Oligopoly and game theory basics - Microeconomics AP Study Notes

Oligopoly is a market structure characterized by a small number of large firms dominating the industry, creating interdependence where each firm's decisions significantly affect competitors. Unlike perfect competition, oligopolies face a downward-sloping demand curve and can influence market price.

Key characteristics include: • High barriers to entry (economies of scale, patents, brand loyalty) • Product differentiation (homogeneous like steel, or differentiated like automobiles) • Strategic behavior where firms must consider rivals' reactions • Non-price competition through advertising and innovation

Game Theory provides the analytical framework for oligopolistic behavior, examining strategic interaction where outcomes depend on all players' choices. The Prisoner's Dilemma illustrates why rational firms may not cooperate even when cooperation benefits everyone.

Critical concepts:

Nash Equilibrium: A situation where no player can improve their payoff by unilaterally changing strategy, given others' strategies remain constant.

Dominant Strategy: A strategy yielding the highest payoff regardless of opponents' choices.

Collusion: When firms coordinate to maximize joint profits, acting like a monopoly. This can be explicit (cartels—illegal in most countries) or tacit (implicit understanding without formal agreement).

Payoff Matrix: A table showing outcomes for each combination of strategies, with typical format:

           Firm B: Low Price | Firm B: High Price
Firm A: Low Price    (2,2)    |      (5,1)
Firm A: High Price   (1,5)    |      (4,4)

Concentration ratios measure market power: CR4 (four-firm concentration ratio) = combined market share of four largest firms. Values >60% indicate oligopoly.

Real-world oligopolies pervade modern economies. The smartphone industry (Apple, Samsung, Google) exemplifies oligopolistic interdependence—when Apple launches iPhone features, Samsung immediately responds with Galaxy innovations. Their advertising battles and ecosystem competition demonstrate non-price rivalry.

The airline industry perfectly illustrates game theory. When one carrier cuts transatlantic fares, rivals must match or lose customers. Yet price wars hurt everyone's profits. This explains why airlines prefer tacit collusion through price leadership—one dominant firm signals price changes, others follow. British Airways might raise London-New York fares; Virgin Atlantic typically matches within days.

Think of oligopoly like chess, not checkers. In perfect competition, firms are checkers pieces—identical, making simple moves independently. Oligopolists are chess players—each move requires anticipating opponents' counter-moves several steps ahead.

The kinked demand curve model explains price rigidity. Imagine you manage a petrol station alongside three competitors. If you raise prices above the current level (£1.50/litre), rivals won't follow—they'll steal your customers. Your demand becomes highly elastic above the kink. If you cut prices, competitors immediately match to protect market share, making demand inelastic below the kink. Result? Prices remain sticky at the kink.

OPEC (Organization of Petroleum Exporting Countries) demonstrates cartel challenges. Member nations agree production quotas to maintain high oil prices, but individual countries face incentive to "cheat"—secretly produce beyond quota while others restrict output. Saudi Arabia benefits most from compliance, while smaller producers like Venezuela face temptation to overproduce when facing budget crises. This instability explains why oil prices fluctuate despite cartel coordination.