Oligopoly

Meaning
Oligopoly is an important form of imperfect

competition. Oligopoly is said to prevail

when there are few firms or sellers in the
market, producing or selling a product. In
other words, where there are four or five
firms producing and selling a product
oligopoly comes into existence.
Oligopoly is defined as competition among
the few.

Features
Few sellers
Inter-dependence
Uncertainty
High cross elasticities
Element of monopoly
Constant struggle
Rigid or sticky price
Kinked demand curve

Kinked demand curve

Oligipoly

Cartels and Collusion

Overt and Covert Agreements
Cartels operate under formal agreements.
Powerful cartels function as a monopoly.
Collusion

exists when
agreements.
Enforcement Problem

firms

reach

secret,

Cartels

are typically rather short-lived

coordination problems often lead to cheating.

covert

because

Cartel subversion can be extremely profitable.

Detecting the source of secret price concessions can be

extremely difficult.

Game Theory
Game theory was developed by an economist, Oskar Morgenstern,

and a mathematician, John von Neumann, in the 1950s. The outcome

of incomes for the players in the game theory is represented in a payoff matrix. The various strategies which the players can adopt are:
the dominant strategy, the Nash equilibrium strategy, and the maximin strategy. These provide an insight into the significance of game
theory in guiding the business behavior.
In a market situation of imperfect competition, specifically when
oligopoly prevails, each firm operating in the market can influence
the prices of goods even when the goods are homogeneous.
Managers of firms need to make business decisions while considering
the moves by other competing firms in the market. Analyzing the
competitor's moves and making decisions to maximize profits for the
firm is facilitated by the use of game theory.
A 'game' is a situation in which the decisions of one player are
interdependent on the decisions of other rival players. Game theory
is a technique which helps in evaluating a situation when different
individuals or organizations differ in their objectives.

Pay-off Matrix
To understand the basic concepts of game theory,

let us analyze a duopoly price war. Duopoly is a

market where only two players supply products to
the same market. In an industry where two firms, X
and Y, are operating, there are four different
outcomes based on the strategies adopted by each
firm. There is a possibility for each firm to operate at
normal prices or to cut prices in order to gain the
market share. The four possible combinations of
strategies are that both firm X and firm Y operate at
normal prices, firm X cuts the price but firm Y
maintains normal price, firm X maintains normal
price and firm Y cuts the price, and both the firms
cuts the prices.

Pay off Matrix

Firm X

Norma Price
Firm Y

Competition
Price

Normal Price

Competition
Price

P (100, 100)
R (-100, -500)

Q (-500, -100)
S (-300, -300)

Pay off Matrix

As per the pay-off matrix given here, both

firms have profits as in cell P when they

operate at normal prices, both firms get
losses as in cell S if both decreases the
prices, and there is difference in the payoffs as represented in the cells Q and R
when only one of the firms cuts the price
and the other operates at normal price.

Dominant Strategy
The dominant strategy is the strategy, which is profitable for

one of the players, irrespective of the strategy adopted by the

other player. For instance, from the pay-off matrix represented
above (previous table ), when the firm X operates with normal
price, it gets Rs.100 if firm Y also operates with normal price. If
firm X gets into price war and cuts the prices but firm Y
maintains normal prices then the firm X will lose Rs. 500. This is
because even if firm X gains market share due to price cut, it
has to sell the products at a price lower than the cost of
manufacturing. Conversely, if firm Y cuts the prices, but firm X
maintains normal prices then the loss for firm X is Rs. 100. And
if firm X enters the price war along with the firm Y, then the loss
is Rs. 300 for firm X. Thus, firm X and firm Y also experience
greater losses when they cut the price but the other firm
operates at normal price. Hence, each firm can benefit by
operating at normal price. Therefore, the dominant strategy for
each firm is to operate at normal price irrespective of the type
of price strategy followed by the other firm.

Nash equilibrium

Nash equilibrium was named after John Nash, a

mathematician, who contributed to the game

theory and also won the Nobel Prize in
economics. In the real world, the applicability of
dominant strategy is limited. When there is no
dominant strategy applicable, each of the firms
considers operating at normal prices or
increases the prices and tries to earn monopoly
profits. In fact, profit-maximizing equilibrium is
where the marginal revenue of a firm equals
marginal cost.

Nash-Equilibrium

coke
Norma Price
pepsi

Normal Price

Price Increase

P (Rs. 100, Rs.

100)

Q(-Rs.150, Rs.
400)

R (Rs. 400, -Rs.

250)

S (Rs. 700, Rs.

300)

Price Increase

As represented in the table , both the firms X and Y will

get a pay-off of Rs. 100 if both operate at normal prices.

If firm X increases the price while firm Y maintains normal
price, firm X will have a loss of Rs.150 while the firm Y
gets Rs. 400 due to increased market share. And if firm X
operates at normal price when firm Y raises the price, the
firm X gets Rs. 400 while firm Y loses Rs. 250. If both the
firms increase prices then the firms X and Y get Rs. 700
and Rs. 300 respectively. Here, firm X has a dominant
strategy but firm Y does not have a dominant strategy.
Firm X can earn profits by adopting the dominant strategy
of operating at normal prices, irrespective of what firm Y
does. But as firm Y does not have a dominant strategy, it
would like to operate at normal price when firm X
operates at normal price, and increase the price when
firm X increases the price. Here, there is a dilemma for
firm Y whether to maintain normal prices or to raise
prices with a hope that the rival firm will also raise prices.
In this case, the solution is the Nash equilibrium.

Maxi-min strategy
The developers of game theory further

suggested that if the players are risk

averse, they will try to maximize the
minimum possible benefit from the game.
With maxi-min strategy, each player tries
to get the maximum profit in the worst
possible outcome at whatever strategy
adopted by the other competing players.

Prisoners Dilemma
The example of theprisoners dilemmaexplains the prominence

of game theory in strategic behavior. Consider an instance where

two prisoners who have allegedly committed a crime are arrested
by the police. Both of them are interrogated separately. They are
told that if he/she does not confess and if the other person
confesses then a sentence of 14 years will be given to him/her.
On the other hand, if both confess a sentence of 5 years will be
given to both. However, if neither of the prisoners confess then
they would be set free as there is no strong evidence.
In this situation, each prisoner is in a dilemma about the strategy
to be adopted. As the prisoners are interrogated separately, they
are not sure about the idea of the other prisoner. If the prisoners
want to avoid risk, they would adopt the mini-max strategy to
minimize the maximum jail sentence. However, the outcome here
is not certain as the move of the other person is not known.