Lecture 17 Oligopoly and Game Theory

Lecture 17: Oligopoly and Game Theory

  • Public Affairs 40 Principles of Microeconomics

  • Instructor: Wesley Yin

  • Institutions: University of California, Los Angeles Luskin School of Public Affairs, Anderson School of Management

Definitions and Characteristics of Oligopoly

  • Oligopoly: A market dominated by a small number of firms.

    • Characteristics:

      • Large firms' profits depend on competitors' actions.

      • Imperfect competition: No monopoly but producers impact market prices.

  • Examples of Oligopoly Markets:

    • Airlines

    • Streaming services

    • Film and TV studios

    • Pharmaceuticals

    • Auto industry

    • Cell phone manufacturers

    • Wireless carriers

    • Internet service providers

Duopoly: A Special Case of Oligopoly

  • Duopoly: An oligopoly consisting of only two firms.

    • Profit maximization can be understood better through duopolies.

    • Firms benefit from limiting production to raise prices—collude like a monopoly.

    • Cooperation vs. Deviation:

      • Cooperation leads to unstable profits due to strong incentives to deviate from the agreement (illegal in the U.S.).

      • Cartels: A type of collusion where producers agree to restrict output; example: OPEC restricts oil production.

Insights from Game Theory

  • Game Theory: Study of strategic interactions and decision-making.

    • Noncooperative Behavior: Each firm acts in self-interest, potentially reducing overall profit.

    • Collusion: Achieving an agreement could maximize combined profits but is illegal.

    • Predictions of oligopolistic outcomes are informed by game theory.

The Prisoner’s Dilemma

  • A classic example illustrating strategic interactions:

    • Two prisoners can either cooperate or betray each other.

    • Cooperative outcome (both stay silent) maximizes collective benefit, but individual incentives lead to betrayal.

    • Outcome leads to Nash Equilibrium – a noncooperative equilibrium where both choose to confess.

Game Theory Strategies

  • Dominant Strategy: Best action for a player regardless of others' actions.

  • Nash Equilibrium: Outcomes where players choose optimal actions considering others' optimal strategies.

Cournot Oligopoly

  • Cournot Setting: Firms compete based on market demand and production levels.

    • Example: Collusion may be more profitable, but firms face dominance to deviate (like OPEC).

    • Mathematical Representation:

      • Market Demand: P = a - bQ.

      • Firms A & B can either collaborate and restrict output or compete.

Cartel Dynamics

  • If firms collude, they act like monopolists to maximize profits.

  • If any firm produces more, it leads to lower prices, thus shedding light on Nash Equilibrium.

Nash Equilibrium in Oligopoly

  • Nash equilibrium results from noncooperative choices in optimal production to maximize profits, leading to profits being lower than in monopolistic scenarios.

    • Profit functions depend on each firm's output strategies.

    • Deviating while the competitor stays colluding can yield higher profits for the firm.

Overcoming the Prisoner's Dilemma: Repeated Games

  • Repeated Interactions: Encourages cooperative play over time.

    • Example: Strategy - "Tit for Tat" encourages cooperation by replicating the opponent's previous action.

    • Cooperation may lead to sustained higher profits over repeated periods.

Anti-Trust Policies

  • Despite earning positive profits, oligopoly pricing is often higher than competitive pricing.

    • Historical context leads to regulatory measures against collusion (e.g., Sherman Act of 1890).

    • Antitrust policies prevent oligopolistic behaviors resembling monopolies.

    • Regulatory focus increased in the EU’s tech industry.

Limitations of Tacit Collusion

  • Tacit collusion can face challenges:

    • Low market concentration leading to high competition.

    • Complexity in product pricing making it hard to monitor competitors.

    • Varied firm interests and buyer power can disrupt collusive agreements.

Measuring Market Power in Oligopoly

  • Herfindahl-Hirschman Index (HHI): Measures market power by summing squared market shares of firms.

    • For instance, HHI for firms with 60%, 25%, and 15% market shares: HHI = 602 + 252 + 152 = 4,450.

Justice Department Guidelines on Antitrust Statutes

  • HHI Scores and Interpretation:

    • < 1,000: Strongly competitive market.

    • 1,000 - 1,800: Somewhat competitive.

    • 1,800: Indicates oligopolistic market.

  • Mergers scrutinized if they significantly increase HHI.

Concentration in Healthcare

  • HHI categories based on concentration:

    • Unconcentrated (HHI<1,500).

    • Moderately concentrated (1,500 ≤ HHI < 2,500).

    • Highly concentrated (2,500 ≤ HHI < 5,000).

    • Super concentrated (HHI ≥ 5,000).

Questions?

  • Contact: wyin@ucla.edu

  • Office Hours: Thursday 4-5:30 pm.