diamonds, but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry. A small town in the country may have only one gas station: is this gas station a “monopoly,” or does it compete with gas stations that might be five, 10, or 50 miles away?

In general, if a firm produces a product without close substitutes, then we can consider the firm a monopoly producer in a single market. However, if buyers have a range of similar—even if not identical—options available from other firms, then the firm is not a monopoly. Still, arguments over whether substitutes are close or not close can be controversial.

While a monopolist can charge any price for its product, nonetheless the demand for the firm’s product constrains the price. No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product. Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping.

Figure 9.3 illustrates this situation. The monopolist can either choose a point like R with a low price (Pl) and high quantity (Qh), or a point like S with a high price (Ph) and a low quantity (Ql), or some intermediate point. Setting the price too high will result in a low quantity sold, and will not bring in much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a profit-maximizing balance between the price it charges and the quantity that it sells. However, why isn’t the perfectly competitive firm’s demand curve also the market demand curve? See the following Clear It Up feature for the answer to this question.

What is the difference between perceived demand and market demand?

The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product. However, the firm’s demand curve as perceived by a monopoly is the same as the market demand curve. The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms. In effect, the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve. In contrast, a monopoly perceives demand for its product in a market where the monopoly is the only producer.

Total Cost and Total Revenue for a Monopolist

We can illustrate profits for a monopolist with a graph of total revenues and total costs, with the example of the hypothetical HealthPill firm in Figure 9.4 . The total cost curve has its typical shape that we learned about in Production, Costs and Industry Structure , and that we used in Perfect Competition ; that is, total costs rise and the curve grows steeper as output increases, as the final column of Table 9.2 shows.

Total revenue, though, is different. Since a monopolist faces a downward sloping demand curve, the only way it can sell more output is by reducing its price. Selling more output raises revenue, but lowering price reduces it. Thus, the shape of total revenue isn’t clear. Let’s explore this using the data in Table 9.2 , which shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output. (In this example, we give the output as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine that the pharmaceutical company measures these output levels and the corresponding prices per 1,000 or 10,000 pills.) As the figure illustrates, total revenue for a monopolist has the shape of a hill, first rising, next flattening out, and then falling. In this example, total revenue is highest at a quantity of 6 or 7.

However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. In the HealthPill example in Figure 9.4 , the highest profit will occur at the quantity where total revenue is the farthest above total cost. This looks to be somewhere in the middle of the graph, but where exactly? It is easier to see the profit maximizing level of output by using the marginal approach, to which we turn next.

Marginal Revenue and Marginal Cost for a Monopolist

In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total costs curves. After all, the firm does not know exactly what would happen if it were to alter production dramatically. However, a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience. A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price.

Table 9.3 expands Table 9.2 using the figures on total costs and total revenues from the HealthPill example to calculate marginal revenue and marginal cost. This monopoly faces typical upward-sloping marginal cost and downward-sloping marginal revenue curves, as Figure 9.5 shows.

Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher than 7. It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, doesn’t an increase in quantity sold not always mean more revenue? For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price. However, a monopolist can sell a larger quantity and see a decline in total revenue . When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because it must now sell every other unit at a lower price. As the quantity sold becomes higher, at some point the drop in price is proportionally more than the increase in greater quantity of sales, causing a situation where more sales bring in less revenue. In other words, marginal revenue is negative.

A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit.

For example, at an output of 4 in Figure 9.5 , marginal revenue is 600 and marginal cost is 250, so producing this unit will clearly add to overall profits. At an output of 5, marginal revenue is 400 and marginal cost is 400, so producing this unit still means overall profits are unchanged. However, expanding output from 5 to 6 would involve a marginal revenue of 200 and a marginal cost of 850, so that sixth unit would actually reduce profits. Thus, the monopoly can tell from the marginal revenue and marginal cost that of the choices in the table, the profit-maximizing level of output is 5.

The monopoly could seek out the profit-maximizing level of output by increasing quantity by a small amount, calculating marginal revenue and marginal cost, and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds marginal revenue. This process works without any need to calculate total revenue and total cost. Thus, a profit-maximizing monopoly should follow the rule of producing up to the quantity where marginal revenue is equal to marginal cost—that is, MR = MC. This quantity is easy to identify graphically, where MR and MC intersect.

Work It Out

Maximizing profits.

If you find it counterintuitive that producing where marginal revenue equals marginal cost will maximize profits, working through the numbers will help.

Step 1. Remember, we define marginal cost as the change in total cost from producing a small amount of additional output.

Step 2. Note that in Table 9.3 , as output increases from 1 to 2 units, total cost increases from $500 to $775. As a result, the marginal cost of the second unit will be:

Step 3. Remember that, similarly, marginal revenue is the change in total revenue from selling a small amount of additional output.

Step 4. Note that in Table 9.3 , as output increases from 1 to 2 units, total revenue increases from $1200 to $2200. As a result, the marginal revenue of the second unit will be:

Table 9.4 repeats the marginal cost and marginal revenue data from Table 9.3 , and adds two more columns: Marginal profit is the profitability of each additional unit sold. We define it as marginal revenue minus marginal cost. Finally, total profit is the sum of marginal profits. As long as marginal profit is positive, producing more output will increase total profits. When marginal profit turns negative, producing more output will decrease total profits. Total profit is maximized where marginal revenue equals marginal cost. In this example, maximum profit occurs at 5 units of output.

A perfectly competitive firm will also find its profit-maximizing level of output where MR = MC. The key difference with a perfectly competitive firm is that in the case of perfect competition, marginal revenue is equal to price (MR = P), while for a monopolist, marginal revenue is not equal to the price, because changes in quantity of output affect the price.

Illustrating Monopoly Profits

It is straightforward to calculate profits of given numbers for total revenue and total cost. However, the size of monopoly profits can also be illustrated graphically with Figure 9.6 , which takes the marginal cost and marginal revenue curves from the previous exhibit and adds an average cost curve and the monopolist’s perceived demand curve. Table 9.5 shows the data for these curves.

Figure 9.7 illustrates the three-step process where a monopolist selects the profit-maximizing quantity to produce; decides what price to charge; and determines total revenue, total cost, and profit.

Step 1: The Monopolist Determines Its Profit-Maximizing Level of Output

The firm can use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve. The profit-maximizing quantity will occur where MR = MC—or at the last possible point before marginal costs start exceeding marginal revenue. On Figure 9.6 , MR = MC occurs at an output of 5.

Step 2: The Monopolist Decides What Price to Charge

The monopolist will charge what the market is willing to pay. A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price which, in Figure 9.6 , is $800. This price is above the average cost curve, which shows that the firm is earning profits.

Step 3: Calculate Total Revenue, Total Cost, and Profit

Total revenue is the overall shaded box, where the width of the box is the quantity sold and the height is the price. In Figure 9.6 , this is 5 x $800 = $4000. In Figure 9.6 , the bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis or 5 x $330 = $1650. The larger box of total revenues minus the smaller box of total costs will equal profits, which the darkly shaded box shows. Using the numbers gives $4000 – $1650 = $2350. In a perfectly competitive market, the forces of entry would erode this profit in the long run. However, a monopolist is protected by barriers to entry. In fact, one obvious sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing increased competition eroding those profits.

Why is a monopolist’s marginal revenue always less than the price?

The marginal revenue curve for a monopolist always lies beneath the market demand curve. To understand why, think about increasing the quantity along the demand curve by one unit, so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price. A demand curve is not sequential: It is not that first we sell Q 1 at a higher price, and then we sell Q 2 at a lower price. Rather, a demand curve is conditional: If we charge the higher price, we would sell Q 1 . If, instead, we charge a lower price (on all the units that we sell), we would sell Q 2 .

When we think about increasing the quantity sold by one unit, marginal revenue is affected in two ways. First, we sell one additional unit at the new market price. Second, all the previous units, which we sold at the higher price, now sell for less. Because of the lower price on all units sold, the marginal revenue of selling a unit is less than the price of that unit—and the marginal revenue curve is below the demand curve. Tip : For a straight-line demand curve, MR and demand have the same vertical intercept. As output increases, marginal revenue decreases twice as fast as demand, so that the horizontal intercept of MR is halfway to the horizontal intercept of demand. You can see this in Figure 9.8 .

The Inefficiency of Monopoly

Most people criticize monopolies because they charge too high a price, but what economists object to is that monopolies do not supply enough output to be allocatively efficient. To understand why a monopoly is inefficient, it is useful to compare it with the benchmark model of perfect competition.

Allocative efficiency is an economic concept regarding efficiency at the social or societal level. It refers to producing the optimal quantity of some output, the quantity where the marginal benefit to society of one more unit just equals the marginal cost. The rule of profit maximization in a world of perfect competition was for each firm to produce the quantity of output where P = MC, where the price (P) is a measure of how much buyers value the good and the marginal cost (MC) is a measure of what marginal units cost society to produce. Following this rule assures allocative efficiency. If P > MC, then the marginal benefit to society (as measured by P) is greater than the marginal cost to society of producing additional units, and a greater quantity should be produced. However, in the case of monopoly, price is always greater than marginal cost at the profit-maximizing level of output, as you can see by looking back at Figure 9.6 . Thus, consumers do not benefit from a monopoly because it will sell a lower quantity in the market, at a higher price, than would have been the case in a perfectly competitive market.

The problem of inefficiency for monopolies often runs even deeper than these issues, and also involves incentives for efficiency over longer periods of time. There are counterbalancing incentives here. On one side, firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high profits—at least for a few years until the competition catches up. In this way, monopolies may come to exist because of competitive pressures on firms. However, once a barrier to entry is in place, a monopoly that does not need to fear competition can just produce the same old products in the same old way—while still ringing up a healthy rate of profit. John Hicks, who won the Nobel Prize for economics in 1972, wrote in 1935: “The best of all monopoly profits is a quiet life.” He did not mean the comment in a complimentary way. He meant that monopolies may bank their profits and slack off on trying to please their customers.

When AT&T provided all of the local and long-distance phone service in the United States, along with manufacturing most of the phone equipment, the payment plans and types of phones did not change much. The old joke was that you could have any color phone you wanted, as long as it was black. However, in 1982, government litigation split up AT&T into a number of local phone companies, a long-distance phone company, and a phone equipment manufacturer. An explosion of innovation followed. Services like call waiting, caller ID, three-way calling, voice mail through the phone company, mobile phones, and wireless connections to the internet all became available. Companies offered a wide range of payment plans, as well. It was no longer true that all phones were black. Instead, phones came in a wide variety of shapes and colors. The end of the telephone monopoly brought lower prices, a greater quantity of services, and also a wave of innovation aimed at attracting and pleasing customers.

Bring It Home

The rest is history.

In the opening case, we presented the East India Company and the Confederate States as a monopoly or near monopoly provider of a good. Nearly every American schoolchild knows the result of the “unwelcome visit” the “Mohawks” bestowed upon Boston Harbor’s tea-bearing ships—the Boston Tea Party. Regarding the cotton industry, we also know Great Britain remained neutral during the Civil War, taking neither side during the conflict.

Did the monopoly nature of these businesses have unintended and historical consequences? Might the American Revolution have been deterred if the East India Company had sailed the tea-bearing ships back to England? Might the southern states have made different decisions had they not been so confident “King Cotton” would force diplomatic recognition of the Confederate States of America? Of course, it is not possible to definitively answer these questions. We cannot roll back the clock and try a different scenario. We can, however, consider the monopoly nature of these businesses and the roles they played and hypothesize about what might have occurred under different circumstances.

Perhaps if there had been legal free tea trade, the colonists would have seen things differently. There was smuggled Dutch tea in the colonial market. If the colonists had been able to freely purchase Dutch tea, they would have paid lower prices and avoided the tax.

What about the cotton monopoly? With one in five jobs in Great Britain depending on Southern cotton and the Confederate States as nearly the sole provider of that cotton, why did Great Britain remain neutral during the Civil War? At the beginning of the war, Britain simply drew down massive stores of cotton. These stockpiles lasted until near the end of 1862. Why did Britain not recognize the Confederacy at that point? Two reasons: The Emancipation Proclamation and new sources of cotton. Having outlawed slavery throughout the United Kingdom in 1833, it was politically impossible for Great Britain, empty cotton warehouses or not, to recognize, diplomatically, the Confederate States. In addition, during the two years it took to draw down the stockpiles, Britain expanded cotton imports from India, Egypt, and Brazil.

Monopoly sellers often see no threats to their superior marketplace position. In these examples did the power of the monopoly hide other possibilities from the decision makers? Perhaps. As a result of their actions, this is how history unfolded.

• Explain the significance of differentiated products
• Describe how a monopolistic competitor chooses price and quantity
• Discuss entry, exit, and efficiency as they pertain to monopolistic competition
• Analyze how advertising can impact monopolistic competition

Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell a variety of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States. When products are distinctive, each firm has a mini-monopoly on its particular style or flavor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names. The term “monopolistic competition” captures this mixture of mini-monopoly and tough competition, and the following Clear It Up feature introduces its derivation.

Who invented the theory of imperfect competition?

Two economists independently but simultaneously developed the theory of imperfect competition in 1933. The first was Edward Chamberlin of Harvard University who published The Economics of Monopolistic Competition . The second was Joan Robinson of Cambridge University who published The Economics of Imperfect Competition . Robinson subsequently became interested in macroeconomics and she became a prominent Keynesian, and later a post-Keynesian economist. (See the Welcome to Economics! and The Keynesian Perspective chapters for more on Keynes.)

Differentiated Products

A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which it sells the product, intangible aspects of the product, and perceptions of the product. We call products that are distinctive in one of these ways differentiated products .

Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. A firm’s location can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory.

Intangible aspects can differentiate a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of ketchup or mayonnaise if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.

The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.

Perceived Demand for a Monopolistic Competitor

A monopolistically competitive firm perceives a demand for its goods that is an intermediate case between monopoly and competition. Figure 9.9 offers a reminder that the demand curve that a perfectly competitive firm faces is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price . In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.

The demand curve as a monopolistic competitor faces is not flat, but rather downward-sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers. Since there are substitutes, the demand curve facing a monopolistically competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its price, some consumers will choose not to purchase its product—but they will then need to buy a completely different product. However, when a monopolistic competitor raises its price, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm. If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.

At a glance, the demand curves that a monopoly and a monopolistic competitor face look similar—that is, they both slope down. However, the underlying economic meaning of these perceived demand curves is different, because a monopolist faces the market demand curve and a monopolistic competitor does not. Rather, a monopolistically competitive firm’s demand curve is but one of many firms that make up the “before” market demand curve. Are you following? If so, how would you categorize the market for golf balls? Take a swing, then see the following Clear It Up feature.

Are golf balls really differentiated products?

Monopolistic competition refers to an industry that has more than a few firms, each offering a product which, from the consumer’s perspective, is different from its competitors. The U.S. Golf Association runs a laboratory that tests 20,000 golf balls a year. There are strict rules for what makes a golf ball legal. A ball’s weight cannot exceed 1.620 ounces and its diameter cannot be less than 1.680 inches (which is a weight of 45.93 grams and a diameter of 42.67 millimeters, in case you were wondering). The Association also tests the balls by hitting them at different speeds. For example, the distance test involves having a mechanical golfer hit the ball with a titanium driver and a swing speed of 120 miles per hour. As the testing center explains: “The USGA system then uses an array of sensors that accurately measure the flight of a golf ball during a short, indoor trajectory from a ball launcher. From this flight data, a computer calculates the lift and drag forces that are generated by the speed, spin, and dimple pattern of the ball. … The distance limit is 317 yards.”

Over 1800 golf balls made by more than 100 companies meet the USGA standards. The balls do differ in various ways, such as the pattern of dimples on the ball, the types of plastic on the cover and in the cores, and other factors. Since all balls need to conform to the USGA tests, they are much more alike than different. In other words, golf ball manufacturers are monopolistically competitive.

However, retail sales of golf balls are about $500 million per year, which means that many large companies have a powerful incentive to persuade players that golf balls are highly differentiated and that it makes a huge difference which one you choose. Sure, Tiger Woods can tell the difference. For the average amateur golfer who plays a few times a summer—and who loses many golf balls to the woods and lake and needs to buy new ones—most golf balls are pretty much indistinguishable.

How a Monopolistic Competitor Chooses Price and Quantity

The monopolistically competitive firm decides on its profit-maximizing quantity and price in much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a downward-sloping demand curve, and so it will choose some combination of price and quantity along its perceived demand curve.

As an example of a profit-maximizing monopolistic competitor, consider the Authentic Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice of vegetables and meats. Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants, it has a differentiated product. The firm’s perceived demand curve is downward sloping, as Figure 9.10 shows and the first two columns of Table 9.6.

We can multiply the combinations of price and quantity at each point on the demand curve to calculate the total revenue that the firm would receive, which is in the third column of Table 9.6. We calculate marginal revenue, in the fourth column, as the change in total revenue divided by the change in quantity. The final columns of Table 9.6 show total cost, marginal cost, and average cost. As always, we calculate marginal cost by dividing the change in total cost by the change in quantity, while we calculate average cost by dividing total cost by quantity. The following Work It Out feature shows how these firms calculate how much of their products to supply at what price.

How a Monopolistic Competitor Determines How Much to Produce and at What Price

The process by which a monopolistic competitor chooses its profit-maximizing quantity and price resembles closely how a monopoly makes these decisions. First, the firm selects the profit-maximizing quantity to produce. Then the firm decides what price to charge for that quantity.

Step 1. The monopolistic competitor determines its profit-maximizing level of output. In this case, the Authentic Chinese Pizza company will determine the profit-maximizing quantity to produce by considering its marginal revenues and marginal costs. Two scenarios are possible:

• If the firm is producing at a quantity of output where marginal revenue exceeds marginal cost, then the firm should keep expanding production, because each marginal unit is adding to profit by bringing in more revenue than its cost. In this way, the firm will produce up to the quantity where MR = MC.
• If the firm is producing at a quantity where marginal costs exceed marginal revenue, then each marginal unit is costing more than the revenue it brings in, and the firm will increase its profits by reducing the quantity of output until MR = MC.

In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing level of output for the firm.

