Oligopoly and Strategic Behavior

Introduction

This chapter explores the structure and behavior of oligopolistic markets, where a few large firms dominate. It covers the defining features of oligopoly, models of firm interaction, the role of game theory, and the implications for efficiency and consumer welfare.

Oligopoly: Definition and Characteristics

Key Features of Oligopoly

• Few Large Producers: Oligopoly is characterized by a small number of large firms that dominate the market.

• Homogeneous or Differentiated Products: Products may be identical (homogeneous oligopoly) or varied (differentiated oligopoly).

• Price Control: Firms have some control over price, but their decisions are interdependent.

• Mutual Interdependence: Each firm's actions affect the others, leading to strategic behavior.

• Barriers to Entry: High barriers, such as economies of scale or legal restrictions, prevent new firms from entering easily.

• Mergers: Firms may merge to increase market power.

Oligopolistic Industries

Measuring Market Concentration

• Concentration Ratio: The percentage of total industry output produced by the four largest firms. A ratio of 40% or more typically indicates oligopoly.

• Herfindahl-Hirschman Index (HHI): The sum of the squares of the market shares of the top 50 firms. Higher values indicate greater concentration.

Table: High-Concentration U.S. Manufacturing Industries

Source: U.S. Census of Manufacturers, 2012.

Oligopoly Behavior

Game Theory and the Prisoner's Dilemma

• Game Theory: The study of strategic interactions where the outcome for each participant depends on the actions of others.

• Prisoner's Dilemma: A scenario where two firms may not cooperate, even if it is in their best interest, due to incentives to cheat.

• Payoff Matrix: A table showing the payoffs for each firm based on their chosen strategies.

Table: Payoff Matrix for a Two-Firm Oligopoly

Example: If both firms set high prices, they each earn $12 million. If one cheats and lowers the price, it earns $15 million while the other earns $6 million. If both lower prices, they each earn $6 million.

Three Oligopoly Models

Overview of Models

• Kinked-Demand Curve Model: Explains price rigidity in oligopoly due to firms' expectations about rivals' reactions.

• Collusive Pricing Model: Firms cooperate to set prices and output, maximizing joint profits.

• Price Leadership Model: One firm sets the price, and others follow.

Kinked-Demand Theory

• Assumptions: Rivals will match price decreases but ignore price increases.

• Implication: Leads to a kinked demand curve and price inflexibility.

• Graphical Representation: The demand curve is more elastic for price increases and less elastic for price decreases.

Example: If a firm raises its price, others do not follow, causing a loss of market share. If it lowers its price, others match, leading to little gain in market share but lower profits for all.

Collusion and Cartels

Overt Collusion

• Definition: Firms explicitly agree to fix prices or output levels.

• Cartel: A formal agreement among firms (e.g., OPEC) to coordinate production and pricing.

• Legality: Collusion is illegal in the United States.

Table: OPEC Country Oil Production

Source: BP Statistical Review of World Energy, 2021.

Price Leadership Model

How Price Leadership Works

• Dominant Firm: One firm (the leader) sets the price for the industry.

• Follower Firms: Other firms accept the leader's price.

• Strategic Pricing: The leader may set prices to deter entry or start a price war.

Oligopoly and Advertising

Role of Advertising

• Nonprice Competition: Oligopolists often compete through product differentiation and advertising rather than price.

• Advantages: Advertising can provide information, promote competition, and support technological progress.

• Disadvantages: Advertising may be manipulative or misleading, leading to higher prices for consumers.

Table: Top Ten Brand Names

Source: Ad Age Marketing Fact Pack 2021.

Oligopoly and Efficiency

Efficiency Implications

• Productive Inefficiency: Price is greater than minimum average total cost ().

• Allocative Inefficiency: Price is greater than marginal cost ().

• Possible Offsets: International competition, price wars, and technological advances can improve efficiency.

Game Theory and Strategic Behavior

Types of Games

• One-Shot (One-Time) Game: Played once; equilibrium is a set of strategies from which neither firm wants to deviate.

• Repeated Game: Played multiple times; allows for strategies like cooperation and retaliation.

• Zero-Sum Game: One player's gain is another's loss.

• Nonzero-Sum Game: Both players can benefit or lose together.

• Dominant Strategy: A strategy that is best regardless of what the other player does.

Credible and Empty Threats

• Credible Threat: A believable threat that can enforce collusion or deter cheating.

• Empty Threat: A threat that is not believable and thus ineffective.

Examples of Repeated Games

• Airlines (Delta and American), soft drinks (Coca-Cola and Pepsi), aircraft manufacturing (Boeing and Airbus), and retail (Walmart and Target) often engage in repeated strategic interactions.

Conclusion

Oligopoly is a complex market structure characterized by interdependent decision-making, strategic behavior, and a mix of competition and cooperation. Understanding oligopoly requires tools from both microeconomic theory and game theory to analyze firm behavior and market outcomes.