1

LECTURE



6
Oligopoly: Games
and Strategies
This lecture discusses markets with a few firms
charactersied by strategic decision making

After studying this chapter, you will be able to
Define and identify oligopoly
Use game theory to explain how firms behave in
oligopoly
Use game theory to explain other strategic decisions
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What Is Oligopoly?
Oligopoly is a market structure in which
there are a small number of firms
These firms can either compete or cooperate with each
other.
Decisions are interdependent.
Natural or legal barriers prevent the entry of new firms.

Small Number of Firms
Because an oligopoly market has only a few firms, they
are interdependent and face a temptation to cooperate.
Interdependence: With a small number of firms, each
firms profit depends on other firms actions.
Temptation to Cooperate: Firms in oligopoly face the
temptation to form a cartel (a group of firms acting
together to limit output, raise price, and increase profit).
What Is Oligopoly?
3
Oligopoly Games
Game theory is a tool for studying strategic decision
making;
Each players decision takes into account the expected
behaviour of others and the mutual recognition of
interdependence.
The concepts that we are going to discuss today include:
Prisoners Dilemma
Strategies
Payoffs
Outcome
The Prisoners Dilemma
In the prisoners dilemma game, two prisoners (A and B)
have been caught committing a petty crime.
Rules
Each prisoner is held in a separate cell and cannot
communicate with the other.
Each is told that both are suspected of committing a
more serious crime; robbing a bank.
Oligopoly Games
4
They are given the following options:
If one of them confesses, he will get a 1-year sentence for
cooperating with the police while his accomplice will get a
10-year sentence for both crimes.
If both confess to the more serious crime, each receives 3
years in jail for both crimes.
If neither confesses, each receives a 2-year sentence for
the minor crime only.
Oligopoly Games
Strategies
A and B each have two possible actions:
1. Confess to the larger crime.
2. Deny having committed the larger crime.
With two players and two actions for each player (a 2X2
game), there are four possible outcomes:
1. Both confess.
2. Both deny.
3. A confesses and B denies.
4. B confesses and A denies.
Oligopoly Games
5
Payoffs
We can tabulate the outcomes in the following payoff
matrix.
Oligopoly Games
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
Outcome: Nash Equilibrium
If both players are rational and act in their self-interest, the
outcome is an equilibrium called Nash equilibrium first
proposed by John Nash.
Oligopoly Games
6
Outcome
What should a self-interested A do if B confesses?
Oligopoly Games
3
Years
10
Years
Bs Strategies
Confess
As
Strategies
Confess
Deny
Outcome
What should a self-interested A do if B confesses?
Oligopoly Games
3
Years
10
Years
Bs Strategies
Confess
As
Strategies
Confess
Deny
7
Outcome
What should a self-interested A do if B denies?
Oligopoly Games
1
Year
2
Years
Bs Strategies
Deny
As
Strategies
Confess
Deny
Outcome
What should a self-interested A do if B denies?
Oligopoly Games
1
Year
2
Years
Bs Strategies
Deny
As
Strategies
Confess
Deny
8
Outcome
What should a self-interested B do if A confesses?
Oligopoly Games
Bs Strategies
Confess Deny
As
Strategies
Confess
Outcome
What should a self-interested B do if A confesses?
Oligopoly Games
Bs Strategies
Confess Deny
As
Strategies
Confess
9
Outcome
What should a self-interested B do if A denies?
Oligopoly Games
Bs Strategies
Confess Deny
As
Strategies
Deny
Outcome
What should a self-interested B do if A denies?
Oligopoly Games
Bs Strategies
Confess Deny
As
Strategies
Deny
10
Outcome: Nash Equilibrium
This is when both A and B simultaneously play their best
strategies
Oligopoly Games
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
Oligopoly Games
The Dilemma
The Nash equilibrium is not the best possible solution for
the two players.
In fact, both will be better off if they chose deny (the
cooperative solution) rather than confess.
So, it is possible for each player to adopt a strategy that is
rational from his or her individual point of view even
though a different choice would have yielded a better
outcome.
Can the better outcome be achieved? No.

