Understanding Oligopolies for AP Microeconomics

Hi everybody, Jacob Reed here from ReviewEcon.com. Today we're going to be talking about oligopolies. If after watching this video you still need a little more help, head over to ReviewEcon.com and pick up the total review booklet. It has everything you need to know to ace your microeconomics or macroeconomics exam. Let's get into the content. So first let's talk about the basics of an oligopoly. An oligopoly is a market structure that has very few sellers within that market. Now there's no specific number, but let's say fewer than 10 sellers within this market. We are also going to have high barriers to entry, which means that it is incredibly difficult for new firms to enter this market and compete with the existing firms. Those are things like high startup costs, customer loyalty, government regulations, and things like that. And since there are so few firms within this market, the firms are going to be mutually interdependent. That means the actions of one firm will impact the outcomes of the other firms. And since these firms are interdependent, that means their actions will have some impact on the price they charge, just not as much control as a monopoly does. Some examples of oligopolies within the United States include cell phone service providers and airlines. Very few sellers within those markets and they're competing for market share. So here's the graph for an oligopoly. It's got a kink demand curve and other than that it looks a little like a monopoly graph. But you're not going to need to know that graph on the AP Microeconomics exam. And that's because that graph is not how we primarily analyze the behavior of oligopolies. Before we get into how we do analyze oligopoly behavior, let's talk about efficiency of oligopolies. Oligopolies are not going to be allocatively efficient, and that's because they will price above marginal cost. They will have higher prices than a perfectly competitive market and produce lower quantities than a perfectly competitive market. As a result. we will see deadweight loss within this market. Oligopolies are also not going to be productively efficient. That means they won't be producing at the minimum of the average total cost. They will be operating on the downward sloping portion of their average total cost curve. When it comes to oligopoly behavior in AP microeconomics, game theory is how we understand it. Game theory is a method for understanding interdependent strategic behavior. In this case, strategic behavior between small numbers of firms. In your psychology class, you may learn about the prisoner's dilemma. It is one of the ways that people teach game theory. Game theory has applications across all different disciplines, and the prisoner's dilemma shows why it might be impossible for two prisoners to work together when it's in their best interest to do so. Instead, both will likely confess, and as a result, both will end up in prison for a very long time. We're not going to go into all of the prisoner's dilemma, but you can read about it at reviewecon.com. Instead, we're going to jump right into the economics and apply oligopoly behavior to game theory. Here we have a game theory payoff matrix. We have two businesses. That means it's a duopoly. A duopoly is an oligopoly with just two firms. And the firms we have here are Simmer's Sandwiches and Ryan's Rubens. And you are likely to see a payoff matrix similar to this one on your next AP microeconomics exam. So we're going to go through how to read this payoff matrix next, and then we'll talk about answering the questions you're likely to see. First, we have the strategies within this payoff matrix. Both of these firms can choose to either lower their price or raise their price in this example. You could see all different possible strategies within a payoff matrix. And on the payoff matrix, you're likely to see on your exam, you'll see one of those sets of strategies on the top there and one over there on the left of the payoff matrix. The ones on top are the ones that Simar has to choose from and the ones there on the left. are the ones that Ryan's Rubens has to choose from. Now, the numbers within the matrix are the payoffs for each of these firms. These are the amounts of economic profit the firms could earn depending on the outcomes. And since there are four quadrants within this payoff matrix, that gives us four possible outcomes. Up here in the upper left, we have Simmer's Sandwiches lowering the price and Ryan's Rubens also lowering price. Over there on the upper right quadrant, we have Ryan's Rubens is going to lower the price and Simmer's Sandwiches is going to raise the price. if we end up in that lower left quadrant there ryan's rubens is raising their price and simmer sandwiches is lowering their price the first question you could be asked about in a payoff matrix question is what the collusion outcome would be a collusion outcome is the outcome that is best for both firms together it's essentially the monopoly outcome if these firms were functioning as one business which quadrant would they choose to end up in When you get that question, it's a pretty easy question to figure out. You just find the quadrant with the highest combined profit. And in this example here, that's going to be that upper left quadrant. The combined profit there is $1,500. And in no other quadrant could these two firms earn that amount of combined profit. Now, since oligopolies and collusion are illegal, thanks to antitrust policies, which prevent monopoly power in oligopolies, we're not likely to see that outcome play out. to find out the outcome that is most likely we need to work through this payoff matrix let's go through that step by step right now the first thing we're going to do is Pick one of these firms to be. We're going to be their brain. First, we're going to start off with Ryan's Rubens. Let's think about what Ryan Ruben will want to do. But remember, since these firms are interdependent in regards to their behavior, Ryan's Rubens doesn't just think about what's best for them. They have to think about what similar sandwiches might do and use that information to determine what their best action in response should be. So the first decision Ryan's Rubens needs to make is what they should do. if Simmer's Sandwiches chooses to lower their price. In that case, Ryan's Rubens is choosing between lowering their price, earning $800, and raising their price to earn $600. Since $800 is greater than 600, Ryan's Rubens is going to choose to lower their price if they expect Simmer's Sandwiches to also