Games Theory and Prisoner’s Dimemma

Games theory
A model of optimality taking into consideration not only benefits less costs, but also the interaction between participants. Used to analyse the oligopolists’ behaviour

Prisoner’s Dimemma
One firm cut prices, other follows and therefore overall price decreases. The prisoners' dilemma illustrates a situation in which individuals arrive at a non-optimal solution, due to a lack of cooperation and trust. A similar situation occurs with oligopolies. If firms within an oligopolistic industry have cooperation and trust with each other, then they can theoretically maximize industry profits by setting a monopolistic price. Firms would then have to figure out how to fairly divide up the profits.

Kinked demand curve model and Dominant firm oligopoly model

Kinked demand curve model
If the firm raises prices other firms won't follow because they don't worry about losing market share to a firm which is raising price; if the firm lowers its prices other firms will respond by lowering their prices also since they don't want to lose market share.

Dominant firm oligopoly model
One firm has significant cost advantage and produces a large share of the industry output and thus can effectively set the market price, the other firms are price takers.

Collusion

Collusion is an agreement between firms to avoid various competitive practices, particularly price reductions. Oligopolists will form a cartel, which is an organization of sellers designed to coordinate supply decisions so that the joint profits of members will be maximized.

Obstacles to collusion:

• Large number of competitors.
• Difficulty in detecting and eliminating cheating
• Low barriers to entry
• Unstable demand
• Vigorous antitrust action by the government.

Government policies for reducing collusion:

• Antitrust actions {Break up monopolies and disapprove mergers}.
• Reduce quotas, tariffs, and other barriers to competition.
• Regulate the price and output.
• Set up government-owned firms to produce and supply the goods.

Note:

• (1) and (2) are approved by economists, while (3) and especially (4) are not.

Profit Maximization

Must consider reaction of rival oligopolists.

In the absence of collusion, output rises to where demand =LRATC and no oligopolist makes an economic profit.

With perfect collusion, output is held down to where MR = LRATC and profit per unit = (Price from demand curve - Price from LRATC curve) at this level of output. Oligopolists have a strong incentive to collude {to keep the price high}, but also a strong incentive to cheat {to increase output and market share}.

Characteristics of oligopoly and Entry Barr

Characteristics

• Small number of interdependent competitors in a market with significant economies of scale
• high barriers to entry
• Similar or differentiated products
• “follow the leader”
• very elastic or flat demand curve make firm tempting to cheat
  

Entry barriers:

• Patents
• control over a resource
• economies of scale
• government license/legal barrier
• Resources control

Difference between monopolistic competition & pure competition

Monopolistic competition faces downward slopping curve; Pure competition- horizontal demand curve.

For long run equilibrium,
Monopolistic competition is not at minimum ATC but pure competition is at minimum ATC.

Characteristics of monopolistic competition

Monopolistic competition is also known as competitive price-searcher

Markets requirements

• Large number of firms producing differentiated products
• no barriers to entry or exit
• Monopolistic competition: All firms are price searcher
• Face a downward sloping demand curve {highly elastic due to availability of close substitutes
• Max profit at MR=MC but charge price from demand curve

In the short run,

• price searcher maximizes profits by setting output where MR = MC

In the long run,

• low barriers increase new firms and competition drives demand curve down to the point where MR = ATC, and economic profit falls to zero

Benefits of Competition:

• increase efficient production and consumer satisfaction
• increase incentive for firm to find new and efficient technologies.
• increase in finding the optimal scale of production.