15 Oligopoly and Game Theory

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CHAPTER OUTLINE

Cartels

The Prisoner’s Dilemma Oligopolies

When Are Cartels and Oligopolies Most Successful?

Government Policy toward Cartels and Oligopolies

Business Strategy and Changing the Game

Takeaway

Appendix: Nash Equilibrium

As oil prices neared a historic high in July 1979, President Jimmy Carter spoke to the nation. Quoting a concerned American, Carter said, “Our neck is stretched over the fence and OPEC has a knife.” What is OPEC and what power did OPEC have to control the price of oil?

OPEC, which is short for the Organization of the Petroleum Exporting Countries, is a cartel, a group of suppliers who try to act together to reduce supply, raise prices, and increase profits. In other words, a cartel is a group of suppliers who try to act as if they were a monopolist.

We analyzed monopoly in Chapter 13 so we have a good understanding of what cartels are trying to achieve, but the question we address in this chapter is when will cartels be able to achieve their goal. As we will see, it’s not easy for a group of firms to act as if they were a monopolist. But even when a group of firms is not able to coordinate or collude to act like a monopolist, prices are likely to be higher in an industry with a small number of firms than in a highly competitive market. We call an industry that is dominated by a small number of firms an oligopoly. Thus, we begin our chapter by discussing cartels, an oligopoly that acts like a monopolist, and then move to a more general discussion of oligopoly.

A cartel is a group of suppliers who try to act as if they were a monopoly.

An oligopoly is a market that is dominated by a small number of firms.

Strategic decision making is decision making in situations that are interactive.

In this chapter, we also introduce a new tool: game theory. Game theory is the study of strategic decision making. An example illustrates what we mean. In Las Vegas, craps players make decisions, but poker players make strategic decisions. Craps is a dice game and deciding when and how much to bet can be complicated, but the outcome depends only on the dice and the bet and not on how other people bet. In contrast, poker is a game of strategy because a good poker player must forecast the decisions of other players, knowing that they in turn are trying to forecast his or her decisions. Game theory is used to model decisions in situations where the players interact.

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Although we introduced game theory with an example from poker, a game in the usual sense of the word, game theory is used to study decision making in any situation that is interactive in a significant way. Game theory has also been used to study war, romance, business decisions of all kinds, evolution, voting, and many other situations involving interaction.

In this chapter, we use game theory to look at the economics of oligopoly.