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Oligopoly. Topic 7(b). OLIGOPOLY Contents. 1. Characteristics 2. Game theory 3. Oligopoly Models: a. Kinked Demand Curve b. Price leadership c. Collusion d. Cost-plus pricing 4. Assessment of Oligopoly. Oligopoly.

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Oligopoly

Oligopoly

Topic 7(b)


Oligopoly contents
OLIGOPOLY Contents

1. Characteristics

2. Game theory

3. Oligopoly Models:

a. Kinked Demand Curve

b. Price leadership

c. Collusion

d. Cost-plus pricing

4. Assessment of Oligopoly


Oligopoly1
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.


Interdependence between firms
Interdependence between firms

  • 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.


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


2 game theory maximin strategy
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 strategy1
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
2. Game Theory – a two-firm Payoff matrix (2)


2 game theory maximin strategy2
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 option

  • For 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 models kinked demand curve model
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


Kinked demand curve for a firm under oligopoly
Kinked demand curve for a firm under oligopoly

$

  • Assumptions:

  • Independent among firms (ie. no collusion)

  • Rivals will match price decreases and ignore price increases

A

B

P1

D

Q

O

Q1

fig


The mr curve
The MR curve

$

B

P1

MR

a

D = AR

Q

O

Q1


The mr curve1
The MR curve

$

P1

a

D = AR

b

Q

O

Q1

MR


3 oligopoly models kinked demand curve

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

=> stable price

3. Oligopoly ModelsKinked Demand curve


Stable price under conditions of a kinked demand curve
Stable price under conditions of a kinked demand curve Qo & price is Po

$

MC2

MC1

P1

a

D = AR

b

Q

O

Q1

MR


Kinked demand curve model
Kinked Demand Curve Model Qo & price is Po

  • 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 models b price leadership model
3. Oligopoly Models Qo & price is Pob)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


Price leader aiming to maximise profits for a given market share
Price leader aiming to maximise profits Qo & price is Pofor a given market share

$

AR = Dmarket

O

Q

fig


Price leader aiming to maximise profits for a given market share1
Price leader aiming to maximise profits Qo & price is Pofor a given market share

$

Assume constant

market share

for leader

AR = Dmarket

AR = Dleader

O

Q

fig


Price leader aiming to maximise profits for a given market share2
Price leader aiming to maximise profits Qo & price is Pofor a given market share

$

AR = Dmarket

AR = Dleader

MRleader

O

Q

fig


Price leader aiming to maximise profits for a given market share3
Price leader aiming to maximise profits Qo & price is Pofor a given market share

$

MC

AR = Dmarket

AR = Dleader

MRleader

O

Q

fig


Price leader aiming to maximise profits for a given market share4
Price leader aiming to maximise profits Qo & price is Pofor a given market share

$

MC

l

PL

AR = Dmarket

AR = Dleader

MRleader

O

QL

Q

fig


Price leader aiming to maximise profits for a given market share5
Price leader aiming to maximise profits Qo & price is Pofor a given market share

$

MC

l

t

PL

AR = Dmarket

AR = Dleader

MRleader

O

QL

QT

Q

fig


3 oligopoly models c collusion
3. Oligopoly Models Qo & price is Poc) 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 collusion1
3. Oligopoly Models Qo & price is Poc) 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
    Collusion Qo & price is Po(contd.)

    • Difficulties:

      • Difference in cost structures

      • Large number of firms in the market

      • Cheating

      • Falling demand

      • Legal barriers


    3 oligopoly models d cost plus pricing
    3. Oligopoly Models Qo & price is Pod) 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
    4. Assessing oligopoly Qo & price is Po

    • Negatives:

      • P > MC : no allocative efficiency

      • P > min. AC : no productive efficiency

      • Collusion

    • Positives:

      • Economies of scale

      • Innovation


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