lower their price. And so I'm going to put a star right there next to Ryan's Rubin's best choice if Simmer's Sandwiches lowers their price. Now we're going to decide what Ryan's Rubin's should do if they think Simmer's Sandwiches is going to raise their prices. Here, Ryan's Rubin's is deciding between $400 economic profit and $200 economic profit. Since $400 is greater than $200, it is clearly the best choice for Ryan's Rubin's to again... lower their price. So we're going to put another star right there indicating the best choice for Ryan's Rubens if Simmer Sandwiches is going to raise their price. Now that leads us to the next definition you need to know and this is a dominant strategy. A dominant strategy is an action that one of these two firms will take regardless of what the other firm does. So getting back to our payoff matrix, we see that Ryan's Rubens is going to lower their price regardless of whether or not Simmer Sandwiches raises their price. or lowers their price. As a result, the dominant strategy for Ryan's Rubens is going to lower the price. If we were going to explain the answer to this question, we would use the numbers we looked at before. 800 is greater than 600 and 400 is greater than 200. That's how you would answer this if there was an explain point here. Now we're going to switch brains to simmer sandwiches and help them decide what they should do. Remember, they don't make their decision in a vacuum. They must consider what Ryan's Rubens might do and then, based on that information, decide what's best for Simmer's Sandwiches. So we're becoming Simmer's Sandwiches here and we're looking at what they might choose if they think that Ryan's Rubens is going to lower their price. In that case, Simmer's Sandwiches is looking between $700 and $800 of economic profit. Since $800 is greater than $700, they are going to choose the $800 of economic profit. so let's go ahead and put a star there because that is the best choice for them if they think ryan's rubens is going to lower their price and now if simmer sandwiches thinks ryan's rubens is going to raise their price simmer sandwiches is choosing between 500 of economic profit and 400 economic profit which one is better clearly 500 is greater than 400 and more profit is better so simmer sandwiches is going to choose to lower their price if they think ryan's rubens is going to raise theirs And so we're going to put a little star once again for the best choice for Simmer Sandwiches. So the next question here is, does Simmer Sandwiches have a dominant strategy? Since Simmer Sandwiches chooses to raise their price when Ryan's Rubens lowers theirs, and Simmer Sandwiches chooses to lower their price when Ryan's Rubens chooses to raise theirs, Simmer Sandwiches does not have a dominant strategy. And that's because their best move is dependent on what Ryan's Rubens does. If this was an explained point, again, you would use numbers here. You would say that 800 is greater than 700 and 500 is greater than 400. That's the explained point and you need to use those numbers. And so that leads us to what's called the Nash Equilibrium. The Nash Equilibrium is the most likely outcome within this market. For Duopoly payoff matrix, the Nash Equilibrium is the quadrant with two selected choices for these firms. We see that by the two stars we've put in there up in that upper right quadrant. That is the Nash Equilibrium. and it's the most likely outcome we're likely to see. Simmer Sandwiches is going to raise their price, and Ryan's Rubens is going to lower theirs. Along with that, Simmer Sandwiches is going to earn $800 economic profit, and Ryan's Rubens is going to earn $400 economic profit. You'll notice this isn't the best outcome for these two firms, but through the payoff matrix and game theory, we know it's the most likely outcome. And what makes this the Nash equilibrium is that if either firm chooses to deviate from this quadrant, that firm will be worse off. If Ryan's Rubens decides to switch strategies, they will actually move from $400 economic profit down to $200 economic profit. That is not in their best interest to do, and so they will stay at this Nash equilibrium. Simmer Sandwiches, on the other hand, if they choose to lower their price as opposed to raise their price, their economic profit will fall from $800 to $700. And losing that $100 of economic profit would not be in their best interest, and so they will stay at that Nash equilibrium. And since there's no incentive for either firm to deviate from this Nash, Both are going to stay there, and this Nash equilibrium is the most likely outcome we will see within this market. Next we're going to talk a little bit more about specifically what you're likely to see on your AP microeconomics exams regarding game theory. Here's a payoff matrix from the 2019 microeconomics exam. Well the Nash equilibrium we have in this question there was actually two of them so be aware that there could be two Nash equilibria. In this case we saw it in 2019's question number three. set one. I made a review video for that question, so check it out if you want to see it. So you might notice that the payoff matrix we see here is a little bit different than the one I showed you earlier. As a result, you might have some trouble reading this one compared to the ones you see in some of the examples and review books. So how do you read these payoff matrices? Well, it's important to understand that the first amounts you see there are the economic profits for the firm that is on the left. So I have them all underlined in green there. All of those numbers of the payoffs and the strategies belong to Patrick's pie. in this example. The second numbers listed within the quadrants on the payoff matrix, along with the strategies that are listed above the payoff matrix, belong to the firm that is on the top of the payoff matrix. Those all here belong to D's Pizzeria, and you would want to keep that in mind when you are going through these problems. I usually underline at least one of the firm's payoffs and strategies along with the name of that firm to help me keep it all straight. And there you have it. That is everything you need to know about oligopolies for your AP microeconomics exam. If you want to practice the skills here and practice solving payoff matrices, head over to reviewecon.com and play the oligopoly game. If you want more information after that, head over to reviewecon.com, pick up the total review booklet. It has everything you need to know to ace your microeconomics and macroeconomics exams. That's it for now. I'll see you all next time.

