OligopolyOligopoly

The challenge of analyzing The challenge of analyzing interdependent strategic interdependent strategic

decisionsdecisions

ObjectivesObjectives

The learner will be able to:The learner will be able to:1.1. Define an oligopoly and identify the Define an oligopoly and identify the

unique characteristics of this market unique characteristics of this market form.form.

2.2. Describe the various approaches that Describe the various approaches that economists use to analyze the decisions economists use to analyze the decisions and behavior of oligopolies.and behavior of oligopolies.

3.3. Explain how game theory is used as a Explain how game theory is used as a tool to understand and predict the tool to understand and predict the strategic decisions of firms in an strategic decisions of firms in an oligopolistic industry. oligopolistic industry.

Oligopoly DefinedOligopoly Defined ““Oligopoly” comes from Greek roots Oligopoly” comes from Greek roots

meaning “few sellers.”meaning “few sellers.” An oligopoly is a market dominated by a An oligopoly is a market dominated by a

few sellers (somewhere between one and few sellers (somewhere between one and very many), at least several of which are very many), at least several of which are large enough to be able to influence the large enough to be able to influence the market price.market price.

Oligopolistic industries account for a Oligopolistic industries account for a major share of economic activity (oil, major share of economic activity (oil, autos, consumer products, metals and autos, consumer products, metals and mining, airlines)mining, airlines)

The Analytical ChallengeThe Analytical Challenge

Oligopolies pose a difficult analytical Oligopolies pose a difficult analytical challenge for economists.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 Choose prices and outputs for their productsproducts

Must anticipate (or at least consider) Must anticipate (or at least consider) the responses of competitors to their the responses of competitors to their actionsactions

The Analytical Challenge The Analytical Challenge (Cont’d)(Cont’d)

Put another way, the business choices faced Put another way, the business choices faced by oligopolies (pricing, output, production by oligopolies (pricing, output, production capacity) are capacity) are strategicstrategic decisions. decisions.

These strategic decisions are These strategic decisions are interdependentinterdependent, in that outcomes are based , in that outcomes are based on the responses of other firms in the on the responses of other firms in the industry.industry.

Actions and variables based on Actions and variables based on interdependent decisions are difficult to interdependent decisions are difficult to isolate and predict.isolate and predict.

A Theoretical Starting A Theoretical Starting pointpoint

In principle, the economic profits In principle, the economic profits generated by an oligopoly should generated by an oligopoly should never be higher than a pure never be higher than a pure monopoly – since a monopoly monopoly – since a monopoly chooses the price that maximizes chooses the price that maximizes industry profits.industry profits.

A brief review …A brief review …

Theoretical Starting Point Theoretical Starting Point (Cont’d)(Cont’d)

An oligopoly should also never earn An oligopoly should also never earn less than the zero economic profit of less than the zero economic profit of a perfectly competitive industry in a perfectly competitive industry in long run equilibrium.long run equilibrium.

A quick refresher on pricing and A quick refresher on pricing and returns in a perfectly competitive returns in a perfectly competitive industry …industry …

Somewhere Between the Somewhere Between the ExtremesExtremes

Common sense says that economic Common sense says that economic returns for oligopolies should lie returns for oligopolies should lie somewhere between the two theoretical somewhere between the two theoretical extremes represented by perfect extremes represented by perfect competition and pure monopoly.competition and pure monopoly.

But where…But where… Let’s look at a few ways that economists Let’s look at a few ways that economists

have attempted to think through this have attempted to think through this analytical challenge.analytical challenge.

Ignore the ComplicationsIgnore the Complications

One approach is to ignore the whole One approach is to ignore the whole issue of interdependent decisions and issue of interdependent decisions and assume that each firm in an assume that each firm in an oligopolistic industry will maximize oligopolistic industry will maximize their own returns without any regard their own returns without any regard for their rivals’ actions.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.

CartelsCartels

Another approach is to assume that firms in Another approach is to assume that firms in an oligopolistic industry agree to coordinate an oligopolistic industry agree to coordinate their price and output decisions, otherwise their price and output decisions, otherwise known as a cartel.known as a cartel.

Cartels do exist (does OPEC sound Cartels do exist (does OPEC sound familiar?), but they are usually difficult to familiar?), but they are usually difficult to form and hold together.form and hold together.

Cartels represent the worst of all worlds Cartels represent the worst of all worlds from an economic standpoint (monopoly from an economic standpoint (monopoly pricing with none of the efficiencies from pricing with none of the efficiencies from scale).scale).

Tacit CollusionTacit Collusion

Another way to think about the problem is Another way to think about the problem is to assume that firms in an oligopolistic to assume that firms in an oligopolistic industry will find ways to signal their industry will find ways to signal their intentions indirectly, in order to maximize intentions indirectly, in order to maximize their economic returns.their economic returns.

This can take the form of price leadership, This can take the form of price leadership, which is exercised (and policed) by the which is exercised (and policed) by the industry leader.industry leader.

