The East and West sides of a city are serviced by 2 rival drug gangs. Due to a City Hall budget issue, there is a sudden drop in police presence in the Central core of the city. This has created a lucrative new territory to sell drugs in, so both drug gangs see an opportunity to expand their territory. Both know that expanding into this territory is going to be tough, since both gangs have equal amounts of firepower and foot soldiers. A violent drug war would be unwise, and cause more harm than good (the definition of ‘good’ being a grey area when it comes to drug dealing), due to the mutually assured destruction of both gangs in the long run. The only way for this turf to be utilized by both gangs is to forgo their competition/feud, call a ceasefire, and cooperate by forming a cartel. Both sides know that jointly they can both achieve a profit of $100K each per month if they can agree to stick to a fixed quota decided on by the leaders of the gangs. This collusion between the 2 gangs is by far the best option, as both gangs achieve a modest profit, and they don’t need to worry about a bloody and wasteful turf war. However, there is no honor amongst thieves, and the goal of each gang is to maximize profits, not to cooperate with their competition. The leader of the West gang knows that the ceasefire would be a golden opportunity to get the jump on the East gang by supplying more than the agreed upon quota. This would give the West a profit of $150K per month, leaving East with a paltry $50K. East knows this is what West is thinking of doing, because East was thinking the exact same thing. The drug war is an eventuality, because it’s worth the chance of achieving that higher profit than your rival. Cheating must take place, because if you do not, then your rival will. The results for both gangs if they cheat is $75K per month, AND they both sides are now involved in a drug war.
On a game theory matrix, this example would look like this.
| | East |
| | Don't Cheat | Cheat |
West | Don't Cheat | 100 / 100 | 50 / 150 |
Cheat | 150 / 50 | 75 / 75 |
Although legitimate (non-criminal) businesses don’t like to be compared to drug cartels, they share a commonality in that achieving maximum total profits is their main motivation. This example illustrates the mutual interdependence of the few rival firms in an Oligopolistic market. To cooperate or to compete? How does a firm decide? Game theory is a way of statistically analyzing the possible outcomes/payoffs of all possible decisions. An oligopoly firm must think about the reactions of their rivals every time they want to make a decision. Colluding with your rivals rarely works because the temptation to cheat is too strong as it results in much higher profits and also leave your rival in a position of weakness.
Oligopolies and Monopolistic competition share the common goal of wanting to maximize profit. They both also have control over the prices they charge. They are also similar in that neither is able to achieve allocative or productive efficiency, and operate at excess capacity.
Monopolistic competition between many firms can sustain itself for so long time before the most successful firms get so large and achieve such scale that the industry gets highly concentrated. At this point, the remaining few and large oligopolistic firms now have much more control over price, and are now forced to practice much more non-price competition (advertising, etc). Their large size inhibits competition by making entry of new firms seem very difficult. This concentrated industry with few players creates an environment that fosters mutual interdependence between firms. All firms want to maximize profits, and all firms are rivals competing for customers.
Personally I believe oligopolistic markets are the best choice. I believe their competition may be wasteful (redundant advertising), but the desire to differentiate your product creates technological changes that benefit not just the industry, but also the consumer in the form of lower prices.
‘Economists Do It With Models’ videos on game theory
