Chapter 14: Oligopoly and Strategic Behavior

prisoner's dilemma

A famous game analyzed in game theory, in which two players who could have reached a mutually beneficial outcome through cooperation will instead end up at a mutually inferior outcome as they pursue their own respective interests (instead of cooperating). Helps to explain why collusion can be difficult for oligopoly firms to achieve or maintain.

cartel

A formal agreement among firms (or countries) in an industry to set the price of a product and establish the outputs of the individual firms (or countries) or to divide the market for the product geographically.

oligopoly

A market structure in which a few firms sell either a standardized or differentiated product, into which entry is difficult, in which the firm has limited control over product price because of mutual interdependence (except when there is collusion among firms), and in which there is typically nonprice competition.

How is mutual interdependence defined?

A situation in which a change in price strategy (or in some other strategy) by one firm will affect the sales and profits of another firm (or other firms). Any firm that makes such a change can expect its rivals to react to the change.

Define collusion.

A situation in which firms act together and in agreement (collude) to fix prices, divide a market, or otherwise restrict competition.

price leadership

A type of implicit understanding used by oligopolists to coordinate prices without engaging in outright collusion.

Oligopolistic firms do which of the following when they change their pricing strategies?

Affect profits and influence the profits of rival firms.

price leadership

An informal method that firms in an oligopoly may employ to set the price of their product: one firm (the leader) is the first to announce a change in price, and the other firms (followers) soon announce identical/similar changes.

differentiated oligopoly

An oligopoly in which firms produce a differentiated product.

homogenous oligopoly

An oligopoly in which firms produce a standardized product.

What is the Nash equilibrium?

An outcome in the payoff matrix from which neither firm wants to deviate since the current strategy is optimal given the the rival's strategic choice.

How can oligopolistic firms influence their profits and the profits of their rivals?

By changing pricing strategies.

cheating

Collusive oligopolists are tempted to engage in secret price cutting to increase sales and profit. Buyers' attempts to play producers against one another may precipitate price wars among other producers.

collusion

Cooperation with rivals.

obstacles to collusion

Demand and cost differences, number of firms, cheating, recession, new entrants, and legal obstacles.

Obstacles to Collusion

Demand and cost differences, number of firms, cheating, recession, potential entry, and legal obstacles/antitrust laws.

Reasons for Three Models

Diversity of oligopolies and mutual interdependence.

What occurs with price leadership?

Dominant firms initiate price changes and then other firms follow the leader. This is implicit collusion because not every one agreed on the price change. It limits pricings and sets a price below the profit-maximizing level to block out new firms. Acts as a barrier of entry to keep firms out.

What does a two-firm payoff matrix show?

Firms' profits from alternative combinations of strategies.

demand & cost differences

If oligopolies face different costs and demand curves, it is difficult for them to agree on a price. Firms usually have somewhat different market shares and operate with differing degrees of productive efficiency. Also unlikely that homogenous oligopolies would have the same demand and cost curves.

What are oligopolists able to do by controlling price through collusion?

Increase profits, reduce uncertainty, and prohibit the entry of new rivals.

Leadership Tactics

Infrequent price changes, communications, and limit pricing.

What is the only stable outcome in a payoff matrix?

Nash Equilibrium

What is the most significant example of an international cartel?

OPEC

Sherman Act

Outlaws all contracts, combinations, and conspiracies that unreasonably restrain interstate and foreign trade.

Why are oligopolies allocatively and productively inefficient?

P > MC and P > min. ATC.

What are barriers to entry in both monopolies and oligopolies?

Patents, large capital investment, preemptive pricing, and ownership and control of raw materials.

infrequent price changes

Price changes always carry the risk that rivals will not follow the lead. Price is changed only when cost and demand conditions have been altered significantly and on an industrywide basis as a result of: industrywide wage increases, increase in excise taxes, or an increase in the price of some basic input such as energy.

Oligopolists often compete through product development and advertising instead of price. Why?

Product development and advertising are relatively difficult to copy.

What are obstacles to collusion in an oligopolistic industry?

Recession, cheating, antitrust laws, and demand and cost differences.

Barriers to Entry in Oligopoly

Scale economies, control of patents or strategic resources, and the ability to engage in retaliatory pricing.

strategic behavior

Self-interested behavior that takes into account the reaction of others.

What is strategic behavior?

Self-interested economic actions that take into account the expected reactions of others.

recession

Slumping markets increase average total cost. In response to a recession, each firm moves leftward and upward to a higher operating point on its ATC curve.

What does game theory reveal?

That oligopolies are mutually interdependent, collusion enhances oligopoly profits, and there is a temptation for oligopolists to cheat on a collusive agreement.

What are three models used to study pricing and output by oligopolies?

The Price Leadership Model, Collusive Pricing Model, and Kinked-Demand Curve Model.

potential entry

The greater prices and profits that result from collusion may attract new entrants, including foreign firms.

number of firms

The larger the number of firms, the more difficult it is to create a cartel or some other form of price collusion.

Oligopoly Characteristics

The market contains a few large producers, firms may sell a homogenous product, firms may sell a differentiated product, and firms' advertising decisions are interdependent.

Why is collusion desirable to oligopolistic firms?

The possibility of price wars diminishes and profits are maximized.

limit pricing

The price leader does not want to always choose the price that maximizes short-run profits for the industry because the industry may want to discourage new firms from entering. To discourage new entry and maintain the current oligopolistic structure of the industry, the price leader may keep price below the short-run profit-maximizing level.

communications

The price leader often communicates impeding price adjustment to the industry through speeches by major executives, trade publication interviews, or press releases.

mutual interdependence

The situation in an oligopolistic industry in which profits of each firm depend on the actions of rivals.

game theory

The study of behavior in strategic situations.

game theory

The study of how one firm reacts to the actions taken by another firm or individual when implementing a strategy.

game theory

The study of how people behave in strategic situations in which individuals must take into account not only their own possible actions, but also the possible reactions of others. It was originally developed to analyze the best ways to play games like poker and chess.

What kinds of products do oligopolies produce?

They may produce homogenous or differentiated products.

legal obstacles/antitrust laws

U.S. antitrust laws prohibit cartels and price-fixing collusion. Less obvious means of price control have evolved in the U.S.

dominant strategy

When a firm's pricing option is better than any alternative pricing option regardless of the pricing strategy its rival follows.

What is mutual interdependence?

When sales and profits of one firm affect another.

Oligopolies are comprised of...

a few large producers.

The study of how people behave in strategic situations.

game theory

What is the diagram called with four cells representing the possible pricing strategies of two firms?

payoff matrix

Oligopolistic behavior implies that oligopolists prefer competition through...

product development and advertising.

Barriers to entry into an oligopoly most resemble those of a...

pure monopoly.

What is the term for self-interested actions that take the reactions of others into account?

strategic behavior

A firm in an oligopolistic market...

can set its price and output to maximize profits.

What is it called when a group of producers creates a formal written agreement stating the level of output by each firm and the prices that must be charged?

cartel

What term means "cooperation with rivals?"

collusion

Three Models of an Oligopoly

1. Kinked Demand Curve Theory 2. Collusive Pricing (Cartels) 3. Price Leadership