#AP Microeconomics: Oligopolies - Your Ultimate Study Guide 🚀

Hey there, future AP Micro ace! Let's dive into the world of oligopolies. This guide is designed to make sure you're not just memorizing facts, but truly understanding the concepts. Get ready to ace that exam! 💪

#What is an Oligopoly?

An oligopoly is a market structure dominated by a few large firms. Think of industries like cereal, oil, or automobiles. Unlike monopolistic competition, oligopolies have high barriers to entry and only a handful of players. It's like a small club where everyone knows each other's moves. 🤝

#Types of Oligopolies

1. Colluding Oligopolies (Cartels): Firms communicate and act as a single entity. Think of it as a secret alliance. 🤫
2. Non-Colluding Oligopolies: Firms compete and don't cooperate, often practicing price leadership. It's more like a strategic rivalry. ⚔️

#Characteristics of Oligopolies

• Few, Large Firms: Typically less than 10 firms dominate the market. Example: Cellular networks like Verizon, T-Mobile, AT&T. 📱
• "Price Makers": Oligopolistic firms have some market power and can influence prices. They're not total dictators, but they have a say. 👑
• High Barriers to Entry: It's tough for new firms to enter the market. This keeps the number of firms small. 🚧
• Long-Run Profits: Due to market power, firms can earn profits in both the short and long run. Cha-ching! 💰
• Differentiated Products: Products have many close substitutes, but aren't exactly the same. Think of different brands of cereal. 🥣
• Non-Price Competition: Firms compete based on factors other than price. This is where game theory comes in! 🎯
• Inefficient if Unregulated: Price isn't necessarily equal to marginal cost, leading to inefficiency. ⚠️

#Game Theory

Game theory is the study of how people behave in strategic situations. In oligopolies, we use a payoff matrix to analyze these situations. It's all about understanding the moves and counter-moves of firms. 🧠

#What is a Game?

In game theory, a game is any situation where the outcome depends on the actions of two or more decision-makers. Think of it as a strategic chess match. ♟️

For AP Micro, we usually assume a duopoly (an oligopoly with two firms) to keep the math manageable. You'll never need to deal with more than two firms on the AP exam. Phew! 😅

#Payoff Matrix

A payoff matrix shows the actions of two firms and the payoffs (usually profit) for each combination of choices. It's like a cheat sheet for understanding the game. 📊

Example: Tom's Tomatoes and Pete's Pizza are in a duopoly. Tom decides whether to enter the market, and Pete decides whether to advertise. They act simultaneously and cannot collude.

#Dominant Strategies

A dominant strategy is the best strategy for a firm, regardless of what the other firm does. Sometimes, a firm doesn't have a dominant strategy. It all depends on the payoff matrix. 🤔

In our example, neither Tom nor Pete has a dominant strategy. Their best choice depends on what the other player does. It's a bit of a dance! 💃

#Nash Equilibrium

The Nash Equilibrium is a stable state where no player can unilaterally improve their position. It's a point where the game equilibrates. ⚖️

In our example, we have two Nash Equilibria:

1. Do Not Advertise and Enter

2. Advertise and Stay Out

#Example Problems

Here's a game theory matrix for Coca-Cola and Pepsi:

1. If Coca-Cola and Pepsi collude, what will be the payoff for both firms?

   • They will both charge a high price and earn $2,000 profit each.$

2. Does Coca-Cola have a dominant strategy, and if so, what is it?

   • Yes, to charge a lower price. (Check the matrix: Low is always better for Coke, regardless of Pepsi's choice.)

3. Does Pepsi have a dominant strategy, and if so, what is it?

   • Yes, to charge a lower price. (Same logic as Coke.)

4. If Coca-Cola and Pepsi decide NOT to collude, what will be the payoff for both firms?

   • Both will earn1000 profit. (This is where their dominant strategies intersect.)

#Sample Free Response Question (FRQ): 2007 Question #3

Two bus companies, Roadway and Rankin Wheels, must choose between an early and late departure. Here's the payoff matrix:

(a) In which market structure do these firms operate? Explain.

• Oligopoly. There are only two firms, and their actions are interdependent.

(b) If Roadway chooses an early departure, which departure time is better for Rankin Wheels?

• Early departure ($900 >$850).

(c) Identify the dominant strategy for Roadway.

