Topic 7(b) Oligopoly

7/30/2019 Topic 7(b) Oligopoly

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Oligopoly

Topic 7(b)



OLIGOPOLY

Contents1. Characteristics

2. Game theory

3. Oligopoly Models: a. Kinked Demand Curve

b. Price leadership

c. Collusion d. Cost-plus pricing

4. Assessment of Oligopoly



In this topic we will consider thebehaviour of firms when the industry ismade up of only a few firms: oligopoly.

A crucial feature of oligopoly is theinterdependence between firms’

decisions.

Oligopoly



In oligopoly, the industry is made up of only afew firms.

Each of these firms makes up a significant partof the total market.

Each can exercise some market power (eg.their output decisions influence the marketprice).

Therefore, each firm’s decisions influence thedecisions made by the other firms.

In other words, firms’ decisions areinterdependent.

Interdependence between

firms



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 usuallybring losses to all parties.



2. Game Theory A model of strategic moves and

countermoves of rivals.

Firms chooses strategies based on theirassumptions about competitors likelybehaviour 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

J e t S t ar

’ s o p t i on s

High fare Low fare

Highfare

A

VA’s profit = $15m

JS’s profit = $15m

B


JS’s profit = $5m

Lowfare

C

VA’s profit = $5m


D

VA’s profit = $8m

JS’s 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 byJS – so the worse VA will make $8m profit.

If they choose a High Fare option, they will receiveeither $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 receiveeither $8m or $20m profit, depending on the option

chosen by VA – so the worse Jetstar will make $8mprofit.

If they choose a High Fare option, they will receiveeither $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 actindependently.

There is an incentive to collude



2. Game Theory –

a two-firm Payoff matrix (2)Vietnam Airlines’ options

J e t S t ar

’ s o p t i on s

High fare Low fare

Highfare

A



B


JS’s profit = $2m

Lowfare

C


JS’s profit = $8m

D


JS’s profit = $5m



2. Game Theory –

MAXIMIN strategyFor VA:

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

=> VA choose High Fare optionFor 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 D1: When the firm changesprices => other firms react

similarly

There is no substitution effect

demand will change but notby much

demand is price inelastic

D2: When the firm changes

price => other firms don’tfollow.

There is substitution effect

Change in demand moresensitive to price changes

Relatively elastic curve

Rivals

ignore

Rivalsmatch



fig

Kinked demand curve for a firmunder oligopoly$

QO

P 1

Q1

D

B

A

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



The MR curve$

QO

P 1

Q1

D = AR a

MR

B



$

QO

P 1

Q1

MR

a

bD = AR

The MR curve



3. Oligopoly ModelsKinked Demand curve

As long as MC shiftswithin C1 & C2, the

optimum output isQo & price is Po

=> stable price

St bl i d diti f



Stable price under conditions of akinked demand curve$

QO

P 1

Q1

MC 2

MC 1

MR

ab

D = AR



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 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

P i l d i i t i i fit



fig

$

QO

AR =

D market

Price leader aiming to maximise profitsfor a given market share

P i l d i i t i i fit



fig

$

QO

AR = D leader

AR =

D market

Assume constant

market sharefor leader




fig

$

QO

MR leader

AR = D leader

AR =

D market




fig

$

QO

MC

MR leader

AR = D leader

AR =

D market




fig

$

QO

P L

MC

MR leader

AR = D leader

QL

l

AR =

D market




fig

$

QO

AR =

D market

P L

MC

QT

MR leader

AR = D leader

QL

l t




3. Oligopoly Modelsc) 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)

Implicit

price leadership model



Collusion (contd.)

Difficulties:

Difference in cost structures

Large number of firms in the market

Cheating

Falling demand

Legal barriers



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 similarcosts, then the cost-plus pricing formula will

result in similar prices and price changes.

Therefore, Cost-plus pricing is consistent withcollusion and price leadership.



4. Assessing oligopoly

Negatives:

P > MC : no allocative efficiency

P > min. AC : no productive efficiency

Collusion

Positives:

Economies of scale

Innovation

Documents

Topic 7(b) Oligopoly