Oligopoly
The challenge of analyzing
interdependent strategic decisions
Objectives
The learner will be able to:
1. Define an oligopoly and identify the unique
characteristics of this market form.
2. Describe the various approaches that
economists use to analyze the decisions and
behavior of oligopolies.
3. Explain how game theory is used as a tool to
understand and predict the strategic decisions
of firms in an oligopolistic industry.
Oligopoly Defined



“Oligopoly” comes from Greek roots meaning
“few sellers.”
An oligopoly is a market dominated by a few
sellers (somewhere between one and very many),
at least several of which are large enough to be
able to influence the market price.
Oligopolistic industries account for a major
share of economic activity (oil, autos, consumer
products, metals and mining, airlines)
The Analytical Challenge



Oligopolies pose a difficult analytical challenge
for economists.
Why is it so difficult?
Firms in an oligopolistic industry:
Choose prices and outputs for their products
 Must anticipate (or at least consider) the responses
of competitors to their actions

The Analytical Challenge (Cont’d)



Put another way, the business choices faced by
oligopolies (pricing, output, production capacity)
are strategic decisions.
These strategic decisions are interdependent, in
that outcomes are based on the responses of
other firms in the industry.
Actions and variables based on interdependent
decisions are difficult to isolate and predict.
A Theoretical Starting point


In principle, the economic profits generated by
an oligopoly should never be higher than a pure
monopoly – since a monopoly chooses the price
that maximizes industry profits.
A brief review …
Theoretical Starting Point (Cont’d)


An oligopoly should also never earn less than
the zero economic profit of a perfectly
competitive industry in long run equilibrium.
A quick refresher on pricing and returns in a
perfectly competitive industry …
Somewhere Between the Extremes



Common sense says that economic returns for
oligopolies should lie somewhere between the
two theoretical extremes represented by perfect
competition and pure monopoly.
But where…
Let’s look at a few ways that economists have
attempted to think through this analytical
challenge.
Ignore the Complications




One approach is to ignore the whole issue of
interdependent decisions and assume that each
firm in an oligopolistic industry will maximize
their own returns without any regard for their
rivals’ actions.
This would equate to a monopoly model.
Good news – it’s simple.
Bad news – it misses the whole point.
Cartels



Another approach is to assume that firms in an
oligopolistic industry agree to coordinate their price
and output decisions, otherwise known as a cartel.
Cartels do exist (does OPEC sound familiar?), but they
are usually difficult to form and hold together.
Cartels represent the worst of all worlds from an
economic standpoint (monopoly pricing with none of
the efficiencies from scale).
Tacit Collusion



Another way to think about the problem is to assume
that firms in an oligopolistic industry will find ways to
signal their intentions indirectly, in order to maximize
their economic returns.
This can take the form of price leadership, which is
exercised (and policed) by the industry leader.
Problems – Unequal distribution of industry profits;
new entrants may rock the boat.
Sales Maximization Model




Based on the theory that professional managers of
large, public companies are paid to maximize the size
of their firm, not its profitability.
Economists know how to model behavior based on a
known variable (sales maximization).
There is some correlation between manager
compensation and the size of firms.
Problem – Management teams that focus on sales to
the exclusion of profitability are eventually removed
and their companies are often acquired or taken private.
Back to the Analytical Problem


As you can probably tell, traditional
microeconomic theory does not have a very
good (or easy) answer to the problem of
predicting oligopoly pricing and returns.
Enter game theory…
Game Theory


Deals with the issue of interdependence directly,
by assuming that firms in oligopolistic industries
act as competing players in a strategic game.
Link between economics and game theory is the
belief that human beings are rational in their
economic choices and always act to maximize
their rewards (seem like reasonable
assumptions).
Game Theory (Cont’d)


Game theory provides a way to analyze and
predict behavior when people interact directly,
rather than indirectly through the market.
Outcomes of the “game” depend not just on
one player’s choices, but on the actions or
reactions of the other player(s) – which is the
essence of the oligopoly analytical problem.
The Prisoners’ Dilemma
Prisoner A
Confess
Confess
Don’t
10, 10
0, 20
20, 0
1, 1
Prisoner B
Don’t
Game Theory (Cont’d)



Provides a model to explain how people (or
firms) in pursuit of their own self interest may
(and often do) act in a manner that leads to
them forgoing a more optimal result.
Think about the Prisoner’s Dilemma in the
context of results that are meaningful (or
potentially painful) to you.
Your grade in AP Economics is an example that
comes to mind.
The Students’ Dilemma
Student A
Help Study
Help Study
Don’t
B, B
F, A
A, F
C, C
Student B
Don’t
Game Theory (Cont’d)


Games (or scenarios) that provide the
opportunity for repeated interactions add
another element of complexity – the ability to
learn your opponent’s personality, anticipate
their actions, and build trust (or mistrust).
This aspect of game theory mimics the
continuous interactions of strong competitors in
a market.
Review – Four Market Forms


Perfect competition and pure monopoly are the
theoretical bookends that frame our thinking
about the different forms of industry structure.
In between these theoretical extremes…
Monopolistic Competition
1.
2.
3.
4.
5.
Differentiated products
Sloped demand curve
Potential for excess returns in the short run
Zero economic profit at long run equilibrium
At long run equilibrium – excess capacity and
inefficiency (intersection of D and AC above
minimum point on AC curve).
Oligopoly
1.
2.
3.
4.
Few large firms that can influence the market
Interdependent decisions
Traditional economic theory does not provide a clear
way to analyze oligopoly pricing, but you should
understand cartels, tacit collusion (price leadership),
and the sales maximization concept.
Game theory provides a useful model to analyze
business strategy and behavior in oligopolistic
industries.