1. Oligopoly
Topic 7(b)

2. 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

3. 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.

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 market
Significant market power
One firm cut the prices => others are affected
Homogenous or differentiated products
High barriers to entry
Examples

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 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.

9. 2. Game Theory – a two-firm Payoff matrix (1)
Vietnam Airlines’ options
Jet Star’s options
High fare
Low fare A
VA’s profit = $15m
JS’s profit = $15m B
VA’s profit = $20m
JS’s profit = $5m C
VA’s profit = $5m
JS’s profit = $20m D
VA’s profit = $8m
JS’s profit = $8m

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 profit
The 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 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

12. 2. Game Theory – a two-firm Payoff matrix (2)
Vietnam Airlines’ options
Jet Star’s options
High fare
Low fare A
VA’s profit = $20m
JS’s profit = $10m B
VA’s profit = $15m
JS’s profit = $2m C
VA’s profit = $12m
JS’s profit = $8m D
VA’s profit = $10m
JS’s profit = $5m

13. 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

14. 3. Oligopoly Models Kinked 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

15. 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 O Q Q1
fig

16. The MR curve $ B P1 MR a
D = AR O Q Q1

17. The MR curve $ P1 a
D = AR b O Q Q1 MR

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$
MC2
MC1 P1 a
D = AR b O Q Q1 MR

20. 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

21. 3. Oligopoly Models b)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

22. Price leader aiming to maximise profits for a given market share$
AR = D market O Q
fig

23. Price leader aiming to maximise profits for a given market share$
Assume constant
market share
for leader
AR = D market
AR = D leader O Q
fig

24. Price leader aiming to maximise profits for a given market share$
AR = D market
AR = D leader
MR leader O Q
fig

25. Price leader aiming to maximise profits for a given market share$ MC
AR = D market
AR = D leader
MR leader O Q
fig

26. Price leader aiming to maximise profits for a given market share$ MC l PL
AR = D market
AR = D leader
MR leader O QL Q
fig

27. Price leader aiming to maximise profits for a given market share$ MC l t PL
AR = D market
AR = D leader
MR leader O QL QT Q
fig

28. 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.

29. 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

30. Collusion (contd.) Difficulties: Difference in cost structures
Large number of firms in the market
Cheating
Falling demand
Legal barriers

31. 3. Oligopoly Models d) 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.

32. 4. Assessing oligopoly Negatives: Positives:
P > MC : no allocative efficiency
P > min. AC : no productive efficiency
Collusion
Positives:
Economies of scale
Innovation