Definitions
- Market Structure: The organization and characteristics of a market, including the number of firms, level of competition, and type of products offered.
- Concentration Ratio: A measure of the total output produced in an industry by a given number of firms, typically used to quantify the level of market control in an oligopoly.
- Barriers to Entry: Obstacles that prevent new competitors from easily entering an industry or area of business.
- Price Leadership: A situation where one firm sets the price for the industry, and other firms follow.
- Product Differentiation: A strategy where firms try to make their products appear unique and more attractive than those of their competitors.
- Cartel: A formal agreement between firms in an industry to coordinate their production, pricing, and marketing policies.
- Tacit Collusion: A situation where firms in an oligopoly indirectly coordinate actions without a formal agreement, often by observing and responding to competitors’ actions.
- Price-Fixing: An agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand.
- Monopoly: A market structure characterized by a single seller, selling a unique product in the market.
- Game: Any set of circumstances that has a result dependent on the actions of two or more decision-makers (players).
- Strategy: A complete plan of action a player will follow in a given game, including the actions the player will take in response to any possible moves by other players.
- Payoff: The reward received by a player in a game, such as profit or utility.
- Nash Equilibrium: A concept within game theory where a player does not change their strategy given the strategy of the other player because the current set of strategies results in the highest payoffs for both.
- Dominant Strategy: A strategy that is the best for a player to follow no matter what the strategy of the other players.
- Prisoner’s Dilemma: A standard example of a game analyzed in game theory that shows why two completely rational individuals might not cooperate, even if it appears that it is in their best interest to do so.
- Cournot Competition: A model of oligopoly in which firms compete on the amount of output they will produce, which they decide on independently and at the same time.
- Bertrand Competition: A model of oligopoly in which firms compete on price.
- Stackelberg Competition: A strategic game in which one firm sets its output before other firms within the industry.
- Kinked Demand Curve: A perceived demand curve that arises when competing oligopoly firms commit to match price reductions but not price increases.
Oligopoly
Definition: An oligopoly is a market structure characterized by a small number of firms that have significant market power, which means they can influence the prices and other market factors. It’s more competitive than a monopoly (where only one company dominates) but less competitive than monopolistic competition and perfect competition.
Characteristics:
- Few Firms: The market has few firms that are large enough to have market control.
- Interdependence: Firms in an oligopoly are interdependent; the actions of one firm affect the others.
- Barriers to Entry: High barriers to entry prevent new firms from entering the market easily.
- Product Differentiation: Products may be differentiated or homogeneous.
- Non-Price Competition: Firms often compete on factors other than price, such as advertising and product quality.
Examples:
- Automotive industry
- Telecommunications
- Airlines
Collusion
Definition: Collusion occurs when firms in an oligopoly agree to control their production, market shares, or prices to gain an advantage over competitors, often leading to higher prices for consumers.
Types of Collusion:
- Formal Collusion (Cartels): When firms openly agree on pricing, production, and other market strategies. For example, OPEC.
- Tacit Collusion: When firms indirectly coordinate actions without explicit agreement, often by following the lead of a dominant firm.
Legality: Collusion is illegal in many countries and is regulated by antitrust laws.
Challenges to Collusion:
- Cheating: Firms may secretly undercut agreed prices to gain market share.
- New Entrants: New firms may enter the market and disrupt the collusive agreement.
- Economic Recession: During a downturn, the pressure to compete on price can increase, leading to a breakdown in collusion.
Game Theory
Definition: Game theory is a mathematical model of strategic interaction among rational decision-makers. It’s used to analyze situations where the outcome for each participant depends on the actions of all.
Key Concepts:
- Players: The decision-makers in the game (e.g., firms in an oligopoly).
- Strategies: The plans of action available to players.
- Payoffs: The rewards received by players resulting from the combination of strategies chosen by all players.
- Nash Equilibrium: A situation where no player can benefit by changing their strategy while the other players keep theirs unchanged.
Applications in Oligopoly:
- Price Wars: Game theory can predict the outcomes of competitive pricing strategies.
- Collusive Behavior: It helps understand the stability of collusion and the incentive to cheat.
- Market Entry: It can analyze the potential responses by incumbent firms to the entry of new competitors.
Prisoner’s Dilemma: A classic example in game theory that shows why two rational individuals might not cooperate, even if it appears that it is in their best interest to do so.
Limitations:
- Assumes rational behavior and complete information, which may not always be the case in real-world scenarios.
- Can be complex to apply due to the number of variables in real-life market situations.
Diagrams and Models to Understand Oligopoly and Game Theory
Kinked Demand Curve: Illustrates how an oligopolistic firm may reduce quantity but not price, leading to a rigid price in the market.
Cournot Model: Assumes firms choose quantities to produce, and each firm’s output decision affects the market price.
Bertrand Model: Assumes firms compete by setting prices simultaneously, leading to a more competitive outcome than the Cournot model.
Stackelberg Model: Assumes one firm is a leader that makes its decision first, with followers making their decisions afterward.
Mark is an A-Level Economics tutor who has been teaching for 6 years. He holds a masters degree with distinction from the London School of Economics and an undergraduate degree from the University of Edinburgh.