Oligopoly and Game Theory: Strategic Behavior in Microeconomics

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Oligopoly

Definition and Characteristics

An oligopoly is a market structure characterized by a small number of firms, each of which has significant market power. The actions of one firm directly affect the others, leading to strategic decision-making.

Few firms: The market is dominated by a small number of firms (often fewer than 10).
Products: Firms may offer identical or differentiated products.
Barriers to entry: High start-up costs, established customer bases, or other obstacles prevent new competitors from entering easily.
Strategic behavior: Firms must consider the actions and reactions of their rivals when making decisions.
Examples: Microsoft, Dell, Wal-Mart, major soft drink companies.

Examples of Oligopolies

Oligopolies are common in both retail trade and manufacturing industries. The concentration ratio measures the market share of the largest firms.

Retail Trade Industry	Four-Firm Concentration Ratio	Manufacturing Industry	Four-Firm Concentration Ratio
Home centers (Home Depot and Lowe's)	96%	Tobacco products (Philip Morris and R.J. Reynolds)	91%
Couriers and express delivery (FedEx and UPS)	91%	Aircraft (Boeing and Lockheed Martin)	90%
Hobby, toy, and game stores (Hobby Lobby and Michaels)	78%	Breakfast cereal (Kellogg's and General Mills)	82%
Department stores (Macy's and Walmart)	75%	Bottled water (Aquafina and Poland Spring)	72%
Passenger airlines (Southwest and American)	71%	Dog and cat food (Hill's and Nestle Purina)	68%
Electronics stores (Best Buy and Apple)	70%	Chocolate and confectionery (Mars and Hershey)	58%
Bookstores (Barnes & Noble and Books-A-Million)	69%	Automobile (General Motors and Ford)	58%
Movie theaters (AMC and Regal)	57%	Soft drinks (Coca-Cola and PepsiCo)	53%

Barriers to Entry

Barriers to entry help maintain oligopoly power by preventing new competitors from entering the market.

Economies of scale: Large firms can produce at lower average costs (), making it difficult for smaller entrants to compete.
Ownership of key inputs: Control over essential resources can block entry.
Government-imposed barriers:
- Patents and copyrights: Legal protection for inventions and creative works.
- Licensing requirements: Occupational licensing for professionals (doctors, dentists, lawyers, accountants) protects the public from incompetent practitioners.
- Barriers to international trade: Tariffs and quotas limit foreign competition.

Moral of the Story: All firms want to:

Charge a price above marginal cost ()
Earn positive economic profit ()
Barriers to entry are necessary to sustain these profits.

Game Theory & Oligopoly

Introduction to Game Theory

Game theory is the study of strategic decision-making, especially relevant in oligopolistic markets where firms' actions affect one another. Developed in the 1940s by John von Neumann, Oskar Morgenstern, and John Nash.

Strategic behavior: The behavior of a firm depends on the behavior of other firms.
Game theory: Provides tools to analyze such strategic interactions.

Elements of a Game

Rules: Define allowable actions.
Strategies/actions: Choices available to each player.
Payoffs: Outcomes associated with each strategy combination.

Business strategy refers to actions taken by a firm to achieve goals, such as maximizing profits.

Forms of Games

Strategic (normal) form: Players choose actions simultaneously. Represented by a payoff matrix.
Sequential (tree) form: Players move in sequence, with later players observing earlier actions. Represented by a decision tree.

Duopoly Game

Price Competition Example

Consider two firms (e.g., Wal-Mart and Target) competing on price for PlayStation 4 in a small city. Each can set a price of $600 or $400.

	Target $600	Target $400
Wal-Mart $600	$10,000, $10,000	$5,000, $15,000
Wal-Mart $400	$15,000, $5,000	$7,500, $7,500

Collusion: Firms may agree to charge the same price (e.g., $600), maximizing joint profits. However, collusion is illegal, though implicit price matching may occur.

Dominant Strategy

A dominant strategy is one that yields the best outcome for a player, regardless of the other player's actions.

If both firms choose $400, each earns $7,500.
If both collude at $600, each earns $10,000 (better outcome).
However, the incentive to undercut leads to the dominant strategy equilibrium at ($400, $400).

Dominant Strategy Equilibrium: Both firms play their dominant strategy, resulting in ($400, $400) and profits of ($7,500, $7,500).

Nash Equilibrium

A Nash equilibrium occurs when each player chooses the best strategy given the strategies of the others. No player has an incentive to deviate unilaterally.

In the duopoly game, ($400, $400) is the Nash equilibrium.

Advertising Game Example

	Pepsi NA	Pepsi A
Coca-Cola NA	$750M, $750M	$400M, $900M
Coca-Cola A	$900M, $400M	$500M, $500M

Dominant Strategy Equilibrium: Both advertise, earning $500M each. Nash Equilibrium: Both advertise, as this is optimal given the other's decision.

Cooperative vs. Noncooperative Equilibrium

Cooperative equilibrium: Players cooperate to increase mutual payoffs.
Noncooperative equilibrium: Players act in their own self-interest without cooperation.

Classic Games in Oligopoly

Prisoner's Dilemma

The prisoner's dilemma illustrates how pursuing dominant strategies can lead to worse outcomes for all players.

	Prisoner B Confess	Prisoner B Not Confess
Prisoner A Confess	-5, -5	0, -7
Prisoner A Not Confess	-7, 0	-1, -1

Both prisoners confess (dominant strategy), resulting in a worse outcome than if both remained silent.

Battle of the Sexes

This game models coordination problems where players prefer different outcomes but benefit from coordinating.

	Husband Ballet	Husband UFC Fight
Wife Ballet	7, 5	2, 2
Wife UFC Fight	0, 5	5, 7

OPEC Cartels Example

OPEC members coordinate output quotas to influence oil prices. Saudi Arabia is the largest supplier.

	Nigeria Low Output	Nigeria High Output
Saudi Arabia Low Output	$100M, $10M	$75M, $15M
Saudi Arabia High Output	$80M, $7M	$60M, $11M

Practice: Duopoly Game

Price Competition Example

Consider HP and Apple competing on price. Each can set a price of $1,200 or $1,000.

	Apple $1,200	Apple $1,000
HP $1,200	HP earns $10M, Apple earns $10M	HP earns $5M, Apple earns $15M
HP $1,000	HP earns $15M, Apple earns $5M	HP earns $7.5M, Apple earns $7.5M

Find the dominant strategy equilibrium: Both firms choose $1,000, earning $7.5M each.
Find the Nash equilibrium: ($1,000, $1,000) is the Nash equilibrium.

Key Terms and Concepts

Oligopoly: Market with few firms and strategic interdependence.
Strategic behavior: Firms consider rivals' actions in decision-making.
Game theory: Analysis of strategic interactions.
Dominant strategy: Best action regardless of rivals' choices.
Nash equilibrium: No player can improve their payoff by changing strategy unilaterally.
Collusion: Firms cooperate to maximize joint profits (often illegal).
Prisoner's dilemma: Dominant strategies lead to suboptimal outcomes.
Cooperative equilibrium: Players work together for mutual benefit.
Noncooperative equilibrium: Players act independently.

Formulas and Equations

Long-run average cost (LRAC):
Profit:
Marginal cost (MC):

Additional info: The notes have been expanded with academic context, definitions, and examples for clarity and completeness.