Oligopoly

Oligopoly is an important form of imperfect competition. Oligopoly is said to prevail when there are few firms or sellers in the market, producing or selling a product. In other words, where there are four or five firms producing and selling a product oligopoly comes into existence. Oligopoly is defined as competition among the few.

Meaning

Few sellers Inter-dependence Uncertainty High cross elasticities Element of monopoly Constant struggle Rigid or sticky price Kinked demand curve

Features

Kinked demand curve

Oligipoly

Cartels and Collusion

Overt and Covert Agreements Cartels operate under formal agreements. Powerful cartels function as a monopoly. Collusion exists when firms reach secret, covert agreements. Enforcement Problem Cartels are typically rather short-lived because coordination problems often lead to cheating. Cartel subversion can be extremely profitable. Detecting the source of secret price concessions can be extremely difficult.

 A formal(explicit) agreement among firms A formal organization of producers who agree to coordinate prices and production.

CARTEL

Price fixing Total industry output Market shares Allocation of customers Allocation of territories Bid rigging Division of profits

CARTEL MEMBERS AGREE ON

Increase individual members profit by reducing competition

Firm B normal Firm B advertising aggressive advertising earns $50 profit A: $0 profit Firm B: $80 profit A: $80 profit earns $15 profit Firm B: $0 profit

Firm A normal advertising Firm A aggressive advertising

18.4%

13.2%

12.4%

16.4%

12.7%

10.5%

6 movie studios receive 90% of American film revenues U.S./Canada market share(2008)

3 leading food processing companies

Game Theoryby an economist, Oskar Morgenstern, and a Game theory was developed
mathematician, John von Neumann, in the 1950s. The outcome of incomes for the players in the game theory is represented in a pay-off matrix. The various strategies which the players can adopt are: the dominant strategy, the Nash equilibrium strategy, and the maxi-min strategy. These provide an insight into the significance of game theory in guiding the business behavior. In a market situation of imperfect competition, specifically when oligopoly prevails, each firm operating in the market can influence the prices of goods even when the goods are homogeneous. Managers of firms need to make business decisions while considering the moves by other competing firms in the market. Analyzing the competitor's moves and making decisions to maximize profits for the firm is facilitated by the use of game theory. A 'game' is a situation in which the decisions of one player are interdependent on the decisions of other rival players. Game theory is a technique which helps in evaluating a situation when different individuals or organizations differ in their objectives.

 To understand the basic concepts of game theory, let us analyze a duopoly price war. Duopoly is a market where only two players supply products to the same market. In an industry where two firms, X and Y, are operating, there are four different outcomes based on the strategies adopted by each firm. There is a possibility for each firm to operate at normal prices or to cut prices in order to gain the market share. The four possible combinations of strategies are that both firm X and firm Y operate at normal prices, firm X cuts the price but firm Y maintains normal price, firm X maintains normal price and firm Y cuts the price, and both the firms cuts the prices.

Pay-off Matrix

Firm X Normal Price Competition Price

Firm Y

Norma Price

P (100, 100)

Q (-500, 100)

Pay off Matrix

Competition Price

R (-100, -500) S (-300, -300)

 As per the pay-off matrix given here, both firms have profits as in cell P when they operate at normal prices, both firms get losses as in cell S if both decreases the prices, and there is difference in the payoffs as represented in the cells Q and R when only one of the firms cuts the price and the other operates at normal price.

Pay off Matrix

Dominant Strategy
The dominant strategy is the strategy, which is profitable for one of the players, irrespective of the strategy adopted by the other player. For instance, from the pay-off matrix represented above (previous table), when the firm X operates with normal price, it gets Rs.100 if firm Y also operates with normal price. If firm X gets into price war and cuts the prices but firm Y maintains normal prices then the firm X will lose Rs. 500. This is because even if firm X gains market share due to price cut, it has to sell the products at a price lower than the cost of manufacturing. Conversely, if firm Y cuts the prices, but firm X maintains normal prices then the loss for firm X is Rs. 100. And if firm X enters the price war along with the firm Y, then the loss is Rs. 300 for firm X. Thus, firm X and firm Y also experience greater losses when they cut the price but the other firm operates at normal price. Hence, each firm can benefit by operating at normal price. Therefore, the dominant strategy for each firm is to operate at normal price irrespective of the type of price strategy followed by the other firm.

Nash equilibrium
Nash equilibrium was named after John Nash, a mathematician, who contributed to the game theory and also won the Nobel Prize in economics. In the real world, the applicability of dominant strategy is limited. When there is no dominant strategy applicable, each of the firms considers operating at normal prices or increases the prices and tries to earn monopoly profits. In fact, profit-maximizing equilibrium is where the marginal revenue of a firm equals marginal cost.

Firm X

Normal Price
Firm Y

Price Increase

Norma Price

P (Rs. 100, Rs. 100)

Q(-Rs.150, Rs. 400)

Nash-Equilibrium

Price Increas R (Rs. 400, -Rs. 250) S (Rs. 700, Rs. 300) e

 As represented in the table , both the firms X and Y will get a pay-off of Rs. 100 if both operate at normal prices. If firm X increases the price while firm Y maintains normal price, firm X will have a loss of Rs.150 while the firm Y gets Rs. 400 due to increased market share. And if firm X operates at normal price when firm Y raises the price, the firm X gets Rs. 400 while firm Y loses Rs. 250. If both the firms increase prices then the firms X and Y get Rs. 700 and Rs. 300 respectively. Here, firm X has a dominant strategy but firm Y does not have a dominant strategy. Firm X can earn profits by adopting the dominant strategy of operating at normal prices, irrespective of what firm Y does. But as firm Y does not have a dominant strategy, it would like to operate at normal price when firm X operates at normal price, and increase the price when firm X increases the price. Here, there is a dilemma for firm Y whether to maintain normal prices or to raise prices with a hope that the rival firm will also raise prices. In this case, the solution is the Nash equilibrium.

 The developers of game theory further suggested that if the players are risk averse, they will try to maximize the minimum possible benefit from the game. With maxi-min strategy, each player tries to get the maximum profit in the worst possible outcome at whatever strategy adopted by the other competing players.

Maxi-min strategy

Prisoners Dilemma
The example of the prisoners dilemma explains the prominence of game theory in strategic behavior. Consider an instance where two prisoners who have allegedly committed a crime are arrested by the police. Both of them are interrogated separately. They are told that if he/she does not confess and if the other person confesses then a sentence of 14 years will be given to him/her. On the other hand, if both confess a sentence of 5 years will be given to both. However, if neither of the prisoners confess then they would be set free as there is no strong evidence. In this situation, each prisoner is in a dilemma about the strategy to be adopted. As the prisoners are interrogated separately, they are not sure about the idea of the other prisoner. If the prisoners want to avoid risk, they would adopt the mini-max strategy to minimize the maximum jail sentence. However, the outcome here is not certain as the move of the other person is not known.