The New IO Theory (from 1970)

As seen above, in the previous two decades there were many different theories of oli­gopoly. However, a unified approach was about to be adopted, thanks to the extraordi­nary spread of game theory, eventually employed by economists to model the strategic interdependence characterizing oligopolistic markets.

Game theory applied to economics became the standard tool of IO only in the late 1970s. Various reasons have been given as to why it took this branch of mathematics over 30 years to become the general analytical framework for dealing with the stra­tegic interaction of firms (Giocoli 2009; Lambertini 2011: ch. 1). Whatever the real cause of this delay, the new method adopted after the game theory revolution made a decisive contribution to re-establishing the theoretical foundations of the discipline. It made it possible to move on from both the S-C-P paradigm and the Chicago school theories through the use of models of strategic interaction in which firms’ behaviour is explained as the outcome of their rational choices. Here it is firms’ conduct that has the pivotal role: it affects both performances and market structures. Focusing on the strategic contexts in which the potential entrants and the incumbents operate, its main concern is with endogenous, not exogenous barriers to entry. Thanks to game theory, imperfect competitive markets can finally be investigated with the use of a unified formal method.

The success of game theory has also led to a change on the policy side. In the 1970s and 1980s antitrust policy was dominated by the laissez-faire orientation of the new Chicago school. As we have seen, its advocates claimed that concentration is dictated by efficiency rather than by market power. Therefore, many practices were considered to be pro-competitive, and government intervention unnecessary. At the end of the 1970s this free-market orientation was also strengthened by the contestable market theory (elaborated by William Baumol, John C. Panzar and Robert D. Willig in 1982), whose fundamental idea was that the threat of new entry compels firms to behave according to the principles of the perfect competitive model. Hence, its policy implication was that monopoly power has no damaging effects in contestable markets, and there is no need for government intervention. Consequently, a wave of deregulation started in the 1980s, in airlines and in the telecommunication industry.

However, during the same decade, the game theory approach to IO showed that monopoly power might persist under free entry “if sunk costs are important, if con­sumers have switching costs, if there are network externalities, and if a monopolist can engage in anti-competitive practices” (Motta 2004: 71). This perspective, also called the post-Chicago approach, confirmed many structuralist prescriptions, re-stating that high profit rates in concentrated industries may be a sign of monopoly power, not only of efficiency (Grillo 2006).