Economics: Oligopolies

Difficulty: 2/3 (A lot of content)
Review: 5/5 (Love the introduction of game theory)

Perfect competition, Monopolistic competition, oligopoly, monopoly. That is the scale of competition, where oligopoly is basically a market controlled by a few firms. It, along with monopolistic competition is known as imperfect competition.

A concentration ratio is the percentage output of a market for the top four firms, i.e. the breakfast cereal has a concentration ratio of 83%.

A duopoly is a market with only 2 firms, hence, 'duo'. When multiple firms cooperate and collude in collusion, they form a cartel. The Nash equilibrium is where one economic participant chooses a strategy based off of the strategies of the other participants. For example, in a duopoly, if profit maximization took place at output of 30 for each of them for a total of 60, and one firm chose to produce at 40, the other firm would choose to find the Nash equilibrium and produce 40 as well.

This tension between cooperation and self-interest causes the price and quantity in an oligopoly market to be in between the socially optimum (competitive) and monopolistic price and quantity.

Each firm makes decisions off of the output effect, raising production by 1 raises profit if price is above marginal cost; and the price effect, since quantity increases, profits decrease on average for all other units sold. Notice that as the oligopoly grows in size (in firms), the price effect disappears and leaves only the output effect and then every firm produces where P = MC. Thus, the more sellers there are in an oligopoly, the more it becomes like a competitive market.

To understand oligopolies, we must understand game theory: the study of how people behave in strategic situations. The prisoner's dilemma highlights the concept of cooperation vs. self-interest. It's where two prisoners choose to confess because whether the other prisoner confesses or not, the prisoner gets a better result if he/she confesses. This happens although the best scenario for the both of them occurs when neither confess. The individual strategy that is best for each player, in this case confessing, is called the dominant strategy.

The prisoner's dilemma relates back to oligopolies because although initially the firms may be outputting at the scenario where profits are maximized for all, a firm will eventually defect because it brings them more profits even though total profits for all decreases. This happens in OPEC, arms races, common resources (like oil drilling, one or two wells?), and more. It seems the best strategy is called tit-for-tat in the long term. A player should start by cooperating and then do whatever the other player did last time, basically, an eye for an eye.

The Sherman Antitrust Act of 1890 (declaring collusion as illegal) and the Clayton Act of 1914 (encourage lawsuits against legitimate economic conspirators) fight mergers and trusts and etc.

There are some other controversial business practices. They are controversial because some business practices that appear to reduce competition may in fact have legitimate purposes. One is resale price maintenance/fair trade, when a firm requires retailers to charge a certain higher price. Some argue that it doesn't allow for the retailer to compete on price, but others argue that the firm wants the retailer to invest more in sales force. Another is predatory pricing, changing prices like attempting to make price cuts in order to knock out rival firms from the market. It seems predatory pricing actually isn't profitable. Finally, there is tying, basically packaging two products together for sale. Some argue that companies pair unwanted products with more popular ones in order to sell more, while others argue that tying doesn't change willingness to pay and that it provides a form of price discrimination.

'Twas a long chapter.