Problems – Unequal distribution of industry Problems – Unequal distribution of industry profits; new entrants may rock the boat. profits; new entrants may rock the boat.

Sales Maximization Sales Maximization ModelModel

Based on the theory that professional managers Based on the theory that professional managers of large, public companies are paid to maximize of large, public companies are paid to maximize the size of their firm, not its profitability.the size of their firm, not its profitability.

Economists know how to model behavior based Economists know how to model behavior based on a known variable (sales maximization).on a known variable (sales maximization).

There is some correlation between manager There is some correlation between manager compensation and the size of firms.compensation and the size of firms.

Problem – Management teams that focus on Problem – Management teams that focus on sales to the exclusion of profitability are sales to the exclusion of profitability are eventually removed and their companies are eventually removed and their companies are often acquired or taken private.often acquired or taken private.

Back to the Analytical Back to the Analytical ProblemProblem

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

Enter game theory… Enter game theory…

Game TheoryGame Theory

Deals with the issue of interdependence Deals with the issue of interdependence directly, by assuming that firms in directly, by assuming that firms in oligopolistic industries act as competing oligopolistic industries act as competing players in a strategic game.players in a strategic game.

Link between economics and game Link between economics and game theory is the belief that human beings theory is the belief that human beings are rational in their economic choices are rational in their economic choices and always act to maximize their and always act to maximize their rewards (seem like reasonable rewards (seem like reasonable assumptions).assumptions).

Game Theory (Cont’d)Game Theory (Cont’d)

Game theory provides a way to Game theory provides a way to analyze and predict behavior when analyze and predict behavior when people interact directly, rather than people interact directly, rather than indirectly through the market.indirectly through the market.

Outcomes of the “game” depend not Outcomes of the “game” depend not just on one player’s choices, but on just on one player’s choices, but on the actions or reactions of the other the actions or reactions of the other player(s) – which is the essence of player(s) – which is the essence of the oligopoly analytical problem.the oligopoly analytical problem.

The Prisoners’ DilemmaThe Prisoners’ Dilemma

10, 10 0, 20

20, 0 1, 1

Confess Don’t

Confess

Don’t

Prisoner A

Prisoner B

Game Theory (Cont’d)Game Theory (Cont’d) Provides a model to explain how people Provides a model to explain how people

(or firms) in pursuit of their own self (or firms) in pursuit of their own self interest may (and often do) act in a interest may (and often do) act in a manner that leads to them forgoing a manner that leads to them forgoing a more optimal result.more optimal result.

Think about the Prisoner’s Dilemma in Think about the Prisoner’s Dilemma in the context of results that are the context of results that are meaningful (or potentially painful) to meaningful (or potentially painful) to you.you.

Your grade in AP Economics is an Your grade in AP Economics is an example that comes to mind.example that comes to mind.

The Students’ DilemmaThe Students’ Dilemma

Help Study

Don’t

Help Study Don’t

Student A

Student B

B, B

A, F

F, A

C, C

Game Theory (Cont’d)Game Theory (Cont’d)

Games (or scenarios) that provide the Games (or scenarios) that provide the opportunity for repeated interactions opportunity for repeated interactions add another element of complexity – add another element of complexity – the ability to learn your opponent’s the ability to learn your opponent’s personality, anticipate their actions, personality, anticipate their actions, and build trust (or mistrust).and build trust (or mistrust).

This aspect of game theory mimics This aspect of game theory mimics the continuous interactions of strong the continuous interactions of strong competitors in a market.competitors in a market.

Review – Four Market Review – Four Market FormsForms

Perfect competition and pure Perfect competition and pure monopoly are the theoretical monopoly are the theoretical bookends that frame our thinking bookends that frame our thinking about the different forms of industry about the different forms of industry structure.structure.

In between these theoretical In between these theoretical extremes…extremes…

Monopolistic Monopolistic CompetitionCompetition

1.1. Differentiated productsDifferentiated products

2.2. Sloped demand curveSloped demand curve

3.3. Potential for excess returns in the short Potential for excess returns in the short runrun

4.4. Zero economic profit at long run Zero economic profit at long run equilibriumequilibrium

5.5. At long run equilibrium – excess capacity At long run equilibrium – excess capacity and inefficiency (intersection of D and and inefficiency (intersection of D and AC above minimum point on AC curve).AC above minimum point on AC curve).

OligopolyOligopoly

1.1. Few large firms that can influence the Few large firms that can influence the marketmarket

2.2. Interdependent decisionsInterdependent decisions

3.3. Traditional economic theory does not Traditional economic theory does not provide a clear way to analyze oligopoly provide a clear way to analyze oligopoly pricing, but you should understand cartels, pricing, but you should understand cartels, tacit collusion (price leadership), and the tacit collusion (price leadership), and the sales maximization concept.sales maximization concept.

4.4. Game theory provides a useful model to Game theory provides a useful model to analyze business strategy and behavior in analyze business strategy and behavior in oligopolistic industries.oligopolistic industries.