Oligopolies and Game Theory

Oligopolies involve a few firms that carry similar brands and operate within similar price ranges.
Examples include Home Depot and Lowe's, which often locate across the street from each other to share the market.
In the fast-food industry, McDonald's competes with alternatives like Subway, offering similar price points.
Competition in oligopolies often manifests as battles over market share.

Oligopolies, like all firms, aim to maximize profit by attracting more customers and increasing sales.
In industries with many similar firms, pricing tends to be competitive, leading to efficient scale production.
With fewer firms, there's potential for collusion and tactics to sell at higher prices.
Oligopolies strategically consider rivals' actions in advertising and messaging to maintain market share; for instance, Lowe's watches Home Depot's strategies.
FedEx and UPS operate similarly, closely monitoring each other's actions.

Oligopoly behavior is modeled using game theory, where firms are mutually interdependent and react to competitors' moves.
Analogy with Scrabble: Players make strategic moves considering opponents' potential plays to maximize their score while minimizing opportunities for opponents.
Firms analyze competitors' actions to make informed decisions, demonstrating mutual interdependence.

Downward Sloping Demand Curve: Similar to monopolies and monopolistic competition, oligopolies face a downward-sloping demand curve, though not as steep as a monopoly.
Firms maximize profit where marginal revenue equals marginal cost, ensuring price exceeds average total cost.
Strategies are influenced by rivals' behavior, affecting advertising, merchandise display, and operating hours.

Significant entry barriers exist due to economies of scale in large businesses.
High financial costs, such as billions of dollars for inventory, personnel, and transportation, deter new entrants.
Established relationships with vendors also pose a hurdle.
Examples: Automobile and airplane manufacturing require substantial upfront costs due to advanced technology like robots.
Patents, copyrights, and trademarks create legal barriers, particularly in the pharmaceutical industry.
Pharmaceutical companies like Pfizer, Johnson & Johnson, and Smith Kline benefit from patent protection, granting them exclusive rights for 20 years.

Established firms use preemptive pricing and advertising to deter new entrants.
Example: Airlines highlight benefits like mileage programs, credit card rewards, hotel discounts, and premium services to maintain customer loyalty.
They emphasize features that low-cost carriers cannot match, such as comfortable seats, in-flight entertainment, and convenient connections.
Established firms can offer sales and discounts that new entrants cannot afford, squeezing out competition.

Market concentration measures, like the four-firm concentration ratio and the Herfindahl-Hirschman Index (HHI), assess market dominance.
The Herfindahl-Hirschman Index (HHI) is more revealing than the four-firm concentration ratio.
The HHI squares market shares to show concentration, with 10,000 indicating a monopoly and values around one indicating pure competition.
Oligopolies fall in the middle range of concentration.

Oligopolies sell differentiated or identical products, like cement or mulch.
Game theory explains strategic thinking and its impact on behavior.
Cooperation among firms maximizes profit, but the tendency to cheat undermines this.

Duopoly: An oligopoly with two firms (e.g., AT&T and Verizon).
In this example: a small community of 40 residents is served by those two companies.
The service offering is free phone with unlimited minutes.
Each firm's cost, they're they have no fixed cost, but their marginal cost is $10.
Competitive firms price services at marginal cost (10) and break even.
Monopolists maximize profit by setting prices above marginal cost.

Firms colluding to share the market are considered a cartel, setting production levels and prices.
Example: OPEC attempted this but failed due to cheating.
If AT&T and Verizon jointly produce 60 units at $40 each, they share $1,800 in profits (900 each).
Cheating: If AT&T increases output to 40 units, the market price drops to $35. AT&T's profit rises to $1,000, but if Verizon matches, both firms' profits fall to $800.
Consumers benefit from competition as prices decrease, but firms are better off cooperating.

Nash Equilibrium: Individuals select the best strategy based on others' strategies.
In the AT&T and Verizon example, the Nash equilibrium occurs at an output of 40 units each.
Any further production reduces total profit.

Oligopolies fall between monopolies and competitive firms.
Oligopolies sell more and charge less than monopolies but sell less and charge more than competitive firms.
Monopolists maximize revenue at $$40 and an output of 60, earning a profit of $1,800.
Competitive firms break even, with zero economic profit.

Firms consider lowering prices when expanding production if the price remains above average total cost.
The price effect and output effect influence decisions; if the price effect is greater than the output effect, expansion is not desirable.
Competition benefits consumers with product variety and lower prices, capping domestic companies' pricing power.

Dominant Strategy: A player's best strategy regardless of others' actions.
The prisoner's dilemma illustrates this concept.
Scenario: Bonnie and Clyde are offered deals; confessing results in a lighter sentence (8 years) than remaining silent if the partner confesses (20 years).
Confessing is the dominant strategy despite the potential for a better outcome if both remain silent.

Applying this to AT&T and Verizon, cheating may increase individual profit but reduces overall profit if both cheat.
Cooperation yields better outcomes but is undermined by mistrust.
Examples: Super Bowl ads, OPEC agreements, arms races, and negative campaign ads illustrate the dilemma.
Negative ads may be effective but lead to voter apathy.

Firms may shift from competition to cooperation, as seen in trade agreements.
Anti-competitive behavior, as outlined in the Sherman Antitrust and Clayton Antitrust Acts, can lead to action depending on the political climate.