Oligopoly Pricing: A Game Theory Overview

   Oligopoly pricing behavior has characteristics of a specific game of strategy. Like chess or poker. The best way to play such a game depends on the way opponent play. Oligopolists (in our case players) must pattern their action according to actions and reactions of rivals. The study of oligopolists behave in this strategic situations is called game theory. We will use game theory model to analyze and explain the pricing behavior of oligopolists. Let’s assume that in our oligopolistic market system are only two firms that produce CDs simply called “A” and “B”. Each firms- “A” and “B”- has a choice of two pricing strategies: increase the price or lower it. The profit of each firm depends on what strategy it chooses and what strategy its rival chooses.
   There are four combinations of strategies possible for these two firms, and letter cells in the table below express them. For example, cell W represents low-price strategy of firm “B” and high-price strategy of firm “A”. This table is called payoff matrix because its cells represent the profit(payoff) each firm makes that result from combination of strategies of firms “A” and “B”. Cell W represents that after firm “A” chooses to adopt high-price strategy and firm “B” chooses to adopt low-price strategy, then firm “B” will make 4 million dollars and firm “A” will make only 1 million.

Mutual Interdependence
   The Data in the payoff matrix are just hypothetical one, but relationship is very realistic. Remind the fact that oligopolistic firms can increase their revenues, and influence rival’s profits, by changing its price strategies. Each firm’s payoff depends on its own pricing policy and that of its rival. This mutual interdependence in economics is very well demonstrated by figure above. If both firm “A” and firm “B” adopt a high-price strategy then revenue of each one will be 3 million of dollars. If firm “A” uses a low-price strategy while firm “B” uses a high-price strategy then firm “A” will increase its market share and profit from 3 to 4 million of dollars, however firm “B” will lose 1 million of dollars, since its revenues will decrease from 2 million to 1 million of dollars. So, firm “B” high-price policy will be efficient only if firm “A” will also choose to employ a high-price strategy.
Collusive Tendency
   The figure above suggests that oligopolists will benefit from collusion, or better said cooperation with rivals. An example of benefit can be when both firms are following high-price strategies, so each firm will get a profit of 3 million of dollars (cell X).
   Note that either firm “A” or firm “B” can increase its profit by switching from high-price to lo-price policy. So, the profit can become 4 million of dollars, but the firm that keeps high-price policy will get only 1 million of dollars as revenue. If the firm that right now employs high-price strategy switches to low-price strategy will increase its revenues by 1 million so it will be able to collect 2 million (cell Z). The effect of all this will be switching the profits from 3 million (cell X) to ones which worth 2 million (cell Z).
   In real situation, however independent actions of oligopolists may lead to competitive low-price strategies, which clearly will be beneficial to consumers but not also to oligopolists whose profits will decrease.
   How can oligopolists avoid low-profit outcome of cell Z? They may collude, rather that installing independent and competitive price. Each firm will increase its profits from 2 to 3 million dollars (from cell Z to cell X).
Cheating
   The payoff matrix explains why oligoplists may be tempted to cheat on a collusive agreement. Suppose that our firms “A” and “B” agree to maintain high-price policy, both of them earning 3 million of dollars (cell X). Both firms are tempted to cheat so that they will be able to increase their revenues to 4 million of dollars. If firm “A” cheats and diminishes its prices then it will increase its revenues from 3 to 4 million of dollars (cell Y), while if firm “B” cheats secretly and moves to low-price policy while firm “A” keeps high-price policy then firm “B” will increase its revenues by 1 million of dollars moving from cell X to cell W.

Oligopoly Market System

   Oligopoly is a market system that is dominated by few big suppliers of homogeneous or differentiated products. Because there are few firms, oligopolists have great control over prices, but they should consider reaction of rivals after they change price of goods, output quantity and amount of money spent on advertising.
Producers
   The phrase “few large producers” is one necessary to describe this kind of market system. Some examples of oligopoly can be two or three zinc producers in Sweden, or five or six producers of auto parts in U.K. When you will read in some magazines at economics about Big Three, Big Four or Big Five, you may be sure that there is described an oligopoly.
 Homogeneous or Differentiated Products
   An oligopoly may be either homogeneous or differentiated one, since the firms in this kind of market system produce a standardized or differentiated product. Many industrial goods( aluminum, lead, cement) are standardized products that are supplied in oligopolies. However, other goods (like cigarettes, automobiles, breakfast cereals) are produced in differentiated oligopolies. Last kind of oligopoly engages in non-price competition by heavy advertising.
   Price and mutual interdependence
   Since in oligopolies there are few firms, each one is a price-maker, like monopolists the y may set the price and output level for their goods, so that these firms control the revenue. However, unlike monopolists (since there are no competitors), oligopolists should consider the reaction of rivals to this changes in price, output, product’s characteristics and money spent on advertising. Thus Oligopolists are described by mutual interdependence: a situation in which firm’s profits doesn’t depend completely on its price and sales policy, but also on that of rivals. For example, before increasing the price of its drinks Pepsi should predict the response of other major producers, like Coca-Cola.
   Entry-Barriers
   Similar entry barriers created in pure monopoly are also created in oligopoly. Economies of scale are a factor that serves as barrier to entry in some oligopolistic industries, such as aircraft, car-producing, and cement industries. In this kind of industries three or four firms control the market supply, so that they have enough money to produce economies of scale, but other firms even if they will want to enter this market will have a small market share so that they won’t be able to have enough revenues to produce economies of scale. They would be high-cost producers, so that these firms won’t be able to survive in this industry.
   Ownership and control of raw materials are another explanation why it’s very difficult to enter in oligopolistic market system. Oligopolists also prevent the entry of new competitors by preemptive pricing and advertising strategies.
Mergers
   Some oligopolies have started because of very fast growth of dominant firms in some industries. But other however, produced an oligopoly by merging with other competing firms. Merging or combination of two or more firms may increase their revenues and economies of scale, because of increased market share they got.
   Another explanation of “urge to merge” is the want for a higher monopolistic power, since larger firm has a greater control over market supply and on the price of its product. Also, because of higher economies of scale they get less costs on producing some goods and services than their rivals.
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