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ECON 201
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Microeconomics
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Welcome
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Oligopoly
01 Game Theory and Nash Equilibrium
Oligopoly and Game Theory
● Oligopoly - A market in which only a few sellers offer similar products

Examples:
○ Credit card companies: MasterCard, Visa, American Express.
○ Aircraft manufacturer: Boeing and Airbus

● Duopoly - An oligopoly that consists of only two firms that dominate the market

Example: Apple and Android dominate the smartphone market.

● Game Theory – A game in which there are players (firms) and payoffs (profits). It studies
how people behave in strategic situations and can be seen in a payoff matrix like the one
below. The outcomes are interdependent (which means profit for one company depends on
what the other company does)

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Dominant Strategy

A dominant strategy is your best strategy no matter what the other firm (player) does. The firm
does not necessarily have a dominant strategy.

Dominant Strategy for Wize

○ In the diagram above, the payoffs (profits) for Wize are the numbers in red.

○ If XYZ does a promotion then Wize should do because they would make
instead of .

○ If XYZ does no promotion then Wize should do because they would

make instead of .

○ No matter what XYZ does it is better for Wize to do a promotion therefore doing a
promotion is Wize's dominant strategy.

Dominant Strategy for XYZ

○ In the diagram above, the payoffs (profits) for XYZ are the numbers in green.

○ If Wize does a promotion then XYZ should do because they would make
instead of .

○ If Wize does no promotion then XYZ should do because they would

make instead of .

○ No matter what Wize does it is better for XYZ to do a promotion therefore doing a
promotion is XYZ's dominant strategy.

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Nash Equilibrium

The Nash equilibrium is a sustainable point where neither player has an incentive to cheat
(change their strategy).

● In the diagram above, this would occur when both firms are doing with a
payoff of each.

● If we are in the top left box and Wize decides to cheat (change their strategy) and do no
promotion, their profit would drop to .

● If we are in the top left box and XYZ decides to cheat and do no promotion, their profit would
drop to .

● Neither player has an incentive to cheat that is why it is the Nash equilibrium

Collusion

The outcome with collusion is also called the mutually beneficial outcome or the outcome with
commitment or a cartel.

● In the diagram above, the outcome with collusion would be where both firms are doing
with a payoff of each.

● However, this point is not sustainable because there is an incentive to .

Example Problem

Example: Oligopoly and Game Theory

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The diagram above shows the payoff matrix for Wizedemy and ABC Inc showing their profits based
on whether they spend on advertising or not.

a) Does ABC Inc have a dominant strategy? If yes, what is it?

b) Does Wizedemy have a dominant strategy? If yes, what is it?

c) What is the Nash equilibrium? What are their total combined profits at Nash equilbrium?

d) Do the two firms have a reason to collude? If yes, what would be the combined profits at this
outcome?

Practice Questions
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02 Prisoner's Dilemma
Prisoner's Dilemma:
Prisoner's Dilemma is the most common example of Nash equilibrium. It consists of two criminals
that have been caught robbing a bank and they are placed in separate cells while being questioned.
Their payoff matrix (years in jail) is presented below.

Dominant Strategy for Criminal A

● If criminal B confesses to the crime, it is better for criminal A to since

years is better than years in prison

● If criminal B denies the crime, it is better for criminal A to since years is

better than year in prison

● Therefore criminal A's dominant strategy is to

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Dominant Strategy for Criminal B

● If criminal A confesses to the crime, it is better for criminal B to since

years is better than years in prison

● If criminal A denies the crime, it is better for criminal B to since years is

better than year in prison

● Therefore criminal B's dominant strategy is to

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Nash Equilibrium

● The Nash equilibrium is when both criminals because neither player has an
incentive to ,

● If we are in the top left box and criminal A cheats, he will end up doing years in jail
instead of years in jail.

● If we are in the top left box and criminal B cheats, he will end up doing years in jail
instead of years in jail.

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Mutually Beneficial Outcome

● If they were able to collude both criminals would the crime and each of them would
do year in jail

● However, this outcome is not sustainable because each criminal has an incentive to
,

● If we are in the bottom right box and criminal A cheats, he would do years in jail instead
of year.

● If criminal B cheats. he would do years in jail instead of year.

