Oligopolies have:
- Few sellers
- High barriers to entry
- Interdependent firms (action of other firms affect)
- Price makers (not as much control as monopolies)
Oligopolies are not allocatively efficient as they price above the marginal cost. They are also not productively efficient as they operate on a downward sloping section of the ATC, which represent economies of scale.
Game Theory
Game theory is an economic method of understanding interdependent strategic behaviour between the small number of firms in oligopolies. Game theory decision making is represented through pay-off matrices:
In such a matrix, there are the following outcomes:
- Collusion Outcome: which quadrant is best for both firms together. Essentially, if these firms were operating as just one business, which quadrant would they pick? Simply pick the quadrant with the highest combined amount
- One-Sided Company: must account for Company Bβs decision-making as well. For example, if they expect Company B to lower their price, they should pick between one of the far right quadrants. If they expect Company B to raise their price, they should pick between one of the far left quadrants
- Dominant Strategy: an action taken by a company regardless of the actions of the other player. Use numbers from previous company outcome and pick the dominant strategy for each company. If the two potential outcome of the companyβs decision making is not identical, it will not have a dominant strategy.
Nash Equilibrium
The Nash Equilibrium is the quadrant in the pay-off matrix with the most likely outcome. In a duopoly, it is the quadrant which is favoured by both companies. This isnβt the best outcome for the two firms, but itβs the most likely outcome. If any firm deviates from this quadrant, it will be worse off.