2 OLIGOPOLY Contents 1. Characteristics 2. Game theory 3. Oligopoly Models:a. Kinked Demand Curveb. Price leadershipc. Collusiond. Cost-plus pricing4. Assessment of Oligopoly
3 OligopolyIn 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.
4 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.
5 Characteristics of Oligopoly Small mutually interdependent number of firms controlling the marketSignificant market powerOne firm cut the prices => others are affectedHomogenous or differentiated productsHigh barriers to entryExamples
6 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.
7 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.
8 2. Game Theory – a two-firm Payoff matrix Two airlines competing for the domestic air travel marketVietnam AirlinesJetstarAssume two airlines choose their strategy independently (ie. No collusion)Payoffs are the outcomes (or profits) for the 2 firms for each combination of strategies.
10 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 profitThe maximum (the best) of these two minimums is $8m, so VA will choose the Low Fare option.
11 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 profitThe 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
13 2. Game Theory – MAXIMIN strategy For VA:Low Fare: Min. $10m profit ; Max. $15m profitHigh Fare: Min. $12m profit; Max. $20m profit=> VA choose High Fare optionFor JS:Low Fare: Min. $5m profit; Max. $8m profitHigh Fare: Min. $2m profit; Max. $10m profit=> JS choose Low Fare optionPossibly, they cater for different market segments. There is no incentive to collude
14 3. Oligopoly Models Kinked Demand Curve Model D1: When the firm changes prices => other firms react similarlyThere is no substitution effectdemand will change but not by muchdemand is price inelasticD2: When the firm changes price => other firms don’t follow.There is substitution effectChange in demand more sensitive to price changesRelatively elastic curveRivals ignoreRivals match
15 Kinked demand curve for a firm under oligopoly $Assumptions:Independent among firms (ie. no collusion)Rivals will match price decreases and ignore price increasesABP1DOQQ1fig
18 3. Oligopoly Models Kinked Demand curve As long as MC shifts within C1 & C2, the optimum output is Qo & price is Po=> stable price
19 Stable price under conditions of a kinked demand curve $MC2MC1P1aD = ARbOQQ1MR
20 Kinked Demand Curve Model Assumptions:All firms are independent (ie. no collusion)Rivals match price decreases and ignore price increasesImplication of Kinked Demand Curve: Stable PriceIf a firm raises price, it will lose customers and sales to other firmsIf 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.LimitationsIt does not explain the determination of current priceSometimes prices rise substantially during inflation period, which is contrary to the stable price conclusions of Oligopoly
21 3. Oligopoly Models b)Price Leadership Model Assumes implicit collusionFollow the leaderdominant firm makes prices changesmost efficient, oldest, most respected, largestothers followUsuallyprices don’t change very oftenprice changes are very publicprice may be low to act as barrier to entry
22 Price leader aiming to maximise profits for a given market share $AR = D marketOQfig
23 Price leader aiming to maximise profits for a given market share $Assume constantmarket sharefor leaderAR = D marketAR = D leaderOQfig
24 Price leader aiming to maximise profits for a given market share $AR = D marketAR = D leaderMR leaderOQfig
25 Price leader aiming to maximise profits for a given market share $MCAR = D marketAR = D leaderMR leaderOQfig
26 Price leader aiming to maximise profits for a given market share $MClPLAR = D marketAR = D leaderMR leaderOQLQfig
27 Price leader aiming to maximise profits for a given market share $MCltPLAR = D marketAR = D leaderMR leaderOQLQTQfig
28 3. Oligopoly Models c) Collusion Definition: when an industry reaches an open or secret agreement tofix pricedivide up or share the marketor other ways of restricting competition b/w themselves.
29 3. Oligopoly Models c) Collusion Why collude?removes uncertaintyno price warsincrease profitsbarrier to entryTypes of collusionExplicitcentralised cartel (OPEC)Implicitprice leadership model
30 Collusion (contd.) Difficulties: Difference in cost structures Large number of firms in the marketCheatingFalling demandLegal barriers
31 3. Oligopoly Models d) Cost-plus pricing Also known as “mark-up” pricingPrice = 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.
32 4. Assessing oligopoly Negatives: Positives: P > MC : no allocative efficiencyP > min. AC : no productive efficiencyCollusionPositives:Economies of scaleInnovation