It has everything you need to know to ace your microeconomics or macroeconomics exam. Let's get into the content. So first let's talk about the basics of an oligopoly.

An oligopoly is a market structure that has very few sellers within that market. Now there's no specific number, but let's say fewer than 10 sellers within this market. We are also going to have high barriers to entry, which means that it is incredibly difficult for new firms to enter this market and compete with the existing firms.

Those are things like high startup costs, customer loyalty, government regulations, and things like that. And since there are so few firms within this market, the firms are going to be mutually interdependent. That means the actions of one firm will impact the outcomes of the other firms.

And since these firms are interdependent, that means their actions will have some impact on the price they charge, just not as much control as a monopoly does. Some examples of oligopolies within the United States include cell phone service providers and airlines. Very few sellers within those markets and they're competing for market share. So here's the graph for an oligopoly.

It's got a kink demand curve and other than that it looks a little like a monopoly graph. But you're not going to need to know that graph on the AP Microeconomics exam. And that's because that graph is not how we primarily analyze the behavior of oligopolies.

Before we get into how we do analyze oligopoly behavior, let's talk about efficiency of oligopolies. Oligopolies are not going to be allocatively efficient, and that's because they will price above marginal cost. They will have higher prices than a perfectly competitive market and produce lower quantities than a perfectly competitive market. As a result. we will see deadweight loss within this market.

Oligopolies are also not going to be productively efficient. That means they won't be producing at the minimum of the average total cost. They will be operating on the downward sloping portion of their average total cost curve.

When it comes to oligopoly behavior in AP microeconomics, game theory is how we understand it. Game theory is a method for understanding interdependent strategic behavior. In this case, strategic behavior between small numbers of firms. In your psychology class, you may learn about the prisoner's dilemma.

It is one of the ways that people teach game theory. Game theory has applications across all different disciplines, and the prisoner's dilemma shows why it might be impossible for two prisoners to work together when it's in their best interest to do so. Instead, both will likely confess, and as a result, both will end up in prison for a very long time.

