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NONCOOPERATIVE OLIGOPOLY MODELS 1. I NTRODUCTION AND D EFINITIONS Definition 1 (Oligopoly) . Noncooperative oligopoly is a market where a small number of firms act inde- pendently but are aware of each other’s actions. 1.1. Typical assumptions for oligopolistic markets. 1. Consumers are price takers. 2. All firms produce homogeneous products. 3. There is no entry into the industry. 4. Firms collectively have market power: they can set price above marginal cost. 5. Each firm sets only its price or output (not other variables such as advertising). 1.2. Summary of results on oligopolistic markets. 1. The equilibrium price lies between that of monopoly and perfect competition. 2. Firms maximize profits based on their beliefs about actions of other firms. 3. The firm’s expected profits are maximized when expected marginal revenue equals marginal cost. 4. Marginal revenue for a firm depends on its residual demand curve (market demand minus the output supplied by other firms) 2. O LIGOPOLY MODELS AND GAME THEORY Definition 2 (Game Theory) . A game is a formal representation of a situation in which a number of decision makers (players) interact in a setting of strategic interdependence . By that, we mean that the welfare of each decision maker depends not only on her own actions, but also on the actions of the other players. Moreover, the actions that are best for her to take may depend on what she expects the other players to do. We say that game theory analyzes interactions between rational, decision-making individuals who may not be able to predict fully the outcomes of their actions. Definition 3 (Nash equilibrium) . A set of strategies is called a Nash equilibrium if, holding the strategies of all other players constant, no player can obtain a higher payoff by choosing a different strategy. In a Nash equilibrium, no player wants to change its strategy. 2.1. Behavior of firms in oligopolistic games. 1. Firms are rational. 2. Firms reason strategically. 2.2. Elements of typical oligopolistic games. 1. There are two or more firms (not a monopoly). 2. The number of firms is small enough that the output of an individual firm has a measurable impact on price (not perfect competition). We say each firm has a few, but only a few, rivals. 3. Each firm attempts to maximize its expected profit (payoff). 4. Each firm is aware that other firm’s actions can affect its profit. 5. Equilibrium payoffs are determined by the number of firms, the rules of the games and the length of the game. Date : December 16, 2004. 1
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2 NONCOOPERATIVE OLIGOPOLY MODELS 2.3. Comparison of oligopoly with competition. In competition each firm does not take into account the actions of other firms. In effect they are playing a game against an impersonal market mechanism that gives them a price that is independent of their own actions. In oligopoly, each firm explicitly takes account of other firm’s expected actions in making decisions.
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This note was uploaded on 12/21/2011 for the course ECON 214 taught by Professor Bayemichael during the Spring '09 term at HKU.

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