First, price-fixing is illegal in the United States, and antitrust laws exist to prevent collusion between firms. Second, coordination among firms is difficult, and becomes more so the greater the number of firms involved. Third, there is a threat of defection. A firm may agree to collude and then break the agreement, undercutting the profits of the firms still holding to the agreement.
Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to effectively punish firms that may break the agreement. In contrast to price-fixing, price leadership is a type of informal collusion which is generally legal. Price leadership, which is also sometimes called parallel pricing, occurs when the dominant competitor publishes its price ahead of other firms in the market, and the other firms then match the announced price.
In an oligopoly, firms are interdependent; they are affected not only by their own decisions regarding how much to produce, but by the decisions of other firms in the market as well. Game theory offers a useful framework for thinking about how firms may act in the context of this interdependence. More specifically, game theory can be used to model situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.
For example, game theory can explain why oligopolies have trouble maintaining collusive arrangements to generate monopoly profits.
While firms would be better off collectively if they cooperate, each individual firm has a strong incentive to cheat and undercut their competitors in order to increase market share. In the game, two members of a criminal gang are arrested and imprisoned. The prisoners are separated and left to contemplate their options. If both prisoners confess, each will serve a two-year prison term.
If one confesses, but the other denies the crime, the one that confessed will walk free, while the one that denied the crime would get a three-year sentence.
If both deny the crime, they will both serve only a one year sentence. Betraying the partner by confessing is the dominant strategy; it is the better strategy for each player regardless of how the other plays. This is known as a Nash equilibrium. The result of the game is that both prisoners pursue individual logic and betray, when they would have collectively gotten a better outcome if they had both cooperated.
The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy. If a player knew the strategies of the other players and those strategies could not change , and could not benefit by changing his or her strategy, then that set of strategies represents a Nash equilibrium.
If any player would benefit by changing his or her strategy, then that set of strategies is not a Nash equilibrium. While game theory is important to understanding firm behavior in oligopolies, it is generally not needed to understand competitive or monopolized markets. In competitive markets, firms have such a small individual effect on the market, that taking other firms into account is simply not necessary. A monopolized market has only one firm, and thus strategic interactions do not occur.
Sometimes firms fail to cooperate with each other, even when cooperation would bring about a better collective outcome. Each prisoner is in solitary confinement with no means of speaking to or exchanging messages with the other.
The police offer each prisoner a bargain:. However, the resulting outcome is not Pareto-optimal. Both players would clearly have been better off if they had cooperated. For both players, the choice to betray the partner by confessing has strategic dominance in this situation; it is the better strategy for each player regardless of what the other player does.
This set of strategies is thus a Nash equilibrium in the game—no player would be better off by changing his or her strategy. As a result, all purely self-interested prisoners would betray each other, resulting in a two year prison sentence for both. On the other hand, if the barriers are low, then the oligopolist will set low prices to prevent new firms from entering the industry or to promote the exit of its competitors.
Sometimes firms in an oligopoly try to form a cartel by agreeing to fix prices or to divide the market among themselves, or to restrict competition some other way. The primary characteristic of the Cartel Model is collusion among the oligopolistic firms to fix prices or restrict competition so that they can earn monopoly profits. However, if any of the firms cheat, then a price war may ensue, lowering the profits of all firms, and maybe even causing them to operate at a loss.
In most modern economies, collusion is generally against the law, however there are certain countries that engage in collusion to maximize their profits from their natural resources. Prices are maintained by restricting each country of the OPEC cartel to a specific production allocation.
The OPEC cartel is largely responsible for the large fluctuations in gasoline prices that occurred in the United States since , although recently, speculation in the commodity markets has also increased volatility. Collusion is often difficult to detect, because it is often based on tacit or covert agreements that are made during social interactions between the executives of the oligopolistic firms.
Nonetheless, there are several obstacles to collusion. One common obstacle is differences in demand and cost. Firms that serve different geographic markets will have varying levels of demand, and they may also have different efficiencies, resulting in different production costs.
If economies of scale are steep for an industry, then smaller firms will aggressively compete on price to increase their market share, so that they can earn reasonable profits. In such cases, it will be difficult for the firms to agree on the price, because they will have different marginal cost curves.
A good example is Saudi Arabia and Venezuela in the production of oil. Saudi Arabia is efficient in producing soil, whereas Venezuela, governed by an inept communist government, is highly inefficient, so it would be very difficult for Venezuela to accept a price that would be suitable for Saudi Arabia. Consequently, there is a great temptation for inefficient producers to cheat, and if they cheat, then price competition ensues. Another factor that increases cheating is recessions. During recessions, demand declines, which shifts the firm's marginal cost and demand curve to the left.
Firms often respond by reducing prices so that they can better utilize their production capacity and to try to gain market share from the other firms. Alternatively, in mixed economies, oligopolies often seek out and lobby for favorable government policy to operate under the regulation or even direct supervision of government agencies. An oligopoly is when a few companies exert significant control over a given market.
Together, these companies may control prices by colluding with each other, ultimately providing uncompetitive prices in the market. Among other detrimental effects of an oligopoly include limiting new entrants in the market and decreased innovation.
