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๐Ÿ’ธย  Unit 1: Basic Economic Concepts

4.5 Oligopoly and Game Theory

#unit4

#gametheory

#oligopoly

#marketstructures

โฑ๏ธย ย 6 min read

written by

jeanne stansak

Caroline Koffke

caroline koffke

(editor)

November 15, 2020


An oligopoly is an imperfect market structure where the industry is dominated by a few, large firms. Some good examples of the types of industries that fall in this type of market structure are the cereal industry, oil industry, and automobile industry.

There are two types of oligopolies that can exist:

  1. Colluding oligopolies, otherwise known as cartels
  2. Non-colluding oligopoliesย that practice what we refer to as price leadership

Characteristics of Oligopolies

  • Few, large Firms
  • Firms are "price makers"
  • High barriers to entry means firms cannot enter the industry
  • Firms earn long-run profits
  • Products sold are differentiated with many close substitutes
  • Non-price competition is used
  • Firms are inefficient if left unregulated

Key Terms Regarding Oligopolies

  • Collusion:ย a secret agreement to cooperate and work together in order to accomplish a common goal. This is similar to when two individuals who are suspected and arrested for a particular crime agree to both remain silent.
  • Interdependent:ย the various firms in an oligopolistic market are very interdependent on each other. This means that they need each other in order to succeed and maintain their control in the market.
  • Price leadership:ย a model of oligopoly where the dominant firm will initiate a price change in the industry. An example of this is when there are three non-colluding gas stations that dominate in a small town. The dominant firm will initiate a price change in the industry. The other gas stations have two opportunities (1) accept the new price change, or (2) ignore the new price change and keep its price the same. If the other firms choose to accept the new price change, then the market price is changes successfully and they are able to continue to maximize profits. If the other firm chooses to ignore the new price change then it can result in a "price war" where firms are continually changing their price in an attempt to outbid each other.
  • Cartel:ย a colluding oligopoly. In this type of oligopoly, a few large firms dominate an industry and use outright collusion to strategically set prices and output.
  • Game Theory:ย the study of how people behave in strategic situations.
  • Dominant Strategy:ย the best strategy for one player, regardless of the strategy the other player follows.
  • Dominated Strategy:ย the strategy that yields a lower payoff, regardless of the strategy the other player follows.
  • Nash equilibrium:ย the outcome that results when both players choose the strategy that makes them better off, given the other player's strategy.

Game Theory

Game theory is the study of how people behave in strategic situations. With the oligopoly market structure, we use a matrix to apply this concept.

Provided below is a game theory matrix for the soft drink industry. Coca-Cola and Pepsi are oligopolistic firms that collude to dominate the soft drink market. In this scenario, both firms have the choice to set their prices high or low, and the potential profits for both firms are listed in the matrix. The firms are aware of the payoffs but do not collude when making their decision. The numbers on the right of each box (in red) belong to Coca-Cola and the numbers on the left of each box (in blue) belong to Pepsi.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-8PYJz1Np6Txs.png?alt=media&token=832d5ac4-0716-4799-b8b2-c321693b4099

Let's look at some sample questions that are typically asked about these type of problems:

  1. If Coca-Cola and Pepsi collude, what will be the payoff for both firms?

    They will both choose to charge a high price and they will both earn a $2,000 profit. (This is the best outcome for both of them while colluding)

  2. Does Coca-Cola have a dominant strategy and if so, what is it?

    Yes, the strategy is to charge a lower price. We determine this by finding which pricing strategy will be more favorable for Coca-Cola depending on Pepsi's pricing strategy. If Pepsi goes high, Coca-Cola can either go high and make a $2000 profit, or go low and make a $2500 profit. Since $2500 > $2000, Coca-Cola will go low when Pepsi goes high. If Pepsi goes low, Coca-Cola can either go high and make a $950 profit, or go low and make a $1000 profit. Since $1000 > $900, Coca-Cola will go low when Pepsi goes low. In both situations, Coca-Cola's pricing strategy is the same, which means that going low is their dominant strategy.

  3. Does Pepsi have a dominant strategy and if so, what is it?

    Yes, it is to charge a lower price. We determine this by finding which pricing strategy will be more favorable for Pepsi depending on Coca-Cola's pricing strategy. If Coca-Cola goes high, Pepsi can either go high and make a $2000 profit, or go low and make a $2500 profit. Since $2500 > $2000, Pepsi will go low when Coca-Cola goes high. If Coca-Cola goes low, Pepsi can either go high and make a $900 profit, or go low and make a $1000 profit. Since $1000 > $900, Pepsi will go low when Coca-Cola goes low. In both situations, Pepsi's pricing strategy is the same, which means that going low is their dominant strategy.

  4. If Coca-Cola and Pepsi decide NOT to collude and choose their price level on their own, what will be the payoff for both firms? Explain.

    Pepsi will have a profit of $1000 and Coca-Cola will have a profit of $1000. Since Coca-Cola has a dominant strategy of a low price and Pepsi has a dominant strategy of a low price, these two decisions meet in the box where Pepsi and Coca-Cola have the profits listed above.

Sample Free Response Question (FRQ): 2007 Question #3

Two bus companies, Roadway and Rankin Wheels, operate a route from Greensboro to Spring City, transporting a mix of passengers and freight. They must file their schedules with the local transportation board each year and cannot alter them during that year. Those schedules are revealed only after both companies have filed. Each company must choose between an early and a late departure. The relevant payoff matrix appears below, with the first entry in each cell indicating Roadway's daily profit and the second entry in each cell indicating Rankin Wheels' daily profit.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-qeOzKOCpAGHm.png?alt=media&token=22ed46d4-b07e-4305-95c5-1ff8d6ad341b

(a) In which market structure do these firms operate? Explain.

The market is an oligopoly because there are only two firms and their actions are mutually interdependent.

(b) If Roadway chooses an early departure, which departure time is better for Rankin Wheels?

Rankin Wheels will choose an early departure because if Roadway is choosing an early departure, then Rankin Wheels' two options are early departure with a profit of $900 or a late departure with a profit of $850. Since $900 is greater than $850, they will choose an early departure.

(c) Identify the dominant strategy for Roadway.

Roadway's dominant strategy is an early departure. When Rankin Wheels departs early, Roadway can make $1000 by departing early or $750 by departing late. When Rankin Wheels departs late, Roadway can make $950 by departing early or $700 by departing late. In both scenarios, early departure results in the highest profit for Roadway ($1000 > $750 and $950 > $700).

(d) Is choosing an early departure a dominant strategy for Rankin Wheels? Explain.

No, because if Roadway chooses a late departure, Rankin Wheels is better off choosing a late departure because $800 profit is greater than $650 from an early departure. However, if Roadway chooses an early departure, Rankin Wheels is better off choosing an early departure because $900 profit is greater than $850 profit from a late departure. Rankin Wheels' does not have a dominant strategy, which means they have to choose based on Roadway's strategy.

(e) If both firms know all of the information in the payoff matrix but do not cooperate, what will be Rankin Wheels' daily profit?

Rankin Wheels' daily profit will be $900.

Comparison on All Market Structures

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-9PUOq2QVsnE5.png?alt=media&token=69176e8d-6978-438f-b60e-e24ec336b5b7

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