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

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

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 firms decisions influence the decisions made by the other firms. In other words, firms decisions are interdependent.

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
High fare High A fare VAs profit = $15m JSs profit = $15m Low fare

Jet Stars options

B
VAs profit = $20m JSs profit = $5m

Low fare

C
VAs profit = $5m JSs profit = $20m

D
VAs profit = $8m JSs 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
High fare High A fare VAs profit = $20m JSs profit = $10m Low fare

Jet Stars options

B
VAs profit = $15m JSs profit = $2m

Low fare

C
VAs profit = $12m JSs profit = $8m

D
VAs profit = $10m JSs profit = $5m

2. Game Theory MAXIMIN strategy

For VA:

=> VA choose High Fare option For JS:

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

=> JS choose Low Fare option

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

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

3. Oligopoly Models Kinked Demand Curve Model

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

Rivals ignore

There is no substitution effect demand will change but not by much demand is price inelastic

Rivals match

D2: When the firm changes price => other firms dont follow.

There is substitution effect Change in demand more sensitive to price changes Relatively elastic curve

Kinked demand curve for a firm under oligopoly

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

A
P1

increases

Q1
fig

The MR curve
$

B P1 MR

D = AR

Q1

The MR curve

P1

a
D = AR

b
O Q1

Q
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

Stable price under conditions of a kinked demand curve

MC2 MC1

P1

a b
O Q1

D = AR

Q
MR

Kinked Demand Curve Model

Assumptions:

All firms are independent (ie. no collusion)

Implication of Kinked Demand Curve: Stable Price

Rivals match price decreases and ignore price increases

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

Assumes implicit collusion Follow the leader

dominant firm makes prices changes

most efficient, oldest, most respected, largest

others follow

Usually

prices dont 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

AR = D market

O
fig

Price leader aiming to maximise profits for a given market share

Assume constant market share for leader

AR = D market

AR = D leader

O
fig

Price leader aiming to maximise profits for a given market share

AR = D market

AR = D leader MR leader
O
fig

Price leader aiming to maximise profits for a given market share

MC

AR = D market

AR = D leader MR leader
O
fig

Price leader aiming to maximise profits for a given market share

MC

PL

l
AR = D market

AR = D leader MR leader
O QL
fig

Price leader aiming to maximise profits for a given market share

MC

PL

t
AR = D market

AR = D leader MR leader
O QL QT
fig

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) price leadership model

Implicit

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

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