We're not going to go into all of the prisoner's dilemma, but you can read about it at reviewecon.com. Instead, we're going to jump right into the economics and apply oligopoly behavior to game theory. Here we have a game theory payoff matrix.

We have two businesses. That means it's a duopoly. A duopoly is an oligopoly with just two firms. And the firms we have here are Simmer's Sandwiches and Ryan's Rubens.

And you are likely to see a payoff matrix similar to this one on your next AP microeconomics exam. So we're going to go through how to read this payoff matrix next, and then we'll talk about answering the questions you're likely to see. First, we have the strategies within this payoff matrix. Both of these firms can choose to either lower their price or raise their price in this example. You could see all different possible strategies within a payoff matrix.

And on the payoff matrix, you're likely to see on your exam, you'll see one of those sets of strategies on the top there and one over there on the left of the payoff matrix. The ones on top are the ones that Simar has to choose from and the ones there on the left. are the ones that Ryan's Rubens has to choose from.

Now, the numbers within the matrix are the payoffs for each of these firms. These are the amounts of economic profit the firms could earn depending on the outcomes. And since there are four quadrants within this payoff matrix, that gives us four possible outcomes. Up here in the upper left, we have Simmer's Sandwiches lowering the price and Ryan's Rubens also lowering price.

Over there on the upper right quadrant, we have Ryan's Rubens is going to lower the price and Simmer's Sandwiches is going to raise the price. if we end up in that lower left quadrant there ryan's rubens is raising their price and simmer sandwiches is lowering their price the first question you could be asked about in a payoff matrix question is what the collusion outcome would be a collusion outcome is the outcome that is best for both firms together it's essentially the monopoly outcome if these firms were functioning as one business which quadrant would they choose to end up in When you get that question, it's a pretty easy question to figure out. You just find the quadrant with the highest combined profit.

And in this example here, that's going to be that upper left quadrant. The combined profit there is $1,500. And in no other quadrant could these two firms earn that amount of combined profit.

Now, since oligopolies and collusion are illegal, thanks to antitrust policies, which prevent monopoly power in oligopolies, we're not likely to see that outcome play out. to find out the outcome that is most likely we need to work through this payoff matrix let's go through that step by step right now the first thing we're going to do is Pick one of these firms to be. We're going to be their brain. First, we're going to start off with Ryan's Rubens.

Let's think about what Ryan Ruben will want to do. But remember, since these firms are interdependent in regards to their behavior, Ryan's Rubens doesn't just think about what's best for them. They have to think about what similar sandwiches might do and use that information to determine what their best action in response should be. So the first decision Ryan's Rubens needs to make is what they should do.

if Simmer's Sandwiches chooses to lower their price. In that case, Ryan's Rubens is choosing between lowering their price, earning $800, and raising their price to earn $600. Since $800 is greater than 600, Ryan's Rubens is going to choose to lower their price if they expect Simmer's Sandwiches to also lower their price. And so I'm going to put a star right there next to Ryan's Rubin's best choice if Simmer's Sandwiches lowers their price. Now we're going to decide what Ryan's Rubin's should do if they think Simmer's Sandwiches is going to raise their prices.

Here, Ryan's Rubin's is deciding between $400 economic profit and $200 economic profit. Since $400 is greater than $200, it is clearly the best choice for Ryan's Rubin's to again... lower their price. So we're going to put another star right there indicating the best choice for Ryan's Rubens if Simmer Sandwiches is going to raise their price.

Now that leads us to the next definition you need to know and this is a dominant strategy. A dominant strategy is an action that one of these two firms will take regardless of what the other firm does. So getting back to our payoff matrix, we see that Ryan's Rubens is going to lower their price regardless of whether or not Simmer Sandwiches raises their price. or lowers their price. As a result, the dominant strategy for Ryan's Rubens is going to lower the price.

If we were going to explain the answer to this question, we would use the numbers we looked at before. 800 is greater than 600 and 400 is greater than 200. That's how you would answer this if there was an explain point here. Now we're going to switch brains to simmer sandwiches and help them decide what they should do.

