Oligopoly and Game Theory

ETP Economics 101

Imperfect Competition
Imperfect competition refers to those market

structures that fall between perfect competition and pure monopoly. Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers.

Types
Types of Imperfectly Competitive Markets
Oligopoly Only a few sellers, each offering a similar or identical product to the others. Monopolistic Competition Many firms selling products that are similar but not identical.

Number of Firms? Many firms Type of Products?

One firm

Few firms

Differentiated products

Identical products

Monopoly (Chapter 15)

Tap water Cable TV

Oligopoly (Chapter 16)

Tennis balls Crude oil

Monopolistic Competition (Chapter 17) Novels Movies

Perfect Competition (Chapter 14) Wheat Milk

Copyright 2004 South-Western

Key Feature
Because of the few sellers, the key feature

of oligopoly is the tension between cooperation and self-interest.

Characteristics
Characteristics of an Oligopoly Market
Few sellers offering similar or identical products
Interdependent firms Best off cooperating and acting like a

monopolist by producing a small quantity of output and charging a price above marginal cost

Simple Type: Duopoly

A duopoly is an oligopoly with only two

members. It is the simplest type of oligopoly.

Collusion and Cartel

The duopolists may agree on a monopoly

outcome.
Collusion An agreement among firms in a market about quantities to produce or prices to charge. Cartel A group of firms acting in unison.

Is Cartel Possible?
Although oligopolists would like to form

cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

The Equilibrium for an Oligopoly

A Nash equilibrium is a situation in which

economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

The equilibrium for an Oligopoly

When firms in an oligopoly individually choose

production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

Size of an Oligopoly
How increasing the number of sellers affects

the price and quantity:

The output effect: Because price is above

marginal cost, selling more at the going price raises profits. The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.

Size of an Oligopoly
As the number of sellers in an oligopoly

grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

Strategic Action
Because the number of firms in an

oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

Game Theory
Game theory is the study of how people

behave in strategic situations. Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

Prisoners Dilemma
The prisoners dilemma provides insight into the

difficulty in maintaining cooperation. Often people (firms) fail to cooperate with one another even when cooperation would make them better off. The prisoners dilemma is a particular game between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

Bonnie s Decision

Confess Bonnie gets 8 years

Remain Silent Bonnie gets 20 years

Confess Clydes Decision Remain Silent Clyde gets 8 years Bonnie goes free Clyde goes free Bonnie gets 1 year

Clyde gets 20 years

Clyde gets 1 year

Copyright2003 Southwestern/Thomson Learning

Dominant Strategy
The dominant strategy is the best strategy for a

player to follow regardless of the strategies chosen by the other players.

Dominant strategies in Prisoners dilemma:

_ Clyde: Confess _ Bonnie: Confess

Nash Equilibrium & Best Outcome

Nash Equilibrium (self-interest):

_ Clyde: Confess & Bonnie: Confess Best Outcome (cooperation): _ Clyde: Silent & Bonnie: Silent
Cooperation is difficult to maintain, because

cooperation is not in the best interest of the individual player.

Game Example: OPEC

Iraq and Iran: Members of OPEC

Their decisions on oil production.

Decisions: High Production or Low

Production

Iraqs Decision High Production Iraq gets $40 billion High Production Irans Decision Low Production Iran gets $30 billion Iran gets $50 billion Iran gets $40 billion Iraq gets $60 billion Iran gets $60 billion Iraq gets $50 billion Low Production Iraq gets $30 billion

Copyright2003 Southwestern/Thomson Learning

Nash Equilibrium
Dominant strategies:

_ Iran: High Production _ Iraq: High Production

Nash Equilibrium (self-interest):

_ Iran: High Production & Iraq: High Production

Best Outcome (cooperation):

_ Iran: low production & Iraq: low production

Game Example: Arm Race

Game Players: USA & Russia

Decisions: Arm or Disarm

Decision of the United States (U.S.)

Arm U.S. at risk Arm

Decision of the Soviet Union (USSR)

Disarm U.S. at risk and weak

USSR at risk

USSR safe and powerful

U.S. safe and powerful

U.S. safe

Disarm
USSR at risk and weak USSR safe

Copyright2003 Southwestern/Thomson Learning

Nash Equilibrium
Dominant strategies:

_ USA: Arm _ Russia: Arm

Nash Equilibrium (self-interest):

_ USA: Arm & Russia: Arm

Best Outcome (cooperation):

_ USA: Disarm & Russia: Disarm

Game Example: Advertising

Players: Camel & Marlboro Decisions: Advertise or Dont advertise

Marlboro s Decision

Advertise Marlboro gets $3 billion profit Advertise Camels Decision Dont Advertise Camel gets $3 billion profit Marlboro gets $5 billion profit Camel gets $2 billion profit

Dont Advertise Marlboro gets $2 billion profit Camel gets $5 billion profit Marlboro gets $4 billion profit Camel gets $4 billion profit

Copyright2003 Southwestern/Thomson Learning

Nash Equilibrium
Dominant strategies:

_ Camel: Advertise _ Marlboro: Advertise

Nash Equilibrium (self-interest):

_ Camel: Advertise _ Marlboro: Advertise

Best Outcome (cooperation):

_ Camel: Dont Advertise _ Marlboro: Dont Advertise

Game Example: Common Resource such as Oil

Players: Texaco & Exxon

Decisions: Drill Two Wells or Drill one Well

Exxon s Decision Drill Two Wells Exxon gets $4 million profit Texaco gets $4 million profit Exxon gets $6 million profit Drill One Well Exxon gets $3 million profit Texaco gets $6 million profit Exxon gets $5 million profit Texaco gets $5 million profit

Drill Two Wells Texacos Decision

Drill One Well

Texaco gets $3 million profit

Copyright2003 Southwestern/Thomson Learning

Nash Equilibrium
Dominant strategies:

_ Texaco: Drill Two Wells _ Exxon: Drill Two Wells

Nash Equilibrium (self-interest):

_Texaco: Drill Two Wells _ Exxon: Drill Two Wells

Best Outcome (cooperation):

_ Texaco: Drill One Well _ Exxon: Drill One Well

Game Example: Where to Advertise?

Players: Competitor.com or We.com

Decisions: NBA and NHL

Where to advertise?
Competitor.com NBA NBA We.com NHL W: 4, C: 3 W: 3, C: 4 NHL W: 3, C: 4 W: 4, C: 3

No Nash equilibrium in pure strategies

No Nash Equilibrium
Dominant strategies:

_ We.com: none _ Competitor.com: none

Nash Equilibrium (self-interest): _ We.com: none _ Competitor.com: none

Game Example: Evening News

Players: ATV and TVB

Decisions: 7:30 pm or 8:00 pm

Evening News:
TVB 7:30pm 7:30pm A: 1, ATV 8:0pm B: 1 A: 4, B: 3 8:0pm A: 3, B: 4 A: 2.5, B: 2.5

Nash Equilibrium
Dominant strategies:

_ ATV: none _ TVB: none

Two Nash Equilibria (self-interest): _ ATV: 7:30pm & TVB: 8:00pm or _ ATV: 8:00pm & TVB: 7:30pm

Why People Sometimes Cooperate

Firms that care about future profits will

cooperate in repeated games rather than cheating in a single game to achieve a onetime gain.