Topic 7(b) Oligopoly
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Transcript of Topic 7(b) Oligopoly
7/30/2019 Topic 7(b) Oligopoly
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Oligopoly
Topic 7(b)
7/30/2019 Topic 7(b) Oligopoly
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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
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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
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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
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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
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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.
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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.
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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.
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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
VA’s profit = $20m
JS’s profit = $5m
Lowfare
C
VA’s profit = $5m
JS’s profit = $20m
D
VA’s profit = $8m
JS’s profit = $8m
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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.
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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
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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
VA’s profit = $20m
JS’s profit = $10m
B
VA’s profit = $15m
JS’s profit = $2m
Lowfare
C
VA’s profit = $12m
JS’s profit = $8m
D
VA’s profit = $10m
JS’s profit = $5m
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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. $10m profit
=> JS choose Low Fare option
Possibly, they cater for different market segments.There is no incentive to collude
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3. Oligopoly Models
Kinked Demand Curve Model D1: When the firm changesprices => other firms react
similarly
There is no substitution effect
demand will change but notby much
demand is price inelastic
D2: When the firm changes
price => other firms don’tfollow.
There is substitution effect
Change in demand moresensitive to price changes
Relatively elastic curve
Rivals
ignore
Rivalsmatch
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fig
Kinked demand curve for a firmunder oligopoly$
QO
P 1
Q1
D
B
A
Assumptions: • Independent among firms(ie. no collusion)• Rivals will match price decreases and ignore price increases
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The MR curve$
QO
P 1
Q1
D = AR a
MR
B
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$
QO
P 1
Q1
MR
a
bD = AR
The MR curve
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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
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Stable price under conditions of akinked demand curve$
QO
P 1
Q1
MC 2
MC 1
MR
ab
D = AR
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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
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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
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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
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fig
$
QO
AR = D leader
AR =
D market
Assume constant
market sharefor leader
Price leader aiming to maximise profitsfor a given market share
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fig
$
QO
MR leader
AR = D leader
AR =
D market
Price leader aiming to maximise profitsfor a given market share
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fig
$
QO
MC
MR leader
AR = D leader
AR =
D market
Price leader aiming to maximise profitsfor a given market share
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fig
$
QO
P L
MC
MR leader
AR = D leader
QL
l
AR =
D market
Price leader aiming to maximise profitsfor a given market share
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fig
$
QO
AR =
D market
P L
MC
QT
MR leader
AR = D leader
QL
l t
Price leader aiming to maximise profitsfor a given market share
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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.
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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
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Collusion (contd.)
Difficulties:
Difference in cost structures
Large number of firms in the market
Cheating
Falling demand
Legal barriers
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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.
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4. Assessing oligopoly
Negatives:
P > MC : no allocative efficiency
P > min. AC : no productive efficiency
Collusion
Positives:
Economies of scale
Innovation