Characteristics of oligopoly markets

Oligopoly is a market structure where a small number of firms dominate the industry. These firms act interdependently, meaning each one considers how its actions will affect and be affected by the others. This setup often leads to unique behaviors compared to more competitive markets.

Key features of oligopoly

• Few firms - Only a small number of sellers control most of the market, unlike the many sellers in perfect competition.
• High barriers to entry - Obstacles like large startup costs, patents, or control over key resources make it difficult for new firms to enter, protecting existing firms.
• Interdependence - Firms must anticipate rivals' reactions to their decisions on prices, output, or advertising, which can lead to strategic behavior.
• Inefficiency - Oligopolies tend to produce less output at higher prices than perfectly competitive markets, resulting in allocative inefficiency where resources are not used in the way that best satisfies consumer wants.

Because of these traits, oligopolistic firms often have market power to influence prices, but their interdependence creates challenges in maximizing profits.

Incentives for collusion in oligopoly

In oligopoly, firms have strong reasons to work together rather than compete aggressively. This cooperation can help them achieve outcomes closer to those of a monopoly, where a single firm controls the market.

Reasons for collusion

• Forming cartels - A cartel is a group of firms that agree to act as a single entity to control prices and output, often by setting quotas or fixing prices to boost collective profits.
• Incentive to collude - By coordinating, firms can avoid price wars that erode profits; instead, they aim for higher prices and lower quantities, similar to a monopoly.
• Challenges in maintaining collusion - Agreements can break down if one firm cheats for short-term gains, leading to instability; legal restrictions also prevent overt collusion in many countries.

This tension between cooperation and competition is often analyzed using game theory, which models strategic interactions.

Introduction to game theory concepts

Game theory is a tool used to study situations where decision-makers interact strategically. It helps explain behaviors in oligopolies by showing how firms' choices depend on what they expect others to do.

Basic elements of a game

• Game - A situation where individuals (called players) take actions, and each player's payoff (benefit or outcome) depends on both their own choice and the choices of others.
• Strategy - A complete plan of actions that a player will take in response to possible scenarios in the game.
• Normal form model - A way to represent a game using a table (also called a payoff matrix) that shows the payoffs for each combination of strategies chosen by the players.

These concepts apply to oligopolies because firms act like players in a game, where decisions on pricing or output affect everyone's profits.

Example of a payoff matrix

Consider a simple game between two firms (Firm A and Firm B) deciding whether to set a high price or a low price. The table below shows their profits (in millions of dollars) based on each combination.

In this matrix, the first number in each cell is Firm A's payoff, and the second is Firm B's. This setup illustrates how interdependent choices lead to different outcomes.

Dominant strategies and Nash equilibrium

Once the basic game is set up, players evaluate their options to find the best approach. Two key ideas help predict outcomes in these strategic situations.

Dominant strategy

A dominant strategy is a choice that gives a player a higher payoff no matter what the other player does. It is the best option regardless of others' actions.

• For example, in the payoff matrix above, if low pricing always yields better results for a firm independent of the rival's choice, then low pricing is dominant.
• Not all games have dominant strategies, but when they do, players are likely to choose them.

Nash equilibrium

A Nash equilibrium occurs when no player can improve their payoff by changing their strategy alone, assuming others keep their strategies the same. It represents a stable outcome where everyone is doing the best they can given others' choices.

• In the example matrix, if both firms choose low price (payoffs: A:5, B:5), this might be a Nash equilibrium if neither can gain by switching to high price unilaterally.
• This concept shows why cooperative outcomes can be hard to achieve without enforcement.

Note that games in this context are limited to two players with two actions each, as more complex setups are beyond basic analysis.

Application of game theory to oligopoly behavior

Game theory reveals why oligopolists often struggle to maintain cooperative outcomes, even when it would benefit them. This mirrors real-world challenges in achieving monopoly-like results.

The prisoner's dilemma in oligopoly

The Prisoner's Dilemma is a classic game where two players can either cooperate or defect, but individual incentives lead to defection, resulting in worse outcomes for both.

Connection to oligopoly:

• Firms face a similar dilemma: colluding (cooperating) could lead to higher profits for all, but each has an incentive to cheat (e.g., undercut prices) for personal gain.
• In oligopoly or duopoly (two-firm oligopoly), prices are generally higher and quantities lower than in perfect competition, but not as high as in monopoly due to the difficulty of sustaining collusion.
• Like in the Prisoner's Dilemma, lack of trust and the temptation to gain short-term advantages prevent firms from achieving the full monopoly outcome.

This explains why oligopolies are inefficient, with higher prices harming consumers but not reaching the extremes of monopoly power.

Worked example - Calculating incentive to alter a dominant strategy

Two firms in an oligopoly are deciding whether to advertise (costly action) or not. The payoff matrix shows profits in thousands of dollars, with advertising as the dominant strategy for both (leading to Nash equilibrium of both advertising, payoffs: A:20, B:20). Suppose Firm A wants to convince Firm B not to advertise by offering a side payment. Calculate the minimum incentive (side payment) Firm A must offer Firm B to alter its dominant strategy, assuming the matrix is as follows:

Step 1: Identify the dominant strategy

• For Firm B, advertising gives higher payoffs regardless of Firm A's choice (20 > 5 if A advertises; 40 > 30 if A does not).
• Thus, advertising is dominant for Firm B.

Step 2: Determine payoffs for alteration

• If Firm B switches to not advertise while Firm A advertises, payoffs become A:40, B:5.
• Firm B's payoff drops from 20 (both advertise) to 5, a loss of 15.

Step 3: Calculate the minimum incentive

• Firm B will only switch strategies if the side payment makes not advertising at least as profitable as advertising.
• Currently advertising gives B a payoff of 20. Not advertising gives B only 5.
• The minimum payment needed: 20 - 5 = 15 thousand dollars.
• With this payment, B earns 5 + 15 = 20 whether advertising or not, so B becomes indifferent between the two strategies.
• Minimum incentive = 15 thousand dollars.

Step 4: Interpretation

This payment alters Firm B's dominant strategy, potentially leading to a better outcome for Firm A (payoff 40 minus 15 = 25, better than 20), illustrating how side incentives can promote cooperation in oligopolies.