This document discusses oligopolies and how economists analyze them. It defines oligopolies as markets dominated by a few large sellers who can influence prices. Analyzing oligopolies is challenging because firms' decisions are interdependent. The document reviews various approaches economists use, including ignoring interdependence, assuming cartels or tacit collusion. It argues game theory provides the best model by treating firms as players in a strategic game responding to each other.

1. OligopolyOligopoly
The challenge of analyzingThe challenge of analyzing
interdependent strategic decisionsinterdependent strategic decisions

2. ObjectivesObjectives
The learner will be able to:The learner will be able to:
1.1. Define an oligopoly and identify the uniqueDefine an oligopoly and identify the unique
characteristics of this market form.characteristics of this market form.
2.2. Describe the various approaches thatDescribe the various approaches that
economists use to analyze the decisions andeconomists use to analyze the decisions and
behavior of oligopolies.behavior of oligopolies.
3.3. Explain how game theory is used as a tool toExplain how game theory is used as a tool to
understand and predict the strategic decisionsunderstand and predict the strategic decisions
of firms in an oligopolistic industry.of firms in an oligopolistic industry.

3. Oligopoly DefinedOligopoly Defined
 ““Oligopoly” comes from Greek roots meaningOligopoly” comes from Greek roots meaning
“few sellers.”“few sellers.”
 An oligopoly is a market dominated by a fewAn oligopoly is a market dominated by a few
sellers (somewhere between one and very many),sellers (somewhere between one and very many),
at least several of which are large enough to beat least several of which are large enough to be
able to influence the market price.able to influence the market price.
 Oligopolistic industries account for a majorOligopolistic industries account for a major
share of economic activity (oil, autos, consumershare of economic activity (oil, autos, consumer
products, metals and mining, airlines)products, metals and mining, airlines)

4. The Analytical ChallengeThe Analytical Challenge
 Oligopolies pose a difficult analytical challengeOligopolies pose a difficult analytical challenge
for economists.for economists.
 Why is it so difficult?Why is it so difficult?
 Firms in an oligopolistic industry:Firms in an oligopolistic industry:
 Choose prices and outputs for their productsChoose prices and outputs for their products
 Must anticipate (or at least consider) the responsesMust anticipate (or at least consider) the responses
of competitors to their actionsof competitors to their actions

5. The Analytical Challenge (Cont’d)The Analytical Challenge (Cont’d)
 Put another way, the business choices faced byPut another way, the business choices faced by
oligopolies (pricing, output, production capacity)oligopolies (pricing, output, production capacity)
areare strategicstrategic decisions.decisions.
 These strategic decisions areThese strategic decisions are interdependentinterdependent, in, in
that outcomes are based on the responses ofthat outcomes are based on the responses of
other firms in the industry.other firms in the industry.
 Actions and variables based on interdependentActions and variables based on interdependent
decisions are difficult to isolate and predict.decisions are difficult to isolate and predict.

6. A Theoretical Starting pointA Theoretical Starting point
 In principle, the economic profits generated byIn principle, the economic profits generated by
an oligopoly should never be higher than a purean oligopoly should never be higher than a pure
monopoly – since a monopoly chooses the pricemonopoly – since a monopoly chooses the price
that maximizes industry profits.that maximizes industry profits.
 A brief review …A brief review …

7. Theoretical Starting Point (Cont’d)Theoretical Starting Point (Cont’d)
 An oligopoly should also never earn less thanAn oligopoly should also never earn less than
the zero economic profit of a perfectlythe zero economic profit of a perfectly
competitive industry in long run equilibrium.competitive industry in long run equilibrium.
 A quick refresher on pricing and returns in aA quick refresher on pricing and returns in a
perfectly competitive industry …perfectly competitive industry …

8. Somewhere Between the ExtremesSomewhere Between the Extremes
 Common sense says that economic returns forCommon sense says that economic returns for
oligopolies should lie somewhere between theoligopolies should lie somewhere between the
two theoretical extremes represented by perfecttwo theoretical extremes represented by perfect
competition and pure monopoly.competition and pure monopoly.
 But where…But where…
 Let’s look at a few ways that economists haveLet’s look at a few ways that economists have
attempted to think through this analyticalattempted to think through this analytical
challenge.challenge.

9. Ignore the ComplicationsIgnore the Complications
 One approach is to ignore the whole issue ofOne approach is to ignore the whole issue of
interdependent decisions and assume that eachinterdependent decisions and assume that each
firm in an oligopolistic industry will maximizefirm in an oligopolistic industry will maximize
their own returns without any regard for theirtheir own returns without any regard for their
rivals’ actions.rivals’ actions.
 This would equate to a monopoly model.This would equate to a monopoly model.
 Good news – it’s simple.Good news – it’s simple.
 Bad news – it misses the whole point.Bad news – it misses the whole point.

10. CartelsCartels
 Another approach is to assume that firms in anAnother approach is to assume that firms in an
oligopolistic industry agree to coordinate their price andoligopolistic industry agree to coordinate their price and
output decisions, otherwise known as a cartel.output decisions, otherwise known as a cartel.
 Cartels do exist (does OPEC sound familiar?), but theyCartels do exist (does OPEC sound familiar?), but they
are usually difficult to form and hold together.are usually difficult to form and hold together.
 Cartels represent the worst of all worlds from anCartels represent the worst of all worlds from an
economic standpoint (monopoly pricing with none ofeconomic standpoint (monopoly pricing with none of
the efficiencies from scale).the efficiencies from scale).

