# 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)

• 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)

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 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