Micro CHAPTER 4.5:

Oligopoly and Game Theory

CHAPTER SUMMARY

Oligopoly is a market structure with:

Only a few sellers that each have high market power
High barriers to entry

Some examples of oligopolies include airplane manufacturing, cars, and breakfast cereal. Oligopolies can be caused by similar conditions as those that cause a monopoly, except that there is less of a duplication effect (adding a second, third, or fourth producer is not as wasteful of resources).

Oligopolistic firms sometimes take actions that other firms do not. One of these is called collusion - this is when a few firms get together and make (usually secret) agreements to raise all of their profits instead of competing. A group of firms that does this is called a cartel. One well-known cartel is OPEC, the Organization of Petroleum Exporting Countries, which decides how much oil each country will produce in order to keep prices - and profits - high.

Other times, oligopolistic firms will instead try to compete with the other firms in the industry. One of the tools they use to make competitive decisions is called game theory. Game theory works best when there are only a small number of firms, because you need to be able to predict the actions of all firms in the market.

Below is what is called a payoff matrix. It shows the result of multiple firms' choices depending on the other firms' choices. For example, this matrix shows that if both Firm A and Firm B set a low price, they will both earn $10 of profit (top left box). However, if Firm A sets a high price and Firm B sets a low price, we can look at the bottom left box and see that Firm A would earn a profit of $25, but Firm B would only profit $5.

This chart can help competitors predict each other's actions. For example, if Firm A thinks Firm B will set a high price, then it will look at its two options. If Firm A sets a low price, it will earn a profit of $25. If it sets a high price, it will earn a profit of $20. In this case, if they think that Firm B will set a high price, then Firm A should set a low price to maximize profit. However, if they are wrong, and Firm B sets a low price, Firm A would only earn $10.

In the next chart, you can see another example of a payoff matrix. In this case, it is based on a decision whether to release their newest star's line of shoes as sneakers or flip-flops. If Adidas chooses sneakers, Nike will earn $100M in profit if they choose sneakers, or $75M in profit if they choose flip-flops. If Adidas chooses flip-flops, Nike will earn $150M in profit if they choose sneakers or $100M if they choose flip-flops. This means that, no matter what Adidas does, Nike is better off choosing to produce sneakers. This is called a dominant strategy, because it means that the choice does not depend on the other firms' decision. If Adidas knows this is Nike's dominant strategy, they can make their decision based on that. Because they know Nike will produce sneakers, they will only look at the left column, where they can see that they will earn $25M in profit if they sell sneakers or $50M if they sell flip-flops, so they would choose to produce flip-flops. When this occurs, where we know exactly what each firm will choose, we reach what is called a Nash equilibrium, named after an economist who helped develop the idea of game theory.