2. Previously…
• Oligopoly
– A market structure in which there are a small number
of firms
– Firms interact strategically
– Can be competitive or collusive
• Game theory helps determine when cooperation
among oligopolists is most likely
– In many cases, cooperation fails to materialize
because decision-makers have dominant strategies
that lead them to be uncooperative.
3. Two Alternate Theories
• Two alternative theories argue that oligopolists
will form long-lasting cartels.
– Kinked demand curve
– Price leadership
4. The Kinked Demand Curve
• Kinked Demand Curve Theory
– A group of oligopolists has established an output
level and price
– Firms will mostly ignore a rival’s price increases
• Firms hold their prices steady to capture rival’s customers
who don’t want to pay more
• Rival who raised price will see a big sales decrease
– Firms have a greater tendency to respond
aggressively to a rival’s price cuts
• A price decrease by a rival will be matched by competitors
• No one firm is able to pick up very many new customers
6. Price Leadership
• Kinked Demand Theory
– Doesn’t explain price changes
• Price leadership
– A dominant firm sets the price that maximizes profits
and the smaller firms follow
– Explains price changes
– Not illegal since it does not involve explicit collusion
– Involves tacit collusion where there is an
understanding among firms that attempts to fight the
changes made by the leader that will lead to lower
profits for everyone
7. Price Leadership
• Example: airlines
– Leader airline sets the
fare for a given route,
and others follow
– Each firm knows that
lowering the price will
hurt everyone, so the
price stays where it
was set by the leader
Editor's Notes
Lecture notes:
Note that “long-lasting” is italicized, emphasizing that the cartel will NOT fall apart due to firms defecting from an agreement.
Lecture notes:
Basically, you don’t want to be the firm with the high price since that will result in you losing market shares to your competitors!
Image: Animated Figure 13A.1
Lecture notes:
This illustration begins with each of the firms in the industry charging P and producing Q.
Since demand is more elastic above P and less elastic below P, the marginal revenue curve (MR) is discontinuous. The gap is illustrated by the dashed black vertical line. The presence of the gap in marginal revenue means that more than one marginal cost curve intersects marginal revenue at output level Q. This is evident in marginal cost curves MC1 and MC2.
As a consequence, small changes in marginal cost, like those shown in the figure, will not cause the firms to deviate from the established price (P) and quantity (Q).
Lecture notes:
Explicit collusion:
Think about firms verbally agreeing, talking, and shaking hands in a secret location while they all smoke cigars together while laughing.
Tacit collusion:
No “official” deal is made, but there is an “unwritten rule” of cooperation that everyone follows. No one wants to “rock the boat.”
Lecture notes:
The smaller firms set their prices by following the larger dominant firm.
