Chapter 14 - Oligopoly

Perfect competition and monopolies aren't strategy dependent but oligopolies and monopolist competition e.g. duopolies are.

There's limited entry in oligopolies.

There's no barriers to entry in perfect competition or monopolistic competition.

Perfect competition is the only market structure where firms are price takers, every other firm is a price setter.

Oligopoly is an industry dominated by a few large firms where each firm is concious of the behavior of its rival firms.

Pricing and output decisions involve strategic behavior. A change in output or pricing by a rival firm is viewed as an attempt to steal its market share.

Barriers to entry in an oligopoly are:

• Economies of scale ‒ Economies where large firms have lower average cost due to cost per unit decreasing as production increases.

• Control over raw materials

• Predatory pricing

• Large advertising budgets

• Eliminating competition via predatory pricing or M&A (i.e. buying you out)

Because of strategic interdependence, in an oligopoly, each company's action influences what other companies want to do.

A nash equilibrium occurs once firms know what the others are doing and therefore no firm wants to change their strategy e.g. profit maximizing output.

Nash equilibrium is where the market clears when no company wants to change its behavior once it knows what other companies are doing (its like simultaneous equilibrium).

In order to determine if an industry is an oligopoly it is necessary to measure the degree to which it is controlled by the largest firms.

There's 2 different ways to measure industry concentration to verify if its an oligopoly: Concentration ratios and HHI.

Concetration ratios (4 and 8 firm ratios) ‒ Percent of industry output produced by the 4 or 8 largest firms.

Herfindahl-Hirschman Index (HHI) is used to measure industry concentration and is calculated by adding the squared market share of each of the largest 50 firms.

• Boundaries of HHI:

  • If HHI < 1500 ‒ Competitive

  • If 1500 < HHI < 2500 ‒ Moderately concentrated

  • If HHI > 2500 ‒ Highly concentrated

Marginal is always the derviative of the total, e.g. MC is the derivative of TC.

Cartel is an oligopoly model where firms in an industry coordinate their pricing and output decision to act as a monopoly. In other words, firms work together to get the prices and output that they want. (This is illegal)

Cournot competition is a duopoly model where firms two firms produce identical goods, compete by choosing quantity rather than price and individual firms sell at market price and choose quantity simultaneously.

In cournot competition, the firms decide on their output and the market demand curve determines the price.

A reaction function shows each firms profit maximizing output as it depends on its rivals output.

In cournot competition, as long as both firms have the same marginal cost (MC), then their reaction functions are the same but you solve for the corresponding firm's profit maximizing output.

Monopolies holds more output which results in a higher price.

Cournot Competition ‒ Duopoly model

• Assumptions:

  • Firms produce identical goods

  • Firms compete by choosing quantity rather than price

  • Individual firms sell at the market price and choose quantity simultaneously.

Overall, the more competition, the higher the output and the lower the price:

, here is the reaction function for example 2 above where M = monopoly, D = duopoly, PC = perfect competition.

In general, monopolies increase price while decreasing output. Perfect competition have high quantity and lower prices. Cournot competition is between monopolies and perfect competition with it comes to price and output.

Nash equilibrium: Each firm is doing the best they can given what their competitor is doing.

In any conflict situation there are decision makers (players), rules of the game, and payoffs.

A zero-sum game is where one person's gain is at another person's expense. The amount you win is the same amount the opponent loses.

There are 3 categories of games:

• Simultaneous games, e.g. Cournot competition) where both players choose their actions at the same time.

• Repeated games where the players play the same game over and over.

• Sequential games where one player moves first then the other player moves

Advanced Games

• Assymetric information: where both players don't have access to the same information.

• Cooperative games: where there's contracts or binding commitments.

Prisoner's Dilemma ‒ A sitution where individual decision makers have an incentive to choose in a way that creates a less than optimal outcome.

The behavior of the members of a cartel can be considered a prisoner's dilemma.

There are games where a player doesn't have a dominant strategy but the outcome is predictable.