UA EC 110 - A Basic Outline for Oligopoly Markets (4 pages)

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A Basic Outline for Oligopoly Markets



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A Basic Outline for Oligopoly Markets

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4
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University of Alabama
Course:
Ec 110 - Prin of Microeconomics
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A Basic Outline for Oligopoly Markets This document provides a basic outline of important concepts for understanding oligopoly markets It is clearly not complete but should serve as a way of filling in the outline to develop some detailed knowledge of the features of an oligopoly setting The key fact is that it is not possible to develop a clear unambiguous model of these markets in the way we can for competitive or monopoly market structures Note that examples will be discussed in class rather than presented as a part of this handout Some of the basics of oligopoly Understanding Entry Barriers Alternative Models to understanding oligopoly markets Cartels and Collusion Monopolistic Competition this is discussed in Chapter 16 we will discuss this very briefly Basic Oligopoly Facts Mutual Interdependence Strategic Interaction Market Structure Conditions Modeling Oligopolies Cooperation vs Non Cooperation Begin with simplest case the Duopoly Best Response concept Equilibrium Concepts Nash Equilibrium Game Theory What is Game Theory Noncooperative Games Central concept of the Nash Equilibrium Prisoner s Dilemma Dominant Strategy Equilibrium Alternatives Oligopoly Markets The key element to understanding this type of market is the concept of Mutual Interdependence This term simply implies that the actions of one firm affect the outcome for all firms For example if one firm decides to raise its price it affects its own demand but it also affects the demand for the other firms in the market as well This in turn affects the profits of that firm and all of the other firms That this means is that all firms have to take into account not only their own actions but also the actions of all of the other firms in the market This means that firms behavior is a form of Strategic Interaction It is useful to compare this type of behavior with a monopolist and a firm in a perfectly competitive market In both cases individual firms act without considering its impact on anyone else nor do these firms have to pay attention to the behavior of any other firm Market Structure Conditions In an oligopoly market we have conditions that are different from other market structures In particular an important element is that there are a few firms in the market so that each firm as a significant share of the market but not so large that any can ignore the behavior others Characteristics 1 Many buyers and few sellers 2 Entry conditions vary the easier the entry the more like perfect competition the market can become 3 Products can be homogeneous or heterogeneous 4 Information is generally incomplete Duopoly Models and Game Theory This is a simplified model of an oligopoly in which there are only two firms This allows enough interaction between the two firms to show the complexities of oligopoly In this context we presume that all firms or players will act in their own self interest This is just another example of maximizing behavior on the part of individuals We call this behavior Best Response This is where a decision maker takes the best course of action given what the other players are doing When all of the firms or players make their best response choice the outcome that results is called Nash Equilibrium This occurs when all players act optimally and rationally in their own self interest They will choose the strategy that maximizes its own profit given the strategies of other players No player can do better than this by a unilateral change in his or her strategy These models can be discussed effectively in terms of Game Theory This set of ideas is a formal way to understand situations in which strategic behavior plays an important role in the decisions made by individual players What we consider here is called Noncooperative Game Theory These are situations in which it is not possible for the player to make binding agreements that govern their actions In other words players do not and cannot cooperate with each other A central idea here is understanding that there are interdependent payoffs that is the profits of my firm depend upon what my rival firm does The Nash Equilibrium is the outcome if an equilibrium occurs There are situations where there is not a single result sometimes there are no outcomes at all and others in which multiple outcomes can occur What we will focus on is situations or games where the players make decisions simultaneously This is where we talk about the Best Response even though it is not truly a response since the decision is made without knowing what the other player has done The most frequently consider situation that applies to markets is the Prisoner s Dilemma The example illustrates the fundamental tension between conflict and cooperation The Prisoner s Dilemma In this game both players prisoners would like to cooperate to minimize their sentences but there is a large temptation to turn in on the other player or prisoner A cooperative agreement is difficult to maintain In the terms of game theory cooperation is not an equilibrium of the game We have a Nash Equilibrium in this case even though there is another outcome that both players would prefer In economic terms we may say this outcome is not efficient It is equivalent to a situation in which all of the gains from trade are not realized There is one special type of Nash Equilibrium in which the choice works e g maximizes profit yields the highest payoff no matter what the other player chooses This is referred to as a Dominant Strategy This strategy is at least as good as any other strategy regardless of what the other players do In other words you make a choice that you will follow and it does not matter what the other player has done If both players have a dominant strategy then a dominant strategy equilibrium is the result Alternatives to the Prisoner s Dilemma There are a large number of other types of games beside the Prisoner s Dilemma We will not have the change to explore these at any length It is also possible to get out of the box that the Prisoner s Dilemma creates It does however require that some action be taken that changes the basic nature of the game For example if it is possible for both players to form a binding agreement then other outcomes can occur see cartel Or if one player can take an action that forces the other player to make a decision that they would not normally take e g a leader follower relationship then the interaction has changed These however are beyond the scope what we want to consider for


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