11
Oligopoly Games
Incentives to Cheat
Let us start from a situation where both players deny (the
cooperative solution)
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
Oligopoly Games
Incentives to Cheat
A thinks that if he switches his strategy to Confess (with B
still playing Deny), he will be better off
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
12
Oligopoly Games
Incentives to Cheat
Similarly B thinks that if she switches her strategy to
Confess (with A still playing Deny), she will be better off
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
Incentives to Cheat
When both A and B simultaneously cheat (switch to
Confess) they are back at the Nash equilibrium
Oligopoly Games
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
13
A Special Case: Dominant Strategy Solution
A strategy that always gives a player a better payoff
irrespective of the strategy chosen by the rival player.
In the prisoners dilemma Confess is the dominant
strategy for each player.
On the other hand, Deny is the dominated strategy that will
never be played by either players.
When both players play their dominant strategy we arrive at
the dominant strategy solution which, in this case, is the
same as the earlier Nash equilibrium.

Oligopoly Games
As Dominant Strategy
Since Confess always gives player A a better payoff (3 is
better than 10 and 1 is better than 2) irrespective of Bs
strategy .
Oligopoly Games
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
14
As Dominant Strategy
. So Confess is the dominant strategy for player A
Oligopoly Games
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
Bs Dominant Strategy
Since Confess always gives player B a better payoff (3 is
better than 10 and 1 is better than 2) irrespective of As
strategy .
Oligopoly Games
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
15
Bs Dominant Strategy
. So Confess is the dominant strategy for player B
Oligopoly Games
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
Dominant Strategy Solution
Since both players only play their dominant strategy so the
solution is Confess-Confess same as the Nash
equilibrium
Oligopoly Games
3
Years
10
Years
1
Year
2
Years
Bs Strategies
Confess Deny
As
Strategies
Confess
Deny
16
An Oligopoly Price-Fixing Game
A game similar to the prisoners dilemma is played in
duopoly; A duopoly is a market in which there are only
two producers.
Firms A and B can form a cartel by entering into a
collusive agreement; an agreement between two (or
more) firms to restrict output, raise the price, and
increase profits (such agreements are illegal in many
countries) ...
.. or the firms can compete with each other by
producing greater output and charging a lesser price.
Oligopoly Games
Strategies
A and B each have two possible actions:
1. High Production.
2. Low Production (Restrict output).
With two players and two actions for each player (a 2X2
game), there are four possible outcomes:
1. Both with high production.
2. Both with low production.
3. A with high and B with low production.
4. B with high and A with low production.
Oligopoly Games
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The Payoff Matrix
If both have low production, each firm makes $2 million a
week in profits.
If both have high production, each firm makes zero
economic profit.

If A has low production and B has high production, A
incurs an economic loss of $1 million and B makes an
economic profit of $4.5 million.