Example Problem

Example: Nash Equilibrium with Common Resources

Common resources like oil wells and fisheries can be overused.

a) What is the dominant Strategy for Exxon (if they have one)?

b) What is the dominant Strategy for Texaco (if they have one)?

c) What is the Nash equilibrium?

d) Is there a mutually beneficial outcome compared to the Nash equilibrium?

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03 Cartels, Collusion, Output and Price

Effect
Cartels, Output and Price Effect
A cartel is when a few firms come together and a act like a monopoly. Instead of competing
against each other they collude (work together). This is technically illegal but it is often difficult to
prove.

Example: OPEC is believed to be a cartel of the biggest oil producing countries that try to limit
supply so that they can raise prices.

Suppose there is a market for bottled water with the demand schedule above and for each firm the
marginal cost = 0.

Perfect Competition

● Remember in perfect competition P = MC.

● Since the MC = 0, the price would be equal to and the quantity sold would be
litres.

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Monopoly

● Remember in a monopoly MR = MC

● Since the MC = 0 we go to the row where MR = 0.

● This would be at a price equal to and the quantity sold would be litres.

● Since there are no costs, the profit for the monopoly would be

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Duopoly

A duopoly can either collude (form a cartel) or compete

Collude

● Forming a cartel or colluding means acting like a monopoly. They would take the same price
as the monopoly and divide the monopoly output by two.

● Each firm in the duopoly would make an output of , charge a price of

and profit of each.

● At this output price is than marginal cost. So if one firm cheats and increases
output to 40 units the total output in the market would now be units. The market price
would fall to and profit for the cheating firm would increase to
while the other firm's profit would fall to .

● For the cheating firm the output effect is than the price effect because their
profit increased.

● If the other firm increases output to 40 units also then the total output would be units.
The profit for each firm would become $ .

● Now if one firm cheats and makes 50 units the total output would be units and profit
for the cheating firm would become $ .

● In this case the output effect is than the price effect because their profit
decreases.

Compete

● If they compete, they will produce at the point where neither firm has an incentive to cheat.

● In the example above this would be when each firm is producing units of output at a
price of .

● Profits are for each firm under collusion rather than competing. But at the
collusion outcome there is an incentive to cheat so they both end up at Nash equilibrium
producing 40 units each.

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Output and Price Effect

● The output effect: Because price is above marginal cost, selling 1 more litre of water at the
going price will raise profit.

● The price effect: Raising production will increase the total amount sold, which will lower the
price of water and lower the profit on all the other litres sold

Example: If the output effect is stronger than the price effect, it will cause the overall profit to
increase.

Practice Questions
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04 Government Policy Towards Oligopolies

Government Policy
Restraint of Trade & Anti-Trust Laws

The government can prevent firms in an oligopoly from colluding (agreeing to work together to
raise prices), by making secret agreements illegal.

Example: the government can prevent Samsung and Apple from merging because together they
might have too much power and raise prices of cell phones.

Resale Price Maintenance

Some people argue that anti-trust laws are not always suitable and they argue that the
government should force all retailers to charge the same price for a specific product.

Example: Some clothing companies make retailers charge a certain price for their products to
make sure they all keep a certain level of quality. If one retailer charges less and does not give good
service and information about a product, customers could get the information from a more
expensive retailer and then buy the product from the cheaper retailer. So it's more efficient if they all
charge the same price.

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Predatory Pricing

When a firm lowers a price so low that it's making a loss just to kill off the competition. Then
when the other firms exit the industry, they can start raising their prices since they have no more
competition. The government can make this type of activity illegal but it is often hard to prove.

Example: Amazon operated at a loss for years to gather a bigger market share.

Tying
When a firm forces people to buy two products together. Sometimes the government can make
this illegal to protect consumers.

Examples:

● Xerox allows companies to lease their photocopy machines, but then they have to use Xerox
paper.
● When Microsoft first started selling their software they required everyone to use Internet
Explorer with it, which was also a form of tying.

Practice Questions
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05 Kinked Demand Curve

Kinked Demand Curve
● Kinked Demand - When the demand curve changes angles.

● If firm A raises their price, the other firms will not follow so consumers will all switch to the
competitors. So if firm A raises their price, the demand is . In the diagram below
this would be any price than $25.

● If firm A cuts their price, other firms will also cut price so they will not gain a lot of extra
customers. When they cut the price, the demand is . In the diagram below this
would be any price than $25.

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