Oligopoly
FOUR MARKET MODELS
Perfect
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Characteristics of Oligopolies:
• A Few Large Producers
• High Barriers to Entry
• Control Over Price (Price Maker)
• Mutual Interdependence
•Firms use Strategic Pricing
Examples: OPEC, Computer
Operating Systems, Cell Service
Providers
HOW DO OLIGOPOLIES OCCUR?
Oligopolies occur when only a few
large firms control an industry.
High barriers to entry keep other
firms from entering.
Types of Barriers to Entry
1. Economies of Scale
•Ex: The car industry is difficult to
enter because only large firms can
make cars at the lowest cost
2. High Start-up Costs
3. Ownership of Raw Materials
Game Theory
The study of how people behave in
strategic situations
An understanding of game theory
helps firms in an oligopoly maximize
profit.
Why learn about game theory?
•Oligopolies are interdependent
since they compete with only a
few other firms.
To maximize profit, firms must
strategize
Game theory helps us analyze
their strategies.
Game Theory Payoff
Matrices
• A payoff matrix represents the
known payoffs to individuals
(players) in a strategic situation
given choices made by other
individuals in the same
situation
6
Example
• Suppose Bert and Ernie are
arrested on suspicion of
manufacturing and
distributing crystal meth.
• They are taken in for
questioning in separate
rooms.
• How many years they’ll
spend in jail for their crimes
depend on whether they
confess or deny
7
Payoff Matrix
• The payoff matrix below shows the number of
years in jail that Bert and Ernie will spend in
jail based on their decisions
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
8
Dominant Strategy
A player’s dominant strategy is the best
move for a him/her to make regardless of
what the other player does
A player may or may not have a dominant
strategy depending on the potential
payoffs
9
Payoff Matrix
What is Ernie’s dominant strategy (if any)?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
10
Payoff Matrix
What is Ernie’s dominant strategy (if any)?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
11
Payoff Matrix
What is Ernie’s dominant strategy (if any)?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
12
Payoff Matrix
What is Bert’s dominant strategy (if any)?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
13
Payoff Matrix
What is Bert’s dominant strategy (if any)?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
14
Payoff Matrix
What is Bert’s dominant strategy (if any)?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
15
Payoff Matrix
What will happen if both Bert and Ernie
follow their dominant strategies?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
16
Payoff Matrix
Is this the best outcome for both?
Ernie
Confess
Confess
Deny
10, 10 0, 20
Bert
Deny
20 , 0
5, 5
17
Example 2:
You and your partner are competing firms.
You have one of two choices: Price High or
Price Low.
Without talking, write down your choice
Firm 2
High
High $20K, $20K
Low
$0, $30K
Firm 1
Low
$30K, $0
$10K, $10K
Example 2:
What is Firm 1’s dominant strategy?
Firm 2
High
High $20K, $20K
Low
$0, $30K
Firm 1
Low
$30K, $0
$10K, $10K
Example 2:
What is Firm 1’s dominant strategy?
Firm 2
High
High $20K, $20K
Low
$0, $30K
Firm 1
Low
$30K, $0
$10K, $10K
Example 2:
What is Firm 2’s dominant strategy?
Firm 2
High
High $20K, $20K
Low
$0, $30K
Firm 1
Low
$30K, $0
$10K, $10K
Example 2:
Notice that you have an incentive to collude
(work together) but also an incentive to cheat
Firm 2
High
High $20K, $20K
Low
$0, $30K
Firm 1
Low
$30K, $0
$10K, $10K
Split or Steal
https://www.youtube.com/watch?v=p3Uos2fzIJ0
23
Video: Split or Steal
What is each player’s dominant strategy?
Player 2
Split
Split
Steal
50K, 50K
0, 100K
100K, 0
0, 0
Player 1
Steal
What did we learn?
1. Oligopolies must use strategic
pricing (they have to worry about
the other guy)
2. Oligopolies have a tendency to
collude to gain profit.
(Collusion is the act of cooperating
with rivals in order to “rig” a
situation)
3. Collusion results in the incentive to
cheat.
4. Firms make informed decisions
based on their dominant strategies
Warm Up
There are two pizza restaurants in College Town, PieCrust and LaPizza. Each
company must decide whether to advertise or to not advertise. In the payoff matrix
below, the first entry in each cell indicates PieCrust’s daily profit, and the second
entry indicates LaPizza’s daily profit. Both firms have complete information.
(a) What strategy should PieCrust choose if LaPizza chooses to advertise?
(b) What is the dominant strategy, if any, for LaPizza?
(c) In the Nash equilibrium (the result if both firms follow their dominant strategies,
or if a firm without a dominant strategy follows its best strategy given the other firm
following its dominant strategy), determine each of the following.
(i) PieCrust’s daily profit
(ii) LaPizza’s daily profit
26
Oligopoly
Graphs
There are 3 types of Oligopolies
1. Price Leadership (no graph)
2. Colluding Oligopoly
3. Non Colluding Oligopoly
#1. Price
Leadership
Price Leadership
• Price leadership is a strategy used
by firms to coordinate prices
Typically occurs when outright
collusion is ILLEGAL
General Process:
1. “Dominant firm” initiates a price
change
2. Other firms follow the leader
Price Leadership
Breakdowns in Price Leadership
• If other firms don’t follow price
increases of dominant firm,
temporary price wars occur when
each firm tries to undercut the
others
#2. Colluding
Oligopolies
Cartel = Colluding Oligopoly
A cartel is a group of producers that
create an agreement to fix prices
high.
1. Cartels set price and output at an
agreed upon level
2. Firms require identical or highly
similar demand and costs
3. Cartel must have a way to punish
cheaters
4. Together they act as a monopoly
Firms in a colluding oligopoly act as a
monopoly and share the profit
P
MC
ATC
D
MR
Q
Market Structures
Venn Diagram
Perfect
Competition
Monopolistic Competition
No Similarities
Oligopoly
Monopoly
Name the market structure(s) that it is
associated with each concept
1. Price Maker (Demand > MR)
2. Collusion/Cartels
3. Identical Products
4. Price Taker (Demand = MR)
5. Excess Capacity
6. Low Barriers to Entry
7. Game Theory
8. Differentiated Products
9. Long-run Profits
10.Efficiency
11.Normal Profit
12.Dead Weight Loss
13.High Barriers to Entry
14.Firm = Industry
15. MR=MC Rule
Perfect
Competition
Monopolistic Competition
No Similarities
Oligopoly
Monopoly
Perfect
Competition
•Identical Products
•No advantage
•D=MR=AR=P
•Both efficiencies
•Price-Taker
•1000s
No Similarities
•Collusion
•Strategic Pricing
(Interdependence)
•Game Theory
•10 or less
Oligopoly
Monopolistic Competition
•Low barriers to entry
•No Long-Run Profit
•Price = ATC
•Excess Advertising
•Differentiated Products
•Excess Capacity
• More Elastic Demand than
Monopoly
•100s
•MR = MC
•Shut-Down Point
•Cost Curves
•Motivation for Profit
•Price Maker (D>MR)
•High Barriers
•Ability to Make LR Profit
•Inefficient
•Price Maker (D>MR)
•Some Non-Price
Competition
•Inefficient
•Unique Good
•Price Discrimination
•1
Monopoly