Microeconomics 011: Oligopoly

Oligopoly is a market setting where a small number of firms have barrier to entry, such that additional firms do not enter the market. It is a setting that is the closest to our markets in in reality. A classic example of an oligopoly is the auto industry. Firms have some market power to set prices but they have to worry about the actions of their competitors.

Oligopoly is in the middle of two extreme market settings: perfect competition and monopoly. In an oligopoly, firms either behave cooperatively or non-cooperatively. When firms behave non-cooperatively, the oligopoly is closer to perfect competition setting. When firms behave cooperatively, the oligopoly turns into a monopoly. A classic example is the OPEC, a cartel that drives the price of oil in the world. It has huge market power and earn huge profit.

A tool to help us look at how firms behave in an oligopoly is the game theory.

Game Theory Basics

Each firm has a strategy to compete against each other. Each firm behaves in the market based on its own strategy, and all firms as a whole will determine the market outcome. This is the equilibrium concept. And a Nash equilibrium is a point at which no firm wants to change its strategy given all the competitors strategy.

The prisoner’s dilemma is a classic scenario to learn about game theory. In this scenario, two prisoners, A and B, are being interrogated separately for a certain crime they had committed. Each of them may take either of the two actions, which are to confess to the crime, or to deny their involvement. The following is the payoff matrix for their situation.

ME 15 Prisoners Dilemma

A dominant strategy is the best action to take no matter what the other party does. For the situation the prisoners are facing, in a non-cooperative setting, the dominant strategy is to deny, which will lead to a Nash equilibrium. From the perspective of each prisoner, no matter what the other party does, denying will give always give the greatest benefit.

Such payoff matrix can be plotted for scenarios in the market as well. Take advertising as an example, two firms in the market can agree to split the market equally, or compete by advertising.

ME 16 Advertisers Dilemma

Advertising

In a non-cooperative setting, the dominant strategy is to advertise, which becomes a race to the bottom, as advertising eats away the profit of both firms.

The opportunity to play repeated games can help to move the firms to a cooperative equilibrium, as the two parties will have the opportunity to build relationship and make more profit for extended period. For example, if the above payoff matrix shows the advertising decision for this current year, the two firms may attempt to collaborate and cease advertising. This arrangement will bring both firms more profit (8 mil each), and firms are less likely to betray the arrangement, because a betrayal will only allow the betrayer to profit more (13 mil) for this current year only, whereas cooperation will allow them to make much more profit over the course of the subsequent years.

However, this condition only works if the games are repeated forever. If any party discover that the game is going to end some years in future, that party will betray the collaboration right before the last game to maximise profit, and if both party knows this information, they will try to beat each other by betraying the collaboration first before the other, and working back from this logic to the starting game, the collaboration will totally fail.

Cournot Model of Non-Cooperative Oligopoly

In a Cournot equilibrium, a firm will choose a quantity to produce, such that holding the production quantity of all other firms constant, the firm is profit maximising. This is similar to the Nash equilibrium, except that the decision to make by firms is the quantity to produce.

In a simplified scenario with two firms in a market, they would simultaneously try to determine the quantity to produce. It will take some rounds of trial and error before they start producing at the optimal quantity. As firms adjust their output quantity, it would affect the supply of the market, which would then influence the market price. The price changes will signal to their competitor to adjust production output. So through a series of output adjustments by the firm and price movements by the market, eventually a market equilibrium would be reached, with an optimal quantity for both firms to maximise profit. This is the non-cooperative equilibrium.

In a cooperative setting, the two firms would form a cartel. They would face the market demand like a monopoly and determine the profit maximising price together, before dividing the production quantity. This would lead to a higher profit for both firms and at the same time they will produce a lower quantity for the society.

Cartels

In reality, cartels are difficult to sustain due to the following reasons:

  1. Instability
    There is an incentive for all parties in a cartel to cheat. A party can lower the price to sell a higher quantity and earn a higher profit than other parties. The effect of lower revenue is shared by all parties, but only the cheater will gain the increase in quantity sold.
  2. Legality
    As cartels are bad for consumer because it reduces social welfare, governments do not allow cartels from forming in certain industries.

Based on welfare economics, the larger the quantity of goods traded in a market, the smaller the deadweight loss, therefore the higher the social welfare. In a Cournot model, the more firms there are in a market, the closer the market will resemble perfect competition, and the better it is for social welfare. And by this concept, mergers of firms in the market will eliminate competition, and therefore should not be allowed by the governments, for the welfare of the society.

The counter argument to this is that merger allows firms to achieve economies of scale, which will help to lower cost. This is a trade off. By giving the firms a larger market power through merger, the government is hoping that costs of production will fall and eventually a larger quantity of goods will be traded and consumed, therefore increasing social welfare. This is similar to the concept of granting patents.

However in reality, there is no way to guarantee that merger will lead to economies of scale. And if that does not happen, the society is essentially allowing firms to form cartels, which makes the consumers worse off.

Bertrand Model of Price Competition

Other than the Cournot model, there are other models of competition. In the Bertrand model, firms set their price and just produce what is demanded by the market at that price. If there are only two firms in the market, then they will compete by lowering their prices, until eventually the market will reach perfect competition price level, even with just two firms.

Models of Oligopoly

So what model does a market behave in? It depends on the condition of the industry. For example, if the industry has a lag in the production process, it will be hard to engage in price competition as firms have difficulty adjusting production quantity to quickly meet market demand. Therefore under such conditions it is more likely that firms will set the production quantity instead and adjust price accordingly, like a Cournot model. Example of such markets are the airlines or the auto industry.

In conditions where production quantity can be easily adjusted to meet demands, then firms will compete by setting prices, like a Bertrand model. Examples are the market of breakfast cereal, sold in the supermarkets.

A way to beat Bertrand competition is through product differentiation. Product differentiation allows firms to gain market power and hence set a higher price as consumers no longer perceive the products as identical. Such a model is called monopolistic competition.

(Reference: MIT OCW Principles of Microeconomics)

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