Oligopoly and game theory

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Oligopoly and game theory

  1. 1. Oligopoly
  2. 2. The Prevalence of OligopolyIn addition to perfect competition and monopoly,oligopoly and monopolistic competition are alsoimportant types of market structure. They are formsof imperfect competition.Oligopoly is a common market structure. It arisesfrom the same forces that lead to monopoly, exceptin weaker form. It is an industry with only a smallnumber of producers. A producer in such an industryis known as an oligopolist.When no one firm has a monopoly, but producersnonetheless realize that they can affect marketprices, an industry is characterized by imperfectcompetition.
  3. 3. Some Oligopolistic IndustriesEconomics in Action - To get a better picture ofmarket structure, economists often use the “four-firm concentration ratio” which asks what share ofindustry sales is accounted for by the top four firms.
  4. 4. Understanding OligopolySome of the key issues in oligopoly can beunderstood by looking at the simplest case, aduopoly.With only two firms in the industry, each wouldrealize that by producing more it would drive downthe market price. So each firm would, like amonopolist, realize that profits would be higher if itlimited its production.So how much will the two firms produce?
  5. 5. Understanding OligopolyOne possibility is that the two companies will engagein collusion— Sellers engage in collusion whenthey cooperate to raise each others’ profits.The strongest form of collusion is a cartel, anagreement by several producers that increases theircombined profits by telling each one how much toproduce.They may also engage in non-cooperativebehavior, ignoring the effects of their actions oneach others’ profits.
  6. 6. Understanding OligopolyBy acting as if they were a single monopolist,oligopolists can maximize their combined profits. Sothere is an incentive to form a cartel.However, each firm has an incentive to cheat—toproduce more than it is supposed to under the cartelagreement. So there are two principal outcomes:successful collusion or behaving non-cooperativelyby cheating.It is likely to be easier to achieve informal collusionwhen firms in an industry face capacity constraints.
  7. 7. Competing in Prices vs. Competing inQuantitiesFirms may decide to engage in quantity or pricecompetition:The basic insight of the quantity competition (or theCournot model) is that when firms are restricted inhow much they can produce, it is easier for them toavoid excessive competition and to “divvy up” themarket, thereby pricing above marginal cost and earningprofits. It is easier for them to achieve an outcome thatlooks like collusion without a formal agreement.
  8. 8. Competing in Prices vs. Competing inQuantitiesThe logic behind the price competition (or theBertrand model) is that when firms produce perfectsubstitutes and have sufficient capacity to satisfydemand when price is equal to marginal cost, then eachfirm will be compelled to engage in competition byundercutting its rival’s price until the price reachesmarginal cost—that is, perfect competition.
  9. 9. Game TheoryWhen the decisions of two or more firms significantlyaffect each others’ profits, they are in a situation ofinterdependence.The study of behavior in situations of interdependenceis known as game theory.
  10. 10. The Prisoners’ DilemmaThe Prisoners’ DilemmaThe reward received by a player in a game, such asthe profit earned by an oligopolist, is that player’spayoff.A payoff matrix shows how the payoff to each ofthe participants in a two player game depends on theactions of both. Such a matrix helps us analyzeinterdependence.
  11. 11. Two firms, ADM and Ajinomoto, must decide how much to produce. The profits of the two firms are interdependent: each firm’s profit depends not only on its own decision but also on the other’s decision. Each row represents an action by ADM, each column one by Ajinomoto. A Payoff MatrixBoth firms will be better off if they both choose the loweroutput; but it is in each firm’s individual interest to choosehigher output.
  12. 12. The Prisoners’ DilemmaEconomists use game theory to study firms’behavior when there is interdependence betweentheir payoffs. The game can be represented with apayoff matrix. Depending on the payoffs, a playermay or may not have a dominant strategy.When each firm has an incentive to cheat, but bothare worse off if both cheat, the situation is knownas a prisoners’ dilemma.
