Topic 10: Oligopolies

Question 1

Define oligopoly

Answer 1

def.: a market structure that lies between competitive industries (many sellers) and monopolies (one seller, characterised by a small number of large firms that are interdependent in their decision making e.g. domestic airline industry, supermarkets, tobacco industry, steel manufacturing industry, soft drink industry, banking and finance industry

• decisions of one firm are influenced by the most likely market response of their competitors.
• oligopolies are like a tennis match where each player’s action depends on what their opponent does

Question 2

What are the characteristics of an oligopoly

Answer 2

1. number of sellers:

• oligopolies are markets with only a few large sellers that dominate the market for a good or service. but this can come in many different forms: e.g. industries which operate with only two large firms (known as duopoly)
• industries which operate with lots of small firms and one large dominant firm
• industries which operate with four or five firms.

1. type of products:

• oligopolies can have either homogenous (same) or differentiated products
• homogenous products: e.g. oil industry and steel industry
• differentiated products: e.g. car industry.

1. barriers to entry:
2. economies of scale: if existing firms already producing a level of output that is at the minimum efficient scale, then difficult for potential producers to enter the market as they would have to be able to sell a high level of output to be competitive
3. ownership of a key input: - similar to monopoly (e.g. de Beers and diamonds)
4. government-imposed barriers: on a small amount of firms e.g. licensing requirements, tariffs and quotas on imports

Question 3

What are the difficulties of analysis of oligopolies?

Answer 3

• as firms in an oligopoly industry are interdependent, analysing their behaviour is complicated i.e. there is no ‘one’ model as we had for perfect competition, monopoly and monopolistic competition.
• oligopolies are more difficult to analyse as the demand curve facing an individual firm cannot be specified until the behaviour of competing firms is known. There are many theories/models developed to explain oligopoly pricing behaviour – there is not one general theory.
• to analyse oligopolies, we need to look at the unique structure of each individual industry: e.g. size of the market, number and concentration of firms (level of competition), degree of interdependence and significance of barriers to entry to the market.
• the different types of interdependence in oligopolies lends itself to the application of strategic behaviour, or game theory.

Question 4

What is game theory, and the general 3 elements of each model?

Answer 4

game theory: models that analyse an oligopoly firm’s behaviour as a series of strategic moves which take into account rivals actions i.e. profits or sales of each firm depend on its interaction with other firms.

all game theory models have 3 elements:

• rules: the initial conditions governing the conduct of the players in the game e.g. no collusion allowed between players.
• strategies: the decision options which the player has e.g. raising or lowering their product price, player’s strategies take into account the most likely reaction of other firms.
• payoffs: what each player stands to gain or lose when certain strategies are followed. payoffs usually take the form of an increase in profit, sales, utility etc.

Question 5

What is a payoff matrix?

Answer 5

• summarise players’ strategies and payoffs
• shows the payoffs that each player will get from every combination of strategies by all players in the game. A player has to analyse the choices available, and the best strategy to employ, given every possible action of the other players

Question 6

What is the prisoner’s dilemma?

Answer 6

prisoner’s dilemma: a two player or two firm game (i.e. a duopoly) which models typical oligopoly behaviour.

oligopoly question this game addresses: do firms cooperate (collude) with each other or do they not cooperate?

how does prisoner’s dilemma work? gets its name from a hypothetical story of two suspects arrested by the police for a bank robbery, and put in separate cells. the police lack evidence on the actual robbery itself, and so can only get a conviction if one or both confess to the crime. they can, however, get them on the minor charge of weapons possession.

• the police offer each prisoner the option of confessing, in which case they will be free to go, while the other person will go to jail for 12 months.
• if they both confess, both will go to jail for 8 months
• if neither confesses, the police can only charge them with weapons possession, which incurs a penalty of 1 month in jail.

Question 7

What is the solution to the prisoner’s dilemma?

Answer 7

step 1: put yourself in the position of one of the prisoners (eg prisoner x)

step 2: go through the payoffs you would receive depending on what prisoner y does

if y keeps quiet, then x’s best strategy is to confess (because 0 is better than 1 month in jail) - if y confesses, then x’s best strategy is also to confess (because -8 is better than -12)

step 3: go through the same process, putting yourself in the position of the other player

step 4: the equilibrium strategy: for both prisoners, regardless of what the other player does, the best strategy is always to confess. this is the dilemma: clearly it would be better for both if they both stayed silent, however, irrespective of what the other does, it is always in each prisoner’s best interest to confess.

Question 8

Discuss the prisoner’s dilemma in terms of business

Answer 8

• two firms get option of charging a higher or lower price for the same good, which price they choose depends on the price charged by the other store
• rules: cannot collude (i.e. agree to both sell tablets for the higher price), firms must choose to charge either price for the goods and must consider what the other store might charge
• dilemma: if both sell at the higher price, they will both earn higher profits than if they charge the lower price. But will they? Optimal situation for both firms ends up charging lower price
• dominant strategy: one strategy is chosen in all situations
• equilibrium: for both stores to charge lower price earning the same amount of profit/week which is lower than what they would receive if they cooperated
• dominant strategy equilibrium: an equilibrium where one strategy is always the optimal strategy to pursue.
• Nash equilibrium: a set of strategies, one for each player, where each player’s strategy is their best choice given the other player’s strategy. That is, an equilibrium where neither player can increase their profit from changing their strategy once each player’s strategy is revealed

Question 9

How can firms escape the prisoner’s dilemma?

Answer 9

• prisoner’s dilemma is a one-off game.
• what happens if the game is played many times?
• if the game is repeated many times, the long-run outcome can differ, there are lots of potential strategies available

1. using signalling as an enforcement mechanism – e.g. each advertises that they will match the lowest price offered by their competitor, firms collude to maintain higher price and profits
2. tit-for-tat (trigger strategy): a firm responds in one period with the same action that the rival firm used in the last period. – i.e. cooperation invites a cooperative response and non-cooperation invites a noncooperative response.

• firms in an oligopoly often prefer to keep a cooperative repeated game strategy on critical factors like price (Firm A increases price leading to Firm B increasing price) and a non-cooperative strategy for factors such as advertising budgets (Firm A advertises, firm B advertises to maintain market share)

Question 10

Discuss the difference between PCs and oligopolies in terms of price, profit and efficiency loss

Answer 10

• differences between PC markets and Oligopoly markets

Price

• if firms in an oligopoly market engage in either implicit or explicit collusion, industry output is lower and price is higher compared to firms in a perfectly competitive market.
• if price wars occur in oligopoly markets then prices could be temporarily lower than in PC markets (until they bankrupt the competition) leading to an increase in price in monopoly – not better as always ends with both firms making losses

Profit

• firms in an oligopoly have the ability to make long-run economic profits whereas firms in a perfectly competitive market do not as oligopolies have barriers of entry, such as economies of scale

Efficiency loss

• there is generally efficiency loss in oligopoly markets, unlike perfectly competitive markets
• efficient resource allocation requires the marginal benefit to the consumer to be equal to the marginal cost. in the oligopoly models examined, price was higher than marginal cost, indicating the presence of some deadweight loss.
• collusive firms generally have a bigger dead weight loss than non-cooperative solutions to games in game theory models.