Market Structures & Game Theory: Key Economic Concepts

Market Structures & Strategic Interactions

Monopolistic Competition

A market in which firms can enter freely, each producing its own brand or version of a differentiated product.

Characteristics of Monopolistic Competition

• Firms compete by selling differentiated products that are highly substitutable for one another but not perfect substitutes. In other words, the cross-price elasticities of demand are large but not infinite.
• Free entry and exit.

Oligopoly

A market in which only a few firms compete with one another, and entry by new firms is impeded. In some oligopolistic markets, some or all firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for new firms to enter.

Cartel

A market in which some or all firms explicitly collude, coordinating prices and output levels to maximize joint profits.

Oligopoly Models & Equilibrium Concepts

Nash Equilibrium

In oligopoly markets, this means that each firm will want to do the best it can given what its competitors are doing, and these competitors will do the best they can given what that firm is doing.

Duopoly

A market in which two firms compete with each other.

Cournot Model

An oligopoly model in which firms produce a homogeneous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce.

Reaction Curve

The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce.

Cournot Equilibrium

An equilibrium model in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.

Stackelberg Model

An oligopoly model in which one firm sets its output before other firms do.

Bertrand Model

An oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge.

Cournot vs. Bertrand Outcomes

Cournot and Bertrand predict completely different outcomes: Bertrand predicts a competitive outcome, and Cournot predicts a non-competitive outcome.

Game Theory Fundamentals

Game

A situation in which players (participants) make strategic decisions that take into account each other’s actions and responses.

Payoff

The value associated with a possible outcome.

Payoff Matrix

A table showing the profit (or payoff) to each firm given its decision and the decision of its competitor.

Strategy

A rule or plan of action for playing a game.

Dominant Strategy

A strategy that is optimal no matter what an opponent does.

Optimal Strategy

A strategy that maximizes a player’s expected payoff.

Cooperative Game

A game in which participants can negotiate binding contracts that allow them to plan joint strategies.

Non-Cooperative Game

A game in which negotiation and enforcement of binding contracts are not possible.

Repeated Game

A game in which actions are taken and payoffs received over and over again.

Tit-for-Tat Strategy

A repeated-game strategy in which a player responds in kind to an opponent’s previous play, cooperating with cooperative opponents and retaliating against uncooperative ones.