Oligopoly is a market structure with only a few sellers occupying the majority of the market share and offering a similar/identical product. The market of soft drinks is a good example in which major players and PepsiCo and Coca-Cola.
I personally like to study about oligopolies because we don’t need core mathematics and formulas to study about it. We just need to apply pure strategic thinking learned from Game Theory.
Game Theory is not about the games that we play on computers or in the playground. It’s about the games we play in real life, strategic games which firms play with one another trying to maximize profits.
What is Game Theory?
Very simple and effective definition of the Game Theory is the study of how people behave in strategic situations. One has to consider how others might respond to the action one takes and the effect of others’actions on the outcome.
Considering the above example, I will try to explain why markets with few companies (in this case two) cannot maximize profits?
Consider this matrix in which we have some numbers/points for each firm taking a particular decision.
In Game Theory, it is called a payoff matrix and the individual scores given to each outcome are called the payoffs. The payoffs are (Pepsi, Coke) which means that the payoff for Coke to advertise when Pepsi doesn’t advertise is 13. It might be million dollars or anything, but it is just a payoff.
The Explanation of Payoff Matrix
If Pepsi does not advertise, Coke is better off advertising (13 > 8) and if Pepsi advertises, Coke is again better off advertising (5 > 2). This means that no matter what Pepsi does, Coke is better off advertising, so it will advertise.
The strategy in which no matter what other party does, you do only one thing is called a strictly dominant strategy. It means that particular strategy dominates every other strategy in the game and you will choose that.
The same is the thing with Pepsi also. If Coke does not advertise, Pepsi is better off advertising (13 > 8) and if Coke advertises, Pepsi is again better off advertising (5 > 2). This means that no matter what Coke is doing, Pepsi is better off advertising, so it will advertise.
What is Nash Equilibrium?
A Nash Equilibrium is a situation in which players (Coke and Pepsi) will each choose their best strategy given the strategy all other players have chosen. The outcome in that situation is called a Nash Equilibrium.
The profit maximizing condition is when they both don’t advertise (8, 8) and each would gain 8 million dollars in revenue. So, they would meet and form a verbal contract of not advertising. In this way, they can gain 50-50 market share and dominate the market.
But, the key feature of the oligopoly market structure is tension between cooperation and self-interest which we can study by game theory.
Verbal contracts are as easy to break as trust. Here, both the firms have an incentive to cheat as they think that if they advertise, they will gain 13 million dollars and are better off which is clearly not the case. If they both advertise, they will land on the outcome (5, 5), in which case they would be worse off (8 > 5).
This particular game is called The Prisoner’s Dilemma, which says that two rational people won’t cooperate even if it’s good for their self-interest. They won’t cooperate because they have a strong incentive to cheat, so they land on the outcome which is worse off for both of them.
So, why do companies in an oligopoly cannot maximize their individual profits?
Because they won’t cooperate and hence they cannot maximize their profits. Each firm is tempted to raise production and capture a larger share of the market. As each of them tries to do so, total production increases, but price decreases, hence individual profits decrease. In this case, most of the loss in revenue would be from money spent in advertising.
This is the reason why contracts are forced onto the firms and then the market works.
This was originally posted on Quora.