MCO - Oligopoly Lesson

Oligopoly Lesson

Oligopoly is a step further away from perfect competition than monopolistic competition. The general characteristics of oligopoly include the following:

• The market is characterized by a few large producers.
• There are significant barriers to entry.
• Products can be standardized (as in perfect competition) or differentiated (as in monopolistic competition).
• The behavior of firms operating in an oligopolistic market is marked by interdependent behavior.

Examples of oligopolistic markets include soft drinks, airlines, tobacco products, and probably video games/consoles.

Oligopoly Video

View the video below to learn more. To make the video full screen, click the double arrows at the bottom right corner of the object.

The key characteristic of an oligopoly is interdependent behavior. Because of the sheer size of the firms in the market, each firm must take into consideration the actions of competing firms. Game theory can be utilized to help understand the importance of interdependent behavior.    

Bonnie and Clyde Activity

Game theory evaluates the strategic decisions of participants in anticipation of the potential response by rivals. Remember, models are best built when kept simple. Let's explore game theory by first looking at the quintessential example of the theory - the prisoner's dilemma. Bonnie and Clyde have just been picked up on their first bank heist. They have been sequestered in separate interrogation rooms for questioning and are not allowed to communicate. Although the two suspects cannot communicate, each is aware of their choices and corresponding prison terms depending on whether they confess or keep quiet.  

The payoff matrix below shows the strategies available and the outcome of those strategies.

Locked away in her own interrogation room, Bonnie must consider her strategy - to confess to the crime or remain silent. She isn't aware of what Clyde will do, but she does know his options and the length of jail time she will do for each possible combination of decisions she and Clyde may make. Clyde faces the same dilemma as Bonnie - trying to decide what he should do in the face of what Bonnie may do. The information in the matrix above shows the jail time Clyde will do to the left of the comma and the jail time Bonnie will do to the right of the comma in each box.

For Bonnie and Clyde, the "confess, confess" strategy is a Nash equilibrium, named after mathematician John Nash. That is, neither player would want to deviate unilaterally from that strategy. However, if the two crooks were able to communicate and had some level of trust established, together they would be better off to remain silent. This would be the cooperative outcome. Repeated "games", or situations like this among players, can eventually result in a cooperative outcome that would be to the benefit of both parties involved. 

Peppy Pizza vs. Pizza Amore Activity

Now, let's consider a case of just two firms competing in a non-collusive manner in an oligopolistic market. A non-collusive model means that the two firms are not cooperating (colluding) with each other. They each operate in their own best interest taking into account the potential actions of their competitor. The payoff in this example will be the potential profit each firm could earn.

Two firms, Peppy Pizza and Pizza Amore are the only two producers of delivery pizzas on the island of Calzone. The payoff matrix below shows the different levels of profit based on pricing options (to run a special or not) for each pizza restaurant.      

The information to the left of the comma represents profits for Pizza Amore and the information to the right of the comma represents profits for Peppy Pizza.

Collusion

In the Unites States' economy, collusion among firms operating in an oligopolistic market is illegal. Through collusion, firms agree to charge very similar (high) prices. In essence, by forming a cartel and practicing collusion the firms act as a monopoly. The oil cartel, OPEC, is an example of collusion in an oligopolistic market. While explicit collusion is illegal in the U.S., tacit collusion is not. Tacit collusion does not involve a direct agreement between firms. Rather, through experience in the market, firms come to realize the strategies that provide the greatest benefits and act (set prices and output) accordingly. This lessens competition in the market, reduces efficiency, and generally harms the consumers. In practice, cartels, explicit collusion agreements, and tacit collusion are difficult to maintain because there is great incentive to defect. Oftentimes, by secretly breaking the terms of the collusion agreement, a firm is able to increase its profit. When a firm defects, it can lead to a price war between the members of the oligopoly. Generally, this is to the benefit of the consumers because prices are driven down. 

Collusion Video

The video below gives more detail on collusion. To make the video full screen, click the double arrows at the bottom right corner of the object.

IMAGES CREATED BY GAVS