10.2 Oligopoly
2 min read•june 25, 2024
Oligopolies are markets dominated by a few big players. These firms have serious clout, able to sway prices and fend off new competitors. It's a delicate dance of competition and cooperation, with each company eyeing the others' moves.
The shows why oligopolies often end up competing instead of teaming up. Even though working together could mean bigger profits, the temptation to undercut rivals usually wins out. It's a classic case of short-term gain versus long-term pain.
Oligopoly
Small Number of Large Firms
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- is a market structure characterized by a small number of large firms each with significant to influence prices
- High (economies of scale, startup costs, patents) prevent new firms from entering and competing
- Firms are interdependent their actions affect the profits and strategies of other firms in the market
- Must consider potential reactions of competitors when making pricing, output, and other strategic decisions
- Products can be homogeneous identical across firms (steel, aluminum) or differentiated with unique features or branding (smartphones, automobiles)
Competition vs Collusion
- Oligopolists face a choice between competing independently to maximize their own profits or colluding to set prices and output to maximize joint profits
- Competition can lead to price wars and lower profits for all firms in the market
- can be explicit with formal agreements or tacit with informal understandings
- Explicit collusion (cartels) is often illegal under antitrust laws designed to promote competition
- analyzes the strategic choices of oligopolists considering the potential actions and reactions of competitors
- Outcomes depend on the specific assumptions and payoffs of the game being played
- Cartels are unstable because firms have an incentive to cheat on the agreement by secretly lowering prices or increasing output
- Enforcement mechanisms are required to prevent cheating and maintain stability
Prisoner's Dilemma
- Game theory model illustrating the tension between cooperation and self-interest
- Two suspects interrogated separately must choose to confess or remain silent
- Both remain silent light sentence (1 year)
- Both confess moderate sentence (5 years)
- One confesses, other silent confessor goes free, silent suspect heavy sentence (10 years)
- Dominant strategy for each suspect is to confess () even though both would be better off remaining silent
- Applied to oligopoly behavior firms face tension between competition (confessing) and collusion (remaining silent)
- Nash equilibrium is to compete even though collusion would result in higher profits
- Explains why cartels are unstable and firms engage in price wars despite potential for higher profits through collusion
Key Terms to Review (26)
Allocative Inefficiency: Allocative inefficiency occurs when the allocation of resources does not maximize societal welfare, resulting in a loss of economic surplus. It arises when the market price deviates from the socially optimal price, leading to an underproduction or overproduction of a good or service.
Barriers to Entry: Barriers to entry are obstacles or factors that make it difficult for new firms to enter a particular market or industry. These barriers can give existing firms a competitive advantage and allow them to maintain higher prices and profits in the long run.
Bertrand model: The Bertrand model is an economic model that describes the behavior of firms in an oligopolistic market. It assumes that firms compete on the basis of price rather than quantity, and that they make their pricing decisions simultaneously.
Cartel: A cartel is an organization formed by several firms or countries that jointly control the production, distribution, and pricing of a product or service in order to maximize profits and reduce competition. Cartels are a form of anticompetitive behavior that can have significant impacts on markets and consumers.
Collusion: Collusion is an agreement between two or more parties, often competitors, to work together to influence or manipulate a market for their own benefit. It typically involves coordinating actions, such as setting prices or dividing up market share, in order to restrict competition and increase profits.
Concentration Ratio: The concentration ratio is a measure of the market share held by the largest firms in an industry. It is a commonly used indicator of the level of competition or market concentration within an oligopolistic market structure.
Conscious Parallelism: Conscious parallelism refers to a situation in an oligopolistic market where firms recognize their interdependence and make similar pricing and output decisions, even without explicit collusion. Firms in an oligopoly actively monitor each other's actions and strategically align their decisions to maintain market stability and avoid price wars.
Cournot Model: The Cournot model is a fundamental economic theory that describes the strategic interaction between firms in an oligopolistic market. It assumes that firms make decisions about their output levels simultaneously, aiming to maximize their own profits while considering the anticipated actions of their competitors.
Deadweight Loss: Deadweight loss refers to the economic inefficiency that occurs when the socially optimal quantity of a good or service is not produced or consumed due to market failures, such as government intervention or the presence of monopolies. It represents the loss in total surplus (the sum of consumer and producer surplus) that results from a deviation from the optimal market equilibrium.
