Oligopoly and Strategic Behavior

Definition: Oligopoly is a market structure characterized by a small number of firms that have significant market power and are interdependent in their pricing and output decisions.
Key Characteristics:
- Few large producers dominate the market.
- Can be homogeneous (similar products) or differentiated (products with distinct qualities).
- Limited control over pricing due to mutual interdependence of firms.
- Barriers to entry and potential for mergers are common.

Four-Firm Concentration Ratio: An industry is classified as an oligopoly if the four largest firms hold 40% or more of the market share.
Limitations: Includes localized markets, competition across different industries, and import competition.

Herfindahl Index: A measure of market concentration calculated by summing the squares of the market shares of all firms in the industry. Higher values indicate less competition.

Collusion: Firms may coordinate their strategies to increase profits, which is often illegal as it reduces competition.
Prisoner’s Dilemma: A situation in which individual decision-making leads to suboptimal outcomes for all parties involved. Each firm may be tempted to lower prices for individual gain, but this can lead to mutual loss.
Payoff Matrix: Used to visualize the potential profits depending on various strategies (e.g., pricing strategies of two firms such as RareAir and Uptown).

Kinked-Demand Curve: Suggests that firms in an oligopoly will match price decreases by competitors but not price increases, leading to a kink in the demand curve. This results in price rigidity.
Collusive Pricing: Firms may agree on prices to avoid competition.
Price Leadership: A dominant firm may set prices that other firms follow, effectively leading the market.

Overt Collusion: Formal agreements among firms to set prices; illegal in the US (e.g., OPEC).
Obstacles to Collusion:
- Demand and cost differences among firms.
- Potential cheating by participants.
- Economic downturns and new entrants can disrupt collusion efforts.

Role of Advertising: Oligopolies invest in advertising as it creates product differentiation which is harder to replicate than pricing strategies.
Positive Effects:
- Provides information to consumers.
- Enhances competition and speeds up tech advancements.
Negative Effects:
- Can be manipulative and lead consumers to higher costs for advertised products vs. unadvertised alternatives.

Efficiency Issues: Oligopolies tend to be productively and allocatively inefficient. They often set prices higher than marginal costs ($P > MC$) leading to deadweight loss in consumer surplus.