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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 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 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

kinked demand curve model
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 models b price leadership model
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
price leader aiming to maximise profits for a given market share1
Price leader aiming to maximise profitsfor 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 profitsfor 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 profitsfor 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 profitsfor 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 profitsfor 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 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 collusion1
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
Collusion (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 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
4. Assessing oligopoly
  • Negatives:
    • P > MC : no allocative efficiency
    • P > min. AC : no productive efficiency
    • Collusion
  • Positives:
    • Economies of scale
    • Innovation
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