Remember, they don't make their decision in a vacuum. They must consider what Ryan's Rubens might do and then, based on that information, decide what's best for Simmer's Sandwiches. So we're becoming Simmer's Sandwiches here and we're looking at what they might choose if they think that Ryan's Rubens is going to lower their price. In that case, Simmer's Sandwiches is looking between $700 and $800 of economic profit. Since $800 is greater than $700, they are going to choose the $800 of economic profit.

so let's go ahead and put a star there because that is the best choice for them if they think ryan's rubens is going to lower their price and now if simmer sandwiches thinks ryan's rubens is going to raise their price simmer sandwiches is choosing between 500 of economic profit and 400 economic profit which one is better clearly 500 is greater than 400 and more profit is better so simmer sandwiches is going to choose to lower their price if they think ryan's rubens is going to raise theirs And so we're going to put a little star once again for the best choice for Simmer Sandwiches. So the next question here is, does Simmer Sandwiches have a dominant strategy? Since Simmer Sandwiches chooses to raise their price when Ryan's Rubens lowers theirs, and Simmer Sandwiches chooses to lower their price when Ryan's Rubens chooses to raise theirs, Simmer Sandwiches does not have a dominant strategy.

And that's because their best move is dependent on what Ryan's Rubens does. If this was an explained point, again, you would use numbers here. You would say that 800 is greater than 700 and 500 is greater than 400. That's the explained point and you need to use those numbers. And so that leads us to what's called the Nash Equilibrium.

The Nash Equilibrium is the most likely outcome within this market. For Duopoly payoff matrix, the Nash Equilibrium is the quadrant with two selected choices for these firms. We see that by the two stars we've put in there up in that upper right quadrant. That is the Nash Equilibrium.

and it's the most likely outcome we're likely to see. Simmer Sandwiches is going to raise their price, and Ryan's Rubens is going to lower theirs. Along with that, Simmer Sandwiches is going to earn $800 economic profit, and Ryan's Rubens is going to earn $400 economic profit. You'll notice this isn't the best outcome for these two firms, but through the payoff matrix and game theory, we know it's the most likely outcome. And what makes this the Nash equilibrium is that if either firm chooses to deviate from this quadrant, that firm will be worse off.

If Ryan's Rubens decides to switch strategies, they will actually move from $400 economic profit down to $200 economic profit. That is not in their best interest to do, and so they will stay at this Nash equilibrium. Simmer Sandwiches, on the other hand, if they choose to lower their price as opposed to raise their price, their economic profit will fall from $800 to $700. And losing that $100 of economic profit would not be in their best interest, and so they will stay at that Nash equilibrium. And since there's no incentive for either firm to deviate from this Nash, Both are going to stay there, and this Nash equilibrium is the most likely outcome we will see within this market.

Next we're going to talk a little bit more about specifically what you're likely to see on your AP microeconomics exams regarding game theory. Here's a payoff matrix from the 2019 microeconomics exam. Well the Nash equilibrium we have in this question there was actually two of them so be aware that there could be two Nash equilibria. In this case we saw it in 2019's question number three.

set one. I made a review video for that question, so check it out if you want to see it. So you might notice that the payoff matrix we see here is a little bit different than the one I showed you earlier.

As a result, you might have some trouble reading this one compared to the ones you see in some of the examples and review books. So how do you read these payoff matrices? Well, it's important to understand that the first amounts you see there are the economic profits for the firm that is on the left. So I have them all underlined in green there. All of those numbers of the payoffs and the strategies belong to Patrick's pie.

in this example. The second numbers listed within the quadrants on the payoff matrix, along with the strategies that are listed above the payoff matrix, belong to the firm that is on the top of the payoff matrix. Those all here belong to D's Pizzeria, and you would want to keep that in mind when you are going through these problems. I usually underline at least one of the firm's payoffs and strategies along with the name of that firm to help me keep it all straight.

And there you have it. That is everything you need to know about oligopolies for your AP microeconomics exam. If you want to practice the skills here and practice solving payoff matrices, head over to reviewecon.com and play the oligopoly game.

If you want more information after that, head over to reviewecon.com, pick up the total review booklet. It has everything you need to know to ace your microeconomics and macroeconomics exams. That's it for now. I'll see you all next time.

Transcript for:Understanding Oligopolies for AP Microeconomics

Transcript for:
Understanding Oligopolies for AP Microeconomics