Oligopoly

Topic 7(b)

OLIGOPOLY Contents

1. Characteristics2. Game theory3. Oligopoly Models:

a. Kinked Demand Curveb. Price leadershipc. Collusiond. Cost-plus pricing

4. Assessment of Oligopoly

In this topic we will consider the behaviour of firms when the industry is made up of only a few firms: oligopoly.

A crucial feature of oligopoly is the interdependence between firms’ decisions.

Oligopoly

In oligopoly, the industry is made up of only a few firms.

Each of these firms makes up a significant part of the total market.

Each can exercise some market power (eg. their output decisions influence the market price).

Therefore, each firm’s decisions influence the decisions made by the other firms.

In other words, firms’ decisions are interdependent.

Interdependence between firms

Characteristics of Oligopoly

Small mutually interdependent number of firms controlling the market Significant market power One firm cut the prices => others are affected

Homogenous or differentiated products High barriers to entry

Examples

Non-price competition…

is common in oligopoly, such as: advertising, product innovation,

improvement of service to customers. is preferred to price wars which

usually bring losses to all parties.

2. Game Theory A model of strategic moves and

countermoves of rivals. Firms chooses strategies based on their

assumptions about competitors likely behaviour or response. Strategies could relate to pricing,

advertising, product range, customer groups etc.

Game theory provides a framework or model to help analyse this behaviour.

2. Game Theory – a two-firm Payoff matrix

Two airlines competing for the domestic air travel market Vietnam Airlines Jetstar

Assume two airlines choose their strategy independently (ie. No collusion)

Payoffs are the outcomes (or profits) for the 2 firms for each combination of strategies.

2. Game Theory – a two-firm Payoff matrix (1)

Vietnam Airlines’ options

Jet S

tar’s

op

tion

s

High fare Low fare

High

fare

A VA’s profit = $15m JS’s profit = $15m

B VA’s profit = $20m JS’s profit = $5m

Low fare

C VA’s profit = $5m JS’s profit = $20m

D VA’s profit = $8m JS’s profit = $8m

2. Game Theory – MAXIMIN strategy

Firms maximise the minimum expected payoff.

For Vietnam Airlines: if they choose a Low Fare option, they will receive

either $8m or $20m profit, depending on the option chosen by JS – so the worse VA will make $8m profit.

If they choose a High Fare option, they will receive either $5m or $15m – the worse is $5m profit

The maximum (the best) of these two minimums is $8m, so VA will choose the Low Fare option.

2. Game Theory – MAXIMIN strategy

For Jetstar: if they choose a Low Fare option, they will receive

either $8m or $20m profit, depending on the option chosen by VA – so the worse Jetstar will make $8m profit.

If they choose a High Fare option, they will receive either $5m or $15m – the worse is $5m profit

The maximum (the best) of these two minimums is $8m, so JS will also choose the Low Fare option.

Both firms choose the Low Fare option if act independently.

There is an incentive to collude

2. Game Theory – a two-firm Payoff matrix (2)

Vietnam Airlines’ options

Jet S

tar’s

op

tion

s

High fare Low fare

High

fare

A VA’s profit = $20m JS’s profit = $10m

B VA’s profit = $15m JS’s profit = $2m

Low fare

C VA’s profit = $12m JS’s profit = $8m

D VA’s profit = $10m JS’s profit = $5m

2. Game Theory – MAXIMIN strategy

For VA: Low Fare: Min. $10m profit ; Max. $15m profit High Fare: Min. $12m profit; Max. $20m profit

=> VA choose High Fare optionFor JS:

Low Fare: Min. $5m profit; Max. $8m profit High Fare: Min. $2m profit; Max. $10m profit

=> JS choose Low Fare option

Possibly, they cater for different market segments. There is no incentive to collude

3. Oligopoly ModelsKinked Demand Curve Model

D1: When the firm changes prices => other firms react similarly

There is no substitution effect

demand will change but not by much

demand is price inelastic

D2: When the firm changes price => other firms don’t follow.

There is substitution effect Change in demand more

sensitive to price changes Relatively elastic curve

Rivals ignore

Rivals match

fig

Kinked demand curve for a firm under oligopoly$

QO

P1

Q1

D

B

A

Assumptions: • Independent among firms (ie. no collusion)• Rivals will match price decreases and ignore price increases

The MR curve$

QO

P1

Q1

D ARa

MR

B

$

QO

P1

Q1

MR

a

bD AR

The MR curve

3. Oligopoly ModelsKinked Demand curve

As long as MC shifts within C1 & C2, the optimum output is Qo & price is Po

=> stable price

Stable price under conditions of a kinked demand curve$

QO

P1

Q1

MC2

MC1

MR

a

bD AR

Kinked Demand Curve Model

Assumptions: All firms are independent (ie. no collusion) Rivals match price decreases and ignore price increases

Implication of Kinked Demand Curve: Stable Price If a firm raises price, it will lose customers and sales to other

firms If it reduces price, other firms will match => a price war. Therefore, firms tend to maintain the same price.

Substantial cost changes will have no effect on output and price as long as MC shifts between C1 & C2. Another reason why price is stable.

Limitations It does not explain the determination of current price Sometimes prices rise substantially during inflation period,

which is contrary to the stable price conclusions of Oligopoly

3. Oligopoly Modelsb)Price Leadership Model

Assumes implicit collusion Follow the leader

dominant firm makes prices changes most efficient, oldest, most respected, largest

others follow Usually

prices don’t change very often price changes are very public price may be low to act as barrier to entry

fig

$

Q O

AR D market

Price leader aiming to maximise profitsfor a given market share

fig

$

Q O

AR D leader

AR D market

Assume constantmarket share

for leader

Price leader aiming to maximise profitsfor a given market share

fig

$

Q O

MR leader

AR D leader

AR D market

Price leader aiming to maximise profitsfor a given market share

fig

$

Q O

MC

MR leader

AR D leader

AR D market

Price leader aiming to maximise profitsfor a given market share

fig

$

Q O

PL

MC

MR leader

AR D leader

QL

l

AR D market

Price leader aiming to maximise profitsfor a given market share

fig

$

Q O

AR D market PL

MC

QT

MR leader

AR D leader

QL

l t

Price leader aiming to maximise profitsfor a given market share

3. Oligopoly Models c) Collusion

Definition: when an industry reaches an open or secret agreement to fix price divide up or share the market or other ways of restricting competition

b/w themselves.

3. Oligopoly Models c) Collusion

Why collude? removes uncertainty no price wars increase profits barrier to entry

Types of collusion Explicit

centralised cartel (OPEC) Implicit

price leadership model

Collusion (contd.)

Difficulties: Difference in cost structures Large number of firms in the market Cheating Falling demand Legal barriers

3. Oligopoly Modelsd) Cost-plus pricing

Also known as “mark-up” pricing Price = unit cost + a margin (%) Example: the unit cost of washing machines

is $200 plus a 50% mark-up => Price = $300.

If producers in an industry have roughly similar costs, then the cost-plus pricing formula will result in similar prices and price changes.

Therefore, Cost-plus pricing is consistent with collusion and price leadership.

4. Assessing oligopoly

Negatives: P > MC : no allocative efficiency P > min. AC : no productive efficiency Collusion

Positives: Economies of scale Innovation