CHAPTER 12: Oligopoly and Strategic Behavior: Microeconomics Study Notes

Oligopoly and Strategic Behavior

Introduction to Oligopoly

An oligopoly is a market structure characterized by a small number of firms offering similar or identical products. The actions of any one seller can significantly impact the profits of other sellers, making firms in an oligopoly interdependent.

• Definition: Oligopoly is a market structure in which only a few sellers offer similar or identical products.

• Example: The U.S. tennis ball market is dominated by four brands: Wilson, Penn, Dunlop, and Spalding.

• Interdependence: Firms must consider the reactions of rivals when making decisions about pricing and output.

Barriers to Entry in Oligopoly

Oligopolies arise due to significant barriers to entry, which prevent new competitors from easily entering the market.

• Economies of Scale: Large firms can produce at lower average costs, creating a natural oligopoly.

• Licenses: Legal restrictions may limit the number of firms in the market.

• Substantial Investment in Advertising: High advertising costs can deter new entrants.

Types of Oligopoly

• Duopoly: An oligopoly with only two firms.

• Cartel: A group of firms that coordinate their pricing or output decisions to act collectively, often to maximize joint profits.

• Example: OPEC (Organization of Petroleum Exporting Countries) is a well-known cartel in the oil market.

Cartel Pricing versus Oligopolist Pricing

When firms in an oligopoly compete, prices and profits tend to fall, and industry output increases. In contrast, cartel members coordinate to restrict output and raise prices, increasing joint profits.

• Oligopolists' Preference: Firms would prefer to cooperate and act as a cartel to maximize profits.

• Challenge: Cooperation is difficult because each member has an incentive to cheat and increase their own profit.

Game Theory in Oligopoly

Game theory is used to analyze strategic interactions among firms in an oligopoly, especially regarding price fixing and output decisions.

• Game Tree: A diagram that shows possible strategies and outcomes for firms.

• Price Fixing Game: Firms must decide whether to cooperate (fix prices) or compete.

• Rule for Solving: Eliminate outcomes that require irrational behavior by firms.

• Dominant Strategy: An action that is the best choice for a firm, regardless of what rivals do.

Duopolist's Dilemma

The duopolist's dilemma occurs when both firms would be better off choosing a high price, but each chooses a low price due to incentives to cheat, resulting in lower profits for both.

• Guaranteed Price Matching: A strategy to avoid the dilemma by committing to match competitors' prices, discouraging price cuts.

Entry Deterrence by an Insecure Monopolist

Monopolists may attempt to deter entry by potential competitors using strategic pricing.

• Limit Pricing: The monopolist sets a price below the monopoly level to discourage entry by other firms.

• Game Tree Analysis: Shows that if the entrant's dominant strategy is to enter, the monopolist may respond by producing a smaller quantity.

Advertising as a Strategic Decision

Advertising decisions in oligopoly can be analyzed using game theory. Often, advertising is the dominant strategy for both firms, even though both would be better off if neither advertised.

• Dominant Strategy: Both firms choose to advertise.

• Dilemma: Mutual advertising leads to higher costs and lower profits than if both refrained from advertising.

Key Terms and Concepts

• Oligopoly: Few sellers, interdependent decisions.

• Duopoly: Two-firm oligopoly.

• Cartel: Cooperative group of firms.

• Dominant Strategy: Best action regardless of rivals' choices.

• Duopolist's Dilemma: Incentive to cheat leads to suboptimal outcomes.

• Limit Pricing: Strategic price setting to deter entry.

Relevant Equations

• Profit Maximization in Cartel:

$\max_{Q} \; \pi = (P(Q) - MC) \cdot Q$

• Limit Pricing Condition:

$P_{limit} < P_{monopoly}$

• Dominant Strategy Equilibrium (Game Theory):

$\text{Each firm's strategy maximizes its payoff, given the strategies of others}$

Summary Table: Oligopoly vs. Monopoly vs. Perfect Competition

Market Structure	Number of Firms	Product Type	Barriers to Entry	Price Control
Perfect Competition	Many	Identical	None	No
Monopoly	One	Unique	High	Yes
Oligopoly	Few	Similar/Identical	High	Some (interdependent)

Additional info: Game trees and payoff matrices are commonly used to analyze strategic behavior in oligopoly, but were not visually provided in the notes. The summary table was inferred for academic completeness.