Oligopolies have been found in the oil industry, railroad companies, wireless carriers, and big tech. One measure that shows if an oligopoly is present is the concentration ratio, which calculates the size of companies in comparison to their industry. Instances where a high concentration ratio is present include mass media. In the U. Meanwhile, within big tech, two companies control smartphone operating systems: Google Android and Apple iOS.
With just four companies controlling nearly two-thirds of all domestic flights in the U. According to a report compiled by the White House, "reduced competition contributes to increasing fees like baggage and cancellation fees.
These fees are often raised in lockstep, demonstrating a lack of meaningful competitive pressure, and are often hidden from consumers at the point of purchase. Prior to this time, the airline industry operated much like a public utility, while fare prices had declined 20 years before the deregulation was introduced.
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We and our partners process data to: Actively scan device characteristics for identification. I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Assume two firms in an oligopoly a duopoly , where the two firms choose the price of their good simultaneously at the beginning of each period.
Consumers purchase from the firm with the lowest price, since the products are homogeneous perfect substitutes. If the two firms charge the same price, one-half of the consumers buy from each firm.
The Bertrand model follows these three statements:. A numerical example demonstrates the outcome of the Bertrand model, which is a Nash Equilibrium. Firm Two has the lower price, so all customers purchase the good from Firm Two. After period one, Firm One has a strong incentive to lower the price P 1 below P 2.
Firm One has the lower price, so all customers purchase the good from Firm One. After period two, Firm Two has a strong incentive to lower price below P 1. The price cannot go lower than this, or the firms would go out of business due to negative economic profits. The Bertrand results are given in Equation 5. The Bertrand model of oligopoly suggests that oligopolies are characterized by the competitive solution, due to competing over price.
There are many oligopolies that behave this way, such as gasoline stations at a given location. Other oligopolies may behave more like Cournot oligopolists, with an outcome somewhere in between perfect competition and monopoly.
Heinrich Freiherr von Stackelberg was a German economist who contributed to game theory and the study of market structures with a model of firm leadership, or the Stackelberg model of oligopoly. A numerical example is used to explore the Stackelberg model.
Assume two firms, where Firm One is the leader and produces Q 1 units of a homogeneous good. Firm Two is the follower, and produces Q 2 units of the good. This model is solved recursively, or backwards. Mathematically, the problem must be solved this way to find a solution. All of this is shown in the following example. This is the reaction function of the follower, Firm Two. We have now covered three models of oligopoly: Cournot, Bertrand, and Stackelberg. These three models are alternative representations of oligopolistic behavior.
The Bertand model is relatively easy to identify in the real world, since it results in a price war and competitive prices. It may be more difficult to identify which of the quantity models to use to analyze a real-world industry: Cournot or Stackelberg? The model that is most appropriate depends on the industry under investigation.
Oligopoly has many different possible outcomes, and several economic models to better understand the diversity of industries. Notice that if the firms in an oligopoly colluded, or acted as a single firm, they could achieve the monopoly outcome. If firms banded together to make united decisions, the firms could set the price or quantity as a monopolist would. This is illegal in many nations, including the United States, since the outcome is anti-competitive, and consumers would have to pay monopoly prices under collusion.
If firms were able to collude, they could divide the market into shares and jointly produce the monopoly quantity by restricting output. This would result in the monopoly price, and the firms would earn monopoly profits.
If the other firms in the industry restricted output, a firm could increase profits by increasing output, at the expense of the other firms in the collusive agreement. We will discuss this possibility in the next section. These two models result in positive economic profits, at a level between perfect competition and monopoly. The most important characteristic of oligopoly is that firm decisions are based on strategic interactions.
Therefore, oligopolists are locked into a relationship with rivals that differs markedly from perfect competition and monopoly. Collusion occurs when oligopoly firms make joint decisions, and act as if they were a single firm. Collusion requires an agreement, either explicit or implicit, between cooperating firms to restrict output and achieve the monopoly price. This strategic interdependence is the foundation of game theory. A game can be represented as a payoff matrix, which shows the payoffs for each possibility of the game, as will be shown below.
A game has players who select strategies that lead to different outcomes, or payoffs. This is shown in Figure 5. The police have some evidence that the two prisoners committed a crime, but not enough evidence to convict for a long jail sentence.
The police seek a confession from each prisoner independently to convict the other accomplice. The outcomes, or payoffs, of this game are shown as years of jail sentences in the format A, B where A is the number of years Prisoner A is sentenced to jail, and B is the number of years Prisoner B is sentenced to jail. However, if either prisoner decides to confess, the confessing prisoner would receive only a single year sentence for cooperating, and the partner in crime who did not confess would receive a long year sentence.
If both prisoners confess, each receives a sentence of 8 years. This story forms the plot line of a large number of television shows and movies. The outcome of this situation is uncertain. How should a prisoner proceed? One way is to work through all of the possible outcomes, given what the other prisoner chooses. This is called a Dominant Strategy , since it is the best choice given any of the strategies selected by the other player.
This is an interesting outcome, since each prisoner receives eight-year sentences: 8, 8. If they could only cooperate, they could both be better off with much lighter sentences of three years. A second example of a game is the decision of whether to produce natural beef or not. Natural beef is typically defined as beef produced without antibiotics or growth hormones. The definition is difficult, since it means different things to different people, and there is no common legal definition.
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