Step 2. The monopolistic competitor decides what price to charge. When the firm has determined its profit-maximizing quantity of output, it can then look to its perceived demand curve to find out what it can charge for that quantity of output. On the graph, we show this process as a vertical line reaching up through the profit-maximizing quantity until it hits the firm’s perceived demand curve. For Authentic Chinese Pizza, it should charge a price of $16 per pizza for a quantity of 40.

Once the firm has chosen price and quantity, it’s in a position to calculate total revenue, total cost, and profit. At a quantity of 40, the price of $16 lies above the average cost curve, so the firm is making economic profits. From Table 10.1 we can see that, at an output of 40, the firm’s total revenue is $640 and its total cost is $580, so profits are $60. In Figure 10.3 , the firm’s total revenues are the rectangle with the quantity of 40 on the horizontal axis and the price of $16 on the vertical axis. The firm’s total costs are the light shaded rectangle with the same quantity of 40 on the horizontal axis but the average cost of $14.50 on the vertical axis. Profits are total revenues minus total costs, which is the shaded area above the average cost curve.

Although the process by which a monopolistic competitor makes decisions about quantity and price is similar to the way in which a monopolist makes such decisions, two differences are worth remembering. First, although both a monopolist and a monopolistic competitor face downward-sloping demand curves, the monopolist’s perceived demand curve is the market demand curve, while the perceived demand curve for a monopolistic competitor is based on the extent of its product differentiation and how many competitors it faces. Second, a monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic competitor who earns profits must expect the entry of firms with similar, but differentiated, products.

Monopolistic Competitors and Entry

If one monopolistic competitor earns positive economic profits, other firms will be tempted to enter the market. A gas station with a great location must worry that other gas stations might open across the street or down the road—and perhaps the new gas stations will sell coffee or have a carwash or some other attraction to lure customers. A successful restaurant with a unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or offer their own unique recipes. A laundry detergent with a great reputation for quality must take note that other competitors may seek to build their own reputations.

The entry of other firms into the same general market (like gas, restaurants, or detergent) shifts the demand curve that a monopolistically competitive firm faces. As more firms enter the market, the quantity demanded at a given price for any particular firm will decline, and the firm’s perceived demand curve will shift to the left. As a firm’s perceived demand curve shifts to the left, its marginal revenue curve will shift to the left, too. The shift in marginal revenue will change the profit-maximizing quantity that the firm chooses to produce, since marginal revenue will then equal marginal cost at a lower quantity.

Figure 9.11 (a) shows a situation in which a monopolistic competitor was earning a profit with its original perceived demand curve (D 0 ). The intersection of the marginal revenue curve (MR 0 ) and marginal cost curve (MC) occurs at point S, corresponding to quantity Q 0 , which is associated on the demand curve at point T with price P 0 . The combination of price P 0 and quantity Q 0 lies above the average cost curve, which shows that the firm is earning positive economic profits.

Unlike a monopoly, with its high barriers to entry, a monopolistically competitive firm with positive economic profits will attract competition. When another competitor enters the market, the original firm’s perceived demand curve shifts to the left, from D 0 to D 1 , and the associated marginal revenue curve shifts from MR 0 to MR 1 . The new profit-maximizing output is Q 1 , because the intersection of the MR 1 and MC now occurs at point U. Moving vertically up from that quantity on the new demand curve, the optimal price is at P 1 .

As long as the firm is earning positive economic profits, new competitors will continue to enter the market, reducing the original firm’s demand and marginal revenue curves. The long-run equilibrium is in the figure at point Y, where the firm’s perceived demand curve touches the average cost curve. When price is equal to average cost, economic profits are zero. Thus, although a monopolistically competitive firm may earn positive economic profits in the short term, the process of new entry will drive down economic profits to zero in the long run. Remember that zero economic profit is not equivalent to zero accounting profit . A zero economic profit means the firm’s accounting profit is equal to what its resources could earn in their next best use. Figure 9.11 (b) shows the reverse situation, where a monopolistically competitive firm is originally losing money. The adjustment to long-run equilibrium is analogous to the previous example. The economic losses lead to firms exiting, which will result in increased demand for this particular firm, and consequently lower losses. Firms exit up to the point where there are no more losses in this market, for example when the demand curve touches the average cost curve, as in point Z.

Monopolistic competitors can make an economic profit or loss in the short run, but in the long run, entry and exit will drive these firms toward a zero economic profit outcome. However, the zero economic profit outcome in monopolistic competition looks different from the zero economic profit outcome in perfect competition in several ways relating both to efficiency and to variety in the market.

Monopolistic Competition and Efficiency

The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency : goods are produced at the lowest possible average cost. However, in monopolistic competition, the end result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition will not be productively efficient.

In a perfectly competitive market, each firm produces at a quantity where price is set equal to marginal cost, both in the short and long run. This outcome is why perfect competition displays allocative efficiency: the social benefits of additional production, as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production. In a monopolistically competitive market, the rule for maximizing profit is to set MR = MC—and price is higher than marginal revenue, not equal to it because the demand curve is downward sloping. When P > MC, which is the outcome in a monopolistically competitive market, the benefits to society of providing additional quantity, as measured by the price that people are willing to pay, exceed the marginal costs to society of producing those units. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. This is the same argument we made about monopoly, but in this case the allocative inefficiency will be smaller. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry. See the following Clear It Up feature for more detail on the impact of demand shifts.

Why does a shift in perceived demand cause a shift in marginal revenue?

We use the combinations of price and quantity at each point on a firm’s perceived demand curve to calculate total revenue for each combination of price and quantity. We then use this information on total revenue to calculate marginal revenue, which is the change in total revenue divided by the change in quantity. A change in perceived demand will change total revenue at every quantity of output and in turn, the change in total revenue will shift marginal revenue at each quantity of output. Thus, when entry occurs in a monopolistically competitive industry, the perceived demand curve for each firm will shift to the left, because a smaller quantity will be demanded at any given price. Another way of interpreting this shift in demand is to notice that, for each quantity sold, the firm will charge a lower price. Consequently, the marginal revenue will be lower for each quantity sold—and the marginal revenue curve will shift to the left as well. Conversely, exit causes the perceived demand curve for a monopolistically competitive firm to shift to the right and the corresponding marginal revenue curve to shift right, too.

A monopolistically competitive industry does not display productive or allocative efficiency in either the short run, when firms are making economic profits and losses, nor in the long run, when firms are earning zero profits.

The Benefits of Variety and Product Differentiation

Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own. Product differentiation is based on variety and innovation. Most people would prefer to live in an economy with many kinds of clothes, foods, and car styles, not in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car. Most people would prefer to live in an economy where firms are struggling to figure out ways of attracting customers by methods like friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.

Economists have struggled, with only partial success, to address the question of whether a market-oriented economy produces the optimal amount of variety. Critics of market-oriented economies argue that society does not really need dozens of different athletic shoes or breakfast cereals or automobiles. They argue that much of the cost of creating such a high degree of product differentiation, and then of advertising and marketing this differentiation, is socially wasteful—that is, most people would be just as happy with a smaller range of differentiated products produced and sold at a lower price. Defenders of a market-oriented economy respond that if people do not want to buy differentiated products or highly advertised brand names, no one is forcing them to do so. Moreover, they argue that consumers benefit substantially when firms seek short-term profits by providing differentiated products. This controversy may never be fully resolved, in part because deciding on the optimal amount of variety is very difficult, and in part because the two sides often place different values on what variety means for consumers. Read the following Clear It Up feature for a discussion on the role that advertising plays in monopolistic competition.

How does advertising impact monopolistic competition?

The U.S. economy spent about $180.12 billion on advertising in 2014, according to eMarketer.com. Roughly one third of this was television advertising, and another third was divided roughly equally between internet, newspapers, and radio. The remaining third was divided between direct mail, magazines, telephone directory yellow pages, and billboards. Mobile devices are increasing the opportunities for advertisers.

Advertising is all about explaining to people, or making people believe, that the products of one firm are differentiated from another firm’s products. In the framework of monopolistic competition, there are two ways to conceive of how advertising works: either advertising causes a firm’s perceived demand curve to become more inelastic (that is, it causes the perceived demand curve to become steeper); or advertising causes demand for the firm’s product to increase (that is, it causes the firm’s perceived demand curve to shift to the right). In either case, a successful advertising campaign may allow a firm to sell either a greater quantity or to charge a higher price, or both, and thus increase its profits.

However, economists and business owners have also long suspected that much of the advertising may only offset other advertising. Economist A. C. Pigou wrote the following back in 1920 in his book The Economics of Welfare :

It may happen that expenditures on advertisement made by competing monopolists [that is, what we now call monopolistic competitors] will simply neutralise one another, and leave the industrial position exactly as it would have been if neither had expended anything. For, clearly, if each of two rivals makes equal efforts to attract the favour of the public away from the other, the total result is the same as it would have been if neither had made any effort at all.

• Explain why and how oligopolies exist
• Contrast collusion and competition
• Interpret and analyze the prisoner’s dilemma diagram
• Evaluate the tradeoffs of imperfect competition

Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firms’ decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.

Why Do Oligopolies Exist?

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.

Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.

Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.

The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.

Collusion or Competition?

When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion . A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel . See the following Clear It Up feature for a more in-depth analysis of the difference between the two.

Collusion versus cartels: How to differentiate

In the United States, as well as many other countries, it is illegal for firms to collude, since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.

The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.

Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits. Adam Smith wrote in  The Wealth of Nations in 1776, “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. A small handful of oligopoly firms may end up competing so fiercely that they all find themselves earning zero economic profits—as if they were perfect competitors.

The Prisoner’s Dilemma

Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.

The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. (Note that the term “prisoner” is not typically an accurate term for someone who has recently been arrested, but we will use the term here, since this scenario is widely used and referenced in economic, business, and social contexts.) The story behind the prisoner’s dilemma goes like this:

Two co-conspirators are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.

The game theory situation facing the two prisoners is in Table 9.8. To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A should confess, too, so as to not get stuck with the eight years in prison. However, if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. To confess is called the dominant strategy. It is the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up being sentenced to a total of 10 years of jail time between them.

The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have been incarcerated for two years each, for a total of four years between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer terms.

The Oligopoly Version of the Prisoner’s Dilemma

The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits. Table 9.9 shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly . If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.

Can the two firms trust each other? Consider the situation of Firm A:

• If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in Table 9.9) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
• If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).

Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions that will lead B also to expand output.

The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits . The following Clear It Up feature discusses one cartel scandal in particular.

What is the Lysine cartel?

Lysine, a $600 million-a-year industry, is an amino acid that farmers use as a feed additive to ensure the proper growth of swine and poultry. The primary U.S. producer of lysine is Archer Daniels Midland (ADM), but several other large European and Japanese firms are also in this market. For a time in the first half of the 1990s, the world’s major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of Investigation (FBI), however, had learned of the cartel and placed wiretaps on a number of their phone calls and meetings.

From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:

I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ’em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us … money. … And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.

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

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

How to Enforce Cooperation

How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.

Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC) , have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.

Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself.

Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.

One example of the pressure these firms can exert on one another is the kinked demand curve , in which competing oligopoly firms commit to match price cuts, but not price increases. Figure 9.12 shows this situation. Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.

If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price , and share a monopoly level of profits even without any legally enforceable agreement.

Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.

Tradeoffs of Imperfect Competition

Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.

Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffered by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Monopoly and Antitrust Policy discusses the delicate judgments that go into this task.

The Temptation to Defy the Law

Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote, “According to a statement a Henkel manager made to the [French antitrust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, sometimes lasting more than four hours, the companies established complex pricing structures. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.

How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Procter & Gamble a total of €361 million ($484 million). A similar fate befell the ice makers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the ice makers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region. There were profits in both the long run and the short run. According to the courts, “these companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.

Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

Key Concepts and Summary

9.1 how monopolies form: barriers to entry.

Barriers to entry prevent or discourage competitors from entering the market. These barriers include economies of scale that lead to natural monopoly; control of a physical resource; legal restrictions on competition; patent, trademark and copyright protection; and practices to intimidate the competition like predatory pricing. Intellectual property refers to legally guaranteed ownership of an idea, rather than a physical item. The laws that protect intellectual property include patents, copyrights, trademarks, and trade secrets. A natural monopoly arises when economies of scale persist over a large enough range of output that if one firm supplies the entire market, no other firm can enter without facing a cost disadvantage.

9.2 How a Profit-Maximizing Monopoly Chooses Output and Price

A monopolist is not a price taker, because when it decides what quantity to produce, it also determines the market price. For a monopolist, total revenue is relatively low at low quantities of output, because it is not selling much. Total revenue is also relatively low at very high quantities of output, because a very high quantity will sell only at a low price. Thus, total revenue for a monopolist will start low, rise, and then decline. The marginal revenue for a monopolist from selling additional units will decline. Each additional unit a monopolist sells will push down the overall market price, and as it sells more units, this lower price applies to increasingly more units.

The monopolist will select the profit-maximizing level of output where MR = MC, and then charge the price for that quantity of output as determined by the market demand curve. If that price is above average cost, the monopolist earns positive profits.

Monopolists are not productively efficient, because they do not produce at the minimum of the average cost curve. Monopolists are not allocatively efficient, because they do not produce at the quantity where P = MC. As a result, monopolists produce less, at a higher average cost, and charge a higher price than would a combination of firms in a perfectly competitive industry. Monopolists also may lack incentives for innovation, because they need not fear entry.

9.3 Monopolistic Competition

Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the firm sells the product, intangible aspects of the product, and perceptions of the product.

The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist, because the monopolistic competitor has direct competition, unlike the pure monopolist. A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. The monopolistic competitor will produce that level of output and charge the price that the firm’s demand curve indicates.

If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will experience exit of firms until economic losses are driven up to zero in the long run.

A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC, but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm.

Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.

9.4 Oligopoly

An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.

The prisoner’s dilemma is an example of the application of game theory to analysis of oligopoly. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.

Microeconomics Copyright © 2024 by LOUIS: The Louisiana Library Network is licensed under a Creative Commons Attribution 4.0 International License , except where otherwise noted.

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Oligopoly Notes & Questions (A-Level, IB)

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Oligopoly Definition: An Oligopoly is a market structure where only a few sellers dominate the market.

Oligopoly Examples & Explanation: Because there are only a few firms (players) in an Oligopoly, they tend to be highly interdependent of one another – meaning they will take in account each others’ actions when trying to compete in the market. Another characteristic is these markets also exhibit high barriers to entry, such that new firms cannot easily enter into the market. This characteristic is shared with Monopolies (one firm dominating) and Duopolies (two-firms dominating), explaining how they can dominate the market with large amounts of market share. If we consider the oil & gas industry, they tend to be an Oligopoly in most countries (think Shell, BP, Exxon) due to the huge capital investment required for oil exploration/mining, making it difficult for new producers to enter into the market. When a large oil/gas producer sells their oil at a lower price to increase their sales volume, other producers are likely to lower their prices as well to protect their share of the market. As a result, Oligopolies tend to keep market prices stable and focus on non-price competition, so that firms can avoid a price war. However, the negative oil prices from the coronavirus pandemic is also caused by other factors, including a lack of storage capacity for oil producers forcing them to sell, and a global lack of demand for oil during the crisis. In general, oil producers in OPEC agree on an amount of output to maintain a relatively high price for oil, meaning higher profits for the industry.

Oligopoly Economics Notes with Diagrams

Oligopoly video explanation – econplusdal.

The left video explains oligopoly and the kinked-demand curve, the right looks at competition and cartels in the oligopoly market structure.

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Definition of oligopoly

An oligopoly is an industry dominated by a few large firms. For example, an industry with a five-firm concentration ratio of greater than 50% is considered an oligopoly.

Examples of oligopolies

Car industry – economies of scale have caused mergers so big multinationals dominate the market. The biggest car firms include Toyota, Hyundai, Ford, General Motors, VW.

• Petrol retail – see below.
• Pharmaceutical industry
• Coffee shop retail – Starbucks, Costa Coffee, Cafe Nero
• Newspapers – In the UK market share is dominated by tabloids Daily Mail, The Sun, The Mirror, The Star, Daily Express.
• Book retail – In the UK market share is dominated by Waterstones, Amazon and smaller firms like Blackwells.

The main features of oligopoly

• An industry which is dominated by a few firms.

The UK definition of an oligopoly is a five-firm concentration ratio of more than 50% (this means the five biggest firms have more than 50% of the total market share) The above industry (UK petrol) is an example of an oligopoly. See also: Concentration ratios

• Interdependence of firms – companies will be affected by how other firms set price and output.
• Barriers to entry. In an oligopoly, there must be some barriers to entry to enable firms to gain a significant market share. These barriers to entry may include brand loyalty or economies of scale. However, barriers to entry are less than monopoly.
• Differentiated products. In an oligopoly, firms often compete on non-price competition . This makes advertising and the quality of the product are often important.
• Oligopoly is the most common market structure

How firms compete in oligopoly

There are different possible ways that firms in oligopoly will compete and behave this will depend upon:

• The objectives of the firms; e.g. profit maximisation or sales maximisation?
• The degree of contestability; i.e. barriers to entry.
• Government regulation.

There are different possible outcomes for oligopoly:

• Stable prices (e.g. through kinked demand curve) – firms concentrate on non-price competition.
• Price wars (competitive oligopoly)
• Collusion- leading to higher prices.

The kinked demand curve model

This model suggests that prices will be fairly stable and there is little incentive for firms to change prices. Therefore, firms compete using non-price competition methods.

• This assumes that firms seek to maximise profits.
• If they increase the price, then they will lose a large share of the market because they become uncompetitive compared to other firms. Therefore demand is elastic for price increases.
• If firms cut price then they would gain a big increase in market share. However, it is unlikely that firms will allow this. Therefore other firms follow suit and cut-price as well. Therefore demand will only increase by a small amount. Therefore demand is inelastic for a price cut.
• Therefore this suggests that prices will be rigid in oligopoly

The diagram above suggests that a change in marginal cost still leads to the same price, because of the kinked demand curve.  Profit maximisation occurs where MR = MC at Q1.

