Market Structures and Game Theory Insights

Introduction to Market Structures

• Market types discussed: Perfect Competition, Monopoly, Oligopoly.
• Oligopoly is characterized by a few large firms, fewer than ten in markets like the auto industry, compared to the misconception of thousands of identical sellers in perfectly competitive markets.

Oligopoly Features

• Definition: Oligopoly is a market structure with a small number of firms whose decisions affect each other.
• Barriers to Entry: Barriers exist that prevent new competitors from easily entering the market, distinct from a monopoly where only one seller exists.
• Examples: The auto industry demonstrates oligopoly, with main competitors conducting extensive advertising and strategic comparisons.

Firm Behavior in Oligopoly

• Cooperative vs Non-Cooperative Behavior:
  • Cooperative: Firms may form a cartel to act as a monopoly, as seen in OPEC (Organization of Petroleum Exporting Countries) which has historically controlled oil prices.
  • Non-Cooperative: Firms compete against one another, potentially driving prices and profits down, leading to outcomes that may resemble perfect competition.

Game Theory in Oligopoly

• Game theory is a critical tool in understanding oligopoly behavior and strategies.
• Key Questions:
  1. What strategies do firms use?
  2. When does the 'game' end (i.e., what determines equilibrium)?
• Nash Equilibrium: Concept where no player can gain by unilaterally changing their strategy.
  • Definition: No player desires to change their strategy if they know the strategies of others.
  • Importance: Highlights the potential inefficiency of competitive outcomes compared to cooperative scenarios.

Prisoner's Dilemma Example

• Description: Two suspects in police custody must choose to either remain silent or betray each other.
• Payoff Matrix:
  • Silent/Silent: Each serves 1 year.
  • Betrayal: If one betrays, they walk free while the other serves 5 years. If both betray, each serves 2 years.
• Dominant Strategy: The logical choice is to betray, resulting in both serving 2 years—illustrating inefficiencies in non-cooperative situations.

Applications to Real-World Scenarios

• Advertising Dilemma (Coke vs. Pepsi):
  • If both companies decided to cooperate, they could maximize profits by limiting outreach; however, advertising becomes the dominant strategy, leading both to lower profits.
• Behavior of Firms: Oligopolists often end up in worse situations than if they had cooperated.

Repeated Games and Cooperation

• In repeated games, firms can establish cooperation over time (e.g., non-advertising arrangements). This cooperation can improve outcomes if not disrupted.
• End of Game Issue: If firms perceive an endpoint (e.g., a regulatory change), they revert to competitive behavior, undermining cooperation and leading back to unfavorable outcomes.

Cournot Model of Oligopoly

• The Cournot model is designed for firms competing on quantity rather than price.
• Steps to Determine Cournot Equilibrium:
  1. Calculate residual demand, considering the amount the competing firm produces.
  2. Derive marginal revenue from this demand function.
  3. Set marginal revenue equal to marginal cost, solving for equilibrium quantities.
  4. Find intersections of quantities from both firms’ responses to each other.

Implications of Nash Equilibrium and Cournot Equilibrium

• Finding points where neither firm wants to deviate leads to a stable outcome.
• Real-World Considerations: Situations can become complex with multiple equilibria or shifting dynamics based on market conditions, thus complicating predictions and strategies.