Game Theory and Oligopoly: Crash Course Economics #26

Summary

This Crash Course Economics episode delves into competition and game theory, explaining different market structures like perfect competition, monopoly, monopolistic competition, and oligopoly. It highlights how oligopolies, controlled by a few companies, engage in non-price competition and use game theory to make strategic decisions, illustrated with the 'prisoner's dilemma' and real-world examples like airline baggage fees. The video also discusses collusion, cartels, and the use of payoff matrices to predict outcomes in competitive scenarios.

Takeaways

• 🎓 Economics discusses competition and game theory, which are essential for understanding market structures and strategic decision-making.
• 🌟 There are four types of market structures: perfect competition, monopolies, monopolistic competition, and oligopolies, each with distinct characteristics.
• 🍓 Perfect competition is characterized by many producers, identical products, and easy entry, such as in the agricultural market for strawberries.
• 🏭 A monopoly is a market dominated by a single company with high barriers to entry, giving it significant control over pricing.
• 🍔 Monopolistic competition involves many producers with similar but not identical products, like fast food chains, where companies can slightly vary their prices.
• 💻 Oligopolies are controlled by a few large companies with high barriers to entry, such as in the computer and mobile phone markets.
• 💰 Non-price competition is a strategy used in oligopolies where companies compete on factors like style, quality, location, or service rather than price.
• 📺 Advertising is a prominent form of non-price competition, where companies spend heavily to differentiate themselves and stand out in the market.
• 🤔 Game theory, including the 'prisoner's dilemma,' helps explain why companies make decisions based on the actions of their competitors and the potential outcomes.
• 💡 The concept of 'price leadership' in oligopolies can be a legal form of companies following each other's price changes, but it can be difficult to distinguish from illegal collusion.
• 📈 Payoff matrices in game theory illustrate the potential outcomes for companies based on their strategic decisions, highlighting the challenges of achieving optimal results.
• 🛒 Healthy competition, driven by game theory insights, can lead to innovation and better products for consumers, but it can also result in winners and losers in the market.

Q & A

What is the main topic discussed in this Crash Course Economics video?

The main topic discussed in this video is competition and game theory, specifically focusing on different market structures and how companies in oligopolies use non-price competition and game theory to make strategic decisions.

What are the four types of market structures mentioned in the script?

The four types of market structures mentioned are perfect competition, monopoly, monopolistic competition, and oligopoly.

Why do individual businesses in a perfectly competitive market have no control over prices?

Individual businesses in a perfectly competitive market have no control over prices because there are many producers offering identical products, and new businesses can easily enter the market, which prevents any single producer from influencing the market price.

What is the difference between monopolistic competition and an oligopoly?

Monopolistic competition is a market with many producers, relatively low barriers to entry, and products that are similar but not identical. An oligopoly, on the other hand, is a market controlled by a few large companies with high barriers to entry, and the products may be similar but are not identical.

How do companies in an oligopoly typically compete with each other without changing prices?

Companies in an oligopoly typically compete through non-price competition, which includes focusing on style, quality, location, service, and advertising to distinguish their products from competitors.

What is the 'prisoner's dilemma' in game theory and what does it illustrate?

The 'prisoner's dilemma' is a classic game theory scenario where two individuals, when unable to communicate, make decisions that may not result in the best collective outcome due to a lack of cooperation, even though it seems rational from an individual perspective.

Why do companies in an oligopoly often end up with similar prices for their products?

Companies in an oligopoly often end up with similar prices because if one company lowers its price, others are likely to follow to remain competitive, resulting in a shared customer base and reduced profits. If they raise prices, they risk losing customers to competitors or attracting new entrants to the market.

What is the difference between collusion and price leadership in the context of oligopolies?

Collusion refers to illegal agreements between companies to fix prices or other market conditions to their mutual benefit, often at the expense of consumers. Price leadership is when one company changes its prices and others follow suit without explicit collusion, which is technically legal but can be difficult to distinguish from collusion.

What is a payoff matrix in the context of game theory?

A payoff matrix is a tool used in game theory to illustrate the possible outcomes and profits for each player in a strategic interaction, based on the different strategies they might choose.

Why is advertising so prevalent in industries with oligopolies?

Advertising is prevalent in industries with oligopolies because companies need to differentiate themselves from competitors without changing prices. Advertising helps create brand awareness and loyalty, which can influence consumer choices and justify premium pricing.

What is the role of antitrust laws in preventing collusion and promoting competition?

Antitrust laws are designed to prevent collusion and maintain fair competition by regulating anti-competitive practices such as price-fixing, market-sharing, and other forms of collusion that can harm consumers and stifle innovation.

How can game theory help companies make strategic decisions in oligopolistic markets?

Game theory helps companies anticipate the actions of their competitors and make strategic decisions that maximize their profits. By understanding the potential outcomes and the best responses to different scenarios, companies can develop strategies that account for the interdependence of their market decisions.

