Oligopoly• A market with a few sellers• The essence of an oligopolistic industry is theneed for each firm to consider how its ownactions affect the decisions of its relatively fewcompetitors• Oligopoly may be characterized by collusionor by non-co-operation
Collusion and cartels• COLLUSION– an explicit or implicit agreement betweenexisting firms to avoid or limit competitionwith one another• CARTEL– is a situation in which formal agreementsbetween firms are legally permittede.g. OPEC
Collusion is difficult if:• There are many firms in the industry• The product is not standardized• Demand and cost conditions are changingrapidly• There are no barriers to entry• Firms have surplus capacity
The kinked demand curveQ0P0Quantity£Consider how a firm mayperceive its demand curveunder oligopoly.It can observe the currentprice and output,but must try to anticipaterival reactions to anyprice change.
Q0P0Quantity£The kinked demand curve (2)The firm may expect rivalsto respond if it reducesits price, as this will be seenas an aggressive move… so demand in responseto a price reduction is likelyto be relatively inelasticThe demand curve willbe steep below P0.D
The kinked demand curve (3)…but for a price increaserivals are less likely toreact,so demand may berelatively elasticabove P0so the firm perceivesthat it faces a kinkeddemand curve.DQ0P0Quantity£
The kinked demand curve (4)Given this perception, thefirm sees that revenue willfall whether price is increasedor decreased,so the best strategy is to keepprice at P0.Price will tend to be stable,even in the face of an increasein marginal cost.DQ0P0Quantity£
Game theory: some key terms• Game– a situation in which intelligent decisions arenecessarily interdependent• Strategy– a game plan describing how the player will act ormove in every conceivable situation• Dominant strategy– where a player’s best strategy is independent ofthose chosen by others
Game Theory and the Economicsof CooperationBecause the number of firms in anoligopolistic market is small, each firmmust act strategically.Each firm knows that its profit depends notonly on how much it produced but also onhow much the other firms produce.
The Prisoners’ DilemmaThe prisoners’ dilemma providesinsight into the difficulty inmaintaining cooperation.Often people (firms) fail to cooperatewith one another even when cooperationwould make them better off.
Oligopolies as aPrisoners’ DilemmaSelf-interest makes it difficult for theoligopoly to maintain a cooperativeoutcome with low production, high prices,and monopoly profits.
Why People SometimesCooperateFirms that care about future profits willcooperate in repeated games rather thancheating in a single game to achieve aone-time gain.
The Prisoners’ Dilemma GameConsider two firms in a duopoly each with a choiceof producing “high” or “low” output:Firm B outputHigh LowHigh 1 1 3 0FirmAoutputLow 0 3 2 2
The Prisoners’ Dilemma• Each firm has a dominant strategy toproduce high• so they make 1 unit profit each• but they would both be better off producinglow– as long as they can be sure that the other firmalso produces low.• So collusion can bring mutual benefits• but there is incentive for each firm to cheat
More on collusion• The probability of cheating may be affectedby agreement or threats• Pre-commitment– an arrangement, entered voluntarily, restrictingfuture options• Credible threat– a threat which, after the fact, is optimal to carryout
Strategic entry deterrence• Some entry barriers are deliberately erectedby incumbent firms:– threat of predatory pricing– spare capacity– advertising and R&D– product proliferation• Actions that enforce sunk costs on potentialentrants