Lecture 6 Oligopoly, Strategic
Behaviour and Competition Policy
EC1101E
Introduction to
Economic Analysis
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Outline
1. Definition and features of oligopoly and the
oligopolist’s problem and strategies.
2. Using Game Theory - dominant strategy and
Nash equilibrium.
3. Cartel pricing and the duopolists’ dilemma.
4. Game Tree, sequential games and price-fixing.
5. Payoff matrix and simultaneous games.
6. The prisoners’ dilemma and overcoming the
prisoners’ dilemma.
7. Other oiligoply models - price leadership and
kinked demand curve
8. Entry deterrence, limit pricing and contestable
markets.
9. Market structure and public policy
OSLS: Chs 13, 14
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Oligopoly
• Is a market served by a few profitable
and interdependent firms with market
power.
• Concentration ratio - a measure of the
degree to which a market or industry is
oligopolistic.
• The four-firm concentration ratio is the
percentage of the market output produced
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by the four largest firms.
Key features of Oligopoly
• Barriers to entry:
• Economies of scale in production
• Artificial barriers to entry
• Advertising campaign
• Entry deterrence
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Key features of Oligopoly
• Firms are interdependent.
• Actions of one firm affect the profits of
other firms in the oligopoly.
• As a result, each firm acts strategically,
taking into account its competitors likely
reactions to its decisions and how it will be
affected by their actions.
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Oligopolist's Problem
• Oligopolists are pulled in two different
directions:
• The interdependence of firms may make
them wish to collude with each other, to
act like a monopoly.
• They are tempted to compete with their
rivals to gain a bigger share of industry
profits for themselves.
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Oligopolist’s Strategies
• Price fixing
• Entry deterrence
• Advertising
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Game Theory
• An area of applied mathematics that
studies the games of strategy, a
theoretical method of analyzing strategic
behavior.
• Plays an important role in modern
economics. Economic situations are
treated as games.
• A framework to explore the actions and
reactions of interdependent decision
makers.
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Game Theory
• All games have three things in common:
• Rules: state who can do what and when they
can do it.
• Strategies: a plan for action in each possible
situation in the game.
• Payoffs: the amount that the player wins or
loses in a particular situation in a game.
• Assumption:
• Players try to maximize their payoffs
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Game Theory
• Dominant strategy:
• An action that is the best (optimal)choice
for a player, no matter what an opponent
does.
• Nash equilibrium:
• An outcome of a game in which each
player is doing the best he or she can,
given the action of the other players.
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Cartel Pricing and
Duopolists’ Dilemma
• We will use a market with two firms— a
duopoly— to explain the key features of an
oligopoly.
• Consider a duopoly in the market for air travel
between two hypothetical cities.
• The two budget airlines can compete for
customers on the basis of price, or they can
cooperate and conspire to raise prices.
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Cartel Picks Monopoly Price
Cartel price
Cartel profit
= ($400 − $300) × 150
= $15,000 per day
c
Price per passenger
$400
Cartel or monopoly
Cartel profit
maximizing point
350
f
LAC = LMC
300
Cartel output
Market
demand
Monopolist marginal
revenue
0
150
Passengers per day
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Cartel Pricing
• A cartel is a group of firms that collude
explicitly, coordinating their pricing
decisions.
• The cartel will maximize profits if it acts
like a monopoly.
• An arrangement under which the two firms
act as one, coordinating their pricing
decisions, is also known as price fixing. 13
Cartel Pricing
• Cartels are illegal in many countries. So
firms collude tacitly. They watch each
other’s prices and keep theirs similar.
• Firms may agree on prices - to avoid price
wars - or aggressive advertising.
• Such collusion will reduce the uncertainty
they face from price under-cutting and
retaliatory advertising.
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Competing Duopolists
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Price Fixing and the Game Tree
• Clearly, each firm would earn more profit under
a price-fixing agreement, but will the firms reach
such an agreement?
• We can answer this question with the help of a
game tree, a graphical tool that provides a
visual representation of the consequences of
alternative strategies.
• Consider two budget airlines ValueAir and
ThriftyJet.
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Components of Game Tree
• 1. The squares are decision nodes.
• 2. The arrows show the path of the game from left
to right.
• 3. The rectangles show the profits (payoffs) for the two
firms.
• There is a profit rectangle for each of the four possible
outcomes of the price-fixing game.
•
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Game Tree for Price-fixing
Game
Profits
1
Y
High price
High price
ValueAir:
high or low
price
Low price
2
Thrifty Value
$1,000 $8,500
X
Thrifty Jet:
high or low
price
Thrifty Value
$7,500 $7,500
3
Low price
High price
Z
ValueAir:
high or low
price
Low price
Thrifty Value
$8,500 $1,000
4
Thrifty Value
$5,000 $5,000
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Predicting the Outcome
• We can predict the outcome of the price-fixing
game by a process of elimination.
• We will eliminate the rectangles (1,3) that would
require one or both of the firms to act irrationally,
leaving us with the rectangle showing the
outcome of the game.