Outlines

00:00

🎮 Introduction to Market Structures and Game Theory

The script opens with Jacob and Adriene introducing the topic of competition and game theory in economics. They explain that markets can be categorized into four types based on factors like the number of producers, price control, and barriers to entry. Perfect competition is exemplified by agricultural products like strawberries, where many producers sell identical goods without price control. At the other end is a monopoly, characterized by a single company with significant price control due to high barriers to entry. Monopolistic competition and oligopolies fall between these extremes, with the former featuring many producers of similar but not identical products and the latter being dominated by a few large companies with high barriers to entry. The script then transitions into discussing non-price competition, where companies differentiate themselves through style, quality, and advertising rather than price adjustments.

05:01

🤝 Game Theory and Strategic Decision Making

This paragraph delves into game theory, starting with the classic 'prisoner's dilemma' to illustrate the challenges of achieving optimal outcomes when individuals or companies act in their self-interest without cooperation. The script uses the example of businesses like drug stores and coffee shops locating next to each other to demonstrate how competition can lead to equilibrium points that may not be the most profitable for either party. It also discusses the concept of price leadership, where one company's pricing decisions influence others, which can be a form of non-collusive coordination. The script highlights the use of payoff matrices to predict outcomes in oligopolistic competition, where companies must consider their competitors' potential moves. The instability of collusion and cartels is also discussed, with the script noting that such agreements are difficult to maintain without strict enforcement. The summary concludes with a reflection on the impact of game theory on business decisions and the importance of adaptation and innovation for companies to remain competitive.

Keywords

💡Competition

Competition refers to the rivalry among businesses striving for the same customer base. In the video, it is explored in the context of different market structures, illustrating how competition influences pricing and market behavior. For example, perfect competition involves many producers with no control over prices, whereas a monopoly lacks competition entirely.

💡Game Theory

Game theory is the study of mathematical models of strategic interaction among rational decision-makers. It is central to the video's discussion on how companies in oligopolies make decisions considering their competitors' potential moves, as illustrated by the 'prisoner's dilemma' and the behavior of firms like drug stores and coffee shops locating next to each other.

💡Market Structures

Market structures are categories that describe the characteristics of a market, such as the number of competitors and the degree of product differentiation. The script outlines four types: perfect competition, monopoly, monopolistic competition, and oligopoly, each with distinct implications for pricing and competitive behavior.

💡Perfect Competition

Perfect competition is a theoretical market structure where there are many producers, no barriers to entry, and products are homogeneous. The script uses strawberries as an example, noting that individual farmers cannot influence the market price due to the ease of entry and identical product offerings.

💡Monopoly

A monopoly is a market structure where a single company dominates the market for a product with no close substitutes. The script explains that monopolies have control over pricing due to high barriers to entry that prevent competition, providing an example of a single company controlling a product market.

💡Monopolistic Competition

Monopolistic competition is a market structure with many producers, low barriers to entry, and differentiated products. The video uses the example of fast food chains like McDonald's and Burger King, which offer similar but distinct products and compete on factors other than price.

💡Oligopoly

An oligopoly is a market structure where a few large companies dominate the market and have high barriers to entry. The script focuses on this concept, providing examples of the laptop and mobile phone markets, where companies like Apple, Samsung, and Dell control the market and engage in non-price competition.

💡Non-Price Competition

Non-price competition is a strategy where firms compete by differentiating their products or services on factors other than price, such as quality, branding, or customer service. The video explains that oligopolies often engage in non-price competition to distinguish their similar products, using advertising as a primary example.

💡Advertising

Advertising is a form of non-price competition where companies promote their products or services to influence consumer behavior. The script notes that despite the billions spent on advertising, much of it goes unnoticed, yet it remains a crucial tool for brands to stand out in competitive markets.

💡Collusion

Collusion is an illegal agreement between companies to limit competition by controlling prices or market share. The video discusses how collusion can lead to higher profits for firms at the expense of consumers, and contrasts it with price leadership, which is a legal practice where one company sets prices and others follow.

💡Payoff Matrix

A payoff matrix is a tool used in game theory to illustrate the possible outcomes of a decision-making scenario for multiple players. The script uses a payoff matrix to explain the dynamics of decision-making in an oligopoly, where companies must predict and react to each other's pricing strategies.

Highlights

Introduction to the concept of competition and game theory in economics.

Market structures vary based on the number of producers, control over prices, and barriers to entry.

Perfect competition is characterized by many producers growing identical products with easy market entry and no control over prices.

Monopoly is a market structure where one company has control over price due to high barriers to entry and lack of substitutes.

Monopolistic competition involves many producers with low barriers and similar but not identical products, allowing some price control.

Oligopolies are controlled by a few large companies with high barriers to entry, selling similar but not identical products.

