Chapter 17 – Oligopoly & Game Theory

Oligopoly: Core Characteristics

• Few sellers dominate the market; each firm’s decisions materially influence rivals.
• Products are often homogeneous or close substitutes (e.g., Wilson, Penn, Dunlop, Spalding tennis balls).
• Strategic interdependence distinguishes oligopoly from perfect competition and monopoly.
• Key tension: cooperation (joint profit-maximising) vs self-interest (individual profit-maximising).

Game Theory & Strategic Thinking

• Game theory: study of decision-making in strategic settings where payoffs depend on others’ actions.
• “Strategic” = recognising one’s payoff is a function of both one’s own move and rivals’ moves.
• Not essential for competitive or monopoly markets (because no strategic interaction) but crucial for oligopoly (few players).
• Chess/checkers metaphors illustrate anticipatory reasoning also used in pricing/production decisions.

Markets with Only a Few Sellers

Duopoly Set-Up (Jack & Jill Water Wells)

• Only two sellers ⇒ “duopoly,” simplest oligopoly.
• Assumptions: marginal cost $MC = 0$; can pump unlimited water.
• Town demand schedule (selected rows):
  • 10 gal → $P=\$110$; 60 gal → $P=\$60$; 120 gal → $P=\$0$.
• Total revenue $TR = P \times Q$ (equals profit because $MC=0$).

Benchmark Outcomes

• Perfect Competition: price driven to $MC$ ⇒ $P=0$, $Q=120$ (efficient quantity).
• Monopoly (joint profit maximisation): $Q=60$, $P=\$60$, $\text{Profit}=\$3{,}600$.
• Collusion/Cartel replicates monopoly result if firms agree and enforce split (e.g., 30 gal each, $\$1{,}800$ profit apiece).

From Collusion to Individual Incentives

• Without binding agreement, each firm is tempted to expand output to capture extra profit.
• Illustrative deviation: If Jill sticks to 30 gal, Jack raises to 40 gal ⇒ market $Q=70$, $P=\$50$, Jack’s profit $=40\times50=\$2{,}000$ (>$\$1{,}800$).
• Both reason similarly ⇒ each ends at 40 gal, $P=\$40$, individual profit $=\$1{,}600$.

Nash Equilibrium

• Definition: outcome where each player’s strategy is best response to the other’s chosen strategy.
• In duopoly game, (40 gal, 40 gal) is Nash: no unilateral incentive to deviate (a move to 50 gal would drop profit to $\$1{,}500$).
• Summary inequality:
  $Q<em>{monopoly} < Q</em>{oligopoly\,(Nash)} < Q<em>{perfect}$$P</em>{monopoly} > P<em>{oligopoly\,(Nash)} > P</em>{perfect}=MC$

Size of the Oligopoly

• As firm count ↑, individual price effect ↓, output effect dominates ⇒ each behaves more competitively.
• In limit (many firms) → price approaches $MC$; output approaches efficient level.
• Free international trade effectively enlarges oligopoly (e.g., auto industry) ⇒ price-reducing, welfare-improving.

Economics of Cooperation

Prisoners’ Dilemma Template

• Two prisoners (Bonnie & Clyde) face sentences based on confess/ silent.
• Payoff matrix shows confess is dominant strategy for both (8-year sentences) vs cooperative silence (1-year each).
• Dominant Strategy: best regardless of opponent’s choice.
• General lesson: mutual cooperation can be individually irrational.

Mapping to Oligopoly

• Jack–Jill output choices mirror confess/silent. Producing 40 gal is dominant; cooperative 30 gal is unstable without enforcement.
• Real-world cartel illustration: OPEC. Members agree to restrict output but cheat for bigger share; 1973-85 success, later breakdown as cheating ↑.

Other Applications

1. Arms Race: U.S. & USSR arm/disarm; arming is dominant ⇒ high risk.
2. Common Resources: Exxon & Texaco drilling additional wells; extra wells are dominant strategy ⇒ over-extraction (tragedy of commons).

Repeated Games & Enforcement

• Future interaction allows threat of punishment (grim-trigger, tit-for-tat) to sustain cooperation.
• Tit-for-tat strategy: start cooperative, then mimic opponent’s last move (friendly, retaliatory, forgiving).

Public Policy toward Oligopolies

Antitrust Foundations

• Common-law tradition refused to enforce “restraint of trade.”
• Sherman Act (1890): contracts/ conspiracies that restrain trade illegal; criminal penalties.
• Clayton Act (1914): triple damages for injured parties; strengthens private enforcement.

Enforcement Examples

• Airline executives’ 1980s phone call (Crandall vs Putnam) highlighted illegality of even discussing price fixing.

Controversial Practices

1. Resale Price Maintenance (RPM)
   • Manufacturer (Superduper) mandates retailer price.
   • Traditional view: anti-competitive; economists’ defense: prevents free-rider problem on retailer services, may enhance inter-brand competition.
2. Predatory Pricing
   • Cutting price below cost to drive rivals out; skeptics (economic theory) argue long-run unprofitability, courts struggle distinguishing from vigorous competition.
3. Tying/Bundling
   • Selling products jointly (e.g., The Avengers + Hamlet; Microsoft Windows + Internet Explorer).
   • Could be price discrimination (extract combined willingness-to-pay) rather than market-power leveraging.

Case Study: Microsoft

• 1998 suit alleged tying browser to Windows to stifle competition.
• District court ordered breakup; reversed on appeal; 2002 settlement imposed conduct remedies.
• Illustrates difficulty distinguishing innovation (integrating features) from anticompetitive bundling.

In the News: NCAA as Cartel

• Op-ed compares colleges’ coordination on athlete compensation to OPEC’s pricing collusion.
• Ethical debate: amateurism vs monopsony power over student-athletes.

Key Concepts & Equations

• Oligopoly: few sellers with interdependent decisions.
• Cartel: formal group acting collectively (collusion).
• Game Theory terminology:
  • Dominant Strategy
  • Nash Equilibrium
  • Prisoners’ Dilemma
• Revenue/Profit in duopoly example: $TR = P \times Q$, $\text{Profit} = TR - TC$ with $TC=0$.
• Output Effect vs Price Effect: decision margin for each seller.

Ethical, Philosophical & Policy Implications

• Collusion benefits producers, harms consumers; antitrust aims to protect consumer surplus.
• Overuse of common resources and arms races illustrate broader social costs of strategic non-cooperation.
• Policymakers must balance deterrence of genuine anticompetitive conduct against chilling legitimate business innovations.

Connections to Earlier Principles

• Reinforces Principle #7: Government can sometimes improve market outcomes (through antitrust).
• Links to comparative advantage and gains from trade: larger markets (via trade) mimic competitive outcomes.
• Demonstrates market failure forms: market power, common resources, public goods.

Practical Takeaways for Exam Prep

• Be able to construct and analyse payoff matrices; identify Nash equilibria.
• Compare outcomes across market structures quantitatively (P, Q, profit, welfare).
• Explain how changes in number of firms or repeated play influence strategic incentives.
• Discuss real-world policy instruments (Sherman, Clayton Acts) and evaluate contested business practices.
• Apply prisoners’ dilemma logic to diverse settings (environment, international relations, labour markets).