Summary
Highlights
The lecture begins by defining oligopoly as a market with a small number of firms competing to provide a good, distinguishing it from perfect competition (many firms) and monopoly (one firm). The auto industry is used as a prototypical example, illustrating how an oligopolistic market lies between the two extremes.
Firms in an oligopoly can either cooperate, forming a cartel to act like a collective monopoly (e.g., OPEC), or behave non-cooperatively. While cooperation can lead to higher profits initially, the lecture foreshadows that cartels are often unstable.
To analyze non-cooperative oligopolies, the lecture introduces game theory. Key concepts are strategy and equilibrium. The Nash equilibrium is defined as a state where no player wants to change their strategy given all other players' strategies. The "Beautiful Mind" movie and John Nash's insights are mentioned.
The prisoner's dilemma is presented as a classic example of a non-cooperative game. Two prisoners, independently, must decide whether to stay silent or talk, with different outcomes for prison sentences based on their choices. The payoff matrix is constructed and analyzed, showing how individual rational choices lead to a collectively worse outcome than cooperation. This concept is extended to economic scenarios like advertising decisions between Pepsi and Coke.
The lecture explores how cooperation can emerge in a non-cooperative setting through repeated games. If firms play the same game infinitely, a threat to advertise forever if the other firm advertises can enforce a cooperative outcome (not advertising). However, if the game has a known end point, this strategy can unravel through backward induction.
The Cournot model is introduced as a specific game-theoretic model for non-cooperative oligopoly. It defines equilibrium as a set of quantities for each firm where, holding other firms' quantities constant, no firm can achieve higher profits by deviating. The market for flights between New York and Chicago, with American and United as the two firms, serves as an example.
As a baseline, the lecture first calculates the optimal quantity and price if American Airlines were a monopolist, demonstrating the standard monopoly profit maximization condition (marginal revenue equals marginal cost).
The Cournot equilibrium result (128 units, $211 price) is compared to the monopoly outcome (96 units, $243 price) and the perfect competition outcome (192 units, $147 price). It illustrates that oligopoly leads to a market quantity and price that fall between those of monopoly and perfect competition, demonstrating the intermediate nature of oligopoly.
The concept of residual demand is explained: if American knows United's quantity, it calculates its own demand (total demand minus United's quantity) and then optimizes its own output. This leads to the idea of a 'best response curve,' which maps American's optimal quantity for every possible quantity United might fly. Due to symmetry, United has a similar best response curve.
The lecture demonstrates how to mathematically derive the Cournot equilibrium by solving the two firms' best response functions (equations) simultaneously. The calculation shows that in this example, both American and United will each produce 64 flights, resulting in a total market quantity of 128 flights and a price of $211.