Evaluation of kinked demand curve

• In the real world, prices do change.
• Firms may not seek to maximise profits,  but prefer to increase market share and so be willing to cut prices, even with inelastic demand.
• Some firms may have very strong brand loyalty and be able to increase the price without demand being very price elastic.
• The model doesn’t suggest how prices were arrived at in the first place.

Firms in an oligopoly may still be very competitive on price, especially if they are seeking to increase market share. In some circumstances, we can see oligopolies where firms are seeking to cut prices and increase competitiveness.

A feature of many oligopolies is selective price wars. For example, supermarkets often compete on the price of some goods (bread/special offers) but set high prices for other goods, such as luxury cake.

• Another possibility for firms in oligopoly is for them to collude on price and set profit maximising levels of output. This maximises profit for the industry.

In the above example, the industry was initially competitive (Qc and Pc). However, if firms collude, they can agree to restrict industry supply to Q2, and increase the price to P2. This enables the industry to become more profitable. At Qc, firms made normal profit. But, if they can stick to their quotas and keep the price at P2, they make supernormal profit.

• Collusion is illegal, but tacit collusion may be hard to spot.
• For collusion to be effective, there need to be barriers to entry.
• A cartel is a formal collusive agreement. For example, OPEC is a cartel seeking to control the price of oil.

See: Collusion

Collusion and game theory

Game theory is looking at the decisions of firms based on the uncertainty of how other firms will react. It illustrates the concept of interdependence. For example, if a firm agrees to collude and set low output – it relies on the other firm sticking to the collusive agreement. If the firm restricts output (sets the High price), and then the other firm betrays its agreement (setting low price). The firm will be worse off.

• This shows different options. If the market is non-collusive, firms make £4m each.
• If they collude, they make £8m.
• But, if they are colluding there is an incentive for one of the firms to exceed quota and increase output. If a firm sets low price whilst the other sets a high price, their profit rises to £10m

Collusion and game theory is more complex if we add in the possibility of firms being fined by a government regulator.

Collusion is illegal and firms can be fined. Usually, the first firm that confesses to the regulator is protected from prosecution, so there is always an incentive to be the first to confess.

• Pricing strategies
• Diagrams for oligopoly
• Game Theory

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Oligopoly (Online Lesson)

Last updated 20 Jul 2020

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In this online lesson, we cover the oligopoly market structure.

WHAT YOU'LL STUDY IN THIS ONLINE LESSON

• the characteristics of an oligopoly market structure
• the construction of a kinked demand curve
• price and non-price competition
• the existence of collusion and cartels
• how game theory impacts on the behaviours of oligopolistic firms

Additional teacher guidance is available at the end of this online lesson.

HOW TO USE THIS ONLINE LESSON

Follow along in order of the activities shown below. Some are interactive game-based activities, designed to test your understanding and application of oligopoly. Others are based on short videos, including activities for you to think about and try at home, as well as some extra worksheet-based activities.

If you would like to download a simple PDF worksheet to accompany the video activities, you can find it here . You can print it off and annotate it for your own notes, or make your own notes on a separate piece of paper to add to your school/college file.

ACTIVITY 1: VIDEO - KEY CONCEPTS

In this video, we look at the key concepts that are required when considering the oligopoly market structure including its characteristics and and some real world examples.

ACTIVITY 2: VIDEO - THE KINKED DEMAND CURVE

Kinked demand curve theory is used to explain some of the behaviours of firms that exist in an oligopolistic market. This video discusses how the kinked demand curve is constructed and how it illustrates non-price competition.

ACTIVITY 3: VIDEO - PRICE AND NON-PRICE COMPETITION

This video explained how firms in an oligopolistic market compete with one another and provides some real world examples of non-price competition in action!

ACTIVITY 4: VIDEO - CARTELS AND COLLUSION

The existence of price rigidity in an oligopolistic market can encourage firms to collude. This video examines the causes of business collusion, the creation of cartels and how this can be represented diagrammatically.

ACTIVITY 5: VIDEO - GAME THEORY

This video examines how economists use game theory to model the behaviour of businesses in concentrated markets.

ACTIVITY 6: GAME - TAKEOVERS

Challenge yourself with this short interactive quiz where you have 60 seconds to match the 8 real-world examples of takeovers in concentrated markets.

ACTIVITY 7: GAME - FIRMS THAT EXIST IN OLIGOPOLY MARKETS

Have a go at this 'concentration' activity where you need to match 6 pairs of firms that exist in the same oligpolistic market.

EXTENSION TASKS

• Read this article from the Economist on cartels on Mexico. Identify the reforms put in place by the Mexican government and explain how these might reduce collusive behaviour.
• Read this article from the Economist on Organisation of Petroleum Exporting Countries (OPEC) . Use a cost and revenue diagram to analyse the impact of OPEC’s production cut on the cartel’s profits.

ADDITIONAL TEACHER GUIDANCE

This lesson comprises:

• around 30 minutes of guided video content, spread across 4 videos
• around 15-20 minutes of student thinking and activity time throughout the videos
• 2 interactive games, designed to build awareness of real-world economics and application
• an additional task reviewing the global examples of cartels and collusion.

Follow up this lesson by trying the online lesson on Contestable Markets .

• Tacit Collusion

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Textbook commentaries project

Hill – mankiw 9th edn chapter 17 – oligopoly.

A commentary on Mankiw 9th Edn Chapter 17 – Oligopoly (Mankiw 9th edition)

Mankiw, N. G. (2021)  Principles of microeconomics  (9th ed.) Principles of economics  (9th ed.) Mason, OH: South-Western Cengage Learning.

University of New Brunswick, Saint John campus

Saint John, New Brunswick, Canada

email: [email protected]

Chapter 17 – Oligopoly

Here are some things to consider when reading this chapter.

• Mankiw’s Duopoly Example

Section 17-1 describes a duopoly of two firms selling spring water produced at constant marginal cost, assumed to be zero in this case. There are no fixed costs. Mankiw doesn’t mention its origin, but the example is taken from a book published by the French economist Augustin Cournot in 1838 (Cournot, 1838 [1960]). It’s the original analysis of what is termed ‘Cournot competition’; each firm decides how much to produce to maximize its profits, based on an assumption about what the other firm is producing. The products produced are identical (or homogeneous), so demand for them can be added together to get market demand. The total quantity produced determines the market price.

An equilibrium occurs when neither firm has any incentive to change the quantity it produces given its correct expectation about what the other firm will produce. The result is often termed a Cournot-Nash equilibrium when it occurs in the context of Cournot’s model.

Incidentally, this parallels the story Mankiw tells at the beginning of the chapter about the market for tennis balls in the United States. Producers “determine the quantity of tennis balls produced and, given the market demand curve, the price at which tennis balls are sold” (p. 335). However, for a market demand curve to exist, tennis balls would have to be perfect substitutes for each other. But tennis balls are differentiated by brand names and balls of different qualities, which makes it unlikely that buyers see them as perfect substitutes. With no market demand curve, a different model seems necessary in that case.

(i) “The Equilibrium for an Oligopoly”

This is the title of Section 17-1c. The word ‘the’ implies that an oligopolistic industry has a unique equilibrium, namely that described by Cournot’s model. Yet this is not the case, even in this simple duopoly setting.

Another French economist, Joseph Bertrand, proposed an alternative to Cournot’s model in a famous paper in 1883. He showed that if the producers of spring water make strategic choices about prices, instead of about quantities, the resulting equilibrium is different from Cournot’s.

In Bertrand’s model, the two firms also have no fixed costs and constant marginal costs. They set prices simultaneously and supply whatever is demanded at that price. Consumers buy from the firm with the lowest price. If firms set the same prices, they share the market equally.

Because the firm at the lowest price gets the entire market, each firm has an incentive to charge a price lower than that of the other firm. As a result, in the Bertrand-Nash equilibrium both firms set price equal to marginal cost. (Because there are no fixed costs and marginal costs are constant, any price below that would result in losses.) Neither firm has an incentive to change its pricing strategy given what the other firm is doing.

The result is the competitive equilibrium, even with just two firms. This contrasts with the Cournot model described by Mankiw, in which sellers’ prices only approach marginal cost as the number of firms gets progressively larger (pp. 339-40).

By briefly setting out Bertrand’s model, whose logic is easily explained, Mankiw could have introduced the idea that there are other possible models of oligopoly, even in this simple static situation, and that judgement is required as to which is most appropriate in a particular setting. In many markets, firms may also make strategic choices about things other than price or the quantity produced. For example, as in the case of tennis balls, producers may make decisions about product characteristics and advertising, differentiating their product from those of their rivals. In other markets, firms may make decisions about location, warranties to offer, the quality of customer service, and so on.

• Rivalry or cooperation among oligopolistic firms?

The Cournot model, as well as the Bertrand model described above, assume that firms don’t cooperate with each other. Mankiw’s text is typical of introductory texts; it explains the prisoners’ dilemma, stressing the difficulty of cooperation if firms choose their strategies simultaneously and must stick with them. If firms interact repeatedly, as is typical in most markets, the prisoners’ dilemma illustrates the temptation to deviate from a cooperative arrangement. This theme is reiterated in the chapter’s conclusion.

Then one section (17-2e, pp. 346-7) describes how “in a game of repeated prisoners’ dilemma, the two players may well be able to reach the cooperative outcome”, for example through the use of the tit-for-tat strategy by which non-cooperators are punished.

What are students to conclude about the frequency with which oligopolistic firms are able to evolve cooperative behaviour? The bulk of the discussion is about the difficulties of cooperation, yet this final section, describing a more realistic market setting, leaves open the possibility that cooperation/collusion could frequently evolve.

Mankiw describes only one kind of collusion: that in which firms make explicit agreements to cooperate, effectively forming cartels. This is overt collusion , which is illegal and can be prosecuted with sufficient evidence.

As Levenstein and Suslow describe, firms can negotiate about prices, market shares, “terms of sale, advertising, transport costs, and production capacities. … Firm asymmetries and changes in firm’s costs can make these negotiations challenging” (2008, p. 2). They report evidence, based on prosecuted cases, that the “average duration of cartels measured over a range of countries and time periods is between five and seven years”. Many last just a year or two, but the average is pulled up by those which last 10 or more years.

Surprisingly, Mankiw fails to mention a second kind of collusion: tacit collusion , in which firms evolve an understanding about how to behave cooperatively without communicating directly with each other. In contrast with overt collusion, tacit collusion is legal, so antitrust law does not apply. (In the United States, the Federal Trade Commission (FTC) can intervene if a firm makes a public announcement about future changes in prices and quantities that can be interpreted as an invitation to other firms to collude (Ballou 2021, p. 242).)

For example, tacit collusion can be maintained if one firm is understood by others to be the price leader , helping to coordinate price changes throughout the industry while keeping them above competitive levels. Other firms could then follow its lead as they change prices in response to changing industry demand or cost conditions. Antitrust authorities cannot deal with such ongoing tacit collusion because there is no explicit communication between the firms.

Unlike with overt collusion, no estimates exist about how long the firms might be able to tacitly collude. Nor can anything be said about how frequently tacit collusion occurs. After all, even if firms are behaving competitively, they will likely be changing their prices in the same way in response to changes in demand and costs. However, careful empirical work can uncover industry behaviour that is consistent with a tacitly collusive oligopoly, as in the gasoline market study cited in part 3(i) the Commentary on Chapter 14.

Some worry that tacit collusion could be facilitated now that prices in some markets are determined not by people but by computer algorithms. This is happening as sellers move online or as sellers adopt ‘dynamic pricing’. With dynamic pricing, algorithms change prices frequently according to the most recent information about market conditions. This can include information about the prices currently being offered by other firms, whose prices are also being set by algorithms. The algorithms could be explicitly written to facilitate tacit collusion or may be capable of learning how to do so (Ezrachi and Stucke, 2020).

Such concerns prompted Brendan Ballou (2021) to propose that the FTC implement a ‘no collusion’ rule. Under such a rule, a firm couldn’t raise its price simply because another firm in the market has raised its price. This would deal with price setting algorithms that consider only on the prices of other firms in the market. It would also address the common practices he cites. “For instance, when American Airlines announced that it would charge passengers for the first checked bag, United and US Airways quickly followed suit. … Conversely, when one carrier instituted a new fee for in-flight soft drinks and competitors failed to follow suit, the carrier retreated” (Ballou 2021, p. 223).

• Antitrust Policy

American antitrust policy has been influenced by the Chicago School, a group of economists and law professors based at the University of Chicago. According to Herbert Hovenkamp and Fiona Scott Morton, they “were libertarians who were committed on ideological grounds to less intervention by the state” (2020, p. 1847). This was accompanied by a faith in the self-correcting nature of markets. Cartels were seen as inherently unstable. Barriers to entry were downplayed, so that even monopolies would have to contend with competition in the long-term. Mergers were beneficial because they reduced costs and ultimately prices to consumers (as explained by Mankiw in Chapter 15, p. 309).

They write: “The Chicagoans embraced economics when it would achieve their anti-enforcement ends, but largely ignored its advances in theory and empirical technique after 1970 because those tools sometimes proved that anticompetitive conduct had occurred, and that enforcement was needed” (2020, p. 1853).

University of Chicago economist George Stigler portrayed regulation as the result of “political struggles under which different interest groups competed to see who could benefit the most from a particular government policy” (2020, p. 1854). Hence his claim that regulators are ‘captured’ by the regulated industry, so that regulations benefit the industry, not the public.

Hovenkamp and Morton describe how the Chicago School’s noninterventionist message is amplified by firms that would profit by it. They fund conservative institutions who organize “education and influence programs targeting academics and the judiciary” (2020, p. 1851). They contend that the result is a gap between relatively weak antitrust enforcement in the United States and current economic theory, which provides a rationale for more enforcement in the face of sophisticated strategies by oligopolistic firms. In an ironic inversion of Stigler’s story, they write the Chicago School has become “an economically outdated but nevertheless powerful tool of regulatory capture” by those “who stand to profit from nonintervention” (2020, p. 1844).

This background about the Chicago School is useful in considering Mankiw’s discussion of public policy towards oligopolies. In examining “controversies over antitrust policy”, he repeatedly emphasizes the position of the Chicago School.

(i) Resale/Retail Price Maintenance (RPM)

The setting of sellers of a minimum price for producer’s product (an example of RPM) is currently illegal under American antitrust law. Mankiw sets out two arguments by “some economists” who defend RPM (p. 349).

The first argument is that a producer wanting “to exert its market power … would do so by raising the wholesale price [that it charges to retailers] rather than controlling the resale price.” While this sounds persuasive, as a general statement it is not true. It overlooks circumstances in which (to give one example) a producer can increase both its own profits and those of retailers by setting both wholesale and retail prices. This prevents individual retailers from using their bargaining power to negotiate lower wholesale prices which, in turn, would result in retail prices lower than those which would maximize the joint profits of producers and retailers (O’Brien and Shaffer 1992).

Mankiw offers an argument in defence of RPM. Suppose the manufacturer believes that point-of-sale service provided by the retailer will increase demand for the product (e.g. providing product information or demonstrations, longer store hours, better after-sales service). Retailers will underprovide such services if they can be undercut by free-riding discount retailers who don’t provide these services. By eliminating retailer competition on prices for the product, it stimulates competition for better retail services. This rationale for RPM originates with a 1960 paper by Lester Telser of the University of Chicago.

This argument overlooks the possibility that different customers value these retail services differently. While the marginal customer is better off, some customers may place little value on such services, but they pay a higher price to cover retailers’ costs of providing them. As a result, fixed retail prices “may either improve or harm economic efficiency and welfare”. The harm may occur “because firms’ and consumers’ interests need not be aligned … [RPM] may well improve profits but hurt consumers and even reduce total welfare” (Jullien and Rey 2007, pp. 983-4).

Bruno Jullien and Patrick Rey also explain how RPM could facilitate collusion among producers. Because of the temptation to cheat on the collusive agreement, as explained in Mankiw’s text, producers would be better able to monitor each other’s behaviour with RPM because they can observe retail prices more easily than wholesale prices.

In short, depending upon circumstances, a retail price floor set by producers may improve or harm consumer welfare in a market. Mankiw is right in concluding that those in charge of enforcing antitrust laws don’t have an easy job in determining “what kinds of behavior actually impede competition and reduce economic well-being” (p. 349). However, his discussion of resale price maintenance is one-sided and incomplete.

 (ii) Could predatory pricing be rational?

Could it make sense for a firm to cut prices and incur losses to drive a competitor out of the market? Mankiw writes that “some economists are skeptical”, believing that this “it is rarely, if ever, a profitable business strategy”. He gives a detailed hypothetical example to illustrate the conclusion that “the predator suffers more than the prey”. However, the section finishes by acknowledging that economists continue to debate the issue and that “questions remain unresolved”, without giving any details (p. 300).

Given the weight that Mankiw places on the sceptics’ view, students would be surprised to know that “it is now the consensus view in modern economics that predatory pricing can be a successful and fully rational business strategy” (Bolton et al. 2000, p. 2242).

In a survey article on predatory pricing, Janusz Ordover contradicted Mankiw’s central story. He wrote, “the strategic approach to modelling pricing debunked the comfortable position that predation is more costly to predator than prey, and hence irrational and unlikely to occur” (2008, p.9).

What about evidence of how firms actually behave? “Recent empirical work has supported the rational predation models… thereby undermining the Chicago School’s claims about its irrationality” (Ordover 2008, p.4). This was based on both studies of legal cases, where firms had been prosecuted for predatory pricing, as well as historical case studies.

Pricing is not the only strategy a dominant firm (or firms) could use to drive out rivals or to deter their entry into the market. For example, in his review of antitrust policy, Oliver Williamson (1987, p.4) mentions the alleged predatory brand proliferation in the ready-to-eat cereals industry, investigated by the US Federal Trade Commission in the 1980s. The few firms that dominated the industry were suspected of deterring entry of competitors by differentiating similar products and increasing advertising spending. The largest four firms had more than 100 brands of cereals. With limited shelf space in supermarkets, brand proliferation and strong brand names helped to keep new entrants from the market (Morris 2019, p. 50).

Firms could also undertake pre-emptive investments , such as investment in excess production capacity. Such unused capacity could deter a potential entrant who would understand that its entry would be resisted with lower prices. The resulting increased demand could be met with the additional production capacity. The excess capacity could also be employed if price cuts were needed to discipline uncooperative rivals if oligopolistic firms were tacitly or overtly colluding.

