IB Economics 2.11.7 Oligopoly Notes

Oligopoly: A Few Firms That Watch Each Other

1. An oligopoly is a market ruled by a few large firms behind high barriers to entry.
2. Their products may be near-identical, like oil or steel, or clearly differentiated, like cars, phones, and supermarkets.
3. What defines it is size: each firm is big enough to move the market on its own, which makes the firms interdependent.
   1. Because one firm's move changes the market for everyone, each watches its rivals and reacts, acting strategically even without any agreement.
4. That interdependence pulls each firm two ways at once.
   1. Together they have an incentive to collude, acting like a single monopoly to set a high price and share the profit.
   2. Individually, each has an incentive to compete, undercutting rivals to win market share.
5. The two pulls are mutually exclusive: the moment one firm cuts price to chase its own gain, the collusion breaks.

1. Collusion takes two forms, differing in whether the firms actually communicate.
   1. Explicit collusion: firms make a formal agreement to fix prices or output, as in a cartel, which is illegal in most countries.
   2. Tacit collusion: firms coordinate informally with no agreement, often through price leadership, where rivals follow the dominant firm's price.

Game Theory: Dominant Strategy and Nash Equilibrium

1. Game theory turns that stand-off into a simple picture called a payoff matrix.
2. Take two firms deciding whether to advertise, with each cell showing the profit both earn, written as (Firm A, Firm B).
3. A firm's dominant strategy is the choice that is best no matter what the rival does.
4. A Nash equilibrium is an outcome where neither firm can do better by changing its own choice alone, given what the other has chosen.

1. Read Firm A's options: if B advertises, A earns 4 million by advertising versus 2 million by not, so advertising wins.
2. If B does not advertise, A earns 8 million by advertising versus 6 million by not, so advertising wins again.
   1. Advertising is therefore A's dominant strategy, and by symmetry it is B's too.
3. So both advertise and land on 4 million each, where neither can gain by switching alone, the Nash equilibrium.
   1. Both would earn 6 million if neither advertised, but that outcome is unstable, since either firm could jump to 8 million by advertising.

Why Cooperation Breaks Down

1. The advertising game is a prisoner's dilemma: each firm chasing its own best move leaves both worse off than if they had cooperated.
2. The same logic drives price-fixing, where both firms would profit from holding a high price, but each is tempted to undercut and grab sales.
3. With no binding contract, that temptation wins, so any collusion unravels back to the competitive outcome.
   1. A binding agreement can hold the cooperative outcome by removing the incentive to cheat.
4. This is why cartels stay fragile unless members can monitor and punish cheating.

Evaluating Oligopoly: It Depends on Behaviour

Whether an oligopoly serves consumers well depends on which way the two pulls resolve, so weigh the gains against the costs.

1. Advantages
   1. Economies of scale: large output lowers unit costs, which can reach consumers as lower prices.
   2. Innovation: high, protected profits give firms the means and the reason to fund research and development.
   3. Stable prices: interdependence discourages price wars, so rivalry shifts onto quality, branding, and features.
2. Disadvantages
   1. Collusion and high prices: firms may act like a monopoly, holding price well above marginal cost.
   2. Inefficiency: output sits below the social optimum and above minimum average cost, so it is neither allocatively nor productively efficient.
   3. High barriers and less choice: new rivals cannot enter to compete profit away, and a few firms can mean fewer genuine alternatives.
3. The deciding factor is behaviour, not structure: where the threat of entry or a maverick price-cutter keeps firms competing, an oligopoly can deliver low prices and fast innovation, but where a stable cartel holds it drifts toward the monopoly outcome.