A-Level Economics Notes on Oligopoly and Game Theory

Definitions

1. Oligopoly: A market structure with a small number of firms that control the market.
2. Barriers to Entry: Factors that prevent new firms from entering the market.
3. Price Leadership: When one firm sets the price and others follow.
4. Non-Price Competition: Competition based on factors other than price, like quality or service.
5. Collusion: An agreement among firms to set prices or output levels.
6. Cartel: A formal organization of producers that agree to coordinate prices and production.
7. Game Theory: A mathematical model that studies strategic interactions among rational decision-makers.
8. Nash Equilibrium: A situation where no player has an incentive to deviate from their current strategy.
9. Dominant Strategy: A strategy that yields the highest payoff regardless of what the other players do.
10. Prisoner’s Dilemma: A game where players can either cooperate for mutual benefit or betray each other for individual gain.
11. Payoff Matrix: A table that shows the payoffs for each player for every possible combination of strategies.
12. Zero-Sum Game: A game where one player’s gain is exactly offset by another player’s loss.
13. Cournot Model: Assumes firms compete on quantity and make decisions simultaneously.
14. Bertrand Model: Assumes firms compete on price and make decisions simultaneously.
15. Stackelberg Model: Assumes one firm acts as a leader and the others as followers in setting output levels.

Oligopoly

An oligopoly is a market structure where a small number of firms dominate the market. These firms often have significant control over price and other market factors.

Characteristics

1. Few Players: Limited number of firms.
2. Price Control: Ability to set prices rather than take them.
3. High Barriers: Difficult for new firms to enter the market.

Real-World Examples

1. Oil and Gas: Major companies like ExxonMobil and Chevron dominate this sector.
2. Airlines: Limited carriers like Delta and American Airlines control the market due to high entry barriers.
3. Soft Drinks: Coca-Cola, PepsiCo, and Dr. Pepper Snapple Group hold almost 90% of the U.S. market.
4. Telecom: Companies like Verizon and AT&T dominate the U.S. telecommunications market.
5. Automobiles: Brands like Ford, Toyota, and Tesla are key players.

Game Theory

Game theory is a framework for modeling scenarios where conflicts of interest exist among players. It helps in understanding how economic agents make choices that produce outcomes related to their preferences.

Prisoner’s Dilemma

This is a classic game theory thought experiment. It involves two rational agents who can either cooperate for mutual benefit or betray each other. The dilemma provides a framework for understanding the balance between cooperation and competition in business.

In the Prisoner’s Dilemma, two individuals are arrested and held in separate cells. They face two options: to cooperate with each other by staying silent or to betray each other by confessing. The outcomes depend on the choices both make.

Outcomes

1. Both Cooperate: Each serves a short sentence.
2. Both Betray: Both get a long sentence.
3. One Betrays, One Cooperates: The betrayer goes free, and the cooperator gets the longest sentence.

The dilemma arises because each individual, acting in their self-interest, would choose to betray, thinking it would lead to the best outcome for them. However, if both betray, they end up with a worse outcome than if they had both cooperated. This is a paradox because acting in their own self-interests does not produce the optimal outcome for either party.

Cournot Competition

Cournot competition is an economic model focusing on oligopolistic markets, where a few firms dominate. In this model, firms independently and simultaneously decide on the quantity of goods to produce.

1. Homogeneous Goods: Firms produce identical or similar products.
2. Quantity Competition: Firms compete based on the quantity they produce, not the price.
3. Negative Externality: Firms don’t consider the impact of their production levels on competitors.
4. Market Price: Determined by the total output of all firms in the market.
5. Equilibrium: Firms reach a stable state where neither wants to change its output level, given the other’s choice.
6. Complexity: In markets with many competitors, finding the equilibrium can become chaotic.
7. Dynamic Interactions: Some models consider how firms’ strategies evolve over time, including R&D efforts.

Cournot competition often applies to industries like refining and wholesale gas operations, where firms produce a homogenous product and compete on quantity.

Stackelberg Model

The Stackelberg model is a game theory framework used to analyze market competition, particularly in oligopolistic settings. In this model, firms are categorized into two roles: a “leader” and one or more “followers.” Here’s how it works:

1. Leader’s Move: The leader firm makes the first move by setting its output level or price.
2. Followers’ Response: After observing the leader’s decision, the follower firms make their output or pricing decisions.
3. Market Equilibrium: The market reaches an equilibrium based on these sequential decisions.
4. Strategic Advantage: The leader has a strategic advantage because it can anticipate how followers will react to its decisions.
5. Identical Products: The model often considers firms with identical products making output decisions simultaneously.

The Stackelberg model is particularly useful for understanding how firms in an oligopoly can gain a competitive edge by strategically positioning themselves as leaders or followers.