(iii) Tying (and bundling)

In the section “Tying”, Mankiw gives an example of two movies which are offered as a package to movie theatres (p. 350). This is an example of what is termed pure bundling . If the theatres also had the option of buying each movie separately , that would be mixed bundling .

In a survey article, Barry Nalebuff describes tying as “a special case of mixed bundling; customers are offered prices for A and B together or for B alone, but not A without B” (2008, p.1). Typically, A and B are different products. Consider this example given by the US Federal Trade Commission (FTC).

The FTC challenged a drug maker that required patients to purchase its blood-monitoring services along with its medicine to treat schizophrenia. The drug maker was the only producer of the medicine, but there were many companies capable of providing blood-monitoring services to patients using the drug. The FTC claimed that tying the drug and the monitoring services together raised the price of that medical treatment and prevented independent providers from monitoring patients taking the drug. The drug maker settled the charges by agreeing not to prevent other companies from providing blood-monitoring services.

Mankiw’s example is not one of tying in the above sense, although the word ‘tying’ is used frequently in the 1962 Supreme Court decision about the bundling of movies that he refers to. His example is one of pure bundling of two similar products where the seller has a monopoly on both. The numerical example and the explanation for the bundling is adapted from Stigler (1963). Mankiw echoes George Stigler’s Chicago School argument that the monopolist is price discriminating to increase profits, but it can’t “increase its market power simply by bundling the two movies together” (p. 350).

Tying, as defined and illustrated above, does apply to Mankiw’s Microsoft example, where the Windows operating system was tied to the Internet Explorer browser. The two are different products and web browsers can be produced by a variety of firms.

Nalebuff writes that “the current literature suggests that, in a dynamic setting, bundling can profitably leverage market power by deterring entry, excluding one-good rivals, and amplifying existing market power” (2008, p.2). Mankiw essentially acknowledges this when he writes: “Yet economists have proposed more elaborate theories for how tying can impede competition”, but he gives no examples. Here is a simple one that illustrates how monopoly power in one market can increase market power in the market for the tied good.

[S]uppose that a restaurant in the only hotel on a resort island competes with local restaurants. If the hotel requires its guests to eat their meals at the hotel restaurant, then there may be fewer local restaurants as a consequence of the reduced patronage. Local residents will then have fewer alternatives, with the result that more of them may decide to frequent the hotel restaurant. In this case, tying can be profitable because it reduces competition in the tied market… (Carlton and Waldman, 2002, p. 195).

Mankiw concludes: “Given our current economic knowledge, it is unclear whether tying is adverse for society as a whole” (p. 350). However, it is clear that there are cases in which tying does reduce social welfare, potentially justifying regulatory action.

(iv) Summary

In each of the three examples of potentially anticompetitive behaviour, Mankiw provides a detailed description of the Chicago School position, which concludes that no regulatory action is necessary, while he briefly acknowledges that that is not the final word. In the conclusion of the chapter he writes that: “Although price-fixing among competing firms clearly reduces economic welfare and should be illegal, some business practices that appear to reduce competition may have legitimate if subtle purposes. As a result, policymakers need to be careful when they use the substantial powers of the antitrust laws to place limits on firm behavior.” (P. 353).

Readers can judge for themselves whether his unbalanced accounts leave the impression that antitrust authorities needn’t worry too much about strategies such as resale price maintenance, predatory pricing or tying.

Ballou, Brendan (2021) “The ‘No Collusion’ Rule, Stanford Law & Policy Review , 32: 213-52. Available here .

Bertrand, Joseph (1883) “Theorie Mathematique de la Richesse Sociale”, Journal des Savants , 67, pp. 499–508; translated by James W. Friedman in Andrew F. Daughety, ed., Cournot Oligopoly , Cambridge University Press, 1988, pp. 73–81.

Bolton, Patrick, Joseph F. Brodley and Michael H. Riordan (2000) “Predatory Pricing: Strategic Theory and Legal Policy”, Georgetown Law Journal , 88(8): 2241-2330.

Carlton, Dennis and Michael Waldman (2002) “The Strategic Use of Tying to Preserve and Create Market Power in Evolving Industries”, The RAND Journal of Economics , 33(2), pp. 194-220.

Cournot, Augustin (1838 [1960]) Researches Into the Mathematical Principles of the Theory of Wealth , English translation of 1897 reprinted by Augustus M. Kelly.

Ezrachi, Ariel and Maurice Stucke (2020) “Sustainable and unchallenged algorithmic tacit collusion”, Northwestern Journal of Technology and Intellectual Property , 17(2), 217-59. Available at: https://scholarlycommons.law.northwestern.edu/njtip/vol17/iss2/2/

Hovenkamp, Herbert J. and Fiona Scott Morton (2020) “Framing the Chicago School of Antitrust Analysis”, University of Pennsylvania Law Review, 168(7): 1843-78. Available at https://scholarship.law.upenn.edu/faculty_scholarship/2113

Jullien, Bruno and Patrick Rey (2007) “Resale Price Maintenance and Collusion”, The RAND Journal of Economics , 38(4): 983-1001.

Levenstein, Margaret and Valerie Suslow (2008) “Cartels”, in Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics , DOI 10.1057/978-1-349-95121-5_1985-1.

Morris, P. Sean (2019) “Intellectual Property for Breakfast: Market Power and Informative Symbols in the Marketplace”, Cleveland State Law Review , 68(1): 36-72. Available at https://engagedscholarship.csuohio.edu/clevstlrev/vol68/iss1/6

Nalebuff, Barry (2008) “Bundling and Tying”, in Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics , DOI 10.1057/978-1-349-95121-5_2534-1.

O’Brien, Daniel and Greg Shaffer (1992) “Vertical control with bilateral contracts”, RAND Journal of Economics , 23(3): 299-308.

Ordover, Janusz (2008) “Predatory Pricing” in Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics , DOI 10.1057/978-1-349-95121-5_1778-2.

Stigler, George J. (1963) “United States v. Loew’s Inc.: A Note on Block-Booking”, The Supreme Court Review , Vol. 1963, pp. 152-157.

Telser, Lester G. (1960) “Why Should Manufacturers Want Fair Trade?” Journal of Law & Economics , Vol. 3, October, pp. 86-105.

Williamson, Oliver E. (1987) “Antitrust Policy”, in S. Durlauf, L.E. Blume (eds.), The New Palgrave Dictionary of Economics , DOI 10.1057/978-1-349-95121-5_680-1.

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10.2 Oligopoly

Learning objectives.

By the end of this section, you will be able to:

• Explain why and how oligopolies exist
• Contrast collusion and competition
• Interpret and analyze the prisoner’s dilemma diagram
• Evaluate the tradeoffs of imperfect competition

Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firm(s)' decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.

Why Do Oligopolies Exist?

A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.

Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.

Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.

The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.

Collusion or Competition?

When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion . A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel . See the following Clear It Up feature for a more in-depth analysis of the difference between the two.

Clear It Up

Collusion versus cartels: how to differentiate.

In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.

The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.

Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. A small handful of oligopoly firms may end up competing so fiercely that they all find themselves earning zero economic profits—as if they were perfect competitors.

The Prisoner’s Dilemma

Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory , a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.

The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. (Note that the term "prisoner" is not typically an accurate term for someone who has recently been arrested, but we will use the term here, since this scenario is widely used and referenced in economic, business, and social contexts.) The story behind the prisoner’s dilemma goes like this:

Two co-conspirators are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.

The game theory situation facing the two prisoners is in Table 10.2 . To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A should confess, too, so as to not get stuck with the eight years in prison. However, if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. To confess is called the dominant strategy. It is the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up being sentenced to a total of 10 years of jail time between them.

The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have been incarcerated for two years each, for a total of four years between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer terms.

The Oligopoly Version of the Prisoner’s Dilemma

The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits. Table 10.3 shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly . If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.

Can the two firms trust each other? Consider the situation of Firm A:

• If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in Table 10.3 ) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
• If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).

Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions that will lead B also to expand output.

The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits . The following Clear It Up feature discusses one cartel scandal in particular.

What is the Lysine cartel?

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

From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:

I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us ... money. ... And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.

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

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

How to Enforce Cooperation

How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.

Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC) , have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.

Visit the Organization of the Petroleum Exporting Countries website and learn more about its history and how it defines itself.

Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.

One example of the pressure these firms can exert on one another is the kinked demand curve , in which competing oligopoly firms commit to match price cuts, but not price increases. Figure 10.5 shows this situation. Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.

If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price , and share a monopoly level of profits even without any legally enforceable agreement.

Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.

Tradeoffs of Imperfect Competition

Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.

Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffered by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers. Monopoly and Antitrust Policy discusses the delicate judgments that go into this task.

Bring It Home

The temptation to defy the law.

Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, sometimes lasting more than four hours, the companies established complex pricing structures. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.

How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region. There were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.

Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

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• Authors: Steven A. Greenlaw, David Shapiro, Daniel MacDonald
• Publisher/website: OpenStax
• Book title: Principles of Economics 3e
• Publication date: Dec 14, 2022
• Location: Houston, Texas
• Book URL: https://openstax.org/books/principles-economics-3e/pages/1-introduction
• Section URL: https://openstax.org/books/principles-economics-3e/pages/10-2-oligopoly

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Monopoly vs. Oligopoly: What's the Difference?

• Antitrust Laws: What They Are, How They Work, Major Examples
• Understanding Antitrust Laws
• Federal Trade Commission (FTC)
• Clayton Antitrust Act
• Sherman Antitrust Act
• Robinson-Patman Act
• How and Why Companies Become Monopolies
• Discriminating Monopoly
• Price Discrimination
• Predatory Pricing
• Bid Rigging
• Price Maker
• Monopolistic Markets
• Monopolistic Competition
• What Are the Characteristics of a Monopolistic Market?
• Monopolistic Market vs. Perfect Competition
• What are Some Examples of Monopolistic Markets?
• A History of U.S. Monopolies
• What Are the Most Famous Monopolies?
• Monopoly vs. Oligopoly CURRENT ARTICLE
• What are Current Examples of Oligopolies?

Monopoly vs. Oligopoly: An Overview

A monopoly and an oligopoly are market structures that exist when there is imperfect competition. A monopoly is when a single company produces goods with no close substitute, while an oligopoly is when a small number of relatively large companies produce similar but slightly different goods. In both cases, significant barriers to entry prevent other enterprises from competing.

A market's geographical size can determine which structure exists. One company might control an industry in a particular area with no other alternatives, though a few similar companies operate elsewhere in the country. In this case, a company may be a monopoly in one region but operate in an oligopoly market in a larger geographical area.

Key Takeaways

• A monopoly occurs when a single company that produces a product or service controls the market with no close substitute.
• In an oligopoly, two or more companies control the market, none of which can keep the others from having significant influence. 
• Anti-trust laws prevent companies from engaging in unreasonable restraint of trade and transacting mergers that lessen competition.  

A monopoly exists in areas where one company is the only or dominant force to sell a product or service in an industry . This gives the company enough power to keep competitors away from the marketplace. This could be due to high barriers to entry such as technology, steep capital requirements, government regulation, patents or high distribution costs.

Once a monopoly is established, lack of competition can lead the seller to charge high prices. Monopolies are price makers. This means they determine the cost at which their products are sold. These prices can be changed at any time. A monopoly also reduces available choices for buyers. The monopoly becomes a pure monopoly when there is absolutely no other substitute available.

Monopolies are allowed to exist when they benefit the consumer. In some cases, governments may step in and create the monopoly to provide specific services such as a railway, public transport or postal services. For example, the United States Postal Service enjoys a monopoly on first class mail and advertising mail, along with monopoly access to mailboxes.  

The United States Postal Service enjoys a monopoly on letter carrying and access to mailboxes that is protected by the Constitution.  

In an oligopoly, a group of companies (usually two or more) controls the market. However, no single company can keep the others from wielding significant influence over the industry, and they each may sell products that are slightly different.

Prices in this market are moderate because of the presence of competition. When one company sets a price, others will respond in fashion to remain competitive. For example, if one company cuts prices, other players typically follow suit. Prices are usually higher in an oligopoly than they would be in perfect competition .

Because there is no dominant force in the industry, companies may be tempted to collude with one another rather than compete, which keeps non-established players from entering the market. This cooperation makes them operate as though they were a single company.

In 2012, the U.S. Department of Justice alleged that Apple ( AAPL ) and five book publishers had engaged in collusion and price fixing for e-books. The department alleged that Apple and the publishers conspired to raise the price for e-book downloads from $9.99 to $14.99.   A U.S. District Court sided with the government, a decision which was upheld on appeal.  

In a free market, price fixing—even without judicial intervention—is unsustainable. If one company undermines its competition, others are forced to quickly follow. Companies that lower prices to the point where they are not profitable are unable to remain in business for long. Because of this, members of oligopolies tend to compete in terms of image and quality rather than price.

Legalities of Monopolies vs. Oligopolies

Oligopolies and monopolies can operate unencumbered in the United States unless they violate anti-trust laws. These laws cover unreasonable restraint of trade; plainly harmful acts such as price fixing, dividing markets and bid rigging; and mergers and acquisitions (M&A) that substantially lessen competition.

Without competition, companies have the power to fix prices and create product scarcity, which can lead to inferior products and services and higher costs for buyers. Anti-trust laws are in place to ensure a level playing field.

In 2017, the U.S. Department of Justice filed a civil antitrust suit to block AT&T's merger with Time Warner, arguing the acquisition would substantially lessen competition and lead to higher prices for television programming. However, a U.S. District Court judge disagreed with the government's argument and approved the merger, a decision that was upheld on appeal.

The government has several tools to fight monopolistic behavior. This includes the Sherman Antitrust Act , which prohibits unreasonable restraint of trade, and the Clayton Antitrust Act , which prohibits mergers that lessen competition and requires large companies that plan to merge to seek approval in advance. Anti-trust laws do not sanction companies that achieve monopoly status via offering a better product or service, or though uncontrollable developments such as a key competitor leaving the market.

Examples of Monopolies and Oligopolies

A company with a new or innovative product or service enjoys a monopoly until competitors emerge. Sometimes these new products are protected by law. For example, pharmaceutical companies in the U.S. are granted 20 years of exclusivity on new drugs. This is necessary due to the time and capital required to develop and bring new drugs to market. Without this protected status, firms would not be able to realize a return on their investment , and potentially beneficial research would be stifled.

Gas and electric utilities are also granted monopolies. However, these utilities are heavily regulated by state public utility commissions. Rates are often controlled, along with any rate increases the company may pass onto consumers.

Oligopolies exist throughout the business world . A handful of companies control the market for mass media and entertainment. Some of the big names include The Walt Disney Company ( DIS ), ViacomCBS ( VIAC ) and Comcast ( CMCSA ). In the music business, Universal Music Group and Warner Music Group have a tight grip on the market.

Federal Trade Commission. " The Antitrust Laws ."

U.S. Government Accountability Office. " U.S. Postal Service: Key Considerations for Potential Changes to USPS's Monopolies ," Pages 3, 4.

U.S. Department of Justice. " Justice Department Reaches Settlement with Three of the Largest Book Publishers and Continues to Litigate Against Apple Inc. and Two Other Publishers to Restore Price Competition and Reduce E-book Prices ."

U.S. Court of Appeals for the Second Circuit. " United States v. Apple Inc. ," Pages 4-19.

U.S. Department of Justice. " Justice Department Challenges AT&T/DirecTV’s Acquisition of Time Warner ."

United States Court of Appeals for the District of Columbia Circuit. " United States of America v. AT&T, Inc. Et Al ," Pages 4-34.

U.S. Food and Drug Administration. " Frequently Asked Questions on Patents and Exclusivity ."

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19 Tacit Collusion in Oligopoly

Edward J. Green, Professor of Economics, Penn State University.

Robert C. Marshall, Department Head, Professor, Department of Economics, Penn State University.

Leslie M. Marx, Robert A. Bandeen Professor of Economics, The Fuqua School of Business, Duke University.

• Published: 07 April 2015
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This chapter examines the economics literature on tacit collusion in oligopoly markets and take steps toward clarifying the relation between economists’ analysis of tacit collusion and those in the legal literature. The chapter provides an example to motivate the idea that collusive profits can be achieved via tacit coordination in an environment where there is a unique, salient way for colluders to maximize and distribute their joint profits. It also surveys the obstacles to obtaining above-competitive profits in less straightforward environments without having recourse to explicit communication.

19.1. Introduction

In this chapter, we examine the economics literature on tacit collusion in oligopoly markets and take steps toward clarifying the relation between tacit collusion in the economics and legal literature. Economists distinguish between tacit and explicit collusion. Lawyers, using a slightly different vocabulary, distinguish between tacit coordination, tacit agreement, and explicit collusion. In hopes of facilitating clearer communication between economists and lawyers, in this chapter we attempt to provide a coherent resolution of the vernaculars used in the economics and legal literature regarding collusion. 1

Perhaps the easiest place to begin is to define explicit collusion. It is our understanding that both the economics and legal professions use the term “explicit collusion” to mean an agreement among competitors that relies on interfirm communication and/or transfers to suppress rivalry. 2 In the United States, Section 1 of the Sherman Act makes explicit collusion illegal, forbidding agreements that unreasonably restrain competition and affect interstate commerce. 3

As described in the seminal work of Stigler (1964) , the key problem faced by firms attempting to collude is the need to deter secret deviations. The successful suppression of rivalry, elevating prices and restricting output relative to what it otherwise would be, creates incentives for secret price cutting by the firms. Thus, as described by Stigler, in order to successfully collude, firms must put in place collusive structures to govern the interaction among the colluding firms and between the colluding firms and other market participants. These necessary structures include pricing, allocation, and enforcement structures. 4 One would typically expect that the establishment and implementation of these structures would require communication and possibly transfers among the colluding firms, in which case the conduct would fall under the heading of explicit collusion.

