Section14 Flashcards
What is an oligopoly?
A market structure with only a few sellers offering similar or identical products and
dominate the market, characterized by:
- high market concentration (small number of firms control the market)
- potential product differentiation
- barriers to entry (natural vs. strategic)
- interdependence among firms (one firm has some influence on the others; reaction function)
What is the concentration ratio in an oligopoly?
- It measures the proportion of total market share controlled by a certain number of firms.
- If >50%, the market is considered an oligopoly.
A market is considered an oligopoly if the concentration ratio of the top firms exceeds 50%.
e.g. Cellular telecommunications
How does production and pricing in an oligopoly compare to monopoly and perfect competition?
- Monopoly output < Oligopoly output < Perfect competition output
- Competitive market price < Oligopoly price < Monopoly price
Total profits are less than the monopoly profit.
What is a duopoly?
An oligopoly with only two firms, often analyzed for cooperative vs. non-cooperative behavior.
e.g. A town in which only two residents (Jacques and Joelle) own wells that
produce potable water.
Demand function
No fixed and variable costs marginal cost = 0
What is Nash Equilibrium in the context of oligopoly?
A situation where economic actors choose their best strategy given others’ strategies, resulting in no incentive to deviate from this point.
Each oligopolist is tempted to raise production and capture a larger share of
the market. As each of them tries to do this, total production rises, and the
price falls.
What is collusion?
Cooperative Behavior
An agreement among firms in an oligopoly on quantities to produce or prices to charge, often leading to cartel formation.
Why are cartels unstable?
Cooperative Behavior
Cartel: A cartel is an organization of independent firms which decide to coordinate
their individual activities explicitly
Firms are tempted to increase production beyond agreed levels, believing others will not respond, leading to competition.
Cartels are prohibited by antitrust laws in most countries; however, they
continue to exist nationally and internationally, formally and informally.
What is the Cournot Model?
An oligopoly model where firms produce a homogeneous good, assume competitors’ output is fixed, and decide quantities simultaneously.
What is the Prisoners’ Dilemma in oligopolies?
A scenario illustrating difficulty in maintaining cooperation; firms have an incentive to cheat for individual gain, harming collective outcomes.
What role does game theory play in oligopoly analysis?
It studies strategic interactions among firms, accounting for interdependence in decisions on output and pricing.
not sure if this is necessary
The industry with the highest degree of concentration shows:
Prices that are much higher than marginal cost and reduced output
Profits which are systematically higher than the average level
More advertising (per unit sold)
Higher expenditure on research and development (per unit sold)
Cooperative and Non-Cooperative Behavior
In perfect competition and in monopoly situations, the producers do not have
to consider a rival’s response when choosing output and price.
In an oligopoly, the producers have to consider the response of
competitors when choosing output and price.
There are two important strategies: cooperative and non-cooperative
behavior.
Factors Affecting the Formation of Cartels
Price elasticity: the more inelastic the demand curve facing the cartel, the
higher the price that the cartel can set and the greater its profit
Market entry of firms: high cost of entry
Organizational cost: the less complex the negotiations and the coordination
efforts are, the lower the cost to form a cartel
Economic stability: stability within the cartel increases the probability of its survival
Expected penalties: ineffectiveness of the competition law and of the
competition commission
Collusive Oligopoly Equilibrium
Assume that an industry is characterized by 4 firms (A,
B, C and D) with same cost curves and same products
(e.g. crude oil).
We can draw the demand curve of a single firm on the
assumption that all other firms follow the increase or
decrease in price of the corresponding firm (e.g. firm A)
Firm A will obtain exactly one fourth of the market.
If oligopolists arranged themselves to maximize profits
with respect to the implicit collusion, price and
quantity would be the same as in a monopolistic
market.
Breaking up cartels results in higher consumers’
welfare. The firms that are not in the agreement
anymore, produce more output than before. This leads
to lower market prices anti-trust authorities
Non-Cooperative Behavior
Because the number of firms in an oligopolistic market is small, each firm
must act strategically.
Each firm knows that its profit depends not only on how much it produces but also
on how much the other firms produce.
Each firm knows that its profit depends not only on the own price but also on the
price of the other firms.
Analysis of Strategic Interactions in Oligopoly
Classical economic model:
Cournot Model: Oligopoly in which firms produce a homogeneous good, each
firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce (quantity).
The Cournot Model and Nash Equilibrium
Reaction Curve
Relationship between a firm’s profit-maximizing output
and the amount it thinks its competitor will produce.
Reaction Curves and Cournot Equilibrium
Firm 1’s reaction curve shows how much it will produce as
a function of how much it thinks Firm 2 will produce.
Firm 2’s reaction curve shows its output as a function of
how much it thinks Firm 1 will produce.
Nash equilibrium: a situation in which economic
actors choose their best strategy given the strategies of
other actors
In Cournot-Nash equilibrium, each firm correctly
assumes the amount that its competitor will produce
and thereby maximizes its own profits. Therefore,
neither firm will move from this equilibrium.
Game Theory
Game theory is
the study of how people behave in strategic situations
characterized by incomplete information about the
intentions of other people.
the study of behavior in situation of interdependence.
Payoff Matrix
Payoff matrix– “a table showing the possible combination of outcomes (payoffs)
depending on the strategy chosen by each player”
The Prisoners’ Dilemma
Nash equilibrium: a
situation in which economic actors choose their best strategy given the strategies of other
actors
The dominant strategy is
the best strategy for a player
to follow regardless of the
strategies chosen by the
other players.
Cooperation is difficult to maintain because cooperation is not in the best
interest of the individual player.
Oligopolies as a Prisoners’ Dilemma: Self-interest makes it difficult for the
oligopoly to maintain a cooperative outcome with low production, high prices,
and monopoly profits.
Take Home Messages
An oligopoly is characterized by a market with few firms that recognize their strategic interdependence.
Oligopolists maximize profits by colluding and acting like a monopolist.
A cartel will typically be instable in the sense that each firm will be tempted to sell more than its agreed output if it believes that the other firms will not respond.
If oligopolists make decisions about production levels individually, the result
is greater quantity and a lower price than under the monopoly outcome.
