10.2 Oligopoly

Oligopolies are markets dominated by a few big players. These firms have serious clout, able to sway prices and fend off new competitors. It's a delicate dance of competition and cooperation, with each company eyeing the others' moves.

The prisoner's dilemma shows why oligopolies often end up competing instead of teaming up. Even though working together could mean bigger profits, the temptation to undercut rivals usually wins out. It's a classic case of short-term gain versus long-term pain.

Oligopoly

Small Number of Large Firms

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• Oligopoly is a market structure characterized by a small number of large firms each with significant market power to influence prices
• High barriers to entry (economies of scale, startup costs, patents) prevent new firms from entering and competing
• Firms are interdependent their actions affect the profits and strategies of other firms in the market
• Must consider potential reactions of competitors when making pricing, output, and other strategic decisions
• Products can be homogeneous identical across firms (steel, aluminum) or differentiated with unique features or branding (smartphones, automobiles)

Competition vs Collusion

• Oligopolists face a choice between competing independently to maximize their own profits or colluding to set prices and output to maximize joint profits
  • Competition can lead to price wars and lower profits for all firms in the market
  • Collusion can be explicit with formal agreements or tacit with informal understandings
  • Explicit collusion (cartels) is often illegal under antitrust laws designed to promote competition
• Game theory analyzes the strategic choices of oligopolists considering the potential actions and reactions of competitors
• Outcomes depend on the specific assumptions and payoffs of the game being played
• Cartels are unstable because firms have an incentive to cheat on the agreement by secretly lowering prices or increasing output
  • Enforcement mechanisms are required to prevent cheating and maintain cartel stability

Prisoner's Dilemma

• Game theory model illustrating the tension between cooperation and self-interest
  • Two suspects interrogated separately must choose to confess or remain silent
  • Both remain silent light sentence (1 year)
  • Both confess moderate sentence (5 years)
  • One confesses, other silent confessor goes free, silent suspect heavy sentence (10 years)
• Dominant strategy for each suspect is to confess (Nash equilibrium) even though both would be better off remaining silent
• Applied to oligopoly behavior firms face tension between competition (confessing) and collusion (remaining silent)
  • Nash equilibrium is to compete even though collusion would result in higher profits
  • Explains why cartels are unstable and firms engage in price wars despite potential for higher profits through collusion