Characteristics of an Oligopoly

  • Characterized by interdependence, a relationship in which the outcome of each firm depends on the actions of the others

  • There are a "few" sellers in the market with significant control of pricing

  • If there are only two sellers, it's duopoly

  • Firms in an oligopoly have an incentive to collude, which is the act of "cooperating" or "not cheating" in order to increase joint profits

  • Cartel is a group of producers that agree to restrict output in order to increase prices and profits

Game Theory

  • The study of behavior in situations of interdependence is knowns as game theory

  • We will be examining a two-player model

    • the x-player and the y-player (x,y)
  • In our pay off matrix, there will only be two possible choices

    • High/Low

    • Confess/Not Confess

    • Early/Late

  • Two firms are playing a "game" in which profits are dependent on other firms' actions

  • Applications in economics, military strategy, politics

  • John Nash, a mathematician, won the Nobel Prize in economics for his work

  • Nash equilibrium is the result when each player chooses the action that maximizes his or her payoff, given the actions of other players

Prisoner's Dilemma

  • Dominant strategy means that you will choose the same option regardless of what your opponents does

  • Prisoner's dilemma means that there exists a collusive outcome that will benefit both players but they will have a dominant strategy which will yield to the Nash Equilibrium of the lowest combined profit possible

  • Example 1 (classic)

Ajinomoto Produce 30 million pounds Ajinomoto makes $180 million
Produce 40 million pounds Ajinomoto makes $200 million profit. Produce
30 million pounds ADM makes $180 million profit. Ajinomoto makes $150
million profit. Produce 40 million pounds ADM makes $200 million profit.
profit. ADM makes $150 million profit. Ajinomoto makes $160 million
profit. ADM makes $160 million profit.

  • Two firms, ADM and Ajinomoto, must decide how much lysine to produce.

  • The profits of the two firms are interdependent: Each firm's profit depends not only on its own decision but also on the other's decision.

  • Both firms will be better off if they both choose the lower output

  • But it is in each firm's individual interest to choose the higher output.

  • Example 2 (One Dominant, One Not)

    Ed's Aloha Buslines Early Early Late ($900, $250) c ($700, $500)
Late ($600, $800) ($800, 81000)

Allen Ed
If early Early Late
If late Late Late
No dominant strategy Late
  • Nash equilibrium: D
  • Overcoming prisoner's dilemma

    • Strategic behavior is when a firm attempts to influence the future behavior of other firms.

    • Tit for tat strategy involves playing cooperatively at first and then adjusting accordingly afterwards.

    • Firms in an oligopoly that do not explicitly form a cartel can engage in "tacit collusion" by limiting production and raising prices without any written agreements

    • Collusion, in any firm, is much more likely to take place when there are few firms

    • With more and more firms, there exists less incentive for a firm to "cheat"

  • Example 3

    Hello Market Advertise Not Advertise Advertise A ($250, $210) Not c
($175, $550) Advertise ($480, $350) ($410, $400)

Hello H & IPM
If advertise Not advertise Advertise
If not advertise Advertise Advertise
No dominant strategy Advertise
  • Does Hello Market have a dominant strategy?

    • No
  • Does H & IPM have a dominant strategy?

    • Yes, to advertise
  • At the Nash Equilibrium, what is H & IPM's daily profit? What is Hello Market's daily profit?

    • Choose B

    • H & IPM's daily profit: $480

    • Hello Market's daily profit: $350

  • Suppose the cost of advertising is $50 per day, redraw the matrix to include advertising costs for each firm

    Hello Market Advertise Not Advertise Advertise A ($200, $ 160) c Not
Advertise ($175, $500) ($430, $350) ($410, $400)

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