If B has low production and A has high production, B
incurs an economic loss of $1 million and A makes an
economic profit of $4.5 million.
Oligopoly Games
Payoffs
We can tabulate the outcomes in the following payoff
matrix.
Oligopoly Games
0
-1
4.5
2
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Low
Production
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Outcome
What should a self-interested A do if B has high production?
Oligopoly Games
0
-1
Bs Strategies
High
Production
As
Strategies
High
Production
Low
Production
Oligopoly Games
0
-1
Bs Strategies
High
Production
As
Strategies
High
Production
Low
Production
Outcome
What should a self-interested A do if B has high production?
19
Oligopoly Games
4.5
2
Outcome
What should a self-interested A do if B has low production?
Bs Strategies
Low
Production
As
Strategies
High
Production
Low
Production
Oligopoly Games
4.5
2
Outcome
What should a self-interested A do if B has low production?
Bs Strategies
Low
Production
As
Strategies
High
Production
Low
Production
20
Oligopoly Games
Outcome
What should a self-interested B do if A has high production?
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Oligopoly Games
Outcome
What should a self-interested B do if A has high production?
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
21
Oligopoly Games
Outcome
What should a self-interested B do if A has low production?
Bs Strategies
High
Production
Low
Production
As
Strategies
Low
Production
Oligopoly Games
Outcome
What should a self-interested B do if A has low production?
Bs Strategies
High
Production
Low
Production
As
Strategies
Low
Production
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Outcome: Nash Equilibrium
This is when both A and B simultaneously play their best
strategies
Oligopoly Games
0
-1
4.5
2
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Low
Production
Nash Equilibrium in the Duopolists Dilemma
The Nash equilibrium is that both firms choose high
production.
The quantity and price are those of a competitive
market, and firms make zero economic profit.
The dilemma is that both firms can do better if they decide
to cooperate with each other and behave like a
monopolist.
But individual self-interest prevents them from doing so.
Oligopoly Games
23
Collusion and Incentives to Cheat
Suppose we start from a situation where the two firms enter
into a collusive agreement.
As mentioned earlier, such agreements are illegal.
Further, cartels are inherently unstable due to incentives to
cheat for each firm involved.
Oligopoly Games
Oligopoly Games
Collusion and Incentives to Cheat
Let us start from a situation where both players choose low
production (the cooperative solution)
0
-1
4.5
2
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Low
Production
24
Oligopoly Games
Collusion and Incentives to Cheat
A thinks that if it switches its strategy to high production
(with B still choosing low production), it will be better off
0
-1
4.5
2
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Low
Production
Oligopoly Games
Collusion and Incentives to Cheat
Similarly B thinks that if it switches its strategy to high
production (with A still choosing low production), it will be
better off
0
-1
4.5
2
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Low
Production
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Collusion and Incentives to Cheat
When both A and B simultaneously cheat (switch to
High Production) they are back at the Nash equilibrium
Oligopoly Games
0
-1
4.5
2
Bs Strategies
High
Production
Low
Production
As
Strategies
High
Production
Low
Production
The Advertising Game (prisoners dilemma again .)
Oligopoly Games
15
-10
35
30
Bs Strategies
Advertise Do Not
Advertise