Duopoly: A duopoly is a market structure where two firms are the sole producers of a good or service. In this oligopolistic setting, the two firms' decisions and actions are interdependent, as the strategies of one firm directly impact the other firm's profitability and market share.
Game Theory: Game theory is the study of strategic decision-making and interactions between rational agents, known as 'players,' who have different preferences and incentives. It provides a framework for analyzing how individuals or organizations make choices in competitive or collaborative situations with the goal of achieving the best possible outcome for themselves.
Kinked Demand Curve: A kinked demand curve is a model used in the theory of oligopoly to explain how firms in an oligopolistic market set their prices. It suggests that the demand curve faced by an oligopolistic firm has a 'kink' at the current market price, leading to a discontinuity in the firm's marginal revenue curve.
Market Power: Market power refers to the ability of a firm or group of firms to influence and control the market by setting prices, restricting output, and limiting competition. It is a measure of a firm's ability to charge prices above the competitive level and earn economic profits in the long run.
Mutual Interdependence: Mutual interdependence refers to a situation where the decisions and actions of firms in an oligopoly market are highly interrelated and interdependent. Firms in an oligopoly recognize that their individual decisions can have a significant impact on the overall market, leading to a complex web of strategic interactions and considerations.
Nash Equilibrium: A Nash equilibrium is a solution concept in game theory where each player's strategy is the best response to the strategies of the other players. It represents a stable outcome where no player can improve their payoff by unilaterally changing their strategy, given the strategies of the other players.
Non-Price Competition: Non-price competition refers to the strategies businesses employ to differentiate their products or services from competitors without relying solely on price adjustments. It involves using various marketing and promotional tactics to create a unique brand identity, enhance product quality, or provide superior customer service to attract and retain customers.
Oligopoly: An oligopoly is a market structure characterized by a small number of firms that collectively dominate the market. In an oligopoly, the actions of one firm can significantly impact the others, leading to interdependent decision-making and strategic behavior.
OPEC: OPEC, or the Organization of the Petroleum Exporting Countries, is an international organization comprised of the world's major oil exporting nations. It serves as a cartel, coordinating and unifying the petroleum policies of its member countries to influence global oil prices and supply.
Payoff Matrix: A payoff matrix is a tool used in game theory to represent the potential outcomes or payoffs for each player in a strategic interaction or game. It is commonly used in the analysis of oligopolistic markets to understand the decision-making process and potential outcomes for firms competing in the same industry.
Price Leadership: Price leadership refers to a situation in an oligopolistic market where one or more dominant firms set the prices for the entire industry, and other firms in the market typically follow these price changes. This behavior is a common strategy used by firms in an oligopoly to maintain market stability and avoid price wars.
Price Rigidity: Price rigidity refers to the phenomenon where prices in a market remain relatively stable or inflexible, even in the face of changes in supply and demand conditions. This concept is particularly relevant in the context of oligopoly markets, where a few dominant firms have the power to influence and control prices.
Prisoner's Dilemma: The prisoner's dilemma is a classic game theory scenario that demonstrates how two individuals acting in their own self-interest can ultimately produce an outcome that is less than optimal for both parties. It highlights the tension between individual and collective rationality.
Product Differentiation: Product differentiation is the process of distinguishing a product or service from others in the market to make it more attractive to a particular target audience. It involves creating perceived differences between one's own product and competing products, allowing a company to charge a premium price and gain a competitive advantage.
Reaction Function: A reaction function is a mathematical representation of a firm's strategic decision-making process in an oligopolistic market. It describes how a firm will respond to changes in the decisions or actions of its competitors.
Stackelberg Model: The Stackelberg model is a strategic model of oligopoly in which one firm, the leader, makes the first move by setting its output level, and then the other firms, the followers, respond by setting their own output levels. This model assumes that the leader has a first-mover advantage and can influence the decisions of the followers.
Tacit Collusion: Tacit collusion refers to a situation in an oligopolistic market where firms are able to coordinate their behavior and restrict competition without explicitly communicating or making any formal agreement. This allows the firms to maintain higher prices and profits than would be possible under perfect competition.