However, firms in an oligopoly can be expected to recognize their mutual interdependence in the market. Each firm realizes that its profits depend not only on its own actions, but also on the actions of its rivals. It is possible that firms, each possessing this insight and understanding that its competitors all possess it, might be able to succeed in the implementation or even the establishment of a collusive agreement without communication. There has been broad agreement in principle that monopoly conduct can arise spontaneously in highly concentrated markets that satisfy some other (possibly restrictive) conditions. But, because economists have not yet been able to characterize those conditions with full confidence and precision, there has been room for courts to vary from one another. Since the 1980s, legal scholars have couched essentially this point in the language of an “extra ingredient” of centralization. As stated in Kovacic and coauthors (2011) :

In highly concentrated markets, the recognition of interdependence can lead firms to coordinate their conduct simply by observing and reacting to their competitors’ moves. In some instances, such oligopolistic coordination yields parallel behavior (e.g., parallel price movements) that approaches the results that one might associate with a traditional agreement to set prices, output levels, or other conditions of trade. The line that distinguishes tacit agreements (which are subject to section 1 scrutiny) from mere tacit coordination stemming from oligopolistic interdependence (which eludes section 1’s reach) is indistinct. The size of the safe harbor that Theatre Enterprises recognized depends on what conduct courts regard as the extra ingredient of centralized orchestration of policy which will carry parallel action over the line into the forbidden zone of implied contract and combination. [ Schwartz, Flynn, and First, 1983 ] Courts enjoy broad discretion to establish the reach of section 1 by defining this extra ingredient broadly or narrowly. ( Kovacic et al., 2011 , 405)

In this chapter, we offer a way to distinguish between the legal profession’s use of tacit coordination and tacit agreement as in the above quote and to reconcile those with notions from the economics literature.

In order to parse the language of the economics profession and the language of the legal profession, it will be useful to recognize that in order to collude, firms have to solve two broad problems: how to initiate a collusive arrangement and how to implement that arrangement. As described by Isaac and Plott (1981) , “First an opportunity for conspiracy must exist. … The opportunity to conspire must be followed by an attempt to conspire. The attempt to conspire must be followed by an actual conspiracy and the resulting conspiracy must have an impact on the market” ( Isaac and Plott, 1981 , 1).

The problem of initiating collusion involves coming to agreement on what the collusive structures required to deter secret deviations will be. This includes coming to agreement (reaching at least mutual knowledge, and perhaps common knowledge) regarding the mechanism for elevating prices, how the rents from collusion will be split among the firms, and how deviations will be detected and deterred. The problem of implementation involves managing the ongoing operation of the collusive arrangement, including the implementation of the collusive structures. The pricing structures may require coordination of price increases, the allocation structures may require transfers among the firms to achieve the agreed division of the collusive gain and to ensure incentive compatibility of the arrangement, and the enforcement structures may require information collection to stay in sync about the environment and to maintain compliance.

Solving the two broad problems of initiation and implementation may require explicit communication among the firms. This is particularly true in environments with strategic buyers. As noted by Isaac and Plott (1981 , 2), “Markets have two sides, and those on the other side and not a party to the conspiracy may not passively acquiesce to the establishment of such a conspiracy. The market reactions might be such that the efforts of the conspirators are rendered ineffectual.”

Collusion without communication at the implementation stage would require that the firms establish during the initiation stage a contingent agreement specifying reactions to observable outcomes during implementation, 5 in particular specifying what outcome would trigger reversion to noncollusive behavior (or, on a temporary basis, to even more severe retaliation). Depending on the product, market, and industry, the set of contingencies may be too numerous or too complicated for there to be the absence of communication during implementation. However, in some environments, which we discuss below, the problem of initiation or implementation may be solvable without explicit communication or transfers.

Table 19.1 illustrates our interpretation of how the economics and legal professions would classify coordination depending on whether there were communication or transfers and either the initiation or implementation stage. It is important to note that this is one interpretation, and that both some legal scholars and some courts may interpret the terms in different ways. 6

An industry with a history of collusion that has resumed collusive conduct after a hiatus may not need communication at the initiation phase.

As described in table 19.1 , communication or transfers at the implementation stage is sufficient for either the economics or legal profession to classify the conduct as explicit collusion. 7 The economics literature would also classify conduct as explicit collusion if there were only communication or transfers at the initiation stage; however, that is likely the case that the legal literature would term tacit agreement. 8 With no communication or transfers at either the initiation or implementation stage, 9 the economics literature would refer to the conduct as tacit collusion or implicit collusion (in what follows we use only tacit collusion), while the legal profession would likely refer to this as tacit coordination—it appears that tacit coordination in the legal profession refers to long-run recognized mutual interdependence among oligopolists that generates outcomes that exceed those that would be realized under myopic interaction (static Nash equilibrium) without any direct interfirm communication or transfers.

Adding to the complexity of parsing terminology, some economics literature focuses only on the implementation stage of a collusive arrangement. In those cases, the outcome may be described in the economics literature as tacit collusion, even though it may be clear that communication would be required in order to initiate the arrangement. In these cases, the label “tacit” applies only to the implementation stage, not to the collusive arrangement as a whole. This was recognized by Green and Porter (1984) . Green and Porter analyze a collusive arrangement that does not require communication at the implementation stage, but they recognize the need for communication at the initiation stage, saying:

It is logically possible for this agreement to be a tacit one which arises spontaneously. Nevertheless, in view of the relative complexity of the conduct to be specified by this particular equilibrium and of the need for close coordination among its participants, it seems natural to assume here that the equilibrium arises from an explicit agreement. ( Green and Porter, 1984 , 89 n. 5)

In the remainder of the chapter, we continue this discussion and provide examples. In section 19.2 , we consider when the economic environment might be such that collusive profits can be achieved without communication and, thus, when tacit coordination is sufficient to elevate profits versus when strong or weak explicit collusion would be required. In section 19.3 , we discuss the evolution of the theory of explicit collusion in the economics literature, particularly as related to the question of under what circumstances explicit coordination among sellers would be required during the operation of the cartel in order to achieve prices above a competitive level. In section 19.4 , we focus on the issue of coordination during the initiation stage. We conclude with section 19.5 , which comments on the role of tacit coordination in antitrust litigation.

19.2. Tacit Coordination versus Strong and Weak Explicit Collusion

Antitrust practitioners turn to the industrial organization economics literature for guidance regarding the issues concerning initiation and implementation of collusive agreements among firms in an industry. In this light, we provide comments regarding the key economic results and link these results to the issues confronted by antitrust practitioners as they evaluate a product/market/industry for a potential collusive agreement.

In the economics literature, a standard folk theorem characterizes the set of equilibria of a repeated oligopoly game and shows that for sufficiently patient firms (or for sufficiently short delay between repetitions of the game), the set of equilibria includes strategy profiles that generate the monopoly outcome. 10 A folk theorem says that, in some environment, the problem of operating the cartel can be solved without setting up any ongoing, centralized mechanism of coordination—there is no need for explicit accounting, settlement, and enforcement. 11

However, folk theorems deal with the implementation of collusion, and have nothing to say about its initiation. The folk theorem itself does not address whether firms would choose to play the strategies that generate the monopoly outcome nor how firms might coordinate on those strategies. As stated in Ivaldi and coauthors (2003 , 6), “While economic theory provides many insights on the nature of tacitly collusive conducts, it says little on how a particular industry will or will not coordinate on a collusive equilibrium, and on which one.”

The economics literature addressing collusion without communication at the implementation stage typically considers repeated interaction among firms that allows the firms to maintain higher prices with the (possibly implied) threat that deviation would trigger retaliation. Retaliation mechanisms must be both credible and sufficient (see Ivaldi et al., 2003 ). For sufficiency, the reduced payoffs from the retaliation must be sufficiently large to deter deviations in the first place, and in order to be credible, it must be in the best interest of the firms to follow through on the retaliation following the observation of a deviation.

The folk theorem literature typically assumes away the problem of cartel initiation by characterizing the set of Nash equilibria without communication in the implementation stage (see, for example, Fudenberg and Maskin, 1986 ). In a Nash equilibrium each player chooses a best response to the strategies of the other players, which means identifying the set of Nash equilibria means essentially identifying outcomes that could arise in the implementation stage if firms were to coordinate on strategies that support that outcome in the initiation stage.

The gas station example of Carlton, Gertner, and Rosenfield (1997) fits within this framework—two firms compete by setting prices, where those prices are perfectly observable and can be adjusted instantaneously, and profit of each firm is determined by the two prices and a fixed demand curve. Carlton, Gertner, and Rosenfield (1997) note, in this environment, that one would not be surprised to find that tacit coordination (involving no communication) could support the monopoly outcome. Any deviations from monopoly pricing would be immediately observed and met by a response from the other firm.

However, such equilibria can be sufficiently complex that it is difficult to believe that firms could coordinate on a particular outcome without communication. 12 As described in Stigler (1964) , the central problem facing a cartel is secret price cutting by cartel members, so effective collusion requires that firms establish collusive structures, including pricing, allocation, and enforcement structures, in order to avert secret deviations (see also Marshall and Marx, 2012 , chapter 6 ). Thus, one would expect that collusion would at least require communication at the initiation stage in order to establish the necessary collusive structures, although it is possible the conspirators might not need further communication once the collusive structures are established. 13

In the gas station example of Carlton, Gertner, and Rosenfield (1997) , no round of preliminary communication was used before the implementation stage, but it is a rare circumstance when that could be effective. For example, there may be several equilibria that provide payoffs in excess of the static Nash equilibrium, and formation stage communication may be needed to coordinate on a given equilibrium. Given the absence of implementation phase communication, the firms may need to select an equilibrium that is not payoff maximizing in order to avoid secret deviations, such as hidden loyalty rebates. Retail gas stations in Canada have been accused of strong explicit collusion in recent years, suggesting that the incremental elevation of prices at the pump required interfirm communication at the implementation stage. Excerpts from the announcements of the price-fixing conspiracy investigations by the Canadian Competition Bureau are as follows:

During the investigation, the Bureau uncovered evidence of agreements between competitors to fix the price at the pump where gasoline was sold to consumers. The evidence indicated that participants carried out the conspiracy mainly by phoning one another to agree on the price of gasoline and about the timing of price increases, contrary to the conspiracy provision, section 45 of the Competition Act. 14 Today’s criminal charges and guilty pleas are the result of an extensive Bureau investigation that found evidence that gas retailers or their representatives in these local markets phoned each other and agreed on the price they would charge customers for gasoline. The Bureau’s investigation into potential price-fixing in the retail gasoline market continues in the Southeastern Ontario market. 15

These investigations do not imply that there was no elevation of price relative to static Nash from tacit coordination, or even weak explicit collusion, prior to the explicit inter-firm communication during the implementation phase. However, the investigations highlight that strong explicit collusion was thought to be incrementally profitable by the colluding firms relative to the tacit coordination or weak explicit collusion that they had functioned under prior to the use of implementation phase communication.

Furthermore, the buyers in the Carlton, Gertner, and Rosenfield (1997) gas station example are not players in the game and so have no ability to take actions that might disrupt the ability of the two firms to maintain their tacit coordination. When buyers are players, they have an incentive to pursue strategies that disrupt equilibria that allow the sellers to capture supracompetitive profits. Buyer resistance limits the ability of firms to maintain collusive prices through only tacit coordination because buyer resistance exploits the lack of communication, monitoring, and enforcement characterizing tacit coordination.

If prices are not observable and demand has at least a small random component, then one enters the environment where the combination of a need for equilibrium path punishments with asymmetry of information about market outcomes has the consequence that perfect collusion is not possible without communication at the operation stage. Other changes in the environment reinforce the need for implementation-stage communication, including moving away from posted prices to, for example, competitive procurements and allowing buyers to be true players in the game.

Collusive equilibria in games with repeated interaction that are supported by reversion to noncooperative behavior or some other equilibrium punishment, theoretically speaking, do not require communication among the firms in the implementation stage. Equilibria such as the collusive equilibrium constructed in Green and Porter (1984) are discussed in the law literature as “oligopoly pricing” or as consciously parallel decisions of a few dominant sellers in an industry to maintain the same high noncompetitive price. 16 The idea is that this type of behavior might arise “without overt communication or agreement, but solely through a rational calculation by each seller of what the consequences of his price decision would be, taking into account the probable or virtually certain reactions of his competitors” ( Turner, 1962 , 661).

In the environment of Green and Porter (1984) , demand uncertainty prevents firms from being able to monitor perfectly the quantity choices of their rivals. Because of this, punishment periods are triggered in equilibrium. In this environment, even in the optimal collusive mechanism without implementation-stage communication, there will be punishment periods with low profits for the firms, and the periods of high profits may not yield profits as high as under strong explicit collusion. In an environment with quantity competition and demand uncertainty, the choice of the quantity targets in cooperative periods must balance the cartel’s desire to decrease those targets to increase payoffs in cooperative periods and the cartel’s desire to increase those targets to reduce the frequency of punishment periods, where payoffs are low. The more aggressive are the cartel’s quantity restrictions, the greater is the incentive for unilateral deviations, which, in this model, can only be prevented by making it more likely that such deviations will trigger a punishment period.

The analysis of collusive mechanisms without implementation-stage communication in theoretical environments can provide valuable insights into collusive behavior. However, in few real-world environments would the informational requirements be met for there to be tacit coordination equilibria or weak explicit collusion equilibria that provide firms with the same level of profits as through strong explicit collusion, where communication occurs at both the initiation and implementation phase. 17

As described in Marshall and Marx (2012 , chapter 1.4), when purchases are sufficiently large and infrequent, or demand is sufficiently uncertain, or buyers are strategic, even though firms are engaged in repeated interaction over time, they may not be able to accomplish payoff-maximizing collusive outcomes. 18 With enough lumpiness or randomness or difficulty interpreting responses from buyers, a firm often cannot rely on repeated play to discipline its rivals. Without communication and transfers, the sellers are left in a tough spot in terms of trying to achieve substantially elevated prices and profits. Secret deviations induced by self-interested profit maximization will creep into their conduct, and joint profits will fall short of monopoly levels. 19 Strong explicit collusion gives the firms the additional tools of communication and interfirm transfers that may allow them to achieve the joint profit-maximizing price. 20

19.2.1. Illustration

In what follows, we describe the distinction between static competition, tacit coordination, weak explicit collusion, and strong explicit collusion using a series of examples. These examples are drawn from chapter 1 of Marshall and Marx (2012) .

19.2.1.1. Example 1: Observable Posted Prices

Consider a small town where, on opposing street corners, there are two firms that sell the same product. 21 These firms are the only two firms that sell this product in the town. Other firms who sell products exactly like this are at least 150 miles away from this town.

The firms can post a price at their location for everyone to see. Each firm can post a price exactly once a day at exactly the same time. Consumers buy from the vendor offering the best value. Absent any nonprice competition between the firms, if the two firms post the same price, then they each get half of market demand.

19.2.1.1.1. Scenario 1: Gas Stations—Static Environment

We begin by assuming the firms are two gas stations, and we label them as A and B. Suppose that each one of these gas stations buys its gasoline for $2 per gallon and that, because demand is noisy, each knows that a price somewhere between $2.90 and $3 per gallon maximizes their combined profits. In a static environment, where no firm was concerned about future profits, rivalry between the firms implies that the price would be the marginal cost, or $2.01 if pricing is done in cent increments.

19.2.1.1.2. Scenario 2: Gas Stations—Dynamic Environment, Uncertain Demand

Now change this environment to allow more dynamic interaction. Suppose that the future matters almost as much as the present to each of the gas station owners. It is natural to think of the folk theorem, which suggests that the monopoly outcome should be possible without implementation-stage communication, but without communication, what price would be selected between $2.90 and $3.00? 22 Perhaps the two firms can settle quickly on a price such as $2.90, but with a small amount of communication at the initiation phase they may be able to agree to higher price, say $3. In this case, weak explicit collusion would allow the two firms to achieve a bigger payoff than tacit coordination.

19.2.1.1.3. Scenario 3: Gas Stations—Dynamic Environment, Uncertain Demand, Nonprice Competition

But suppose there are nonprice dimensions for interfirm rivalry such as loyalty rebates, cleanliness of facilities, service for cars, and a variety of items available in the service station shop. If both firms are charging $2.90 through tacit coordination, but firm A starts to experience an erosion of its market share, then firm A would infer that firm B is competing on nonprice dimensions. Firm A can then either cut its price or increase non-price offerings.

In this kind of environment, with nonprice competition available to each firm, it may not be possible for each firm to experience an increase in profits from an increase in price—each firm may invest in the nonprice competition to an extent that no incremental profit is left from the price increase. But the two firms could communicate at the initiation of collusive play and commit to the absence of nonprice competition. If the market share of any firm falls significantly below 50%, then they know there was a breach in that the other firm was offering nonprice enhancements, implying that the agreement will end and prices will revert to marginal cost. Each firm may recognize that without communication during implementation it will not be possible to maintain a price of $3—there will be just too much temptation for nonprice competition. But they may determine a lower price, say $2.15, where they are each relatively confident that the initiation-stage communication regarding assurances of nonprice incremental enhancements will be honored, since the payoff to a secret deviation is just too low (relative to a price of $2.90).

There may also be a lower price, such as $2.10, that the firms need no initiation stage communication to achieve. Specifically, the payoff to investment in nonprice enhancements is just too low when the price is $2.10 for either firm to undertake it—a slightly higher price would induce such investments in the absence of initiation-stage communication.

In this example, tacit coordination at $2.10, weak explicit collusion at $2.15, and strong explicit collusion at $3 are each conceptually possible.

The price increment that can be achieved with weak explicit collusion depends on the magnitude of the investment each firm would need to make in secret nonprice actions to deviate without direct detection. If the investment is small, then the price increment above $2.10 that can be achieved with weak explicit collusion is small. Similarly, if the investment is large, then the price increment will be much larger.

19.2.1.2. Example 2: Unobservable Bid Prices

We now change things again. Suppose that the two firms are not gas stations but instead are manufacturers of plastic industrial bags used for packaging a number of different types of finished products.

If you think about a plastic bag that is used for packaging some types of processed vegetables, fertilizer, or ready-mix concrete, there will be printing on the bag. Many firms that package and ship their product, or are engaged in the business of shipping, buy plastic industrial bags. There are standard bags constructed of standard materials with no printing. An example might be an 18 × 12 inch 3ml thick bag. However, these kinds of bags are typically a small percentage of sales for an industrial bag plant. Rather, most sales are to manufacturers or shipping companies that buy large numbers of bags of specific sizes, where the material used in the bag construction, the thickness of the bag, and the printing on the bags are specified by the buyer.

