Mostly summarized from Gregory Mankiw’s Principles of Economics, 5^th Ed.

PART 5 Firm Behavior and the Organization of Industry

Chapter 17 of 36 Oligopoly     

Section 10 of 25

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Table 1 here

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Figure 2 here

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Figure 2 - Jack and Jill's Oligopoly Game

In this game between Jack and Jill profit each earns from selling water depends on both the quantity he or she chooses to sell and the quantity the other chooses to sell.

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The game oligopolists play in trying to reach the monopoly outcome is similar to the game two prisoners play in the prisoners' dilemma.

Consider the choices for Jack and Jill, per Table 1.

These two water suppliers negotiate and agree to keep production at 30 gallons each.

The price will be kept at $60 and together they will earn the maximum total profit of $3600.

After they agree on production levels of 30 gallons each they must decide whether to cooperate and live up to this agreement or to ignore it and produce a greater quantity.

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Figure 2 shows how the profits of the two producers result from the strategies they choose.

Jack reasons

· I could keep at low production 30 gallons as we agreed, cell D

· or I could raise my production and sell at high production 40 gallons, cell C

· if, which I doubt, Jill stays with the agreement and keeps low production 30 gallons

· with my high production 40 gallons I earn profit of $2,000

· rather than $1,800 with my low production of 30 gallons

Jack further reasons

· if, as I expect, Jill does not stay with the agreement and produces high production 40 gallons

· then I earn $1,600 with high production, Cell A

· and $1,500 with low production, Cell B

· so, regardless of what Jill chooses to do and considering my expectations

· I am better off reneging on our agreement and producing at a high production 40 gallons

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High production 40 gallons is the dominant strategy for both Jack and Jill.

As both expected, they end up producing at the higher level of 40 gallons, Cell A.

The result is

· outcome of less-than-monopoly-production of total 80 gallons

· with lower profits for the two producers, cell A $1600

· instead of cell D $1800 if they had maintained cooperation

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This example shows why oligopolies have difficulty maintaining monopoly profits.

The monopoly outcome is rational for the oligopoly members, but each oligopolist has an incentive to renege on the cooperation.

Just as self-interest drives the prisoners in the prisoners' dilemma to confess self-interest makes it difficult for the oligopoly to maintain the jointly optimum outcome with low production, high prices, and maximum monopoly profits.