Oligopoly The challenge of analyzing interdependent strategic decisions

Objectives The learner will be able to: 1. Define an oligopoly and identify the unique characteristics of this market form. 2. Describe the various approaches that economists use to analyze the decisions and behavior of oligopolies. 3. Explain how game theory is used as a tool to understand and predict the strategic decisions of firms in an oligopolistic industry.

Oligopoly Defined “Oligopoly” comes from Greek roots meaning “few sellers.” “Oligopoly” comes from Greek roots meaning “few sellers.” An oligopoly is a market dominated by a few sellers (somewhere between one and very many), at least several of which are large enough to be able to influence the market price. An oligopoly is a market dominated by a few sellers (somewhere between one and very many), at least several of which are large enough to be able to influence the market price. Oligopolistic industries account for a major share of economic activity (oil, autos, consumer products, metals and mining, airlines) Oligopolistic industries account for a major share of economic activity (oil, autos, consumer products, metals and mining, airlines)

The Analytical Challenge Oligopolies pose a difficult analytical challenge for economists. Oligopolies pose a difficult analytical challenge for economists. Why is it so difficult? Why is it so difficult? Firms in an oligopolistic industry: Firms in an oligopolistic industry:  Choose prices and outputs for their products  Must anticipate (or at least consider) the responses of competitors to their actions

The Analytical Challenge (Cont’d) Put another way, the business choices faced by oligopolies (pricing, output, production capacity) are strategic decisions. Put another way, the business choices faced by oligopolies (pricing, output, production capacity) are strategic decisions. These strategic decisions are interdependent, in that outcomes are based on the responses of other firms in the industry. These strategic decisions are interdependent, in that outcomes are based on the responses of other firms in the industry. Actions and variables based on interdependent decisions are difficult to isolate and predict. Actions and variables based on interdependent decisions are difficult to isolate and predict.

A Theoretical Starting point In principle, the economic profits generated by an oligopoly should never be higher than a pure monopoly – since a monopoly chooses the price that maximizes industry profits. In principle, the economic profits generated by an oligopoly should never be higher than a pure monopoly – since a monopoly chooses the price that maximizes industry profits. A brief review … A brief review …

Theoretical Starting Point (Cont’d) An oligopoly should also never earn less than the zero economic profit of a perfectly competitive industry in long run equilibrium. An oligopoly should also never earn less than the zero economic profit of a perfectly competitive industry in long run equilibrium. A quick refresher on pricing and returns in a perfectly competitive industry … A quick refresher on pricing and returns in a perfectly competitive industry …

Somewhere Between the Extremes Common sense says that economic returns for oligopolies should lie somewhere between the two theoretical extremes represented by perfect competition and pure monopoly. Common sense says that economic returns for oligopolies should lie somewhere between the two theoretical extremes represented by perfect competition and pure monopoly. But where… But where… Let’s look at a few ways that economists have attempted to think through this analytical challenge. Let’s look at a few ways that economists have attempted to think through this analytical challenge.

Ignore the Complications One approach is to ignore the whole issue of interdependent decisions and assume that each firm in an oligopolistic industry will maximize their own returns without any regard for their rivals’ actions. One approach is to ignore the whole issue of interdependent decisions and assume that each firm in an oligopolistic industry will maximize their own returns without any regard for their rivals’ actions. This would equate to a monopoly model. This would equate to a monopoly model. Good news – it’s simple. Good news – it’s simple. Bad news – it misses the whole point. Bad news – it misses the whole point.

Cartels Another approach is to assume that firms in an oligopolistic industry agree to coordinate their price and output decisions, otherwise known as a cartel. Another approach is to assume that firms in an oligopolistic industry agree to coordinate their price and output decisions, otherwise known as a cartel. Cartels do exist (does OPEC sound familiar?), but they are usually difficult to form and hold together. Cartels do exist (does OPEC sound familiar?), but they are usually difficult to form and hold together. Cartels represent the worst of all worlds from an economic standpoint (monopoly pricing with none of the efficiencies from scale). Cartels represent the worst of all worlds from an economic standpoint (monopoly pricing with none of the efficiencies from scale).

Tacit Collusion Another way to think about the problem is to assume that firms in an oligopolistic industry will find ways to signal their intentions indirectly, in order to maximize their economic returns. Another way to think about the problem is to assume that firms in an oligopolistic industry will find ways to signal their intentions indirectly, in order to maximize their economic returns. This can take the form of price leadership, which is exercised (and policed) by the industry leader. This can take the form of price leadership, which is exercised (and policed) by the industry leader. Problems – Unequal distribution of industry profits; new entrants may rock the boat. Problems – Unequal distribution of industry profits; new entrants may rock the boat.