11. Tacit CollusionTacit Collusion
 Another way to think about the problem is to assumeAnother way to think about the problem is to assume
that firms in an oligopolistic industry will find ways tothat firms in an oligopolistic industry will find ways to
signal their intentions indirectly, in order to maximizesignal their intentions indirectly, in order to maximize
their economic returns.their economic returns.
 This can take the form of price leadership, which isThis can take the form of price leadership, which is
exercised (and policed) by the industry leader.exercised (and policed) by the industry leader.
 Problems – Unequal distribution of industry profits;Problems – Unequal distribution of industry profits;
new entrants may rock the boat.new entrants may rock the boat.

12. Sales Maximization ModelSales Maximization Model
 Based on the theory that professional managers ofBased on the theory that professional managers of
large, public companies are paid to maximize the size oflarge, public companies are paid to maximize the size of
their firm, not its profitability.their firm, not its profitability.
 Economists know how to model behavior based on aEconomists know how to model behavior based on a
known variable (sales maximization).known variable (sales maximization).
 There is some correlation between managerThere is some correlation between manager
compensation and the size of firms.compensation and the size of firms.
 Problem – Management teams that focus on sales toProblem – Management teams that focus on sales to
the exclusion of profitability are eventually removedthe exclusion of profitability are eventually removed
and their companies are often acquired or taken private.and their companies are often acquired or taken private.

13. Back to the Analytical ProblemBack to the Analytical Problem
 As you can probably tell, traditionalAs you can probably tell, traditional
microeconomic theory does not have a verymicroeconomic theory does not have a very
good (or easy) answer to the problem ofgood (or easy) answer to the problem of
predicting oligopoly pricing and returns.predicting oligopoly pricing and returns.
 Enter game theory…Enter game theory…

14. Game TheoryGame Theory
 Deals with the issue of interdependence directly,Deals with the issue of interdependence directly,
by assuming that firms in oligopolistic industriesby assuming that firms in oligopolistic industries
act as competing players in a strategic game.act as competing players in a strategic game.
 Link between economics and game theory is theLink between economics and game theory is the
belief that human beings are rational in theirbelief that human beings are rational in their
economic choices and always act to maximizeeconomic choices and always act to maximize
their rewards (seem like reasonabletheir rewards (seem like reasonable
assumptions).assumptions).

15. Game Theory (Cont’d)Game Theory (Cont’d)
 Game theory provides a way to analyze andGame theory provides a way to analyze and
predict behavior when people interact directly,predict behavior when people interact directly,
rather than indirectly through the market.rather than indirectly through the market.
 Outcomes of the “game” depend not just onOutcomes of the “game” depend not just on
one player’s choices, but on the actions orone player’s choices, but on the actions or
reactions of the other player(s) – which is thereactions of the other player(s) – which is the
essence of the oligopoly analytical problem.essence of the oligopoly analytical problem.

16. The Prisoners’ DilemmaThe Prisoners’ Dilemma
10, 10 0, 20
20, 0 1, 1
Confess Don’t
Confess
Don’t
Prisoner A
Prisoner B

17. Game Theory (Cont’d)Game Theory (Cont’d)
 Provides a model to explain how people (orProvides a model to explain how people (or
firms) in pursuit of their own self interest mayfirms) in pursuit of their own self interest may
(and often do) act in a manner that leads to(and often do) act in a manner that leads to
them forgoing a more optimal result.them forgoing a more optimal result.
 Think about the Prisoner’s Dilemma in theThink about the Prisoner’s Dilemma in the
context of results that are meaningful (orcontext of results that are meaningful (or
potentially painful) to you.potentially painful) to you.
 Your grade in AP Economics is an example thatYour grade in AP Economics is an example that
comes to mind.comes to mind.

18. The Students’ DilemmaThe Students’ Dilemma
Help Study
Don’t
Help Study Don’t
Student A
Student B
B, B
A, F
F, A
C, C

19. Game Theory (Cont’d)Game Theory (Cont’d)
 Games (or scenarios) that provide theGames (or scenarios) that provide the
opportunity for repeated interactions addopportunity for repeated interactions add
another element of complexity – the ability toanother element of complexity – the ability to
learn your opponent’s personality, anticipatelearn your opponent’s personality, anticipate
their actions, and build trust (or mistrust).their actions, and build trust (or mistrust).
 This aspect of game theory mimics theThis aspect of game theory mimics the
continuous interactions of strong competitors incontinuous interactions of strong competitors in
a market.a market.

20. Review – Four Market FormsReview – Four Market Forms
 Perfect competition and pure monopoly are thePerfect competition and pure monopoly are the
theoretical bookends that frame our thinkingtheoretical bookends that frame our thinking
about the different forms of industry structure.about the different forms of industry structure.
 In between these theoretical extremes…In between these theoretical extremes…

21. Monopolistic CompetitionMonopolistic Competition
1.1. Differentiated productsDifferentiated products
2.2. Sloped demand curveSloped demand curve
3.3. Potential for excess returns in the short runPotential for excess returns in the short run
4.4. Zero economic profit at long run equilibriumZero economic profit at long run equilibrium
5.5. At long run equilibrium – excess capacity andAt long run equilibrium – excess capacity and
inefficiency (intersection of D and AC aboveinefficiency (intersection of D and AC above
minimum point on AC curve).minimum point on AC curve).

22. OligopolyOligopoly
1.1. Few large firms that can influence the marketFew large firms that can influence the market
2.2. Interdependent decisionsInterdependent decisions
3.3. Traditional economic theory does not provide a clearTraditional economic theory does not provide a clear
way to analyze oligopoly pricing, but you shouldway to analyze oligopoly pricing, but you should
understand cartels, tacit collusion (price leadership),understand cartels, tacit collusion (price leadership),
and the sales maximization concept.and the sales maximization concept.
4.4. Game theory provides a useful model to analyzeGame theory provides a useful model to analyze
business strategy and behavior in oligopolisticbusiness strategy and behavior in oligopolistic
industries.industries.