My favorite oligopoly example just got better!

Though my students are quickly becoming far too young to remember the advent of Netflix, I often start a unit on oligopoly or game theory by posing the question of how much the DVD rental service cost when it started. The answer, you might not remember yourself, is around $20. Now, that seemed like a bargain at the time, when your only real option to rent a movie was to haul your butt over to Blockbuster and pay $4.99 for a single movie, and then face late charges, etc, when you couldn’t get it back the next day. Blockbuster didn’t like the competition of course, and soon got into the online/mail business of renting DVDs itself, leaving us with two big companies sharing the bulk of the market–an oligopoly, or a duopoly, more precisely in this situation.

In principles, and in my intermediate classes, too, I use this example to talk about the options oligopolies face. at least in our simplified, basic model. They can collude, or try to keep prices high and capture as much of the monopoly surplus as possible. Or they can cheat, undercutting their competitor’s prices. In a dichotomous world, we see the two options play out in different ways, allowing our oligopoly to look like a monopoly or to look like perfect competition. That is, high prices mean small quantity, and the consumer gets very little surplus. In the other case, where the companies continue to undercut each other, this drives prices towards the perfectly competitive equilibrium, where each company is charging their marginal cost and capturing very little of the surplus.

In some cases, they’ll even drop below their marginal cost, taking a loss in order to try to drive the other companies out of business. If one company can sustain losses for a long time, he might be able to get rid of the others and then raise prices back up to the monopoly level, thus capturing all the monopoly surplus for himself. Now, he doesn’t have to share with the other guys.

Netflix and Blockbuster have spent the last few years lowering their prices, creating more and more types of plans to have the lowest prices. But lately, Blockbuster has been in trouble. And, just in time for a new school year, Netflix announced today that it was raising prices by 60% come September 1. That makes my example even better! Netflix has a monopoly, Blockbuster enters with a lower price, Netflix responds by lowering their prices, and tit-for-tat until Blockbuster is in trouble, closing stores down all over the place. So, what does Neflix do? They see less competition and raise their prices. Full circle. I love it.

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