Chapter 16

17
Oligopoly

OLIGOPOLY

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes

1. If the members of an oligopoly could agree on a total quantity to produce, they would
choose to produce the monopoly quantity, acting in collusion as if they were a monopoly.

If the members of the oligopoly make production decisions individually, self-interest induces
them to produce a greater quantity than the monopoly quantity.

2. The prisoners’ dilemma is the story of two criminals suspected of committing a crime, in
which the sentence that each receives depends both on his or her decision to confess or
remain silent and on the decision made by the other. The following table shows the
prisoners’ choices:

286

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287 ❖ Chapter 17/Oligopoly

Bonnie’s Decision

Confess Remain Silent

Confess Bonnie gets eight years Bonnie gets 20 years
Clyde’s Clyde gets eight years Clyde goes free
Remain Bonnie goes free Bonnie gets one year
Decision
Silent Clyde gets 20 years Clyde gets one year

The likely outcome is that both will confess, since that is a dominant strategy for both.

The prisoners’ dilemma teaches us that oligopolies have trouble maintaining the cooperative
outcome of low production, high prices, and monopoly profits because each oligopolist has
an incentive to cheat.

3. It is illegal for businesses to make an agreement about reducing output or raising prices.

Antitrust laws are controversial because some business practices may appear anti-
competitive while in fact having legitimate business purposes. An example is resale price
maintenance.

Chapter Quick Quiz

1. d

2. c

3. a

4. d

5. c

6. d

Questions for Review

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 Chapter 17/Oligopoly ❖ 288

1. If a group of sellers could form a cartel, they would try to set quantity and price like a
monopolist. They would set quantity at the point where marginal revenue equals marginal
cost, and set price at the corresponding point on the demand curve.

2. Firms in an oligopoly produce a quantity of output that is greater than the level produced by
a monopoly. They sell the product at a price that is lower than the monopoly price.

3. Firms in an oligopoly produce a quantity of output that is less than the level produced by a
competitive market. They sell the product at a price that is greater than the competitive
price.

4. As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and
more like a competitive market. The price approaches marginal cost, and the quantity
produced approaches the socially efficient level.

5. The prisoners’ dilemma is a game between two people or firms that illustrates why it is
difficult for opponents to cooperate even when cooperation would make them both better
off. Each player has a great incentive to cheat on any cooperative agreement to make herself
or itself better off. Thus, firms in an oligopoly have a difficult time maintaining a cooperative
agreement.

6. The arms race and common resources are some examples of how the prisoners’ dilemma
helps to explain behavior. In the arms race during the Cold War, the United States and the
Soviet Union could not agree on arms reductions because each was fearful that after
cooperating for a while, the other country would cheat. When two companies share a
common resource, they would be better off sharing it. But, fearful that the other company
will use more of the common resource, each company ends up overusing it.

7. Antitrust laws prohibit firms from trying to monopolize a market. They are used to prevent
mergers that would lead to excessive market power in any firm and to keep oligopolists from
acting together in ways that would make the market less competitive.

Problems and Applications

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289 ❖ Chapter 17/Oligopoly

1. a. If there were many suppliers of diamonds, price would equal marginal cost ($1,000), so
the quantity would be 12,000.

b. With only one supplier of diamonds, quantity would be set where marginal cost equals
marginal revenue. The following table derives marginal revenue:

Price Quantity Total Revenue Marginal Revenue

$8,000 5,000 $40,000,000 ----

7,000 6,000 42,000,000 2,000,000

6,000 7,000 42,000,000 0

5,000 8,000 40,000,000 –2,000,000

4,000 9,000 36,000,000 –4,000,000

3,000 10,000 30,000,000 –6,000,000

2,000 11,000 22,000,000 –8,000,000

1,000 12,000 12,000,000 –10,000,000

With marginal cost of $1,000 per diamond, or $1 million per thousand diamonds, the
monopoly will maximize profits at a price of $7,000 and a quantity of 6,000. Additional
production beyond this point would lead to a situation where marginal revenue is lower
than marginal cost.

c. If Russia and South Africa formed a cartel, they would set price and quantity like a
monopolist, so the price would be $7,000 and the quantity would be 6,000. If they split
the market evenly, they would share total revenue of $42 million and costs of $6 million,
for a total profit of $36 million. So each would produce 3,000 diamonds and get a profit
of $18 million. If Russia produced 3,000 diamonds and South Africa produced 4,000, the
price would decline to $6,000. South Africa’s revenue would rise to $24 million, costs
would be $4 million, so profits would be $20 million, which is an increase of $2 million.

d. Cartel agreements are often not successful because each party has a strong incentive to
cheat to make more profit. In this case, each could increase profit by $2 million by
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 Chapter 17/Oligopoly ❖ 290

producing an extra 1,000 diamonds. However, if both countries did this, profits would
decline for both of them.

2. a. OPEC members were trying to reach an agreement to cut production so they could raise
the price.

b. They were unable to agree on cutting production because each country has an incentive
to cheat on any agreement. The “turmoil” is a decline in the price of oil because of
increased production.

c. OPEC would like Norway and Britain to join their cartel so that they could act as a
monopoly.

3. a. Buyers who are oligopolists try to decrease the prices of goods they buy.

b. The owners of baseball teams would like to keep players’ salaries low. This goal is
difficult to achieve because each team has an incentive to cheat on any agreement,
because they will be able to attract better players by offering higher salaries.

c. The salary cap would have formalized the collusion on salaries and helped to prevent any
team from cheating.

4. a. If Mexico imposes low tariffs, then the United States is better off with high tariffs,
because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico
imposes high tariffs, then the United States is better off with high tariffs, because it gets
$20 billion with high tariffs and only $10 billion with low tariffs. The United States has a
dominant strategy of high tariffs.