Almost all of the purchases of such bags will be done by procurement. Specifically, a buyer will invite bag plants to submit bids, where the details of the bag size/thickness, material used, and printing will be part of the bid solicitation. The bag plants may post a price for the aforementioned 18 × 12 inch standard bag and may offer such bags at the posted price in small volumes at each firm’s office location, but the bulk of sales for each bag plant will be through procurements. The posted price for a standard bag has no effect on the bid submitted by any bag plant in a procurement, and the buyers know that.

Each bag plant has a reasonably good idea of the costs of its rival. Also, unlike the gas station example, where no consumer is going to drive 150 miles each way to buy gas from a cheaper nonlocal gas vendor, it is economically viable to buy bags from a bag plant that is 150 miles away, although such a bag plant has additional transport costs. The bid by any bag plant in any procurement is not revealed by the buyer to the competing firm—a bag plant only knows if it won or lost any given procurement. For this example, we assume that each bag plant values the future highly.

If we consider an environment with just large buyers, the two bag plants can potentially agree on bids to submit at the initiation phase to make sure that the work is shared in a relatively equal way. If one bag plant has won a recent large contract, then the other bag plant can win the next one. The two bag plants can potentially develop initiation phase contingent plans about the bids each will submit. Thus, the behavior can be supported with weak explicit collusion.

19.2.1.2.1. Scenario 4: Bag Plants—a Small Number of Large Strategic Buyers, Uncertain Demand

To answer the question as to why strong explicit collusion might be required above and beyond weak explicit collusion, suppose that buyers are small in number, large in size, and strategic. In addition, assume demand is uncertain. Suppose that the large buyers conduct procurements infrequently and at irregular intervals. Suppose that each bag plant expects to receive, in total, one bid solicitation each quarter. Furthermore, suppose that these large buyers may choose to extend their current bag contract terms for a year or more without reconducting a procurement. There are not many contract awards each year—on average, only four per year. If one bag plant receives only one or even none of the awards, then it will be in dire straits.

For a given procurement, suppose that a bag plant submits a bid that is close to the joint monopoly price and observes that it loses the award. This could be from one or more of four causes: (1) random bad luck, (2) its competitor undercut it in the bidding, (3) there was a negative demand shock in the market that affected both bag plants but the shock was unknown as such to either bag plant, and (4) the buyer acted strategically by offering the contract award to a competitor with extended award length if the bid price were lowered by that firm. Suppose the bag plant in question loses a second procurement. Now the bag plant that has not won a contract in six months is really feeling the financial pinch.

Strong explicit collusion can resolve the conundrum for the two firms. By communicating and monitoring one another during the implementation phase the firms are able to eliminate certain conjectured causes for the lack of an award and directly address buyer resistance.

Weak explicit collusion is much more difficult to implement. The number and complexity of contingencies that would need to be specified at the initiation phase is substantial. Creating contingent plans to address the entire range of potential buyer resistance would be like creating a contingent plan for a chess game.

The results of Green and Porter (1984) imply that even a minor incremental payoff from tacit coordination would not be possible. When a procurement environment has this much noise from a number of sources, direct interfirm communication at both the initiation and implementation phase is needed to suppress interfirm rivalry.

19.2.1.2.2. Scenario 5: Bag Plants—Many Nonstrategic Buyers, Uncertain Demand

Consider another scenario where there are many small manufacturers buying bags with great regularity. Suppose that these buyers are all in the same business. For example, they make frozen French fries. They need bags to ship their frozen French fries. But suppose that frozen French fry demand for these local manufacturers is highly unstable, and the instability affects each of them in a similar way. Suppose that the bag plants cannot observe frozen French fry demand conditions. Furthermore, each bag plant cannot observe how much production is occurring at its rival’s plant. In normal demand conditions, each bag plant expects to receive 500 bid solicitations each quarter. But a given frozen French fry manufacturer may decide not to make any award in a given quarter if demand conditions are sufficiently depressed.

Suppose that a bag plant submits bids over the course of a quarter that are at the joint profit-maximizing level. If it observes that it has won approximately 250 of 500 solicitations, then it will continue to hold to that price. But, if it observes that it has won 125 of 500 solicitations, then the bag plant has some serious questions to address. Are the frozen French fry manufacturers experiencing a negative demand shock, or has the other bag plant undercut the joint profit-maximizing price to obtain more awards, or is some of both occurring?

By assumption, the bag plant in question is unable to determine the cause for the reduced number of contract awards. As a consequence, a bag plant will reduce its bid below the joint profit-maximizing price and move it toward the marginal cost of production. To see this, note that if the bag plant does not react based on the belief that bad outcomes are attributable to negative demand shocks and not the conduct of its rival, then the rival would take advantage of this belief by undercutting the high-priced bag plant.

In this case, strong explicit collusion can elevate profits, probably to the joint profit-maximizing level. But weak explicit collusion can produce a payoff above static Nash albeit below strong explicit collusion. Initiation-stage communication can resolve the price that each firm will bid at the procurements. The weak explicit collusion described here is the same as that in Green and Porter (1984) .

19.2.2. Context for Merger Reviews

The issues of tacit and explicit collusion also arise in the context of merger reviews. The 2010 Horizontal Merger Guidelines (Guidelines) of the US Department of Justice and Federal Trade Commission discuss concerns about “express collusion,” by which they presumably mean strong explicit collusion, and also about “coordinated interaction.” 23 According to the Guidelines (24–25):

Coordinated interaction includes a range of conduct. Coordinated interaction can involve the explicit negotiation of a common understanding of how firms will compete or refrain from competing. Such conduct typically would itself violate the antitrust laws. Coordinated interaction also can involve a similar common understanding that is not explicitly negotiated but would be enforced by the detection and punishment of deviations that would undermine the coordinated interaction. Coordinated interaction alternatively can involve parallel accommodating conduct not pursuant to a prior understanding. Parallel accommodating conduct includes situations in which each rival’s response to competitive moves made by others is individually rational, and not motivated by retaliation or deterrence nor intended to sustain an agreed-upon market outcome, but nevertheless emboldens price increases and weakens competitive incentives to reduce prices or offer customers better terms. Coordinated interaction includes conduct not otherwise condemned by the antitrust laws.

Thus, it appears that the Guidelines intend for the term “coordinated interaction” to encompass conduct ranging from tacit coordination to strong explicit collusion and apparently more. For an attempt to disentangle the notion of parallel accommodating conduct, which is introduced in the 2010 revision of the Guidelines, from existing notions of collusion, see Harrington (2012) .

19.3. Evolution of the Theory of Explicit Collusion

Before the arrival of formal dynamic game theory, ideas on collusion without communication relied on two theories: focal points and price leadership. The theory of focal points stated in Schelling’s (1960)   The Strategy of Conflict played an important role in the justification of tacit coordination as shown in Scherer (1970 , 192): “Even a price that has no particular uniqueness or compulsion in its own right may become a focal point simply by virtue of having been quoted repeatedly.” On price leadership, when Bain (1968) analyzed conventions and agreements to set a price leader, he argued:

Evidence of such direct consensual action not being found (and it seldom is), it is more usual to recognize price leadership as a form of tacit collusion, resulting from the existence of an unspoken agreement. The notion of tacit agreement, however, is itself somewhat nebulous, and it seems perhaps equally appropriate to designate the conduct pattern in question as one of interdependent seller action without basis in agreement. ( Bain, 1968 , 312)

From this starting point evolved the analysis of collusion in terms of repeated and dynamic games using the tools of game theory. 24 The focus was on the tension described by Bagwell and Staiger (1997 , 82): “Collusion is a balancing act. Each colluding firm balances the short-term temptation to cut its price against the expected long-term cost of the price war that such an act might instigate.” In this literature, the threat of punishment of deviations is the force driving collusive outcomes. Naturally, the ability of firms to detect deviations plays an important role.

At the same time as one community of economists was developing the relatively informal theories of focal points and price leadership, another community was developing explicit, formal theories of equilibrium in repeated games. However, after having flourished for more than a decade, by the mid-1960s game theory was viewed by many economists as a sterile mathematical field that was too highly schematic to be applied successfully to collusion or to other concrete issues of economics and social science. Large credit for superseding that negative view is due to James W. Friedman. Both through his own research and through his lucid presentation of the game-theoretic ideas in Oligopoly and the Theory of Games (1977), Friedman educated “mainstream” IO economists about the way of thinking and the specific results and techniques developed by game theorists in the 1960s and 1970s. One of his important, specific contributions was to frame repeated games in a discounted-payoff context, rather than using the limit-of-payoffs criteria that had dominated preceding research. By doing so, he brought into focus the crucial role of the trade-off between short- and long-term costs and benefits that Bagwell and Staiger’s summary emphasizes.

The main limitation of Friedman’s theory of collusion without implementation-stage communication was its restriction of attention to an environment with perfect monitoring. Abreu (1986) provided the capstone of that research program by characterizing the maximum profits that can be sustained without implementation-stage communication or transfers in terms of the most severe punishments for defection that colluders could impose on one another.

The literature advanced to consider the possibility of collusion without implementation-stage communication, that is, weak explicit collusion in our terminology, in ever more complex environments. For the case of imperfect monitoring, Green and Porter (1984) show that some degree of collusion can be achieved in a quantity-setting supergame even when firms are not able to perfectly observe their opponents actions. Abreu, Pearce, and Stacchetti (1986) study the same issues as Abreu (1986) but for the imperfect monitoring case. 25   Brock and Scheinkman (1985) and Lambson (1994) study weak explicit collusion in price-setting supergames. The first shows that some degree of price elevation can be achieved and study how this is affected by the number of firms in the industry. The second studies the maximum profits achievable through weak explicit collusion and shows that the structure of the most severe (optimal) punishments is much simpler in price-setting supergames than in quantity-setting supergames. Finally, Benoit and Krishna (1987) study weak explicit collusion in a model in which firms choose both quantities and prices.

Additional complexities are considered in literature that considers environments with incomplete information. In environments with incomplete information, belief-free equilibria are important for private monitoring. If players observe different signals—for example, an oligopolistic market in which each firm observes only its profits but no prices, quantities, or other firms’ profits—then beliefs about what other players are observing complicate the equilibrium analysis. But still, given that the signals are informative enough, it is possible to sustain some level of collusion with a subset of subgame perfect equilibria in which beliefs about what the other players have observed play no role, the belief-free equilibria (see Ely and Valimaki, 2002 ; Ely, Hörner, and Olszewski, 2005 ).

In environments with incomplete information about the profitability of a market, recent work shows that collusive payoffs may still be possible without communication at the implementation stage. See, for example, Yamamoto (2014) and Schenone (2012) . 26 In this literature, in some cases, the necessary conditions for folk theorem type results are restrictive, telling us that a folk theorem does not hold for a wide range of games.

Additional challenges to the legal interpretation of firm behavior and enforcement of antitrust laws are raised by more recent literature such as Hörner and Jamison (2007) , which presents a model in which almost no information is required to sustain full collusion. The model consists of an infinitely repeated price-setting game with inelastic demand. At each period, each firm draws a per unit cost that can be either high or low. Costs are private information. At each period, the firm with the lowest price gets the whole demand and if more than one firm set the lowest price, a randomly selected firm gets the whole demand. A firm only observes its own price and whether it sells. In this model, full collusion is understood as an equilibrium in which in almost all periods a low price gets the sale, and the firm charges a price close to the monopoly price. The main result states that if firms are patient enough, they can get arbitrarily close to the monopoly outcome without implementation-stage communication.

19.4. The Initiation Phase of Collusion

Prior to this point, our discussion has focused primarily on the question of under what circumstances explicit coordination among sellers would be required during the operation of the cartel, in order to be successful in maintaining prices above a competitive level. However, we have emphasized that coordination might also be necessary prior to the cartel beginning to operate, in order to agree on a mechanism by which subsequent collusion would be enforced and on how the rents from successful collusion would be distributed among the cartel’s members. We now turn to the questions: under what conditions would such explicit coordination/communication ex ante be required, and under what conditions would it even be helpful, in order for a viable cartel to be born? Throughout most of our investigation, we maintain the view taken in the several preceding sections that industry conduct is a Nash equilibrium outcome of strategic interaction between agents in the market environment.

19.4.1. Nash Equilibrium as Self-Enforcing Agreement

A widely held interpretation of a Nash equilibrium is that it is a self-enforcing agreement among the players of a game ( Myerson 1991 ). Taking this interpretation literally, a Nash equilibrium could not be tacit coordination, since an agreement cannot be reached without communication.

A less restrictive interpretation is that players conduct themselves as though they had previously reached an agreement among themselves, and moreover the counterfactual agreement would enforce itself. That is, the prior meeting to reach and ratify an agreement can be treated as a parable rather than as an actual historical event, much as the political theorists interpret the “social contract.” Aumann and Brandenburger (1995 , 1162–63) have made explicit what such a counterfactual account of agreement entails:

Suppose that the game being played [by two players] (i.e., both payoff functions), the rationality of the players, and their conjectures [about the probabilities with which actions their respective opponents will take] are mutually known. Then the conjectures constitute a Nash equilibrium. … [Moreover, suppose that there are more than two players, that] their payoff functions and their rationality are mutually known, and that their conjectures [about one another’s actions] are commonly known. Then [their conjectures coincide and constitute] a Nash equilibrium. 27

To say that something is mutually known just means that everyone knows it. To say that it is commonly known means that everyone knows it, everyone knows that everyone else knows it, and so forth. People generally do not need to meet, in order to have mutual knowledge of some aspect of their shared environment. For example, if ten people read this sentence, then they have mutual knowledge that it begins with a three-letter word. But, unless they are all read the sentence in one another’s presence (in which case, they are meeting) or they subsequently discuss the sentence after having read it (in which case they also meet, subsequently to their reading), presumably none would know that the others know this fact.

Moreover, although direct observation (without communication) by all competitors is sufficient to establish mutual knowledge of an observable fact, it is not sufficient to establish mutual knowledge of one another’s intentions. In particular, given that repeated games of the sort considered above have both competitive and collusive equilibria, one competitor cannot observe which equilibrium another expects everyone else to play (and so will play himself). Thus, in any cartel situation—even a duopoly—it is difficult to see how prospectives would achieve mutual knowledge of each other’s intent to collude, unless they were to communicate those intentions to one another. Common knowledge, and mutual knowledge about other players’ mental states (e.g., intentions, beliefs) is called higher-order knowledge.

So, let’s formulate a two-part Need to Meet (NTM) principle:

In general, players cannot arrive at a Nash equilibrium by a process of reasoning, unless they attain higher-order knowledge of one another’s conjectures. In particular, they cannot “reason their way” to a collusive Nash equilibrium without attaining higher-order knowledge.

Such higher-order knowledge cannot be attained, in practice, without having an explicit meeting.

Let us acknowledge, before going further, that the NTM principle is not a logical consequence of Aumann and Brandenburger’s result. They have framed a sufficient condition for Nash equilibrium, while the NTM principle envisions common knowledge, and hence occurrence of a meeting, as a necessary condition. They write (1163) that “It is always possible for the players to blunder into a Nash equilibrium ‘by accident,’ [but a higher-order-knowledge assumption] cannot be … significantly weakened.” 28 But, attaining such higher-order knowledge is virtually a necessary prerequisite for players (e.g., sellers in a market) to reason their way to any particular type of Nash conduct, collusive or otherwise. Henceforth we will treat it as being necessary. That is, we stipulate clause (1) of the NTM condition.

If clause (1) of the NTM condition holds, then clause (2) is tantamount to an assertion that higher-order knowledge of competitors’ intent to collude must always be reached explicitly, rather than tacitly. In the next two sections, we assess clause (2).

19.4.2. What Does “Arrive by Reasoning” Mean?

We have identified a situation in which Aumann and Brandenburger’s higher-order-belief conditions are satisfied, and in which there is a self-confirming conjecture that a particular Nash equilibrium will be played, with a situation in which the players have arrived by reasoning at the equilibrium. This situation is contrasted with the one in which, in Aumann and Brandenburger’s words, the players have blundered into an equilibrium by accident. But to make this identification is of no help for assessing whether or not clause (2) is reasonable. To make that assessment, we need an explicit account of the process that players are envisioned to follow. That account is provided by the theory of rationalizable play. A player is rational if he plays an action that is a best response to his conjecture (represented by a probability measure over opponents’ possible actions) of what actions other players may take. The first step of his reasoning process is to eliminate actions that would not be a best response to any conjecture about what others might do. Then, he would put himself in the shoes of other players, whom he knows to be rational. He would realize that, at a minimum, each of them would also be eliminating any never-a-best-response actions. At that point, the player would review his actions that have survived being eliminated in the first round. Has any of those actions been retained solely because it would be a best response to some opponent’s action that is never a best response for the opponent? In that case, he knows that the opponent will not play the action in question, so he should eliminate the action that he retained on account of it. When each player has gone through this second round of eliminating actions, and has again put himself in the shoes of other players who have done likewise, there will be a third round, and so on. A player’s actions that survive elimination in every round, forever, are rationalizable for that player. Pearce (1984) and Bernheim (1984) formulated the concept of rationalizability, and they showed that all actions played (with positive probability) in a (mixed-strategy) Nash equilibrium must be rationalizable. Tan and Werlang (1988) showed that a profile of actions in a game is rationalizable for the respective players if and only their being played is consistent with it being common knowledge that all players are rational. 29 That is, the iterative process of reasoning by which players determine their rationalizable actions ( a ) never eliminates any action that is ever played in any Nash equilibrium, and ( b ) always eliminates any action that would be inconsistent with common knowledge of rationality.

In view of these results, rationalizability is evidently the right concept to make precise the idea of “arrival by reasoning” at Nash play in a game.