  13. 13. The Prisoners’ DilemmaThe game is based on two premises:(1) Each player has an incentive to choose anaction that benefits itself at the other player’sexpense.(2) When both players act in this way, both areworse off than if they had chosen different actions.
  14. 14. The Prisoners’ Dilemma Each of two prisoners, held in separate cells, is offered a deal by the police—a light sentence if she confesses and implicates her accomplice but her accomplice does not do the same, a heavy sentence if she does not confess but herIt is in the joint interest of both accomplice does, and soprisoners not to confess; it is in on.each one’s individual interest toconfess.
  15. 15. The Prisoners’ DilemmaAn action is a dominant strategy when it is aplayer’s best action regardless of the action taken bythe other player. Depending on the payoffs, a playermay or may not have a dominant strategy.A Nash equilibrium, also known as a non-cooperative equilibrium, is the result when eachplayer in a game chooses the action that maximizeshis or her payoff given the actions of other players,ignoring the effects of his or her action on the payoffsreceived by those other players.
  16. 16. Overcoming the Prisoners’ DilemmaRepeated Interaction and Tacit CollusionPlayers who don’t take their interdependence intoaccount arrive at a Nash, or non-cooperative,equilibrium. But if a game is played repeatedly,players may engage in strategic behavior, sacrificingshort-run profit to influence future behavior.In repeated prisoners’ dilemma games, tit for tat isoften a good strategy, leading to successful tacitcollusion.When firms limit production and raise prices in a waythat raises each others’ profits, even though theyhave not made any formal agreement, they areengaged in tacit collusion.
  17. 17. A strategy of “tit for tat” involves playing cooperatively at first, then following the other player’s move. This rewards good behavior and punishes bad behavior. If the other player cheats, playing “tit for tat” will lead to only a short-term loss in comparison to playing “always cheat.” But if the other player plays “tit for tat,” also playing “tit for How Repeated tat” leads to a long-term Interaction Can Support gain. CollusionSo, a firm that expects other firms to play “tit for tat” may wellchoose to do the same, leading to successful tacit collusion.
  18. 18. Oligopoly in PracticeThe Legal Framework-Oligopolies operate under legal restrictions in theform of antitrust policy. But many succeed inachieving tacit collusion.Tacit collusion is limited by a number of factors,includinglarge numbers of firms,complex pricing, andconflicts of interest among firms.
  19. 19. Oligopoly in PracticeWhen collusion breaks down, there is a price war.To limit competition, oligopolists often engage inproduct differentiation.When products are differentiated, it is sometimespossible for an industry to achieve tacit collusionthrough price leadership.Oligopolists often avoid competing directly onprice, engaging in non-price competition throughadvertising and other means instead.
  20. 20.  Some Oligopolistic Industries2. Which of the following industries is not an oligopoly? A) cigarettes B) breakfast cereals C) light bulbs D) restaurants 20
  21. 21.  Some Oligopolistic Industries2. Which of the following industries is not an oligopoly? A) cigarettes B) breakfast cereals C) light bulbs D) restaurants 21
  22. 22. TEST YOUR UNDERSTANDING4. In an oligopoly: A) there are a few sellers. B) there are some barriers to entry. C) firms recognize their interdependence. D) all of the above are true. 22
  23. 23. TEST YOUR UNDERSTANDING4. In an oligopoly: A) there are a few sellers. B) there are some barriers to entry. C) firms recognize their interdependence. D) all of the above are true. 23
  24. 24. TEST YOUR UNDERSTANDING5. Game theory is commonly used to explain behavior in oligopolies, because oligopolies are characterized by: A) large profits in the long run. B) either homogenous or heterogeneous products. C) interdependence. D) imperfect competition. 24
  25. 25. TEST YOUR UNDERSTANDING5. Game theory is commonly used to explain behavior in oligopolies, because oligopolies are characterized by: A) large profits in the long run. B) either homogenous or heterogeneous products. C) interdependence. D) imperfect competition. 25

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