Sales Maximization Model Based on the theory that professional managers of large, public companies are paid to maximize the size of their firm, not its profitability. Based on the theory that professional managers of large, public companies are paid to maximize the size of their firm, not its profitability. Economists know how to model behavior based on a known variable (sales maximization). Economists know how to model behavior based on a known variable (sales maximization). There is some correlation between manager compensation and the size of firms. There is some correlation between manager compensation and the size of firms. Problem – Management teams that focus on sales to the exclusion of profitability are eventually removed and their companies are often acquired or taken private. Problem – Management teams that focus on sales to the exclusion of profitability are eventually removed and their companies are often acquired or taken private.

Back to the Analytical Problem As you can probably tell, traditional microeconomic theory does not have a very good (or easy) answer to the problem of predicting oligopoly pricing and returns. As you can probably tell, traditional microeconomic theory does not have a very good (or easy) answer to the problem of predicting oligopoly pricing and returns. Enter game theory… Enter game theory…

Game Theory Deals with the issue of interdependence directly, by assuming that firms in oligopolistic industries act as competing players in a strategic game. Deals with the issue of interdependence directly, by assuming that firms in oligopolistic industries act as competing players in a strategic game. Link between economics and game theory is the belief that human beings are rational in their economic choices and always act to maximize their rewards (seem like reasonable assumptions). Link between economics and game theory is the belief that human beings are rational in their economic choices and always act to maximize their rewards (seem like reasonable assumptions).

Game Theory (Cont’d) Game theory provides a way to analyze and predict behavior when people interact directly, rather than indirectly through the market. Game theory provides a way to analyze and predict behavior when people interact directly, rather than indirectly through the market. Outcomes of the “game” depend not just on one player’s choices, but on the actions or reactions of the other player(s) – which is the essence of the oligopoly analytical problem. Outcomes of the “game” depend not just on one player’s choices, but on the actions or reactions of the other player(s) – which is the essence of the oligopoly analytical problem.

The Prisoners’ Dilemma 10, 100, 20 20, 01, 1 Confess Don’t Confess Don’t Prisoner A Prisoner B

Game Theory (Cont’d) Provides a model to explain how people (or firms) in pursuit of their own self interest may (and often do) act in a manner that leads to them forgoing a more optimal result. Provides a model to explain how people (or firms) in pursuit of their own self interest may (and often do) act in a manner that leads to them forgoing a more optimal result. Think about the Prisoner’s Dilemma in the context of results that are meaningful (or potentially painful) to you. Think about the Prisoner’s Dilemma in the context of results that are meaningful (or potentially painful) to you. Your grade in AP Economics is an example that comes to mind. Your grade in AP Economics is an example that comes to mind.

The Students’ Dilemma Help Study Don’t Help StudyDon’t Student A Student B B, B A, F F, A C, C

Game Theory (Cont’d) Games (or scenarios) that provide the opportunity for repeated interactions add another element of complexity – the ability to learn your opponent’s personality, anticipate their actions, and build trust (or mistrust). Games (or scenarios) that provide the opportunity for repeated interactions add another element of complexity – the ability to learn your opponent’s personality, anticipate their actions, and build trust (or mistrust). This aspect of game theory mimics the continuous interactions of strong competitors in a market. This aspect of game theory mimics the continuous interactions of strong competitors in a market.

Review – Four Market Forms Perfect competition and pure monopoly are the theoretical bookends that frame our thinking about the different forms of industry structure. Perfect competition and pure monopoly are the theoretical bookends that frame our thinking about the different forms of industry structure. In between these theoretical extremes… In between these theoretical extremes…

Monopolistic Competition 1. Differentiated products 2. Sloped demand curve 3. Potential for excess returns in the short run 4. Zero economic profit at long run equilibrium 5. At long run equilibrium – excess capacity and inefficiency (intersection of D and AC above minimum point on AC curve).

Oligopoly 1. Few large firms that can influence the market 2. Interdependent decisions 3. Traditional economic theory does not provide a clear way to analyze oligopoly pricing, but you should understand cartels, tacit collusion (price leadership), and the sales maximization concept. 4. Game theory provides a useful model to analyze business strategy and behavior in oligopolistic industries.