19.4.3. The (Im)plausibility of Arriving at Collusion by Reasoning

The standard, intuitive view of tacit coordination in the IO/legal literature seems to be as follows. At the beginning of the story, each of prospective colluders is pondering whether to act competitively or monopolistically. These agents do not communicate with one another. Nevertheless, it is common knowledge that all of them want to maximize their respective profits, and it is also common knowledge that there is a self-enforcing profile of actions such as has been discussed above in section 19.2.1 , which would solve the problem of maximizing joint profits and distributing them equitably (according to some standard that they commonly know that they all embrace) subject to the constraint that collusion must be self-enforcing. In this situation, according to the intuitive view, each agent should conjecture that the other agents will play as specified in that profit-maximizing equilibrium, and therefore should also play according to the equilibrium because the equilibrium is a self-enforcing arrangement.

This statement of the intuitive view is ambiguous between two versions. One version—let’s call it the convergent-elimination view—assumes that, bootstrapping from just the facts that have been stipulated to be common knowledge, the iterative elimination procedure will zero in on precisely the profit-maximizing Nash equilibrium. That is, that equilibrium profile of actions will be the unique profile of actions that survives the iterative-elimination process. The other version—let’s call it the focal-point view—recognizes that the rationalizable actions are those that could be chosen by agents with arbitrary beliefs (subject only to having certainty of the facts that are stipulated to be common knowledge) and makes a further assumption that all of the agents’ beliefs place very high prior probability on the profit-maximizing equilibrium being played. On this view, the role of the iterated-elimination process is to condition probabilities repeatedly on higher-order-belief conditions, raising agents’ probability assessments from the initial, very high levels to virtual certainty that the profit-maximizing equilibrium will be played.

The explication of “reasoning to an equilibrium” as rationalizability shows that the convergent-elimination view is completely untenable. To begin, the game among prospective colluders always has a competitive Nash equilibrium, as well as possibly having a collusive one. Property (a) of rationalizability is that no action consistent with any Nash equilibrium is ever eliminated. Thus, at most, rationalizability might establish that some Nash equilibrium or other might be played, but it could not establish that the collusive equilibrium specifically would be played. Further analysis is even less favorable than that to the convergent-elimination view. Specifically, rational-izability is such a weak solution concept that it is consistent with it being common knowledge that no player will play a Nash strategy. 30 Convergence to Nash equilibrium in general, let alone to a specific Nash equilibrium of a multiple-equilibrium game, cannot be achieved entirely from the “Archimedean lever” of common knowledge of rationality.

The focal-point view is logically coherent, because it adds a strong hypothesis about the prospective colluders’ prior beliefs to the minimal hypothesis of common knowledge of rationality. The focal-point view is as plausible, but only as plausible, as is that hypothesis. The gist of the argument for the hypothesis is that, when players of a game share a common background, and when that common background is common knowledge among them, then their conjectures are much closer to being coincident than would be the case if they lacked such shared experience. 31

Consider the plausibility of the focal-point view with respect to the spectrum of cases of collusion described in section 19.2.1 . Three questions should be considered:

Is it plausible that all prospective colluders would conjecture that some Nash equilibrium would be played?

If so, then is it plausible that they would all conjecture that some collusive equilibrium (that is, one that would achieve an above-competitive level of profit) would be played?

If so, would their conjectures all be (nearly) identical, so that they collectively would succeed in playing a specific, collusive equilibrium?

Let’s stipulate for now that the answer to questions (1) and (2) are affirmative. Certainly the predominant economic modeling strategy in IO is to assume Nash play. We will further consider question (2) below, but at the very least, a collusive equilibrium is a natural conjecture in a context where it is common knowledge that everyone wants to maximize profits.

In our basic example of gas-station duopolists, affirmative answers to questions (1) and (2) strongly suggest an affirmative answer to question (3), as well. This implication reflects our assumptions in the example, such as that gasoline is an undifferentiated product, that competitors have no private information about their respective costs, and that price discrimination of any sort is impossible for any seller to implement. It is not quite true that there is a unique profit-maximizing equilibrium in this setting, but there is a unique price-maximizing equilibrium path , and it is a deterministic path. It does not matter much, then, what kind of punishments the colluders believe would be imposed off the equilibrium path. In fact, as long as each colluder conjectures that he would be punished with sufficient severity if he were to break the cartel, the equilibrium path of play will be realized. This outcome is robust to that type of heterogeneity of conjectures.

But the farther one moves away from the basic example, the less plausible it is that industry participants would share a focal point. Consider three representative reasons why coordination would be unlikely to be achieved in various situations:

In a differentiated-product oligopoly, joint profit maximization is no longer salient. Rather, there is a Pareto frontier of profit-maximizing price profiles. Because of imperfect substitutability, a seller can be better off to maintain a price somewhat above its competitor’s price than to sell at the competitive price. A firm that charges a high price, but one that is slightly lower than its competitor’s price, gets the lion’s share of the rents. The division of rents would be determined by the competitors’ respective bargaining power against one another. If each competitor believes that it is in the strongest bargaining position, for example, then the various competitors’ conjectures will correspond to different points on their Pareto frontier of profitability, and coordination on a focal Nash equilibrium will fail.

Even if competitors agree about what is their desired imputation of rents, there are a plethora of ways to achieve it. Consider, for example, the notorious cartel of electrical-generator manufacturers in the 1950s. Bidding in procurement auctions was rigged by a scheme that selected a winner according to the phase of the moon on the day bids were requested. As long as purchasers remained unaware of the arrangement, the lunar phase would be random, so the selection of the winning bidder would be equitable. But, certainly it could not have been common knowledge, prior to any communication, that this was the scheme that would be adopted. That is no more a focal point than using the last two digits of the number (mod 4) of shares traded on the New York Stock Exchange on the day prior to the opening of bidding. Or, one month prior to the opening of bidding. Or, the high temperature (mod 4) in Chicago on that day, as reported by the US National Weather Service. The number of equally salient candidates for a coordination device is huge. To implement a Nash equilibrium, it is not sufficient for cartel participants to agree that they will split the market in a way that provides equal shares in the long run. They must have a unanimous conjecture about precisely how the splitting will be done.

In an environment with private information, the equilibrium path will be stochastic. If “punishment phases” are randomly triggered by outcomes such as steep decline in demand at the cartel price, for which a deviation from collusion has a high likelihood-ratio statistic (even though deviation is not believed to have actually occurred), then colluders face a coordination problem. If the “punishment” is not going to last forever, then all colluders must abandon it simultaneously. The reason is that, while anyone acts as prescribed in that phase, prices tend to remain low. Thus, if someone continues that conduct for longer than the others conjecture, then they will perceive the resulting low price to be occurring during the active-monopoly phase of the cartel and will initiate the punishment phase. With that phase being in force most of the time, the cartel will not be profitable. But there are many equilibria corresponding to various rules about when to re-enter the active-monopoly phase, none of which is an obvious candidate to be a focal point. One candidate, the profit-maximizing equilibrium, involves successive punishment phases of independent, random duration. ( Abreu, Pearce, and Stacchetti, 1986 ). Analogously to the problem of random selection of the respective winning bidders in a sequence of rigged auctions, there is indeterminacy in the selection of the randomizing device, and coordination will fail unless all participants adopt the same device.

To summarize, there are two versions of the idea that sellers in a market might coordinate on a specific pattern of collusive conduct without the need to communicate plans with one another. One version, that such coordination would occur simply as a result of the sellers following the logic of optimization in their shared situation—that is, the idea of “reasoning to an equilibrium”—does not survive careful game-theoretic analysis. The other version—the focal-point view—is logically sound. Nevertheless, because most market environments are sufficiently complex that there are numerous possible ways to collude, none of which will work unless it is adopted by all of the significant market participants, that view suggests that it is difficult, and probably rare, for successful collusion to obtain in the absence of explicit communication. The exception to this generalization is a market that is so simple and transparent—such as the gas-station-duopoly example discussed earlier—that there is a unique candidate for the optimal collusive agreement.

19.4.4. Risk Dominance as an Obstacle to Collusion

Let’s further consider an infinite-horizon version of the gas-station duopoly. Suppose that the stations are identical, having a fixed cost F of operation and selling gas at constant marginal cost. Moreover, suppose that there are only two prices that could be charged: a high p H and a low p L .

Let’s make an assumption that the gas stations will continue to charge p H forever if they both charge that price initially, but that they will both charge p L subsequently if they do not both charge p H the first time. This assumption expresses, in stark form, the idea that initial success in collusion establishes a successful long-term arrangement, but that any convergence to collusion after an initial failure to collude would be slow enough that the present discounted value of eventual collusive profits would be low.

If both sellers charge p H , then each receives half of the monopoly profit M in each period, and the cartel continues forever. Thus, the discounted present value of participating in the cartel is ρ M , where ρ=1. 32 If they both charge the low p L , then each earns zero profit. 33 If they start out making opposite choices, then the high-price station initially sells no gas but bears its fixed cost, losing F , while the low-price station initially earns revenue p L D ( p L ) = 2 F and consequently earns positive profit F net of its fixed cost. Subsequently to the initial period, by the assumption above, both stations charge p L and earn zero profit. These payoffs are summarized by the following matrix.

If the interest rate is low (so that ρ is large), M is large, and F is small, then ρ M / 2 = F , and both symmetric-price profiles are Nash equilibria, with the collusive one (that is, for both sellers to charge p H ) being the more profitable one. Profitability seems to make collusion a focal point. However, there is a countervailing argument. A seller who sets price p H will suffer a loss if, contrary to his conjecture, the other seller charges p L . In contrast, a seller who sets price p L will make an unanticipated profit if, contrary to his conjecture, the other seller charges p H . In this sense, setting p L is the less risky choice. Indeed, if a seller conjectured that the other seller was equally likely to charge p L   or   p H , then he would charge p L in order to maximize his expected profit.

The technical name for this property of the low-price equilibrium is risk dominance. It was introduced by Harsanyi and Selten (1988) , who proposed the tracing procedure as an account of how rational players choose among multiple Nash equilibria of a game that they are playing. 34 Roughly speaking, their proposal was first to discard all but the Pareto frontier of the Nash equilibrium set, and then to use risk dominance to select among the remaining equilibria. But Aumann (1990) subsequently argued, in effect, that such a lexicographic priority for Pareto efficiency was misguided, and that risk dominance is actually the more compelling criterion. Harsanyi (1995) accepted Aumann’s argument and formulated a new equilibrium-selection theory based solely on a version of risk dominance.

The case for the risk-dominant equilibrium being played is even further strengthened by research of Carlsson and van Damme (1993) . They consider games such as the one above, to which they add the realistic consideration that players’ information about one another’s payoffs is accurate but not perfectly precise. Imagine, for example, that two gas-station owners are franchisees of different chains and are contractually obligated to use their respective franchisers as their sole suppliers of gasoline. Each supplier sets its price at any date in a way that closely reflects the market price of crude petroleum, and each gas station owner can read the price of crude in the newspaper but cannot directly observe the wholesale refined-gas price of his competitor’s supplier. Thus, each owner is highly confident that the other purchases gas at a price very close to his own price, but does not know his competitor’s price—or, consequently, his competitor’s payoff function—with complete accuracy. The generalization of Nash equilibrium to such a situation is Bayesian Nash equilibrium , and Carlsson and van Damme prove that the risk-dominant Nash equilibrium of the complete-information game corresponds to the unique Bayesian Nash equilibrium of the incomplete-information version of the game, even as the precision of information tends to certainty. 35

Carlsson and van Damme’s formal proof is a piece of mathematical analysis that may seem to be a magician’s hat trick, but they provide a discussion that makes it seem much more intuitive. Recall the distinction between mutual knowledge and common knowledge that was introduced above. Something is mutual knowledge among a group of competitors if each knows it. A synonym for mutual knowledge is first-order knowledge. Define the competitors to have second-order knowledge of some fact if each of them both knows the fact itself and knows that the others know it. Third- and higher-order knowledge are defined successively in this way. A fact is common knowledge if there is first-order and second-order and … n th-order and … knowledge of it. When information is sufficiently precise, it can be n th-order knowledge (for very high n ) that rational competitors will charge the monopoly price (that is, will play the payoff-dominant but risk-dominated strategy), but that is never common knowledge unless information about competitors’ payoffs is absolutely precise. Rubinstein (1989) has shown that no finite level of belief is sufficient to make it rational for everyone to play the payoff-dominant Bayesian Nash equilibrium. Only common knowledge will do. This same insight is the economic content of Carlsson and van Damme’s result.

Two rejoinders to the foregoing arguments why the risk-dominant equilibrium would be played are available. One rejoinder, specific to Carlsson and van Damme’s argument, is that the technical assumptions of their theorem are more restrictive than their account of the assumptions’ intuitive content would suggest, and that those technical assumptions are unlikely to hold exactly. This rejoinder can be rebutted, in turn, by the observation that assumptions of scientific theories invariably fail to correspond precisely to the truth. In a specific form, the rejoinder simply expresses an antiscientific attitude, and it is not worthy of being taken seriously. At this point, there is nothing further to be said on either side. Probably neither party to the discussion will have persuaded the other, and their views will be as far apart as when they began. Just as it is not likely to produce scientific agreement, this line of argument is also unlikely to produce consensus about practical questions of competition policy or jurisprudence.

A much more compelling and interesting rejoinder is based on an argument made by Aumann (1990) . To begin to set forth this rejoinder, let’s step back for a moment and put Carlsson and van Damme’s argument in context. Someone who uses that argument to argue that monopolistic outcomes cannot arise from tacit coordination intends, presumably, to contrast tacit coordination with weak explicit collusion involving overt negotiation of a cartel arrangement, and to assert that the cartel members could possibly reach common knowledge of their collusive intent through communication. But Aumann claims to refute that assertion. 36 According to Aumann, a player can credibly communicate to an opponent that he would like the opponent to play the payoff-dominant strategy, but he cannot credibly communicate to the opponent that he will play the payoff-dominant strategy himself. The upshot is that the risk-dominant (that is, nonmonopolistic) equilibrium is the only one that could rationally be played, even if there is unlimited opportunity for explicit communication among prospective colluders.

The conjunction of Aumann’s conclusion (that explicit collusion cannot be more feasible than tacit coordination is) and Carlsson and van Damme’s conclusion (that tacit coordination is not feasible) flies in the face of the incontrovertible evidence that explicit collusion has sometimes occurred and been stable through long intervals of time. 37 Thus, if the soundness of Aumann’s argument is conceded, then Carlsson and van Damme’s conclusion must be denied.

Again, though, there is a rebuttal to the rejoinder. The rebuttal is that there is experimental evidence against Aumann’s view. Specifically, Charness (2000) reports an experiment in which a high proportion of subjects played a payoff-dominant, risk-dominated equilibrium after having had opportunity for explicit communication, but in which that equilibrium was rarely played by subjects who had not had such an opportunity. 38 On the basis of this evidence, someone might decide to reject Aumann’s conclusion (even if he could not pinpoint where the logic of Aumann’s argument for it goes wrong), and could consequently hold the view that explicit collusion is likely to occur but that tacit coordination is implausible.

19.4.5. Initial Capital Investment as Communication

So far in this section, we have supposed that industry conduct begins immediately with decisions about output or pricing, with capital investment implicitly having been determined previously and not being subject to adjustment. That is, investment (or capacity) is not a strategic choice. The argument of Aumann that has just been discussed, in particular, is formulated in that context.

Now, let’s reconsider that argument in the context of an industry with a two-stage life. In the first stage, an incumbent with large production capacity is joined by an entrant who bears an investment cost of acquiring capacity. (Whatever cost the incumbent may have borne in the past to build capacity, is now “sunk cost” and will not figure in the analysis that we make under these assumptions.) In the second stage, the firms will be quantity-setting competitors who choose their respective outputs at every date (0, 1, 2, …) subject to their respective capacity constraints. These constraints are at the exogenous (but nonbinding) level for the incumbent and the level determined by stage-1 investment for the entrant, and cannot be adjusted during stage 2. At each date, firms produce perfect-substitute goods and the market price is perturbed by a demand shock that the firms cannot observe, as in the model of Green and Porter (1984) .

As in the preceding discussion we simplify the analysis by supposing that only finitely many—in this case, three—output levels are feasible. One is the static Cournot level. Call this output q 2 . The other two feasible levels are parameters of the joint-profit-maximizing equilibrium of the Green-Porter environment that Abreu, Pearce, and Stacchetti (1986) (APS) have characterized. In that equilibrium, each firm produces output q 1 < q 2 , which is approximately the static monopoly output, in the “cooperative” phase of equilibrium; and each produces a maximin output q 3 = q 2 during reversionary episodes. Thus we specify { q 1 , q 2 , q 3 } to be the set of feasible output levels.

Given this assumption about feasible output levels, it is natural to specify also that, in stage 1, the entrant must choose a capacity level in { q 1 , q 2 , q 3 }.

Now, the question is, can the entrant credibly signal collusive intent and also motivate the incumbent to collude by choosing some particular level of capacity.

Of course, the entrant could do more than signaling—he could commit always to produce the collusive output—by choosing capacity q 1 . But, if the entrant did that, then he would lose the capability to punish the incumbent for not reciprocating in collusion. The incumbent would make strictly higher profit in any period by producing q 2 than by producing q 1 , and so would never produce q 1 . The resulting industry conduct would not be collusive.

Nevertheless, the entrant would succeed in both signaling collusive intent and also motivating the incumbent to collude as well, if he were to choose capacity q 3 . The rational incumbent should understand the implication of that choice in terms of a thought process that game theorists call forward induction. He should think as follows: If the entrant conjectured that I were going to play static Cournot, then he would be certain that he would never benefit (either directly or indirectly, by setting incentives for me) by producing more than q 2 . Therefore, he would be sacrificing profit by making more costly investment to acquire capacity q 3 . Since he is a profit maximizer, I deduce (by modus tollens ) that his conjecture is that we are going to play the APS equilibrium rather than the static Cournot equilibrium in stage 2. Consequently, if I were to produce more than q 1 at the initial production date, then with high probability, the market price would be lower than the trigger price, and he—with certainty that I am behaving identically—would switch to the reversionary output level q 3 , which would be bad for my profitability. That is, my conjecture is that he is going to produce the monopoly level of output as long as the market price stays above the trigger price, and my Nash response to that conduct is to do likewise.

