A case study in the chapter describes a phone
conversation between the presidents of Braniff Airways and
American Airlines. Suppose each company can charge
either a high price or low price for tickets. If one company
charges $100, it earns low profits if the other company
company charges $100 too. It earns high profits, if the
other company charges $200. On the other hand, if the
company charges $200, it earns very low profits if the other
company charges $100 and medium profits if the other
company charges $200 too. The same set of choices
applies to the second company.
– Draw a payoff matrix/decision box for this game.
– What is the Nash equilibrium in this game? Explain.
– Is there an outcome that would be better than the
Nash equilibrium for both airlines? How would it be
achieved? Who would lose, if it were achieved?
Tacit Collusion
• Our analysis of oligopoly from last class
was that the equilibrium in the market will
be tacit collusion, if firms play repeated
games.
• The kinked demand theory explains how
firms will behave in this situation.
The oligopolist believes
that his demand curve is
kinked at the tacit
collusion price and
quantity
Price
MC1
MC2
D
Quantity
MR
KINKED DEMAND THEORY:
Price
NONCOLLUSIVE OLIGOPOLY
Rivals tend to
follow a price cut
D2
D1
Quantity
MR1
MR2
Price
Rivals tend to
follow a price cut
or ignore a
price increase
D2
D1
Quantity
MR1
MR2
Price
Effectively creating
a kinked demand curve
D2
D1
Quantity
MR1
MR2
Price
Effectively creating
a kinked demand curve
D
Quantity
Profit maximization
MR = MC occurs
at the kink
Price
MC1
MC2
D
Quantity
MR
Price stability and Price Wars
• The kink in the demand curve results in the
break in the marginal revenue curve.
• Any MC within the break, yields the same level
of output.
• So, starting at the tacit collusion outcome, small
changes in MC will leave the equilibrium
unchanged.
• This price stability is periodically interrupted by
price wars, sometimes due to large changes in
MC.