Oligopoly and Strategic Behavior: Microeconomics Study Notes

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

Industry	Percentage of Output by Four Largest Firms	Herfindahl Index (Top 50 Firms)
Primary aluminum	100	ND
Refrigerators and freezers	93	ND
Bottled water	88	2,897
Gasoline pumps	86	3,561
Bar soaps	85	ND
Burial caskets	86	3,152
Printer toner cartridges	84	2,848
Alcohol distilleries	84	3,395
Turbines and generators	80	3,287
Motor vehicles	79	2,333
Primary copper	75	1,667

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

	RareAir High Price	RareAir Low Price
Uptown High Price	$12M, $12M	$6M, $15M
Uptown Low Price	$15M, $6M	$6M, $6M

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

Country	Barrels of Oil per Day
Saudi Arabia	11,039,000
Iraq	4,114,000
United Arab Emirates	3,657,000
Iran	3,084,000
Kuwait	2,686,000
Nigeria	1,798,000
Algeria	1,332,000
Libya	390,000
Republic of the Congo	307,000
Equatorial Guinea	161,000

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

Rank	Brand
1	Apple
2	Amazon
3	Microsoft
4	Google
5	Samsung
6	Coca-Cola
7	Toyota
8	Mercedes-Benz
9	McDonald's

Source: Ad Age Marketing Fact Pack 2021.

Oligopoly and Efficiency

Efficiency Implications

• Productive Inefficiency: Price is greater than minimum average total cost ($P > min ATC$).

• Allocative Inefficiency: Price is greater than marginal cost ($P > MC$).

• 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.