Chapter 17 – Oligopoly & Game Theory

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: 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.

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).

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).

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.

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{monopoly} < Q{oligopoly\,(Nash)} < Q{perfect} P{monopoly} > P{oligopoly\,(Nash)} > P{perfect}=MC

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.

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.

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 ↑.

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

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).

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.

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

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.
Predatory Pricing
- Cutting price below cost to drive rivals out; skeptics (economic theory) argue long-run unprofitability, courts struggle distinguishing from vigorous competition.
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.

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.

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

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.

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.

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.

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).