• Rectangles 1 and 3 involving a high price for
ValueAir will be eliminated. This means that the
low price is a dominant strategy for ValueAir.19
Predicting the Outcome
• There are now two rectangles left (2 and 4), and
ThriftyJet’s action will determine which rectangle we
will reach.
• It would be irrational for ThriftyJet to allow itself to be
underpriced, so we can eliminate rectangle 2. This
also means that the low price is ThriftyJet’s
dominant strategy.
• The remaining rectangle shows the outcome of the
game: Each player chooses the low price. The thick
arrows show the path of the game, from square X
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to square Z to rectangle 4.
Nash Equilibrium
• The Nash equilibrium is for both firms to pick the low
price:
– If ThriftyJet picks the low price, the best action for
ValueAir is to pick the low price, too.
– If ValueAir picks the low price, the best action for
Thrifty is to pick the low price, too.
• In this price-fixing game, with ValueAir and ThriftyJet
playing their dominant strategy.
• The equilibrium is the outcome of both firms playing
their dominant strategies, and is a special case of a
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Nash equilibrium.
Duopolists’ Dilemma and
Nash Equilibrium
• The duopolists’ dilemma is that although
both firms would be better off if they both
chose the high price, each firm chooses
the low price.
• There is a big payoff from underpricing the
other firm and a big penalty from being
underpriced, so both firms will pick the low
price.
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Representing Game with
Payoff Matrix
• A Payoff matrix shows the payoffs to the players for
different combinations of actions.
• A Simultaneous decision making game
• is a game in which each player makes a choice
without the other person knowing what that choice is.
A payoff matrix is used to represent a simultaneous
decision making game.
•
• A Sequential decision making game is a
• game in which one player makes a choice before the
other, and is typically represented by game trees.
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Payoff Matrix for Simultaneous
Game
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Predicting the Outcome
• The low price is the dominant strategy
for ThriftyJet. Knowing this, ValueAir will
pick the low price too.
• Therefore, the outcome is the same as
with the game-tree approach:
• Both firms will pick the low price, and the
equilibrium is a Nash Equilibrium.
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The Prisoner’s Dilemma
• Although both prisoners would be better
off if they both kept quiet, they implicate
each other because the police reward
them for doing so.
• There is an incentive for squealing, just as
there is an incentive for one duopolist to
underprice the other.
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The Prisoners' Dilemma
• The Story:
• Bonnie and Clyde are accused of committing a
crime. The police give each person an opportunity
to confess to the crime.
• The Prisoners' Dilemma:
• The prosecutor isolates Bonnie and Clyde and
offers each a deal:
• Confess to the crime and the other accomplice will
get a 10-year prison sentence and you will get I
year.
• If both confess, both will serve a reduced sentence
of 5 years.
• If neither confesses, each gets a 2-year sentence.
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The Prisoners' Dilemma
• The Prisoners' Strategies:
• Neither confesses.
• Both confess.
• Clyde confesses and Bonnie does not.
• Bonnie confesses and Clyde does not.
• Outcome:
• Although both prisoners would be better
off if they both kept quiet, they implicate
each other because the police reward
them for doing so.
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The Prisoners’ Dilemma
Years in Prison
1
Not confess
Y
Clyde:
confess or
not confess
Not confess
Confess
X
Bonnie:
confess or
not confess
Bonnie Clyde
2 years 2 years
2
Bonnie Clyde
10 years 1 year
3
Confess
Not confess
Z
Clyde:
confess or
not confess
Confess
Bonnie
1 year
Clyde
10 years
4
Bonnie Clyde
5 years 5 years
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Overcoming
Duopolists’Dilemma
• The duopolists’ dilemma occurs
because the two firms are unable to
coordinate their pricing decisions and
act as one.
• Each firm has an incentive to underprice
the other firm because the low-price
firm will capture a larger share of the
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market and earn a larger profit.
Overcoming
Duopolists’Dilemma
• Guaranteed price matching - A strategy where a
firm guarantees it will match a lower price by a
competitor; also known as a “meet-the competition” policy.
• Example: ThriftyJet can advertise in the newspaper
promising to match ValueAir's price.
• ValueAir's response:
• ValueAir can respond to ThriftyJet's promise to
match price by picking a high price or a low price.
• ValueAir won't have to think long before choosing
the high price.
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Overcoming
Duopolists’Dilemma
• Poser: Does guaranteed refund policy
protect consumers from high prices?
• You have probably heard an
advertisement that goes like this: “If you
buy a digital camera from us and find the
same digital camera for sale somewhere
else for a lower price, we will pay you the
difference in price.” Does this refund policy
lead to higher or lower digital camera
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prices?
Overcoming
Duopolists’Dilemma
• Repeated Pricing Games with Retaliation for
Underpricing• 1. Duopoly pricing strategy
• ThriftyJet picks high price until ValueAir underprices it.
• Once under-priced, ThriftyJet picks duopoly
price for remaining lifetime of firm.
• 2. Grim-trigger strategy
• When under-priced, ThriftyJet drops price to
level at which each firm earns zero economic
profit forever.