As
Strategies
Advertise
Do Not
Advertise

Both firms end up advertising. Why?
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An R&D Game (the chicken game)
Two firms have to make a decision regarding whether or
not to spend on research and development.
In absence of patents, both firms have an opportunity to
benefit from the new technology developed by others
spending on R&D (free riding).
The game has more than one Nash equilibrium.
Suppose that either Apple or Samsung can spend on
developing a new touch-screen technology that both
would end up being able to use, regardless of which firm
develops the new technology.
Oligopoly Games
Payoffs
We can tabulate the outcomes in the following payoff
matrix.
Oligopoly Games
5
10
1
0
Apples Strategies
R&D No R&D
Samsungs
Strategies
R&D
No R&D
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Outcome
What should a self-interested Samsung do if Apple spends
on R&D?
Oligopoly Games
5
10
Apples Strategies
R&D
Samsungs
Strategies
R&D
No R&D
Outcome
What should a self-interested Samsung do if Apple spends
on R&D?
Oligopoly Games
5
10
Apples Strategies
R&D
Samsungs
Strategies
R&D
No R&D
28
Outcome
What should a self-interested Samsung do if Apple does
not spend on R&D?
Oligopoly Games
1
0
Apples Strategies
No R&D
Samsungs
Strategies
R&D
No R&D
Outcome
What should a self-interested Samsung do if Apple does
not spend on R&D?
Oligopoly Games
1
0
Apples Strategies
No R&D
Samsungs
Strategies
R&D
No R&D
29
Outcome
What should a self-interested Apple do if Samsung spends
on R&D?
Oligopoly Games
Apples Strategies
R&D No R&D
Samsungs
Strategies
R&D
Outcome
What should a self-interested Apple do if Samsung spends
on R&D?
Oligopoly Games
Apples Strategies
R&D No R&D
Samsungs
Strategies
R&D
30
Outcome
What should a self-interested Apple do if Samsung does
not spend on R&D?
Oligopoly Games
Apples Strategies
R&D No R&D
Samsungs
Strategies
No R&D
Outcome
What should a self-interested Apple do if Samsung does
not spend on R&D?
Oligopoly Games
Apples Strategies
R&D No R&D
Samsungs
Strategies
No R&D
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Outcome: Two Nash Equilibria
The equilibrium suggests that just one firm spends on R&D.
But which firm? We do not know in the simultaneous move
game.
Oligopoly Games
5
10
1
0
Apples Strategies
R&D No R&D
Samsungs
Strategies
R&D
No R&D
Oligopoly Games
An R&D Game with sequential moves
Essentially the same game with one firm moving before
the other.
Samsung moves before Apple in the following decision
tree, i.e.,
Samsung decides first whether to spend on R&D or not.
Apple then makes its decision.
Notice: This game has a first movers advantage; the
firm that moves first ends up with the higher payoff/profit
32
Oligopoly Games
Samsung Moves First
Samsung
Apple
Apple
5
R&D
R&D
No R&D
No R&D
R&D
No R&D
1
10
0
Oligopoly Games
Samsung Moves First: Solving the decision tree
We start solving the tree from extreme right (Apples choices
given Samsungs strategies)
Samsung
Apple
Apple
5
R&D
R&D
No R&D
No R&D
R&D
No R&D
1
10
0
33
Oligopoly Games
Samsung Moves First: Solving the decision tree
We start solving the tree from extreme right (Apples choices
given Samsungs strategies)
Samsung
Apple
Apple
5
R&D
R&D
No R&D
No R&D
R&D
No R&D
1
10
0
Oligopoly Games
Samsung Moves First: Solving the decision tree
We reduce the tree by eliminating the choices that give Apple
a lesser payoff given Samsungs strategies.
Samsung
Apple
Apple
R&D
No R&D
No R&D
R&D
1
10
34
Oligopoly Games
Samsung Moves First: Solving the decision tree
After reducing the tree we solve for Samsungs choices
Samsung
R&D
No R&D
1
10
Oligopoly Games
Samsung Moves First: Solving the decision tree
After reducing the tree we solve for Samsungs choices
Samsung
R&D
No R&D
1
10
35
Oligopoly Games
Samsung Moves First: Solving the decision tree
We reduce the tree by eliminating the choices that give
Samsung a lesser payoff.
Samsung
No R&D 10
Oligopoly Games
Samsung Moves First: The Outcome
Samsung chooses No R&D and Apple responds by
choosing R&D
Samsung
Apple
Apple
5
R&D
R&D
No R&D
No R&D
R&D
No R&D
1
10
0
36
Oligopoly Games
Apple Moves First
Apple
Samsung
Samsung
5
R&D
R&D
No R&D
No R&D
R&D
No R&D
10
1
0
Oligopoly Games
Apple
Samsung
Samsung
5
R&D
R&D
No R&D
No R&D
R&D
No R&D
10
1
0
Apple Moves First: The Outcome
Apple chooses No R&D and Samsung responds by
choosing R&D (Work it out yourself?)
37
Repeated Games and Sequential Games
A Repeated Oligopoly Price-Fixing Game
If the game is played repeatedly, it is possible for
oligopolists to successfully collude and make a monopoly
profit.
Repeated interaction enables firms to punish others when
they cheat.
One possible punishment strategy is a tit-for-tat strategy; a
firm cooperates in the current period if the other firm
cooperated in the previous period but cheats in the current
period if the other cheated in the previous period.
This enables the firms to comply and achieve a cooperative
equilibrium and share the monopoly profit.