7.3 Oligopoly models and strategic behavior

Oligopolies are markets with a few big players who have significant influence. These firms engage in strategic decision-making, considering how their actions affect competitors. Game theory helps analyze these complex interactions.

Oligopoly models like Cournot, Bertrand, and Stackelberg predict different market outcomes. Firms may collude to maximize joint profits, but this is often unstable and illegal. Understanding these dynamics is crucial for analyzing real-world markets.

Oligopoly Market Characteristics

Market Structure and Entry Barriers

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• Oligopoly markets dominated by small number of large firms (typically 2-10)
• High barriers to entry
  • Economies of scale
  • High capital requirements
  • Brand loyalty
• Significant market power allows firms to influence prices and output levels
• Concentration measured by concentration ratio and Herfindahl-Hirschman Index (HHI)

Firm Interdependence and Competition

• Actions of one firm significantly affect others, leading to strategic decision-making
• Products can be homogeneous (steel) or differentiated (automobiles)
• Non-price competition prevalent
  • Advertising
  • Product differentiation
  • Innovation
• Firms compete to maximize profits through pricing and output decisions

Strategic Interactions in Oligopoly

Game Theory Fundamentals

• Mathematical framework analyzes strategic decision-making
• Firm payoffs depend on own actions and competitors' actions
• Key concepts
  • Nash equilibrium represents state where no player can unilaterally improve position
  • Dominant strategies are optimal regardless of opponents' choices
  • Mixed strategies involve probabilistic decision-making
• Models strategic interactions using normal form (matrix) games or extensive form (tree) games

Advanced Game Theory Applications

• Prisoner's dilemma illustrates tension between cooperation and competition
• Repeated games analyze long-term oligopolistic behavior
• Subgame perfect equilibrium crucial for sequential decision-making analysis
• Applications to oligopoly scenarios
  • Pricing decisions
  • Capacity choices
  • Entry deterrence strategies

Oligopoly Model Outcomes

Cournot Model

• Firms compete by choosing output levels simultaneously
• Equilibrium output is best response to competitors' choices
• Conjectural variations concept explains firms' anticipation of rivals' responses
• Comparative statics analyze how market changes affect equilibrium

Bertrand and Stackelberg Models

• Bertrand model
  • Firms compete on price rather than quantity
  • Often results in more competitive outcomes than Cournot, especially for homogeneous products
• Stackelberg model
  • Introduces sequential element with first-mover (leader) and follower(s)
  • Yields different equilibrium outcomes compared to simultaneous-move models

Model Comparisons and Applications

• Each model predicts specific market outcomes
  • Price levels
  • Quantities produced
  • Firm profits
• Model applicability depends on industry characteristics
  • Nature of competition
  • Product homogeneity
  • Sequence of decision-making

Collusion and Cartels in Oligopoly

Collusion Dynamics

• Firms coordinate actions to restrict output and raise prices
• Aim to achieve joint profit maximization
• Prisoners' dilemma framework explains inherent cartel instability
• Factors facilitating collusion
  • Small number of firms
  • High entry barriers
  • Frequent interactions
  • Ability to detect and punish deviations

Cartel Analysis and Regulation

• Cartels formalize collusion agreements, often illegal due to anti-competitive nature
• Tacit collusion (conscious parallelism) occurs without explicit agreements
• Game theory models analyze collusive agreement sustainability
  • Trigger strategies
  • Folk theorems
• Welfare implications of collusion
  • Reduced consumer surplus
  • Deadweight loss
  • Potential dynamic inefficiencies in innovation and resource allocation