If the United States imposes low tariffs, then Mexico is better off with high tariffs,
because it gets $30 billion with high tariffs and only $25 billion with low tariffs. If the
United States imposes high tariffs, then Mexico is better off with high tariffs, because it
gets $20 billion with high tariffs and only $10 billion with low tariffs. Mexico has a
dominant strategy of high tariffs.

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management
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291 ❖ Chapter 17/Oligopoly

b. A Nash equilibrium is a situation in which economic actors interacting with one another
each choose their best strategy given the strategies others have chosen. The Nash
equilibrium in this case is for each country to have high tariffs.

c. The NAFTA agreement represents cooperation between the two countries. Each country
reduces tariffs and both are better off as a result.

d. The payoffs in the upper left and lower right parts of the box do reflect a nation’s
welfare. Trade is beneficial and tariffs are a barrier to trade. However, the payoffs in the
upper right and lower left parts of the box are not valid. A tariff hurts domestic
consumers and helps domestic producers, but total surplus declines, as we saw in
Chapter 9. It would be more accurate for these two areas of the box to show that both
countries’ welfare will decline if they imposed high tariffs, whether or not the other
country had high or low tariffs.

5. a. Synergy does not have a dominant strategy. If Synergy believes that Dynaco will go with
a large budget, it will also choose a large budget. However, if Synergy believes that
Dynaco will go with a small budget, it will want a small budget as well.

b. Yes, Dynaco has a dominant strategy of going with a large budget. It is the best strategy
for Dynaco to follow no matter what Synergy chooses.

c. The Nash equilibrium is that both firms will choose a large budget. Dynaco will follow its
dominant strategy so Synergy will choose a large budget as well.

6. a. The payoffs are:

Your Decision
Work Shirk
Work You get 15 units of You get 30 units of
Classmate’s happiness happiness
Classmate gets 15 Classmate gets 5 units
Decision units of happiness of happiness

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 Chapter 17/Oligopoly ❖ 292

You get 5 units of You get 10 units of

happiness happiness
Shirk
Classmate gets 30 Classmate gets 10 units
units of happiness of happiness

b. The likely outcome is that both of you will shirk. If your classmate works, you’re better
off shirking, because you would rather have 30 units of happiness than 15. If your
classmate shirks, you are better off shirking because you would rather have 10 units of
happiness than 5. Your dominant strategy is to shirk. Your classmate faces the same
payoffs, so she will also shirk.

c. If you are likely to work with the same person again, you have a greater incentive to
work, so that your classmate will work, and you will both be better off. In repeated
games, cooperation is more likely.

d. The payoff matrix would become:

Your Decision
Work Shirk
You get 15 units of You get 30 units of
happiness happiness
Work
Classmate gets 55 Classmate gets 25 units
Classmate’s units of happiness of happiness
You get 5 units of You get 10 units of
Decision happiness happiness
Shirk
Classmate gets 50 Classmate gets 10 units
units of happiness of happiness

Work is a dominant strategy for this new classmate. Therefore, the Nash equilibrium will
be for you to shirk and your classmate to work. You would get a B and thus would prefer
this classmate to the first. However, she would prefer someone with a dominant strategy
of working as well so that she could get an A.

7. a. The decision box for this game is:

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293 ❖ Chapter 17/Oligopoly

Braniff’s Decision
Low Price High Price
Low Low profit for Braniff Very low profit for Braniff
American’s Price Low profit for American High profit for American
High High profit for Braniff Medium profit for Braniff
Decision
Price Very low profit for American Medium profit for American

b. If Braniff sets a low price, American will set a low price. If Braniff sets a high price,
American will set a low price. American has a dominant strategy to set a low price.

If American sets a low price, Braniff will set a low price. If American sets a high price,
Braniff will set a low price. Braniff has a dominant strategy to set a low price.

Because both have a dominant strategy to set a low price, the Nash equilibrium is for
both to set a low price.

c. A better outcome would be for both airlines to set a high price; they would both get
higher profits. That outcome could only be achieved by cooperation (collusion). If that
happened, consumers would lose because prices would be higher and quantity would be
lower.

8. a. The playoff matrix for this game is:

Player One’s Decision

Take Drug Don’t Take Drug
Take Drug Player 1 gets 5,000 – X Player 1 gets 0
Player Player 2 gets 5,000 – X Player 2 gets 10,000 – X
Two’s Don’t Player 1 gets 10,000 – X Player 1 gets 5,000
Take Drug Player 2 gets 0 Player 1 gets 5,000
Decision

b. Taking the drug will be a dominant strategy for each player as long as X is less than
5,000.
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 Chapter 17/Oligopoly ❖ 294

c. Making the drug safer (lowering X) raises the likelihood of taking the drug because it
increases the payoff.

9. a. If Kona enters, Big Brew would want to maintain a high price. If Kona does not enter, Big
Brew would want to maintain a high price. Thus, Big Brew has a dominant strategy of
maintaining a high price.

If Big Brew maintains a high price, Kona would enter. If Big Brew maintains a low price,
Kona would not enter. Kona does not have a dominant strategy.

b. Because Big Brew has a dominant strategy of maintaining a high price, Kona should
enter. This is the only Nash equilibrium.

c. Little Kona should not believe this threat from Big Brew because it is not in Big Brew’s
interest to carry out the threat. If Little Kona enters, Big Brew can set a high price, in
which case it makes $3 million, or Big Brew can set a low price, in which case it makes
$1 million. Thus, the threat is an empty one, which Little Kona should ignore; Little Kona
should enter the market.

d. If the two firms could successfully collude, they would agree that Big Brew would
maintain a high price and Kona would remain out of the market. They could then split a
profit of $7 million.

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