27.1 Cartel Pricing and the Duopolists’ Dilemma

• Oligopoly is a market served by a few firms.

• Game theory is the study of decision-making in strategic situations.

• Concentration ratios are the percentage of the market output produced by the largest firms.

• Duopoly is a market with two firms.

• We’ll use a duopoly to explain the key features of an oligopoly.

  • Consider a duopoly in the market for air travel between two hypothetical cities.

  • The two airlines can use prices to compete for customers, or they can cooperate and conspire to raise prices.

  • Let’s assume that the average cost of providing air travel is constant, which means that marginal cost equals average cost.

• A cartel is a group of firms that act in unison, coordinating their price and quantity decisions.

• Price fixing is an agreement in which forms conspire to fix prices.

• A game tree is a graphical representation of the consequences of different actions in a strategic setting.

• A dominant strategy is an action that is best chosen for a player, no matter what the other player does.

• A duopolists’ dilemma is a situation in which both firms in a key would be better off if both chose the high price, but each chooses the low price.

• The Nash equilibrium is an outcome of. Game in which each player is doing the best he or she can, given the action of the other player.

27.2 Overcoming the Duopolists’ Dilemma

• The duopolists' dilemma occurs because the two firms are unable to coordinate their pricing decisions and act as one.

• Firms can avoid the dilemma by low-price guarantees and repetition of the pricing game, with retaliation for underpricing.

• The low-price guarantee eliminates the possibility of underpricing, so it eliminates the duopolists’ dilemma and promotes cartel pricing.

• Although consumers might think that a low-price guarantee will protect them from high prices, it means they are more likely to pay the high price.

• A grim-trigger strategy is a strategy where a firm responds to underpricing by choosing a price so low that each firm makes zero economic profit.

• A tit-for-tat strategy is a strategy where one firm chooses whatever price the other firm chose in the preceding period.

• Price leadership is a system under which one firm in an oligopoly takes lead in setting prices.

• When one firm suddenly drops its price, the other firm could intercept the price cut in one of two ways:

  • A change in market conditions. Perhaps the first firm observed a change in demand or production cost and decided that both forms would benefit from a lower price.

  • Underpricing. Perhaps the first firm is trying to increase its market share and profit at the expense of the second firm.

27.3 Simultaneous Decision Making and the Payoff Matrix

• A payoff matrix is a matrix or table that shows, for the possible outcomes of a game, the consequences for each player.

• For example, in the northeast corner, if Jill picks the high price and Jack picks the low price, Jill earns a profit of $3,000 and Jack earns a profit. Of $12,000.

  • We can use the payoff matrix to predict the equilibrium of the price-fixing game. In a simultaneous-decision game, Jack doesn’t know whether Jill will pick the low price or the high price. There are two possibilities:

    • If Jill picks the high price, we will be in the upper half of the matrix, and Jack’s best response is the low price. In the northeast corner of the matrix, he can earn $12,000 by picking the low price. This is better than the $9,000 he can earn by picking the high price in the northwest corner.

    • If Jill picks the low price, we will be in the lower half of the matrix, and Jack's best response is the low price. This is better than the $3,000 he can earn by picking the high price in the southwest corner.

  • The low price is the dominant strategy for Jack. Jill knows this, so she realizes that the equilibrium will be in the eastern half of the matrix.

  • Her best option is the low price. In the southeast corner of the matrix, she can earn $8,000 by picking the low price which is better than the $3,000 she can earn in the northeast corner by picking the high price.

  • Therefore, the equilibrium is the same as the game-tree approach: Both firms pick the low price.

27.4 The Insecure Monopolist and Entry Deterrence

• Suppose Mona initially has a secure monopoly in the market for air travel between two cities.

• When there is no threat of entry, Mona uses the marginal principle to pick a quantity and a price.

  • Profit = ($400 - $100) X 60 = $18,000

• If Mona discovers that a second airline is thinking about exerting the market, can:

  • Now that her monopoly is secured, she has two options:

    • She can be passive and allow the second airline to enter the market, or she can try to prevent the other form from entering the market.

  • To prevent the second firm from entering the market, Mona must commit herself to serve a large number of passengers.

  • If she commits to a large passenger load, there won’t be enough passengers left for a potential entrant to make a profit.

  • Mona must compute the quantity of output that is just large enough to prevent the second firm from entering the market.

  • The quantity requires to prevent the entry of the second form is computed as follows:

Deterring quantity = zero profit quantity- minimum quantity

• 100 = 120 - 20

• Limit pricing is the strategy of reducing the price to deter entry.

• Limit price is the price that is Jose low enough to deter entry.

• A contestable market is a market with low entry and exit costs.

27.5 The Advertisers’ Dilemma

• A third strategic behavior of firms in an oligopoly concerns advertising.

• Consider the producers of two brands of aspirin. Each firm must decide whether to spend $7 million on an advertising campaign for its product.

  • Each firm earns $8 million in net revenue and spends no money on advertising, so each firm earns $8 million in profits.

• If one firm advertises and the other does not, a firm that doesn’t advertise can decrease its profit while the firm that does advertise increases its profits.

• Both advertisers' dilemma is they would both be better off if neither advertised.

• The advertisers’ dilemma occurs when advertising causes a relatively small increase in the total sales of the industry but allows a firm that advertises gain at the expense of firms that don’t.

• The increase in revenue is less than the cost of advertising, so advertising decreases total profit.

• If the increase in industry-wide net revenue were larger, advertising could benefit both firms.