Week 9 - Micro-Economics - Oligopoly

Oligopoly is one of the key types of market structures, along with perfect competition and monopoly.
Defined by imperfect competition when no single firm holds a monopoly but can influence market prices.
Characterized by a small number of producers, with each referred to as an oligopolist.

Economic measure: Herfindahl-Hirschman Index (HHI).
- Calculated as the sum of the squares of each firm's market share.
- Example: HHI calculation for three firms with market shares 60%, 25%, and 15%.
  - HHI = 60² + 25² + 15² = 4,450.
HHI guidelines:
- Below 1,000: strongly competitive market.
- 1,000 to 1,800: somewhat competitive market.
- Above 1,800: indicates oligopoly.
Mergers leading to significant increase in HHI are scrutinized and likely disallowed.

Simplest case: duopoly (two firms). Each firm recognizes the impact of production levels on price.
Oligopoly behavior:
- Similar to monopolists, with higher profits resulting from production limits.
- Possibility of collusion to maximize joint profits.
Collusion types: Cartels (formal agreements) are illegal due to monopolistic outcomes.
Individual incentives lead towards cheating rather than sticking to collusion agreements.

Firms choose between quantity competition (Cournot model) or price competition (Bertrand model).
Quantity competition: easier to maintain higher prices through limits on production.
Price competition: leads to prices driven down to marginal cost, resulting in perfect competition.
Importance of differentiation and collusion.

Example: Encyclopedia Britannica vs. Encarta under competitive pressures leading to massive price changes and strategy shifts.

Late 1990s conspiracy involving drug companies and the vitamin market.
Companies colluded on pricing and market division starting in 1989.
Consequences: They were found guilty, and firms like Rhone Poulenc deviated from agreements.</br>

Firms are interdependent in profit decisions.
Game theory studies behaviors in interdependence.
Payoff matrix illustrates impacts of firms’ decisions.
Prisoners’ Dilemma: situation where firms have incentives to cheat, leading to poorer outcomes for both.

1964: Heavy advertising by US tobacco companies; Surgeon General's warnings lead to liability fears.
1970: Agreement to carry warning labels, cease ads, and gain protection from lawsuits.

Post-1970: Advertising drops significantly, while profits rise, showcasing equilibrium dynamics.

Premises:
1. Players opt for self-benefiting actions.
2. Mutual choices lead to worse outcomes than cooperation.
Dominant strategies lead to detrimental equilibrium outcomes.

Without strong agreements, firms default to non-cooperative behaviors, explaining conduct in cartels or tacit collusion.

Tacit collusion is where firms subtly agree on strategies without explicit communication.

Demand curve characteristics:
- Oligopolists refrain from price increases due to anticipated loss of sales, while reacting hesitantly to slight production increases.
- The curve is flat above a certain price level, steep below.

Cartels can maximize profits, but face legal constraints from antitrust policies to prevent monopolistic behavior.
Successful tacit collusion occurs despite restrictions, influenced by numerous factors.

Government efforts exist to prevent abusive monopoly behaviors that could harm consumers.
Contestable markets may mitigate threats from firms with high market shares, e.g., AT&T example.

Price wars can result when collusion fails.
Companies differentiate products to limit competition.
Price leadership involves one firm setting prices, while others follow, resulting in non-price competition measures.