Oligopoly
Topic 7(b)
OLIGOPOLY
Contents
1. Characteristics
2. Game theory
3. Oligopoly Models:
a. Kinked Demand Curve
b. Price leadership
c. Collusion
d. Cost-plus pricing
4. Assessment of Oligopoly
Oligopoly
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In this topic we will consider the
behaviour of firms when the industry is
made up of only a few firms: oligopoly.
A crucial feature of oligopoly is the
interdependence between firms’
decisions.
Interdependence between
firms
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In oligopoly, the industry is made up of only a
few firms.
Each of these firms makes up a significant part
of the total market.
Each can exercise some market power (eg.
their output decisions influence the market
price).
Therefore, each firm’s decisions influence the
decisions made by the other firms.
In other words, firms’ decisions are
interdependent.
Characteristics of Oligopoly

Small mutually interdependent number of
firms controlling the market
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Significant market power
One firm cut the prices => others are affected

Homogenous or differentiated products
High barriers to entry

Examples
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Non-price competition…

is common in oligopoly, such as:
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advertising, product innovation,
improvement of service to customers.
is preferred to price wars which usually
bring losses to all parties.
2. Game Theory


A model of strategic moves and
countermoves of rivals.
Firms chooses strategies based on their
assumptions about competitors likely
behaviour or response.
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Strategies could relate to pricing, advertising,
product range, customer groups etc.
Game theory provides a framework or
model to help analyse this behaviour.
2. Game Theory –
a two-firm Payoff matrix
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Two airlines competing for the domestic
air travel market
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Vietnam Airlines
Jetstar
Assume two airlines choose their strategy
independently (ie. No collusion)
Payoffs are the outcomes (or profits) for
the 2 firms for each combination of
strategies.
2. Game Theory –
a two-firm Payoff matrix (1)
Vietnam Airlines’ options
Jet Star’s options
High fare
High A
fare VA’s profit = $15m
JS’s profit = $15m
Low
fare
C
VA’s profit = $5m
JS’s profit = $20m
Low fare
B
VA’s profit = $20m
JS’s profit = $5m
D
VA’s profit = $8m
JS’s profit = $8m
2. Game Theory –
MAXIMIN strategy
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Firms maximise the minimum expected
payoff.
For Vietnam Airlines:
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if they choose a Low Fare option, they will receive either
$8m or $20m profit, depending on the option chosen by
JS – so the worse VA will make $8m profit.
If they choose a High Fare option, they will receive
either $5m or $15m – the worse is $5m profit
The maximum (the best) of these two minimums is
$8m, so VA will choose the Low Fare option.
2. Game Theory –
MAXIMIN strategy

For Jetstar:
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if they choose a Low Fare option, they will receive
either $8m or $20m profit, depending on the option
chosen by VA – so the worse Jetstar will make $8m
profit.
If they choose a High Fare option, they will receive
either $5m or $15m – the worse is $5m profit
The maximum (the best) of these two minimums is
$8m, so JS will also choose the Low Fare option.
Both firms choose the Low Fare option if act
independently.
There is an incentive to collude
2. Game Theory –
a two-firm Payoff matrix (2)
Vietnam Airlines’ options
Jet Star’s options
High fare
High A
fare VA’s profit = $20m
JS’s profit = $10m
Low
fare
C
VA’s profit = $12m
JS’s profit = $8m
Low fare
B
VA’s profit = $15m
JS’s profit = $2m
D
VA’s profit = $10m
JS’s profit = $5m
2. Game Theory –
MAXIMIN strategy
For VA:
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Low Fare: Min. $10m profit ; Max. $15m profit
High Fare: Min. $12m profit; Max. $20m profit
=> VA choose High Fare option
For JS:
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Low Fare: Min. $5m profit; Max. $8m profit
High Fare: Min. $2m profit; Max. $10m profit
=> JS choose Low Fare option
Possibly, they cater for different market segments.
There is no incentive to collude
3. Oligopoly Models
Kinked Demand Curve Model
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D1: When the firm changes
prices => other firms react
similarly
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Rivals
ignore
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Rivals
match
There is no substitution effect
demand will change but not
by much
demand is price inelastic
D2: When the firm changes
price => other firms don’t
follow.
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There is substitution effect
Change in demand more
sensitive to price changes
Relatively elastic curve
$
Kinked demand curve for a firm
under oligopoly
Assumptions:
• Independent among firms
(ie. no collusion)
• Rivals will match price
decreases and ignore price
A
P1
B
increases
D
O
Q
Q1
fig
The MR curve
$
B
P1
MR
a
O
Q1
D = AR
Q
$
The MR curve
P1
a
D = AR
b
O
Q
Q1
MR
3. Oligopoly Models
Kinked Demand curve