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Overcoming
Duopolists’Dilemma
• 3. Tit-for-tat strategy
• Starting with third month, ThriftyJet picks price
ValueAir picked in the previous month.
• The cartel price will persist as long as ValueAir
picks cartel price. Cartel breaks down if ValueAir
under-prices ThriftyJet.
• To restore cartel outcome, ValueAir must pick
cartel price, allowing ThriftyJet to under-price it for
a month.
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Tit-for-Tat Strategy
Price
$400
350
1
Cartel
2
Underpricing
4
3
Duopoly Underpricing
5
Month
Cartel
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 Square: ThriftyJet; circle:
ValueAir
Overcoming
Duopolists’Dilemma
• These three pricing schemes promote cartel
pricing by penalizing the underpricer.
• If the two firms expect to share the market
for a long time, the long-term cost of
underpricing will exceed the short-term
benefit, so underpricing is less likely
because of the threat of punishment.
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Other Oligopoly Models
• Model of Price leadership
• A model where there is an implicit agreement
under which firms in a market choose a price
leader, observe that firm’s price, and match it.
• Kinked demand curve model
• A model under which firms in an oligopoly
match price reductions by other firms but do
not match price increases by other firms.
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Kinked Demand Curve Model
2
Firm's quantity decreases
by large amount.
1
h
Price
$8
Elastic demand: When one
firm increases its price,
other firms do not follow.
Kink at the prevailing
market price
k
6
4
Firm's quantity increases
by small amount.
j
4
3
0
10
30
33
Quantity sold per day
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Inelastic demand: When one
firm decreases its price,
other firms follow.
Entry Deterrence
• How an insecure monopolist might try to prevent
a second firm from entering its market.
• The Passive Approach: Do Nothing to Deter
Entry.
• The Entry Deterrence Approach: Use Limit
Pricing to Deter Entry.
• Limit pricing
• A scheme under which a monopolist accepts a
price below the normal monopoly price to deter
other firms from entering the market.
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Deterring Entry with Limit
Pricing
Market demand
$400
Secure monopoly
Insecure monopoly: Produces
large quantity that deters entry.
m
370
Price
i
350
Duopoly
d
Insecure monopoly: Produces large
quantity but is unable to deter entry.
Market has two firms.
300
h
Long-run
average cost
0
150 180 200
Passengers per day
40
250
Entry Deterrence
• Using the example of MerAir and LionAir
• 2 Questions
• Question1: What must MerAir do to deter entry?
• To prevent LionAir from entering the market,
MerAir must commit itself to serving a large
number of passengers.
• Entry-deterring quantity = zero economic
profit quantity – minimum entry quantity
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Game Tree for Deterring Entry
Profits
1
Enter:
P = $350
Y
X
Small quantity
MerAir:
small or large
quantity
LionAir
enter or
stay out
Stay out:
P = $400
Z
Enter:
P = $300
Mer
$5,000
Lion
$5,000
2
Mer
Lion
$15,000 $0
3
Large quantity
LionAir:
enter or
stay out
Stay out:
P = $370
Mer
$0
Lion
$0
4
Mer
Lion
$12,600 $0
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Entry Deterrence
• Question 2:
• Given what it must do to deter entry, is
deterrence more profitable than being passive
and sharing the market with a second firm?
• Entry deterrence is not sensible when the
minimum entry quantity is relatively low.
• As a result, the limit price required to deter entry
is close to the average cost of production, and
the profit from the insecure monopoly is less
than the profit from sharing the market.
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Entry Deterrence and
Contestable Markets
• The threat of entry faced by an insecure
monopolist like the airline underlies the
theory of market contestability.
• A contestable market is a market in
which the costs of entering and leaving are
low, so the firms that are already in the
market are constantly threatened by the
entry of new firms, so prices and profits
will be low.
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Market Structure and
Public Policy
•Regulating Natural Monopoly
•Competition (Antitrust) Policy
– Breaking Up Monopolies
– Preventing Mergers
– Regulating Business Practices – price fixing,
tie-in sales, predatory pricing
• Deregulation to Promote Competition –
Airlines, Telecommunications (Postal)
• Electricity (Natural Gas)
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Competition Law
• In Singapore, anti-competitive agreements and
anti-competitive practices involving price-fixing,
market-sharing or restriction of output are illegal.
• Abuses of dominant positions (such as
predatory pricing - temporarily underpricing to
drive out competitors or limit pricing – pricing to
to deter entry) and mergers and acquisitions
which substantially reduces competition are also
prohibited.
• Sectors excluded (telecommunications, media,
and energy) are those which are being
liberalized and have their own competition rules.
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Regulating Natural Monopoly
• A natural monopoly occurs when the
economies of scale for producing a
product are so large that only a single firm
can survive.
• In this case, the government can intervene
by regulating the price charged by the
natural monopolist.
• Why wouldn’t a second firm enter?
• Regulating using average cost pricing.
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Natural Monopoly’s
Output Decision
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