• Early departure. (Early is always better for Roadway, regardless of Rankin Wheels' choice.)

(d) Is choosing an early departure a dominant strategy for Rankin Wheels? Explain.

• No. Rankin Wheels' best choice depends on what Roadway does. (If Roadway chooses late, Rankin Wheels should also choose late).

(e) If both firms know all of the information in the payoff matrix but do not cooperate, what will be Rankin Wheels' daily profit?

• $900 (Both firms will choose early departure).$

#Kinked Demand Curve for an Oligopoly

In oligopolies, firms often exhibit price leadership. The dominant firm initiates a price change, and other firms either follow or ignore. This can lead to a kinked demand curve. 📉

If a firm increases its price, competitors will likely ignore it, leading to a more elastic demand (consumers switch to cheaper options). If a firm decreases its price, competitors will likely match it, leading to a more inelastic demand. This creates a kink in the demand curve at the current price.

<key_point> While the kinked demand curve isn't a major focus on the AP exam, it's a great visual for understanding interdependence in oligopolies. </key_point>

#Comparison of All Market Structures <high_value_topic>

Here's a handy chart comparing all market structures:

#Final Exam Focus <exam_tip>

Focus on mastering game theory and understanding the characteristics of oligopolies. These are high-value topics on the AP exam. </exam_tip>

• High-Priority Topics: - Game theory and payoff matrices - Dominant strategies and Nash Equilibrium - Characteristics of oligopolies (few firms, high barriers, interdependence)
• Common Question Types: - Interpreting payoff matrices - Identifying dominant strategies and Nash Equilibria - Comparing different market structures
• Time Management Tips: - Quickly scan the payoff matrix to identify dominant strategies. - Don't overthink Nash Equilibria – look for stable points. - Practice, practice, practice! The more you do, the faster you'll get.
• Common Pitfalls: - Confusing dominant strategies with Nash Equilibria. - Forgetting that firms in oligopolies are interdependent. - Not understanding the implications of collusion vs. non-collusion.

#Practice Questions <practice_question>

#Multiple Choice Questions

1. Which of the following is a characteristic of an oligopoly? (A) Many small firms (B) Low barriers to entry (C) Differentiated products (D) Perfect information (E) Price takers

2. In a game theory matrix, a Nash Equilibrium occurs when: (A) Both firms collude to maximize joint profits. (B) One firm has a dominant strategy. (C) Neither firm can unilaterally improve its position. (D) All firms earn zero economic profit. (E) Firms are price takers

3. If a firm in an oligopoly increases its price, its demand curve is likely to be: (A) Perfectly elastic (B) Relatively elastic (C) Unit elastic (D) Relatively inelastic (E) Perfectly inelastic

#Free Response Question

Two firms, Alpha and Beta, are the only producers of a specialized computer chip. They must decide whether to produce a high or low quantity. The payoff matrix below shows their profits (in millions of dollars):

(a) Identify the dominant strategy for Firm Alpha, if any. Explain.

(b) Identify the dominant strategy for Firm Beta, if any. Explain.

(c) What is the Nash Equilibrium in this game? Explain.

(d) If the firms collude, what output level would they agree on? What would their profits be?

#FRQ Scoring Breakdown

(a) (2 points)

• 1 point for identifying that Firm Alpha has a dominant strategy.
• 1 point for stating that the dominant strategy is to produce a high quantity. Explanation: If Beta produces a high quantity, Alpha earns 10 by producing high and 2 by producing low. If Beta produces a low quantity, Alpha earns 15 by producing high and 8 by producing low. High is always the better outcome for Alpha.

(b) (2 points)

• 1 point for identifying that Firm Beta has a dominant strategy.
• 1 point for stating that the dominant strategy is to produce a high quantity. Explanation: If Alpha produces a high quantity, Beta earns 10 by producing high and 2 by producing low. If Alpha produces a low quantity, Beta earns 15 by producing high and 8 by producing low. High is always the better outcome for Beta.

(c) (2 points)

• 1 point for stating that the Nash Equilibrium is when both firms produce a high quantity.
• 1 point for explaining that neither firm can unilaterally improve its position by changing its output given the other firm's output.

(d) (2 points)

• 1 point for stating that the firms would agree to produce a low quantity.
• 1 point for stating that their profits would be8 million each.

You've got this! Go get that 5! 🎉