Bài giảng topic 7(b) oligopoly

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


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.
Oligopoly


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.
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 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
Jet Star’s options
High fare Low fare
High
fare
A
VA’s profit = $15m
JS’s profit = $15m
B
VA’s profit = $20m
JS’s profit = $5m
Low
fare
C
VA’s profit = $5m
JS’s profit = $20m
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 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
Jet Star’s options
High fare Low fare
High
fare
A
VA’s profit = $20m
JS’s profit = $10m
B
VA’s profit = $15m
JS’s profit = $2m
Low
fare
C
VA’s profit = $12m
JS’s profit = $8m
D
VA’s profit = $10m
JS’s profit = $5m

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

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
fig
Kinked demand curve for a firm
under oligopoly
$
Q
O
P
1
Q
1
D

B
A
Assumptions:

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

The
MR
curve
$
Q
O
P
1
Q
1
D = AR
a
MR
B

$
Q
O
P
1
Q
1
MR
a
b
D = AR
The
MR
curve

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
$
Q
O

P
1
Q
1
MC
2
MC
1
MR
a
b
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 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

fig
$
Q
O
AR = D
market

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

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

leader
AR = D
market

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

Price leader aiming to maximise profits
for a given market share