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Oligopoly
Two men are in custody for a crime they may or may not have
committed: armed robbery. The police have the men in separate
cells so they can’t communicate and have told them the following:
Game Theory
The study of how people behave in strategic
situations
A Duopoly Example
Suppose there are only two gas stations in a small rural town of
Boonetuckey.
These gas stations, Margaret’s Gas Stop and Pam’s Station, are
duopolists in the gasoline market and they each sell 50% of all of
the gas in town.
The demand schedule for gasoline in Boonetuckey is given in
the following table. We will assume that the marginal cost of
selling a gallon of gas is $1.
Duffka School of Economics
A. A Duopoly Example
If these station
owners operated in a
perfectly competitive
world, P=MC=$1.
A. A Duopoly Example
But two sellers do not need
to behave as perfectly
competitive firms.
They could decide to
collude and charge a price
of $4 per gallon and each
would sell 800/2 = 400
gallons.
At this collusive price, each
firm would earn $3200/2 =
$1600 of total revenue.
Duffka School of Economics
A. A Duopoly Example
But would such an
agreement (to not
compete) last?
Probably not
2. Game Theory – a two-firm Payoff matrix
Payoffs are the outcomes (or profits) for the 2 firms for
each combination of strategies.
2. Game Theory – a two-firm Payoff matrix (1)
A B
High
VA’s profit = $15m VA’s profit = $20m
fare
JS’s profit = $15m JS’s profit = $5m
C D
Low VA’s profit = $5m VA’s profit = $8m
fare JS’s profit = $20m JS’s profit = $8m
Firms maximise the minimum expected payoff.
High A B
fare VA’s profit = $20m VA’s profit = $15m
JS’s profit = $10m JS’s profit = $2m
C D
Low VA’s profit = $12m VA’s profit = $10m
fare
JS’s profit = $8m JS’s profit = $5m
For Vietnam Airlines :
Low Fare: Min. $10m profit ; Max. $15m profit
High Fare: Min. $12m profit; Max. $20m profit
Assumptions:
• Independence among firms
(ie. no collusion)
A
• Rivals will match price decreases
and ignore price increases
B
P1
O Q1 Q
fig
The MR curve
$
B
P1
MR
a
D = AR
O Q1 Q
$
The MR curve
P1
a
D = AR
b
O Q1 Q
MR
Kinked Demand curve
MC2
P1 MC1
According to normal
demand and supply
analysis, an increase in
costs would cause a fall
in output and an
increase in price.
a
D = AR
b
O An example of cost absorption in practice is when the price of crude oil rises
Q
Q1
and petrol companies wish to increase price, but do not as no company wants
to be the first to do so. MR
Kinked Demand Curve Model
Assumptions:
All firms are independent (ie. no collusion)
Rivals match price decreases and ignore price increases
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
Oligopoly Models -Price Leadership Model
This type of price leadership occurs where a firm, probably by virtue of its
size comes to dominate an industry in terms of its power to influence
market supply.
The dominant firm sets a price to suit its own needs and the smaller firms
then adjust their planned output in line with the market price that has been
set for them.
others follow
Price leader aiming to maximise profits for a given market share
AR = D market
O Q
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 Q
fig
Price leader aiming to maximise profits for a given
$ market share
AR = D market
AR = D leader
MR leader
O Q
fig
Price leader aiming to maximise profits for a given
$ market share
MC
AR = D market
AR = D leader
MR leader
O Q
fig
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
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
Oligopoly Models c) Collusion
fix price
divide up or share the market
or other ways of restricting competition between
themselves.
The most common type of formal collusion is through the cartel;
• a small number of rival firms,
• selling a similar product,
The cartel members come to the conclusion that it is in their joint interests to
formally collude rather than compete, they may establish a cartel arrangement
in which they agree to set an industry price and output which enables them to
achieve a common objective.
This is likely to involve the setting of agreed output quotas for each member in
order to maintain the agreed price.
no price wars
increase profits
barrier to entry
Types of collusion
Explicit
centralised cartel (OPEC)
Implicit
price leadership model
Collusion
Difficulties:
Difference in cost structures
Cheating
Falling demand
Legal barriers
In practice, cartels may tend to be rather fragile and may not last for very long.
• necessity to limit output to keep price high will tend to leave individual firms
with spare productive capacity, and provide the temptation to increase profits
by expanding output.
• Such an expansion would not only generate profit on the additional sales, but
would also increase the profits on existing sales, as average fixed costs would
fall as output expanded.
Oligopoly Review
decisions.
OLIGOPOLY 40
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q Smalltown has 140 residents
$0 140
The “good”: cell phone service with
5 130
unlimited anytime minutes and free
10 120 phone
15 110
20 100
Smalltown’s demand schedule
25 90 Two firms: T-Phone, V-Phone
30 80 (duopoly: an oligopoly with two firms)
35 70 Each firm’s costs: FC = $0, MC = $10
40 60
45 50
OLIGOPOLY 41
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q Revenue Cost Profit Competitive
$0 140 $0 $1,400 –1,400 outcome:
5 130 650 1,300 –650
P = MC = $10
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000 Monopoly
outcome:
25 90 2,250 900 1,350
P = $40
30 80 2,400 800 1,600
Q = 60
35 70 2,450 700 1,750
Profit = $1,800
40 60 2,400 600 1,800
45 50 2,250 500 1,750
We can estimate MR at Q=60 as follows:
42
Increase output from 50 to 70, dR = $200, dQ=20, MR = dR/dQ = $200/20 = $10.
EXAMPLE: Cell Phone Duopoly in Smalltown
One possible duopoly outcome: collusion
Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
T-Phone and V-Phone could agree to each produce
half of the monopoly output:
For each firm: Q = 30, P = $40, profits =
$900
Cartel: a group of firms acting together,
e.g., T-Phone and V-Phone in the outcome with
collusion
OLIGOPOLY 43
Collusion vs. self-interest
OLIGOPOLY 46
The oligopoly equilibrium
OLIGOPOLY 49
CHAPTER SUMMARY
50