Detailed Study Notes on Oligopoly and Game Theory

week 9

  • Definition of Oligopoly:

    • A market structure characterized by a few firms that possess market power.

    • Oligopolies have barriers to entry that prevent new competitors from entering the market.

    • Oligopoly versus Monopoly: If there is only one firm, it is a monopoly; if there are many, it is considered perfect competition.

    • The number of firms constituting an oligopoly is not fixed but generally ranges from two to a few.

Characteristics of Oligopoly

  • Market Power: Firms have some ability to set prices above marginal costs due to limited competition.

  • Types of Goods:

    • Goods may be identical or differentiated among competing firms.

  • Graphical Representation:

    • The equilibrium price and quantity are in between that of monopoly and perfect competition.

    • In oligopoly, firms can set prices higher than perfect competition but lower than monopoly pricing.

  • Imperfect Competition:

    • Oligopoly demonstrates features of imperfect competition where firms operate below perfect competition conditions.

    • Barriers to entry present challenges to new entrants, leading to less vigorous price competition.

Measuring Oligopoly: Herfindahl-Hirschman Index (HHI)

  • Definition of HHI: An index that computes market concentration by squaring the market shares of each firm and summing them.

  • Calculation of HHI:

    • For one firm with 100% market share, HHI = 100² = 10,000.

    • For three firms with shares of 60%, 25%, and 15%, HHI = 60² + 25² + 15² = 4,450.

  • Interpretation:

    • HHI < 1000 indicates highly competitive markets.

    • HHI 1000 - 1800 signifies moderate concentration, and HHI > 1800 indicates a highly concentrated market (indicative of oligopoly).

  • Regulatory Relevance: Used by the US Justice Department and FTC to assess merger implications on market concentration.

Oligopolistic Behavior and Strategies

Collusion and Cartels

  • Definition of Collusion: When firms agree to limit production to keep prices high, often forming a cartel.

  • Example of Collusion Mechanism:

    • Two firms agree to restrict production to 50 each to keep prices elevated above marginal cost.

    • Legality: Cartels are illegal due to anti-competitive practices.

    • Incentive to Cheat: Firms may diverge from collusion due to individual profit motivations, leading to overproduction and price drops.

Competitive Behavior

  • Types of Non-Cooperative Behavior:

    • Competition on quantity.

    • Competition on price.

  • Quantity Competition:

    • Known as the Cournot model where firms adjust output without considering competitors’ impacts directly.

    • Firms limit their production capacities to avoid price wars and disastrous profit margins.

Price Competition

  • Bertrand Model:

    • In scenarios where firms compete on price, they may reduce prices until they reach marginal cost.

    • Example: Gas stations like Total and Shell could enter price competition, leading to zero profits at equilibrium.

Game Theory and the Prisoner's Dilemma in Oligopoly

Introduction to Game Theory

  • Definition: A mathematical framework to analyze strategic interactions where the outcome for each participant depends on the actions of others.

  • Importance in Oligopoly: Decisions of firms are interdependent due to their mutual market reliance.

  • Payoff Matrix: A diagram that illustrates the payoffs associated with the different strategies of players, demonstrating the outcomes of various actions taken by firms.

The Prisoner's Dilemma

  • Concept Explanation: Each player makes a decision that results in a worse outcome than if both had cooperated.

  • Application to Oligopoly:

    • Both firms choose to advertise (confess) even when mutual non-advertising (cooperation) leads to better outcomes.

    • Example: Tobacco advertising scenario where firms face a choice; both end up worse off due to mutual strategies that benefit individual firms but harm collective outcomes.

Examples of Collusion and Non-Compliant Behaviors

Notable Cases in History

  • The Great Vitamin Conspiracy:

    • Major drug firms coordinated to fix prices on vitamins, leading to multi-million dollar penalties after exposure and resulting in market price inflation.

  • E-commerce Example: Encyclopedia Britannica faced competitive pressure from Microsoft’s Encarta; price wars led to lowered prices for consumers until offerings became free online.

  • Arm’s Race Example: Illustrates the impracticality of mutual disarmament during the Cold War when both nations chose to escalate military expenditure to deter perceived threats.

Antitrust Policies and their Role in Oligopolistic Markets

  • Purpose of Antitrust Policy: Designed to prevent the formation of cartels and minimize practices leading to market monopolization.

  • Methods of Enforcement:

    • Monitoring HHI to assess market concentration levels for both cartels and tacit collusion.

    • Investigating collusive behavior through case studies, interviews, and market analyses.

  • Limitations on Proving Collusion:

    • Easier to prove cartel activity than tacit collusion, which may operate without direct agreements but still leads to price controls.

  • Market Contestability:

    • Presence of entry barriers is crucial to defining market behavior; efficient monopolists may not abuse positions if they maintain low prices.

    • Case Study: AT&T’s monopoly in New York abandoned due to findings that its market position was due to operational efficiency, not collusive behavior.

Conclusion

  • Oligopoly studies highlight the complex interplay between market structures, firm behaviors, and regulatory frameworks.

  • Future discussions in class will continue with game theory applications to deepen insights into firm interactions and strategic behaviors.