Non-price competition involves distinguishing products through style, quality, location, or service rather than changing the price.

Advertising is a primary form of non-price competition, with companies spending billions to stand out.

Game theory is used to understand strategic decision making in oligopolies, where companies consider competitors' actions.

The 'prisoner's dilemma' illustrates the challenges of cooperation and the tendency to follow self-interest in game theory.

Collusion, where companies conspire to form a cartel and charge high prices, is illegal in the US due to antitrust laws.

Price leadership is a legal practice where one company changes prices and competitors decide whether to follow, avoiding collusion.

Payoff matrices in game theory help predict outcomes based on companies' best responses to each other's strategies.

Dominant strategies in game theory always provide the best outcome regardless of the competitor's actions.

Game theory highlights the unpredictability of payoffs and the importance of adapting to competitors' strategies.

Healthy competition promotes innovation and benefits consumers with improved products and services.

Transcripts

Jacob: Welcome to Crash Course Economics, I’m Jacob Clifford

Adriene: and I’m Adriene Hill, and today we’re talking about competition and game theory.

Jacob: Games? Like board games or video games? I can beat my seven year old at Call of Duty.

Adriene: No, not quite like that. In this kind of game, if you lose, you’re bankrupt.

[Theme Music]

Jacob: So when we talk about markets, there are basically four different types, or market structures.

They vary based on things like number of producers, control over prices,

and barriers to entry -- how hard it is for new businesses to jump in the market.

Most agricultural products, like strawberries, are in a type of market called perfect competition.

There are thousands of farmers all growing identical strawberries and it's pretty easy

to get in the market. You just plant strawberries. Individual businesses don't have control over prices.

One farmer can’t convince you to pay $10, if you can it buy from other farmers for $4.

A monopoly is on the other end of the spectrum. There is one large company that produces a

product with few substitutes. And because high barriers prevent competition,

a monopoly has a lot of control over price.

There are two types of markets in between these extremes. Monopolistic competition is

a market with many producers and relatively low barriers; their products are very similar

but not identical. This could be something like furniture stores or fast food. McDonald's

and Burger King do have noticeably different products.

One might be able to charge a slightly higher price if, for whatever reason, consumers prefer

that type of burger. But, if either tried to increase their prices a lot, everyone would

just go to their competitor. And, if McDonalds and Burger King both tried to raise prices

at the same time, some other company would enter the market since the barriers are relatively

low. Taco Bell would start selling hamburguesas.

The last type are Oligopolies and that's what we're gonna focus on today. Oligopolies are

markets that have high barriers to entry and are controlled by a few large companies.

Oligopolies are all over the place. In fact their products are likely in front of you

right now. The laptop computer market is dominated by companies like HP, Dell, and Apple. And

the majority of mobile phones are produced by Apple, Samsung, and LG.

You also see this type of thing in markets for cars, air travel, movies, candy, and game consoles.

Adriene: Like monopolistic competition, oligopolies often sell products that are similar but not

identical and this gives them some control over their prices. But how much? You might

love your iPhone, but if Apple raised the price of a phone to $3,000 you might switch to Android.

But the price of an iPhone is pretty close to the price of a high-end Android. So how do they compete?

The answer is non-price competition and, as you might guess, it's competing without changing the price.

This happens in a lot of industries. Companies focus on things like style, quality, location, or service.

The goal is to distinguish their product from their competitors.

Like, the jeans that one company sells might be virtually identical to everyone else’s

in terms of quality, but if they can convince consumers that having a designer label on

their butt is cool, buyers might pay much much more. The same logic holds true if a

company has better customer service or has more convenient locations.

The most recognizable form of non-price competition is advertising. Companies spend billions of

dollars each year introducing new products or services and differentiating themselves

from their competitors. And despite all that spending, most of the time, advertising just

kind of fades into the background. Can you remember the ad that ran before this video? No? Me neither.

Don Draper might tell you, “half the money spent on advertising is wasted; the trouble

is, you don't know which half.” It’s clear that not every advertisement sticks, but advertising

can work to help a brand stand out.

Jacob: So, those ads that run before YouTube videos? Some are for products sold in monopolistically

competitive markets, but the majority are probably from oligopolies. I mean, think of

car companies -- they advertise A LOT.

Generally, monopolies don’t bother advertising because they have no competition, and firms

in perfectly competitive markets don’t run ads because their products are identical.

Advertising just increases their costs and drives up the prices, which means customers go to their competitors.

So oligopolies sound like they operate pretty much like monopolistic competition but the

big difference between the two is that oligopolies are made up of a few large companies. This

means that each company makes decisions with the actions of their competitors in mind.

They use game theory -- the study of strategic decision making. Let’s go to the Thought Bubble.

Adriene: Let’s start with a classic of game theory, something called the “prisoner’s dilemma.”

