This document describes a game theory scenario involving two pizzerias, Luigi's and Mario's, that must choose prices for their premium pizza before seeing what the other chooses. The pizzerias operate in an oligopolistic market with few firms and product differentiation. Mario's dominant strategy is to choose a low price. Luigi's does not have a dominant strategy. If both choose rationally without cooperating, both will choose low prices, resulting in daily profits of $800 for Mario.

1. Assumptions of the
1.5.4 Monopolistic Competition and Oligopoly Oligopoly Model
Oligopoly: Oligopoly is a market in which a few large firms produce a
homogeneous or differentiated product
Market share Each of the few large firms have a significant share of the total market
Competition There are few enough firms that collusion (cooperation on prices and other
strategies) is possible.
Product differentiation Products may be differentiated or homogeneous
• Oil is a product produced by a few large firms that is homogenous. One
firm's output is identical to all other firms.
• Laptop computers are a product produced by a few large firms that are
differentiated. Sony's laptops have features that set them apart from Dell
and HP's.
Entry barriers There are significant entry barriers into the oligopolistic market. This means that
economic profits can be earned in the long-run if the firms successfully produce
goods in demand from consumers
Interdependence of Firms Firms are mutually interdependent: each must consider its rivals‟ reactions in
response to its decisions about prices, output, and advertising.
Concentration ratio Used to measure market dominance.
• The four-firm concentration ratio gives the percentage of total industry sales
accounted for by the four largest firms.
• When the largest four firms in an industry control 40% or more of the market,
that industry is considered oligopolistic.

2. Assumptions of the
1.5.4 Monopolistic Competition and Oligopoly Oligopoly Model
Barriers to entry in Oligopolistic Markets
Significant barriers to entry keep the number of firms small and allow oligopolists to
earn economic profits in the long-run.
• Economies of scale: may exist due to technology and market
share.The capital investment requirement may be very large. Example:
Airbus and Boeing
• Other barriers to entry: Legal barriers could include patents,
copyrights, trademarks. Control of raw materials could prevent other
firms from entering a market, preemptive and retaliatory pricing might
be used to compete new firms out of the market, traditional brand
loyalty may make new entry difficult.
• Mergers: Already large firms may merge to increase market share and
concentrate power. Mergers are common among large monopolistic
firms as they give firms more power over output and price.

3. Kinked Demand
1.5.4 Monopolistic Competition and Oligopoly Curve
Non-collusive Oligopolies:
Assuming that the firms in an oligopolistic market do NOT cooperate with one other
on prices, we can analyze the demand as seen by an individual seller using a model
called the Kinked Demand Curve. Individual firm’s demand
P
Assumptions:
• Assume there only two firms (firm M
and firm B) are competing in the fast
food market. P1
• Each firm knows that if it lowers its
price for a hamburger meal, its
competitor will match the price
decrease so as to not lose its market D1
share.
• Each also knows that if it raises its
price the competitor will ignore the
price increase so as to capture the D2 MR1
consumers who will switch sellers
Q1 Q
when one raises its price.
MR2
With these assumptions, we can assume that the individual firm faces TWO
demand curves, one representing demand if it lowers its price (D2, highly
inelastic) and one representing demand if it raises its price (D1, highly elastic).

4. Kinked Demand
1.5.4 Monopolistic Competition and Oligopoly Curve
Kinked Demand Curve
When we put the two demand curves for the individual firm together, we get a Kinked
demand curve, highly elastic above the current price and highly inelastic below the
current price.
P P
P1
P1
D1
D2 MR1 D
Q1 Q Q1 Q
MR2 MR

5. Kinked Demand
1.5.4 Monopolistic Competition and Oligopoly Curve
Analysis of the Kinked Demand
Curve P
• In order to lower its price a firm must
increase its output, which means higher
costs.
• Since demand is inelastic beyond Q1, the P1
firm's total revenue will fall as it
increases output beyond this point while
its total costs increase, meaning profits
will decrease.
• If the firm wishes to raise its price, it
must be aware that demand is highly
elastic above P1. D
• A price increase when demand is elastic
leads to a fall in total revenue Q1 Q
MR
Implications of analysis
Price in non-collusive oligopolistic markets tends to be very sticky. Firms
tend not to raise or lower their prices, even with fluctuations in their costs
of production, out of fear or losing market share to their competitors.

6. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
Collusive Oligopoly – a Game Theory Introduction
Game theory studies the behavior of firms in an oligopoly from the perspective of a
game. Firms are the "players" that can make "moves". Depending on the moves
firms make, they may end up being winners or losers.
Blog post: Understanding Oligopoly Behavior – a Game Theory Overview
Blog post: Golden Balls, Game Theory and the Prisoner‟s Dilemma
A simple example of Game Theory: the Prisoner's Dilemma
Introduction: Two thieves have been caught Rules of the game: The prisoners are
by the cops. placed in two separate interrogation rooms
• There is not enough evidence to convict and not allowed to communicate with one
them of the crime of assault, which the another. Each prisoner is given the
prosecutor suspects they committed. following choices:
• But the prosecutor has enough evidence to • If you confess to assault and your accomplice
convict them of breaking and entering, a does not, you will go free and your stubborn
minor one for which the sentence is only 1 accomplice will receive 20 years in jail
year. So the prosecutor must try to get them • If you both confess you will both serve three
to confess to the more serious crime. years in jail.

7. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
The Dilemma
• If both prisoners remain silent, the prosecutor can only convict them for the minor offense,
in which case they'll each receive one year in jail.
• But if one confesses and the other does not, the one who remained silent will get 10
years in jail, and he knows this. This creates a major incentive to confess, as 10 years is
a LONG TIME!
• Assuming the prisoners are both rational, self-interested individuals, the most likely
"move" the "players" will make is to confess, meaning they both end up getting 3 years in
jail.
The possible outcomes of the game can be plotted in a "payoff matrix"
Prisoner 1
remain silent confess
• The "players": Prisoner 1 and
remain silent
-1 0 Prisoner 2
• The "moves": Confess or
-1 -10 Remain silent
Prisoner 2
• The "payoffs": possible jail
terms resulting from various
-10 -3 "moves" by players
confess
0 -3

8. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
Playing the Game
Assuming both players know all possible outcomes, which "move" will the
prisoners make?
Prisoner 1 If Prison 1 remains silent, what should
remain silent confess Prisoner 2 do?
Remain silent, or Confess
remain silent
-1 0 If Prison 1 confesses, what should Prisoner
2 do?
-1 -10
Remain silent, or Confess
Prisoner 2
What is Prisoner 2's „dominant strategy‟?
-10 -3
Remain silent, or Confess
confess
0 -3 What is Prisoner 1's „dominant strategy‟?
Remain silent, or Confess
Dominant Strategies:
If a player has a move that will always result in a better payoff than any other move
regardless of his opponents move, then that is known as a dominant strategy. In
this game, the dominant strategy is always to confess. Both prisoners will get 3
years in jail

9. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
Why will the players in the Prisoners Dilemma always confess?
• If one move minimizes losses or maximizes winnings regardless of
what the other player does, this is a "dominant strategy"
• The players will examine the possible moves by his opponent, and
ask "what move will make me better off based on my opponent's
move?"
• In the Prisoner's Dilemma game, both players have a dominant
strategy: CONFESS. Because if either player remains silent, they can
always do better by confessing regardless of what the other player
does.
• The incentive to confess is too strong. Since the prisoners cannot
communicate with one another, they cannot agree to remain silent,
which would result in a better outcome for both prisoners.

10. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
Oligopoly behavior is similar to a game
Each firm in an oligopolistic market is interdependent with the other firms in its
market. Depending on what one firm does, it will have a major impact on the profits or
losses of itself and all other firms in the market. Firms play “games” in which they
have to decide on factors such as
• Whether to charge a high price or low price
• Whether to advertise or not
• Whether to offer free warranties or customer service
• Whether to open a shop in a certain location Coffee shop A
Consider the decision of two coffee don't advertise advertise
shops whether to advertise or not
don't advertise
$15 $20
The "players" are the firms: Two coffee Coffee shop B
shops, Starbucks and San Francisco Coffee. $15 $10
The "moves" are the actions the firms can
take: The coffee shops can either advertise
around town or not advertise.
advertise
$10 $12
The "payoffs" are the profits the firms will
earn: Advertising increases firms' costs, but $20 $12
can also increase revenues.

11. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
Coffee shop A
Analyzing the Payoff Matrix
The two coffee shops in this example don't advertise advertise
have to decide whether to advertise
don't advertise
or not $15 $20
• If neither firm advertises, they will
Coffee shop B
enjoy high profits of $15 $15 $10
• If one advertises and the other
doesn‟t, the one that advertised
advertise
will earn $20 and the one that $10 $12
doesn‟t only $10.
• If both advertise they‟ll both earn $20 $12
only $12
What will be the equilibrium outcome of this game?
If the firms are able to collude, it is obvious what they will do. Neither will
advertise. But this is an unstable equilibrium, meaning that both firms have a
strong incentive to cheat since there are big profits to be earned by unilaterally
advertising.
• Under collusion, both firms enjoy higher profits.
• But if each firm acts in its own self-interest, both firms will earn smaller profits.

12. 1.5.4 Monopolistic Competition and Oligopoly Game Theory
Alternative ways to analyze Oligopoly behavior
Price Leadership: When there exists an implicit understanding by which
oligopolists can coordinate prices
• Usually a "dominant firm" (typically the largest in the industry) establish the
price and smaller firms follow.
• Prices tend to be "sticky" upwards, since firms are hesitant to raise their
prices and lose market share to rivals.
• However, prices are "slippery" downwards, which means if one firm lowers
its prices, others will follow suit so they don't lose all their business.
Price Wars: When agreements break down, firms may engage in price wars,
in which they continually lower their prices and increase output in order to try
and attract more customers than their rivals.
• This can cause sudden increases in output and decreases in price,
temporarily approaching an efficient level.
• Once firms realize low prices hurt everyone, price leadership is usually
restored, and prices rise once more.

13. Oligopoly Practice
1.5.4 Monopolistic Competition and Oligopoly Question
Two Pizzerias, Luigi's and Mario's, provide all the pizza in the village of Wangi. They must order their
menus from the printing company at the beginning of the year and cannot alter the prices on their menus
during that year. The prices on the menus are revealed to the public and to the competition only after both
companies have received the printed menus from the printer and put them up in the window. Each pizzeria
must choose between a high price and a low price for its "supremo-premium pie", the deluxe pizza that the
people of Wangi are most eagerly anticipating.
The payoff matrix showing the profits that the two firms will experience appears below, with the first entry
in each cell indicating Luigi's weekly profit and the second entry in each cell indicating Mario's weekly
profit.
1. In which market structure do these firms operate? Mario's Pizzeria
Explain.
high price low price
2. If Mario's choses a low price, which price is better
high price
for Luigi's
$1,000/$700 $700/$600
Luigi's Pizzeria
3. Identify the dominant strategy for Mario's
4. Is choosing a low price a dominant strategy for low price
Luigi's? Explain. $750/$950 $900/$800
5. If both firms know all the information in the payoff
matrix but do not cooperate, what will be Mario's
daily profit?