Oligopolies & Game Theory

Oligopolies

Key Concepts

• Oligopoly: A market structure dominated by a few large firms, leading to interdependent decision-making

  • airlines

• Duopoly: A specific type of oligopoly with only two firms

  • ex: coke/pepsi, boeing/airbus

• Collusion: An agreement among firms to limit competition, often by setting prices or output levels

• Cartel: A formal organization of firms that collude to act as a monopoly

Characteristics of Oligopolies

• Interdependence: Firms must consider the potential reactions of rivals when making decisions

• High barriers prevent new firms from entering the market easily

• Non-Price Competition: Firms often compete through advertising and product differentiation rather than price

Collusion and Cartels

• Purpose: To maximize joint profits by reducing competition

• Collusion and cartels are illegal in many countries due to their anti-competitive nature

• Cartels are inherently unstable as members have incentives to cheat for individual gain

• An example of a cartel is OPEC

Nash Equilibrium

Key Concepts

• Prisoners' Dilemma: A game theory scenario where two individuals can either cooperate or betray each other. The optimal collective outcome is achieved if both cooperate, but individual incentives often lead to mutual betrayal

• Nash Equilibrium: A situation where no player can benefit by changing their strategy while the other players keep theirs unchanged. In the context of the Prisoners' Dilemma, mutual betrayal is a Nash Equilibrium

• Dominant Strategy: A strategy that is the best for a player, regardless of the strategies chosen by other players

Application in Oligopolies

• Game Theory: Used to model strategic interactions in oligopolies, where firms must consider the potential reactions of competitors when making decisions

• Collusion and Cartels: Firms may attempt to cooperate to maximize joint profits, but the temptation to cheat for individual gain can lead to a breakdown in cooperation

Cartels

Main Points

• Incentive to Cheat: Firms in a cartel secretly lower prices or increase production to increase their individual market share and profits. While the cartel aims to reduce competition and increase prices collectively, cheating allows a firm to capture more customers by offering a better deal than the agreed price

• Short-Term Gain: Cheating provides immediate benefits to the firm that lowers prices or increases output, since they can sell more products at a higher profit than they would if they followed the cartel's agreement

• Long-Term Problems: While cheating is profitable in the short term, it can destabilize the cartel. If all firms cheat, the cartel’s agreed prices and output levels collapse, causing market prices to drop and profits to shrink for everyone

• Instability of Cartels: Cartels are inherently unstable because of the temptation for individual firms to cheat. This temptation can eventually break down the cartel, leading to a price war or market inefficiencies

Why It's a Problem

• Mutual Betrayal: The cheating by one firm can lead others to follow suit, reducing overall profits for everyone

• Lack of Enforcement: Since collusion is illegal in most places, cartels are difficult to enforce, and firms may not trust each other to keep the agreement