As long as MC shifts
within C1 & C2, the
optimum output is
Qo & price is Po
=> stable price
$
Stable price under conditions of a
kinked demand curve
MC2
MC1
P1
a
D = AR
b
O
Q
Q1
MR
Kinked Demand Curve Model
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Assumptions:
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Rivals match price decreases and ignore price increases
Implication of Kinked Demand Curve: Stable Price
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All firms are independent (ie. no collusion)
If a firm raises price, it will lose customers and sales to other firms
If it reduces price, other firms will match => a price war.
Therefore, firms tend to maintain the same price.
Substantial cost changes will have no effect on output and price as long
as MC shifts between C1 & C2. Another reason why price is stable.
Limitations
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It does not explain the determination of current price
Sometimes prices rise substantially during inflation period, which is
contrary to the stable price conclusions of Oligopoly
3. Oligopoly Models
b)Price Leadership Model
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Assumes implicit collusion
Follow the leader
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dominant firm makes prices changes
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most efficient, oldest, most respected, largest
others follow
Usually
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prices don’t change very often
price changes are very public
price may be low to act as barrier to entry
$
Price leader aiming to maximise profits
for a given market share
AR = D market
O
Q
fig
$
Price leader aiming to maximise profits
for a given market share
Assume constant
market share
for leader
AR = D market
AR = D leader
O
Q
fig
$
Price leader aiming to maximise profits
for a given market share
AR = D market
AR = D leader
MR leader
O
Q
fig
$
Price leader aiming to maximise profits
for a given market share
MC
AR = D market
AR = D leader
MR leader
O
Q
fig
$
Price leader aiming to maximise profits
for a given market share
MC
PL
l
AR = D market
AR = D leader
MR leader
O
QL
Q
fig
$
Price leader aiming to maximise profits
for a given market share
MC
PL
l
t
AR = D market
AR = D leader
MR leader
O
QL
QT
fig
Q
3. Oligopoly Models
c) Collusion

Definition: when an industry reaches an
open or secret agreement to

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fix price
divide up or share the market
or other ways of restricting competition b/w
themselves.
3. Oligopoly Models
c) Collusion
Why collude?
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removes uncertainty
no price wars
increase profits
barrier to entry
Types of collusion
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Explicit
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centralised cartel (OPEC)
Implicit
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price leadership model
Collusion
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(contd.)
Difficulties:
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Difference in cost structures
Large number of firms in the market
Cheating
Falling demand
Legal barriers
3. Oligopoly Models
d) Cost-plus pricing
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Also known as “mark-up” pricing
Price = unit cost + a margin (%)
Example: the unit cost of washing machines is
$200 plus a 50% mark-up => Price = $300.
If producers in an industry have roughly similar
costs, then the cost-plus pricing formula will
result in similar prices and price changes.
Therefore, Cost-plus pricing is consistent with
collusion and price leadership.
4. Assessing oligopoly
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Negatives:
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P > MC : no allocative efficiency
P > min. AC : no productive efficiency
Collusion
Positives:
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Economies of scale
Innovation