1. Oligopoly and Game Theory
ETP Economics
Jack Wu

2. Key Feature
Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

3. Characteristics Characteristics of an Oligopoly Market
Few sellers offering similar or identical products
Interdependent firms
Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost

4. Simple Type: Duopoly
A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.
Duopoly
Oligopoly with only two members
Decide quantity to sell
Price – determined on the market
By demand

5. Duopoly Collude and form a cartel Don’t collude – self-interest
Act as a monopoly
Total level of production
Quantity produced by each member
Don’t collude – self-interest
Difficult to agree; Antitrust laws
Higher quantity; lower price; lower profit
Not competitive allocation
Nash equilibrium

6. Collusion and Cartel The duopolists may agree on a monopoly outcome.
An agreement among firms in a market about quantities to produce or prices to charge.
Cartel
A group of firms acting in unison.

7. Is Cartel Possible?
Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

8. The Equilibrium for an Oligopoly
A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

9. The equilibrium for an Oligopoly
When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.
The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

10. Size of an Oligopoly
How increasing the number of sellers affects the price and quantity:
The output effect: Because price is above marginal cost, selling more at the going price raises profits.
The price effect: Raising production will increase the amount sold, which will lower the price and the profit per unit on all units sold.

11. Size of an Oligopoly
As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.
The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

12. Strategic Action
Because the number of firms in an oligopolistic market is small, each firm must act strategically.
Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

13. Game Theory
Game theory is the study of how people behave in strategic situations.
Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

14. Prisoners’ Dilemma
The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.
Often people (firms) fail to cooperate with one another even when cooperation would make them better off.
The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

15. Confess Remain Silent Bonnie gets 8 years Clyde gets 8 years
Bonnie’ s Decision
Confess
Remain Silent
Bonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes free
Confess
Clyde’s
Decision
Bonnie goes free
Clyde gets 20 years
gets 1 year
Bonnie
Clyde gets 1 year
Remain
Silent
Copyright©2003 Southwestern/Thomson Learning

16. Dominant Strategy
The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.
Dominant strategies in Prisoners’ dilemma:
_ Clyde: Confess
_ Bonnie: Confess

17. Nash Equilibrium & Best Outcome
Nash Equilibrium (self-interest):
_ Clyde: Confess & Bonnie: Confess
Best Outcome (cooperation):
_ Clyde: Silent & Bonnie: Silent
Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

18. Game Example: OPEC Iraq and Iran: Members of OPEC
Their decisions on oil production.
Decisions: High Production or Low Production

19. Iraq ’ s Decision High Production Low Production Iraq gets $40 billion
Iran gets $40 billion
Iraq gets $30 billion
Iran gets $60 billion
High
Production
Iran ’ s
Decision
Iraq gets $60 billion
Iran gets $30 billion
Iraq gets $50 billion
Iran gets $50 billion
Low
Production
Copyright©2003 Southwestern/Thomson Learning

20. Nash Equilibrium Dominant strategies: _ Iran: High Production
_ Iraq: High Production
Nash Equilibrium (self-interest):
_ Iran: High Production & Iraq: High Production
Best Outcome (cooperation):
_ Iran: low production & Iraq: low production

21. Game Example: Where to Advertise?
Players: Competitor.com or We.com
Decisions: NBA and NHL

22. Where to advertise? No Nash equilibrium in pure strategies 8
Two on-line e-commerce providers planning advertising strategy -- advertise in NBA (basketball) or NHL (hockey) series?
We.com plan to use comparative advertising -- more effective when viewers see advertisements of both competitors;
Competitor.com using unique advertising -- more effective on separate channel.
Draw arrows: no Nash equilibrium in pure strategies:
in some games in strategic form, there may be no Nash equilibrium in pure strategies
No Nash equilibrium in pure strategies 8

23. No Nash Equilibrium Dominant strategies: _ We.com: none
_ Competitor.com: none
Nash Equilibrium (self-interest):

24. Game Example: Evening News
Players: ATV and TVB
Decisions: 7:30 pm or 8:00 pm

25. Evening News: Prime time for news is 8:0pm; second best is 7:30pm;
since audience is limited, get maximum viewership if two channels schedule at different times.
Question: which station gets 8:0pm? Situation has elements of
coordination -- avoiding same time slot
competition -- getting the 8:0pm slot

26. Nash Equilibrium Dominant strategies: _ ATV: none _ TVB: none
Two Nash Equilibria (self-interest):
_ ATV: 7:30pm & TVB: 8:00pm or
_ ATV: 8:00pm & TVB: 7:30pm

27. Why People Sometimes Cooperate
Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

28. Repeated prisoners’ dilemma
Encourage cooperation
Penalty for not cooperating
Better strategy
Return to cooperative outcome after a period of noncooperation
Best strategy: tit-for-tat
Player - start by cooperating
Then do whatever the other player did last time
Starts out friendly
Penalizes unfriendly players
Forgives them if warranted