The foregoing analysis follows closely the analysis of forward induction first proposed by van Damme (1989) for equilibrium of the burning-the-dollar game. That is a two-stage game, in which some particular single-stage game with several Nash equilibria is to be played in stage 2. In stage 1, one of the players has the opportunity publicly to burn a dollar bill. This action has no implication whatsoever for the feasibility of strategies or for the payoffs to any player of strategy profiles in stage 2. Nevertheless, the two-stage game has a unique equilibrium consistent with forward induction: the player does not burn the dollar, and even though he abstains from that action, the Nash equilibrium most favorable to him is played in stage 2. The analogy between the oligopoly game discussed here and the burning-the-dollar game is not exact, because the analogue of burning a dollar bill would be to invest in even more capacity than is required to play the APS equilibrium, and we have specified that option not to be available. Nevertheless, the logic of the incumbent’s thought process described above is precisely that spelled out in the analysis of burning the dollar.

Alternately, consider an industry such as production of a good that has just been invented by a nonproducer (e.g., by a government laboratory), so that all prospective producers make simultaneous capacity choices in stage 1. Does forward induction also select the APS equilibrium in this environment?

The answer is negative. Ben-Porath and Dekel (1992) have shown that, if both players of a single-stage game have the opportunity to publicly burn a dollar beforehand, then all equilibria of the single-stage game can be consistent with forward induction.

The upshot is that there is a theoretical model in which capacity choice functions as communication of collusive intent in the context of one, specific, initial configuration of an industry, but that the model does not show investment invariably to succeed to function in that way. In the current state of its development, game theory does not provide any more concrete guidance about how general may be the circumstances in which tacit coordination might arise via forward-induction reasoning.

19.4.6. Blundering into Tacit Coordination

In the introductory section of this chapter, we stated, “There has been broad agreement in principle that monopoly conduct can arise spontaneously in highly concentrated markets that satisfy some other (possibly restrictive) conditions.” Building largely on the analysis provided by Aumann (1990) and Aumann and Brandenburger (1995) of Nash equilibrium as an outcome of rational interaction among players, we have found on the whole that the conditions for monopoly conduct to arise spontaneously as a result of such rational interaction are indeed restrictive.

But Aumann and Brandenburger provided sufficient conditions for players’ conjectures to be a Nash equilibrium, not necessary ones. They mentioned the possibility that players might “blunder into an equilibrium by accident,” even in a situation where their sufficient conditions for Nash equilibrium were not satisfied.

To assess this possibility requires a complement to the theory of outcomes of rational interaction under strong assumptions about higher-order knowledge of other players’ rationality: a theory of equilibrium as a long-run outcome of “blundering” by (predominantly) rational agents. Those agents can be modeled as making “optimal” decisions based on understanding their environment and on knowing what actions other players are using (on average, at least), but without consideration of what other agents might be thinking and of how their future actions might change as a result of their own optimization/reasoning processes. This complementary theory is the topic of evolutionary game theory. Like other theories, this one is actually a family of related models. Virtually all evolutionary models have the implication that behavior almost surely approaches some Nash equilibrium in the long run. The models that make the most precise predictions introduce a low level (made asymptotic to zero, in formal analysis) of irrational behavior that corresponds to mutation in a biological population. The canonical models of this sort were formulated by Young (1993) and by Kandori, Mailath, and Rob (1993) . Analysis of those models provides a formal foundation for the informal Aumann-Harsanyi argument that when one Nash equilibrium is payoff dominant and another one is risk dominant, play will converge to the risk-dominant equilibrium. As they relate to our analysis in section 19.4.4 , those models suggest that firms will not blunder into tacit coordination.

However, by relaxing only slightly the assumptions of those models about the optimality of nonmutant actions, Fudenberg and Imhof (2008) formulate a model in which the efficient outcome can be selected in repeated prisoner’s dilemma games that are the abstract analogue of the repeated-interaction environments discussed earlier in this chapter. Thus, Fudenberg and Imhof’s model lends some support to a favorable view toward the possibility of competitors blundering into tacit coordination.

Sabourian and Juang (2008) ably survey general issues regarding use of evolutionary game theory to select the most plausible among the Nash equilibria in an environment. As they mention, the predictions of particular evolutionary models are sensitive to the specific assumptions that are incorporated in those models, and that might not be persuasive to a skeptic. Bergin and Lipman (1996) have shown that, if “mutations” are modeled as being state dependent, then any strict Nash equilibrium (that is, equilibrium in which each player’s Nash action is strictly preferred to all of his other actions) can be selected. The gist of Bergin and Lipman’s research is that, until economists develop intuitively compelling justifications for specific mutation processes, evolutionary game theory will remain an insightful but inconclusive framework for reasoning about whether “blundering” will lead to payoff-dominant (that is, tacitly coordinated) outcomes, or to risk-dominant (that is, noncollusively oligopolistic) ones.

19.5. Tacit Coordination in Antitrust Litigation

A potentially collusive pattern of prices is a violation of the first section of the Sherman Act only if it is shown that there is an agreement among competitors. Unfortunately, there is no recipe to identify agreements from economic circumstantial evidence if the environment is such that collusive prices may arise without communication. Posner (2001) states that

in some circumstances competing sellers might be able to coordinate their pricing without conspiring in the usual sense of the term—that is, without any overt or detectable acts of communication. This is the phenomenon that lawyers call “conscious parallelism” and some economists term “oligopolistic interdependence,” but which I prefer to call tacit collusion in contrast to explicit collusion of the formal cartel or its underground counterpart. ( Posner, 2001 , 52–53)

In the same chapter, Posner (2001) tells the history of the price-fixing criminalization including the possibility of tacit coordination. He argues that just after the Sherman Act, judges and lawyers based their cases in the mere fact of explicit collusion and not in the economic consequences, probably because lawyers were more comfortable with conspiracy doctrine that with an economic theory of pricing. Posner (2001) points out the inadequacy of considering the existence of overt communication as the only decisive factor in collusion prosecution. Once the economic effects are taken into account, one must consider the possibility that a seemingly collusive price may have been reached without communication or even an agreement but from the understanding of the strategic interdependence. Posner (2001) approaches the issue of what constitutes a tacit agreement by referring to Turner (1962) . For Turner (1962) , whether a pattern of prices was reached through an agreement or not could be “considered purely as a problem in linguistic definition.” Posner (2001) then discusses when “plus factors” may allow the inference of explicit collusion from economic evidence. 39

Baker (1993) also reached the conclusion that distinguishing an “agreement” among competitors when the evidence is “entirely circumstantial” is difficult from both a legal and an economic perspective:

Courts and commentators have debated for decades whether parallel price changes by oligopolists who recognize their interdependence provide a sufficient basis for a court to infer an unlawful horizontal agreement under Sherman Act 1, and if not what additional circumstantial evidence is required to prove a conspiracy. ( Baker, 1993 , 144)

Baker (1993) concludes that regardless of the requirements to distinguish among coordination and agreement, antitrust policy should prevent practices that facilitate oligopoly coordination, which is the approach of the European Commission.

Turning to Europe, Garces-Tolon, Neven, and Seabright (2009) and Ivaldi and coauthors (2007) analyze the evolution of tacit coordination in Europe from 1990, year in which merger control became a responsibility of the European Union. Ivaldi and coauthors (2007) point out that tacit coordination, or collective dominance as it is called by the European Commission, has been a controversial issue. According to the article, the interpretation of collective dominance in litigation used to have no structural links and it was not until recent years that it was more precisely specified. Consistency is up to some point due to a regulation in 2004 in which the Commission declared “incompatible with the EC treaties mergers that create or strengthen a dominant position as a result of which effective competition would be significantly impeded” ( Ivaldi et al., 2007 , 217–18). In this sense, the European Commission is relying on game theory, mainly results on subgame perfect equilibrium in repeated games, to determine whether or not a concentration or a merger is strengthening a dominant position. An analysis of how results in repeated games have been used in litigation can be found in Garces-Tolon, Neven, and Seabright (2009) . Ivaldi and coauthors (2007) also analyze the impact of game theory on European merger policy.

We hope this chapter facilitates communication between lawyers and economists on these issues by providing a common language and framework for discussion. It is clear that for years to come antitrust enforcement authorities will wrestle with the identification of what types of conduct violate antitrust laws.

Acknowledgments

The authors thank the Human Capital Foundation ( http://www.hcfoundation.ru/en/ ), and especially Andrey Vavilov, for financial support. The paper benefited from discussions with Roger Blair, Louis Kaplow, Bill Kovacic, Vijay Krishna, Steven Schulenberg, and Danny Sokol. We thank Gustavo Gudiño for valuable research assistance.

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It is important to note that there is substantial debate within the legal profession on the meaning of these terms, as most recently noted by Kaplow (2011) . See also Kaplow and Shapiro (2007) and Kaplow (2013) . In this chapter, in order to take steps toward clarifying communication between economists and lawyers, we opt for specific definitions of terms but recognize that there remain both substantial debate among legal scholars and latitude for interpretation by courts regarding these definitions.

As we discuss legal concepts it should always be understood that it is our interpretation as economists, not as legal scholars, since we are not the latter.

See Turner (1962) . The Sherman Act states: “Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal” (15 USC § 1).

For elaboration on collusive structures, see Marshall and Marx (2012 , chapter 6 ). Levenstein and Suslow (in this volume) state, “While it has often been presumed that cartels’ demise results from cheating by member firms tempted by short-term profits, empirical analysis suggests that cheating rarely destroys cartels. The potential profits from collusion provide sufficient incentives for cartels to develop creative ways to limit the temptations that inevitably arise.”

In the context of illegal agreements, there is no distinction between verifiable and observable, unless we consider a third-party cartel organizer with quasi-judicial powers (see Marshall and Marx, 2012 , chapter 6.6).

“All concur that express agreements are a subset of interdependent behavior that counts, that is, triggers liability. There is, however, no sharp consensus either on the boundaries of this subset or on whether other subsets, such as one including tacit agreements, also suffice. These and other questions are interrelated. For example, if express agreements are defined broadly, to include what others might deem to be tacit agreements, then express agreements might be viewed as exhausting the space of interdependent behavior that suffices, supposing that the only other candidate behavior involves tacit agreements. Many, including the Supreme Court in both earlier decisions and its most recent …, do in fact state that tacit agreements are sufficient, yet it is hard to know what to make of these proclamations given the great ambiguity of the term” ( Kaplow, 2011 , 700).

Direct interaction that is disguised through the use of an intermediary, such as a trade association, would be included in the definition of direct interaction. “The communication among colluding sellers needed to insure successful price reporting may be indirect, in that it all proceeds through a trade association or statistical service, but it is none the less explicit” ( Kaysen, 1951 , 266). On this point, Kaysen (1951) cites the Maple Flooring Manufacturers Association discussed in 268 U.S. 563 (1925).

Kaplow (2011 , 700) notes that there is no clear consensus in the law as to the illegality of a “tacit agreement.” It is our impression that this speaks to the lack of agreement regarding the definition of “tacit agreement” in the law. Again, we are posing one interpretation to take steps forward in clarifying communication between lawyers and economists.

With the understanding that transfers would require communication, in some cases we limit our description to requiring only an absence of communication.

The first folk theorem (cf. Friedman, 1977 ) assumed perfect information and perfectly patient players. The next generation (e.g., Fudenberg and Maskin, 1986 ; Radner, 1986 ) assumed near perfect patience (i.e., a discount factor asymptotic to 1) and perfectly correlated information. The current state of the art (cf. Mailath and Samuelson, 2006 ) makes much less stringent assumptions about information, but continues be phrased in terms of theorems about the asymptotic approach to perfect patience. Current folk theorems strongly support the idea that a collusive arrangement can be operated in an environment that is not informationally rich if producers are sufficiently patient. Econometric studies (e.g., Porter’s [1983b] study of the JEC cartel), as well as information disclosed in court proceedings, show that various groups of producers have been sufficiently patient for successful operation.

For a discussion of the canonical model of weak explicit collusion in a repeated-game model of Bertrand price competition, see Choi and Gerlach in this volume.

The equilibria in question include those in which certain market outcomes trigger a Nash-reversion punishment phase as in Porter (1983a) and Green and Porter (1984) , and other equilibria involve more sophisticated stick-and-carrot strategies as in Abreu (1986) and Abreu, Pearce, and Stacchetti (1986 , 1990 ). Athey, Bagwell, and Sanchirico (2004) assume firms observe the realized prices of their rivals. As long as this information is available without communication, these equilibria would be viewed as weak explicit collusion.

Levenstein and Suslow (in this volume) state, “The most successful cartels do not simply agree to a certain set of parameters. They create organizations or governance structures that allow them to address challenges that arise sequentially, expand the scope of the agreement, and provide flexibility in changing economic conditions. … In the most sophisticated cartels, top- level management sets overall cartel strategy, but the inherent uncertainty of the economic environment requires ongoing communication and decision-making among operational employees.”

Posner (1976 , 40) refers to this as “tacit collusion.”

“Oligopolists behaving in a legal and consciously parallel fashion could achieve high and rising prices, even as costs remain stable, by engaging in price leadership. The odds that they could achieve a price and profit increase and maintain incredibly high incumbency rate—that is, maintain the very same distribution of municipal contracts year after year—are miniscule, however, unless the oligopolists were communicating with one another.” City of Tuscaloosa v. Harcros Chem., Inc., 158 F.3d 548, 565 (11th Cir. 1998). The clear presumption of the court in this case was that buyers, the municipalities in Stateplace, Alabama, would conduct competitive procurements and push back against price increases by the sellers to the effect that incumbency rates would be volatile. It was not the presumption of the court that the buyers were passive. Rather, the court presumed that the buyers were players in the game, and thus much different from the customers of the gas stations in Carlton, Gertner, and Rosenfield (1997) .

See Ivaldi et al. (2003) on how the feasibility of weak explicit collusion is affected by the number of firms, asymmetries among firms, entry barriers, market transparency, demand growth, innovation, product differentiation, multimarket contact, and other factors. See Choi and Gerlach (in this volume) on how the feasibility of weak explicit collusion is affected by the number of firms, symmetry and concentration, demand conditions, multimarket contact, imperfect observability and monitoring, incomplete information and communication, vertical mergers and restraints, and the presence of antitrust leniency programs.

The difficulties associated with sustaining successful tacit collusion when buyers make purchases infrequently or demand is uncertain can be seen formally in Tirole’s (1988 , chapter 6.7.1, 262–65) exposition of Green and Porter’s (1984) model of tacitly collusive behavior ( Marshall and Marx, 2012 , chapter 1.10).

Levenstein and Suslow (2011 , table 3) show that approximately one-third of the cartels they consider used a mechanism to arrange transfers when a cartel member’s sales exceeded its cartel allocation.

This example is based on Carlton, Gertner, and Rosenfield (1997) .

For empirical evidence of collusion in retail gasoline, see Borenstein and Shepard (1996) . See also Slade (1992 ).

The Guidelines are available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf .

See Choi and Gerlach (in this volume) for a review of experimental evidence on collusion and antitrust leniency programs.

Abreu, Pearce, and Stacchetti (1990) rely on a different method to solve for the equilibria of dynamic games, using the notion of self-generation, which allows applications to asymmetric games.

The results of Yamamoto (2014) imply that under some conditions a cartel can self-enforce some degree of collusion even if firms do not know how profitable the market is. The environment is a two-player game with a public randomization device and private monitoring. The state of the world is chosen by nature at the beginning of play and it influences the distribution of signals and/or payoff functions of the stage game. Yamamoto’s (2014) solution concept is belief-free ex post equilibria (BFXE). In a BFXE a player’s best response does not depend on her beliefs about the state of the world or her beliefs about her opponents’ private information. A folk theorem for this environment/solution is not obtained, but some degree of collusion is sustainable. Schenone (2012) considers an environment different from Yamamoto’s. First, instead of private monitoring, Schenone’s game is one of perfect monitoring. Second, each player knows its own payoff, and the state of the world can be uniquely identified by pooling together the information of all players. Schenone finds conditions that are both necessary and sufficient for a perfect Bayesian equilibrium folk theorem. The conditions are also necessary and sufficient for a belief-free equilibria folk theorem to hold. In this case, the solution concept is perfect type-contingent ex post equilibria, which is equivalent to a belief-free equilibrium under perfect monitoring.

Because we will not discuss it here, we have omitted a common-prior assumption of Aumann and Brandenburger’s result.

Aumann and Brandenburger (1995 , sec. 5) show that their result would fail if any of the conditions were weakened significantly.

Again here, we are giving a brief incomplete statement of a result in order to avoid digression from the topic of the chapter.

Bernheim (1984 , 1011–12) provides an example of a game that has a unique Nash equilibrium. It is a pure-strategy equilibrium in which each player plays one specific action with certainty. However, that Nash action is not the player’s only rationalizable action. To the contrary, there is a set of profiles of actions, in each of which all players play non-Nash actions, such that rational players can have common knowledge of those profiles as conjectures.

The focal-point view was first set forth by Schelling (1960) . Schelling envisioned two people who have common knowledge that they need to meet in Manhattan, but have not had an opportunity to communicate about where they should meet. He suggested that two tourists would both go to the Empire State Building, while two NYC natives would both go to Grand Central Station. That is, a common background makes a particular Nash equilibrium to be focal, but which equilibrium were to become focal would depend on specifics of the background.

If the duopolists face 1-period interest rate r , then ρ = (1 + r ) / r .

So, if D(p) is market demand at price p , then p L D ( p L ) / 2 = F . Note that, as pointed out by Edgeworth, this price would not be a Bertrand equilibrium (and, with positive F , no Bertrand equilibrium would exist) if a seller could marginally lower its price and capture the entire market.

See Harsanyi and Selten (1988) for a formal definition of risk dominance and discussion of its significance.

Actually, Carlsson and van Damme prove an even stronger conclusion than this.

Moreover Harsanyi, a game theorist of unparalleled subtlety and insight, was persuaded by Aumann’s argument.

On the prevalence of cartels, see Levenstein and Suslow (in this volume).

Charness cites some previous research that also suggests that conclusion. See also Choi and Gerlach (in this volume).

See Kovacic et al. (2011) on identifying the strength of various plus factors.

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