Study Notes on Oligopoly

Chapter 15: Oligopoly

Key Topics

• Define and identify oligopoly

• Use game theory to explain how price and output are determined in oligopoly

• Use game theory to explain other strategic decisions

• Describe the antitrust laws that regulate oligopoly

Definition and Characteristics of Oligopoly

• Oligopoly: A market structure characterized by

  • Natural or legal barriers preventing the entry of new firms

  • A small number of firms competing

• Examples:

  • Car manufacturers (e.g. Ford, GM, Toyota)

  • Airplane manufacturers (e.g. Boeing, Airbus)

Barriers to Entry

• Natural Barriers: Such as economies of scale that make it difficult for new firms to enter

• Legal Barriers: Government regulations and restrictions can create an oligopoly

• Natural Duopoly: A market with only two firms competing

  • A legal oligopoly can occur even where the demand and costs could support a larger number of firms

Interdependence of Firms

• Small Number of Firms: Firms are interdependent, meaning each firm's profit depends on the actions of the other firms in the market.

• Temptation to Cooperate:

  • Firms face the temptation to form a cartel, which is a group of firms that collude to limit output, raise prices, and increase profits.

  • Cartels are illegal under antitrust laws.

Game Theory in Oligopoly

• Game Theory: A tool for studying strategic behavior, which considers the expected behavior of other firms and the mutual recognition of interdependence

• Common Features of Games:

  • Rules: Define the setting and possible actions

  • Strategies: Possible actions of players

  • Payoffs: Outcomes associated with different actions

  • Outcome: The final result of the strategic interactions

The Prisoners’ Dilemma

• Scenario:

  • Two prisoners, Art and Bob, are caught committing a petty crime.

• Rules of the Game:

  • They cannot communicate and are offered deals to confess or deny involvement in a more serious crime.

• Payoff Structure:

  • If one confesses while the other denies, the confessor gets 1 year, and the denier gets 10 years.

  • If both confess, each serves 3 years.

  • If neither confesses, both serve 2 years for a minor crime.

Strategies

• Possible Actions for Each Player:

  1. Confess

  2. Deny

• Outcomes: There are four possible outcomes based on their choices:

  1. Both confess

  2. Both deny

  3. Art confesses, Bob denies

  4. Bob confesses, Art denies

Payoff Matrix

• Payoff matrix: A table summarizing the payoffs for every combination of actions taken by the players.

  • Here is the payoff matrix for the prisoners' dilemma:
    | | Confess | Deny |
    |---------------|---------|-------|
    | Confess | 3 years | 1 year|
    | Deny | 10 years| 2 years|

Finding the Nash Equilibrium

• Rational Choice: Each player seeks the action that maximizes their payoff based on the other player's choice.

• Nash Equilibrium: An equilibrium reached when both players make their best decision given the other's choice, leading to a situation where neither has the incentive to deviate.

Dilemma and Equilibrium

• Dilemma Example: Each prisoner contemplates that while it’s best if both deny, the incentive to confess still exists.

• Bad Outcome: The Nash Equilibrium leads both prisoners to confess, resulting in the worst joint outcome of 3 years each, instead of a better outcome where both deny (2 years each).

Oligopoly Price-Fixing Game

• Duopoly: A market consisting of two producers

• Collusion:

  • If Trick and Gear (two firms) agree to restrict output, raise prices, and increase profits, they operate under a cartel-forming collusion.

• Strategies:

  • Comply or cheat

• Payoff Matrix:

  • If both comply, each makes $2 million; if both cheat, they make nothing.

  • Trick incurs a loss of $1 million if Gear cheats, while Gear makes a profit of $4.5 million, and vice versa for Trick cheating.

Nash Equilibrium in Duopolists’ Dilemma

• The Nash equilibrium occurs when both firms decide to cheat, leading to a competitive market outcome (zero economic profit).

Other Oligopoly Games

• Advertising and R&D Games: These are variations of the prisoners’ dilemma. For example, the R&D competition in tissue manufacturing led to innovations driven by mutual interdependence.

R&D Payoff Matrix Example

• Payoff matrix shows the potential outcomes for both Kimberly-Clark and P&G based on their strategies regarding R&D investments, leading to profits or losses.

Equilibrium of R&D Game

• The outcomes depend heavily on the strategic choices made by both companies, significantly impacting their profitability.

Repeated Duopoly Games

• Repetition enables firms to establish cooperative equilibria that can lead to monopoly-like profits through structured strategic interactions.

• Punishment Strategies:

  • Tit-for-Tat Strategy: Cooperate if the rival cooperated previously; cheat if they cheated.

  • Trigger Strategy: Cooperation is maintained until one player cheats, after which the Nash equilibrium strategy is used indefinitely.

Antitrust Laws

• Purpose: Antitrust law regulates oligopolies and prevents them from becoming monopolies or behaving like monopolies.

• Key Laws:

  • The Sherman Act (1890): Outlaws combinations or conspiracies that restrict interstate trade and attempts to monopolize.

  • The Clayton Act (1914): Created the Federal Trade Commission and made certain business practices illegal, such as price discrimination and interlocking directorates if they lessen competition significantly.

Price Fixing

• Definition: Price fixing is always illegal; the Justice Department can prosecute firms without a defense if price fixing is proven.

Controversial Antitrust Practices

• Resale Price Maintenance: Agreements regarding the resale price can promote efficient retail service, but can also lead to monopoly pricing.

• Tying Arrangements: Agreements that tie purchasing one product to buying another can facilitate profit maximization through price discrimination.

• Predatory Pricing: Setting low prices to eliminate competition with the intent of raising them later; regarded as unlikely and difficult to prove legally.

Mergers and Acquisitions

• FTC Guidelines: The Federal Trade Commission assesses mergers using the Herfindahl-Hirschman Index (HHI):

  • If the original HHI is between 1,500 and 2,500, mergers raising it by 100 or more are challenged.

  • If the HHI exceeds 2,500, mergers increasing it by 200 or more are typically blocked.