oligopoly

OligopolyOligopoly

The challenge of analyzing The challenge of analyzing interdependent strategic decisionsinterdependent strategic decisions

ObjectivesObjectives

The learner will be able to:The learner will be able to:1.1. Define an oligopoly and identify the unique Define an oligopoly and identify the unique

characteristics of this market form.characteristics of this market form.2.2. Describe the various approaches that Describe the various approaches that

economists use to analyze the decisions and economists use to analyze the decisions and behavior of oligopolies.behavior of oligopolies.

3.3. Explain how game theory is used as a tool to Explain how game theory is used as a tool to understand and predict the strategic decisions understand and predict the strategic decisions of firms in an oligopolistic industry. of firms in an oligopolistic industry.

Oligopoly DefinedOligopoly Defined

““Oligopoly” comes from Greek roots meaning Oligopoly” comes from Greek roots meaning “few sellers.”“few sellers.”

An oligopoly is a market dominated by a few An 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 be at 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 major Oligopolistic industries account for a major share of economic activity (oil, autos, consumer share of economic activity (oil, autos, consumer products, metals and mining, airlines)products, metals and mining, airlines)

The Analytical ChallengeThe Analytical Challenge

Oligopolies pose a difficult analytical challenge Oligopolies 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 responses Must anticipate (or at least consider) the responses

of competitors to their actionsof competitors to their actions

The Analytical Challenge (Cont’d)The Analytical Challenge (Cont’d)

Put another way, the business choices faced by Put another way, the business choices faced by oligopolies (pricing, output, production capacity) oligopolies (pricing, output, production capacity) are are strategicstrategic decisions. decisions.

These strategic decisions are These strategic decisions are interdependentinterdependent, in , in that outcomes are based on the responses of that outcomes are based on the responses of other firms in the industry.other firms in the industry.

Actions and variables based on interdependent Actions and variables based on interdependent decisions are difficult to isolate and predict.decisions are difficult to isolate and predict.

A Theoretical Starting pointA Theoretical Starting point

In principle, the economic profits generated by In principle, the economic profits generated by an oligopoly should never be higher than a pure an oligopoly should never be higher than a pure monopoly – since a monopoly chooses the price monopoly – since a monopoly chooses the price that maximizes industry profits.that maximizes industry profits.

A brief review …A brief review …

Theoretical Starting Point (Cont’d)Theoretical Starting Point (Cont’d)

An oligopoly should also never earn less than An oligopoly should also never earn less than the zero economic profit of a perfectly the 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 a A quick refresher on pricing and returns in a perfectly competitive industry …perfectly competitive industry …

Somewhere Between the ExtremesSomewhere Between the Extremes

Common sense says that economic returns for Common sense says that economic returns for oligopolies should lie somewhere between the oligopolies should lie somewhere between the two theoretical extremes represented by perfect two 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 have Let’s look at a few ways that economists have

attempted to think through this analytical attempted to think through this analytical challenge.challenge.

Ignore the ComplicationsIgnore the Complications

One approach is to ignore the whole issue of One approach is to ignore the whole issue of interdependent decisions and assume that each interdependent decisions and assume that each firm in an oligopolistic industry will maximize firm in an oligopolistic industry will maximize their own returns without any regard for their their 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.

CartelsCartels

Another approach is to assume that firms in an Another approach is to assume that firms in an oligopolistic industry agree to coordinate their price and oligopolistic 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 they Cartels 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 an Cartels represent the worst of all worlds from an economic standpoint (monopoly pricing with none of economic standpoint (monopoly pricing with none of the efficiencies from scale).the efficiencies from scale).

Tacit CollusionTacit Collusion

Another way to think about the problem is to assume Another way to think about the problem is to assume that firms in an oligopolistic industry will find ways to that firms in an oligopolistic industry will find ways to signal their intentions indirectly, in order to maximize signal their intentions indirectly, in order to maximize their economic returns.their economic returns.

This can take the form of price leadership, which is This 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.

Sales Maximization ModelSales Maximization Model

Based on the theory that professional managers of Based on the theory that professional managers of large, public companies are paid to maximize the size of large, 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 a Economists know how to model behavior based on a known variable (sales maximization).known variable (sales maximization).

There is some correlation between manager There is some correlation between manager compensation and the size of firms.compensation and the size of firms.

Problem – Management teams that focus on sales to Problem – Management teams that focus on sales to the exclusion of profitability are eventually removed the exclusion of profitability are eventually removed and their companies are often acquired or taken private.and their companies are often acquired or taken private.

Back to the Analytical ProblemBack to the Analytical Problem

As you can probably tell, traditional As you can probably tell, traditional microeconomic theory does not have a very microeconomic theory does not have a very good (or easy) answer to the problem of good (or easy) answer to the problem of predicting oligopoly pricing and returns.predicting oligopoly pricing and returns.

Enter game theory… Enter game theory…

Game TheoryGame Theory

Deals with the issue of interdependence directly, Deals with the issue of interdependence directly, by assuming that firms in oligopolistic industries by 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 the Link between economics and game theory is the belief that human beings are rational in their belief that human beings are rational in their economic choices and always act to maximize economic choices and always act to maximize their rewards (seem like reasonable their rewards (seem like reasonable assumptions).assumptions).

Game Theory (Cont’d)Game Theory (Cont’d)

Game theory provides a way to analyze and Game 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 on Outcomes of the “game” depend not just on one player’s choices, but on the actions or one player’s choices, but on the actions or reactions of the other player(s) – which is the reactions of the other player(s) – which is the essence of the oligopoly analytical problem.essence of the oligopoly analytical problem.

The Prisoners’ DilemmaThe Prisoners’ Dilemma

10, 10 0, 20

20, 0 1, 1

Confess Don’t

Confess

Don’t

Prisoner A

Prisoner B


Provides a model to explain how people (or Provides a model to explain how people (or firms) in pursuit of their own self interest may firms) 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 the Think about the Prisoner’s Dilemma in the context of results that are meaningful (or context of results that are meaningful (or potentially painful) to you.potentially painful) to you.

Your grade in AP Economics is an example that Your grade in AP Economics is an example that comes to mind.comes to mind.

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


Games (or scenarios) that provide the Games (or scenarios) that provide the opportunity for repeated interactions add opportunity for repeated interactions add another element of complexity – the ability to another element of complexity – the ability to learn your opponent’s personality, anticipate learn 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 the This aspect of game theory mimics the continuous interactions of strong competitors in continuous interactions of strong competitors in a market.a market.

Review – Four Market FormsReview – Four Market Forms

Perfect competition and pure monopoly are the Perfect competition and pure monopoly are the theoretical bookends that frame our thinking theoretical 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…

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 and At long run equilibrium – excess capacity and inefficiency (intersection of D and AC above inefficiency (intersection of D and AC above minimum point on AC curve).minimum point on AC curve).

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 clear Traditional economic theory does not provide a clear way to analyze oligopoly pricing, but you should way 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 analyze Game theory provides a useful model to analyze business strategy and behavior in oligopolistic business strategy and behavior in oligopolistic industries.industries.