Suppose Stan and I are arrested for scrawling in wet cement outside the YouTube studios.

We’re being interviewed separately. If we both confess, we’ll both have to pay

a $10,000 fine. If neither of us confesses, we’ll get off scot free. And If I take a

deal and confess, but Stan doesn’t -- I’ll walk away and Stan will owe $20,000. And vice versa.

So what do we do? Because we can’t discuss it, we both confess, and both end up owing

$10,000. This is Game Theory: even if people or companies rationally follow their own self-interest,

the best outcome is hard to reach when they can’t or don’t cooperate.

Game theory helps explain why you get drug stores and coffee shops next to each other.

Let’s say that Craig and Phil both start selling tchotchkes on the Coney Island Boardwalk.

At first they start on opposite sides of the strip -- sharing customers equally. Phil realizes

that if he gets closer to Craig, he’ll retain all of his old customers...and snag some of

Craig’s. But Craig’s no dummy; he moves his cart closer to Phil’s.

This continues until they both wind up right in the middle of the boardwalk, sharing customers

equally--and unable to improve their position.

This also plays out with pricing. If Craig lowers his price on Crash Course nesting dolls,

Phil will likely compete by dropping his prices as well. In the end they’re gonna continue

to share customers equally, and earn less money.

If Craig understands game theory, he knows there’s no reason to change his price. Instead

he focuses on providing knick-knacks that differentiate his kiosk from Phil’s. This

can help explain why prices in oligopolies tend to get stuck and why companies focus

so much on non-price competition.

Thanks Thought Bubble. So, What if Craig and Phil don’t compete at all? What if instead,

they agree to charge the same high price, conspiring to form what economists call a cartel?

Again they split the customers 50/50, but now they make even more profit --

benefiting at the expense of consumers.

This is called COLLUSION, and it’s illegal in the US. There are strict antitrust laws

designed to prevent it. But that doesn’t mean companies don’t figure out other ways to raise prices.

Price leadership is when one company changes its prices, and its competitors have to decide

if they’re going to follow suit. Since they're not actively colluding, it’s technically legal.

But it can be hard to tell the difference. Look at airline baggage fees.

When some airlines started charging fees for checked bags, other airlines quickly joined them.

And when one big airline changes their baggage fee, the others tend move to the same price point.

Are they colluding, or is this a case of price leadership?

Well, the Justice Department’s looking into it.

Other countries’ laws differ, and cartels do exist. The best example is OPEC -- The

Organization of Petroleum Exporting Countries. It’s an international cartel made up of

12 oil-producing countries that manipulate oil supplies to control prices. They control

80% of the world’s known oil reserves and nearly half of the world’s crude oil production.

Jacob: Economists like to explain oligopolies and game theory by creating something called a payoff matrix.

Let’s say Stan and Brandon have competing companies. Each can set prices high or low.

The numbers in the boxes represent the amount of profit each company will earn in different situations.

The profit on the left in each cell is for Stan and the numbers on the right are for Brandon.

So if Stan has a low price and Brandon has a high price, Stan earns $300 and Brandon earns $50.

Now, payoff scenarios for companies are never this transparent, but the matrix says a lot

about oligopolies. The optimal outcome is for each business to charge high prices so they both get $200.

Stan knows this, but he also recognizes that there could be even more profit by charging

a lower price. Brandon comes to the same conclusion, so they both price low and they end up in

the worst combined outcome with each only making $80 profit.

Even if they collude and agree to price high, they both have an incentive to cheat on that agreement.

So collusion and cartels are often unstable. They can only last if the agreement is monitored and strictly enforced.

A lot of times, it's possible to predict the final outcome based on the information in

the payoff matrix. The best outcome for Stan, when Brandon makes a move, is called Stan’s best response.

So, if Brandon prices high, Stan’s best response is to price low and if Brandon prices

low than Stan’s best response is, again, to price low. That’s called having a dominant

strategy: it always gives the best available outcome, no matter what the other guy does.

For Brandon, pricing low is his dominant strategy too: regardless of what Stan does, pricing

low always results in a better outcome.

Adriene: Game theory helps companies make decisions, but, potential payoffs are never

easy to predict and there are many situations where there's no clear dominant strategy.

Sometimes, the best response changes depending on what competitors do.

Those that don’t keep up or are slow to adapt are pushed aside. It’s called Game

Theory, but to former industry leaders like Pan American Airways, Atari, and Research

In Motion -- that made Blackberry phones, the end of the game was not that fun.

In any game, there are winners and losers, unless it’s some lame co-op thing. But at

its best, healthy competition promotes innovation which, in the end, makes us all better off.

Jacob: And ideally we get cheaper air fares, constantly improving cell phones, and amazing

video game consoles. Thanks for watching, we’ll see you next week.

Thanks for watching Crash Course Economics, which is made with the help of all these awesome people.

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