Topic 9. Market structure:
theories of Oligopoly (1)
November 19th 2004
We will begin today’s lecture by
briefly discussing some remaining
points from previous topics:
First degree price discrimination
Perfect contestability


The aim of today’s lecture is to:
 State the broad characteristics of
oligopoly.
 Explain the tension between
collusion and competition
 Explain the predictions of two
models of oligopolistic behaviour:
 kinked demand curve
 dominant firm
Essential reading:
 Sloman chapter 7, Section 7.2
1. Oligopoly: assumptions/
characteristics.
 small number of firms
 making products that are
identical/close substitutes
(differentiated)
 Barriers to entry
→ firms are not small in relation to the
industry as a whole
→ each firm’s actions affect the
industry as a whole
→ firms cannot take action
independently of the expected actions
of rival firms
 Interdependency in decision
making is a key feature of
oligopoly
2. Firms’ behaviour: compete or
collude?
Oligopolists are pulled in 2 opposing
directions:
(a) if they collude with other firms
they can jointly act like a monopoly
and jointly maximise total industry Π
 Cartels: price fixing; quotas
 Tacit collusion
But
(b) They will be tempted to compete
with their rivals to gain a bigger
share of industry Π
The strategies are incompatible
e.g. the more firms compete to get a
bigger share of Π, the smaller
industry Π become!
3. The breakdown of collusion
OLIGOPOLISTIC FIRM (Q=1/5th)
OLIGOPOLISTIC INDUSTRY
Price
Price
MC
MC
Cartel price
(=MR if
price
remains
fixed)
£10
Cheating
MR
D
D
200
1,000
Quantity
400
600
MR
Quantity
Cheating
 How much can we get away with without provoking retaliation?
 If price war breaks out, will we be the winners?
4. Models
There is no single model of oligopoly –
but rather a number of models. The
specific assumptions underpinning
each is different.
 Dominant firm price leadership
under constant shares
 Kinked demand curve
today
 Game theory under duopoly:
optimal strategies under
interdependence.
Monday
5. Tacit collusion: dominant firm
price leadership
Assumptions:
One large firm in a market, which has
cost advantages over other firms, and
many small firms, all producing
products that are close substitutes.
Predictions:
The dominant firm behaves as a
monopoly and is a ‘price-maker’,
since it can ignore the actions of
smaller firms.
The smaller firms behave as if they
are perfectly competitive and are
price-takers, given the price set by
the dominant firm.
5a. Price leader Π max for a given
market share.
Price, Cost
MC (leader)
P
MR
(leader)
Q(leader)
Q(industry)
D (market)
D (leader)
Quantity
 Leader assumes constant market
share (why?)
 Leader chooses Π max Q, where
MC = MR, and price = P
 Other firms ‘take’ that price.
 Q industry - Q leader = Q followers
Limitations: will followers be content
with their market share? What if
leader’s P (= their MR) > their MC?
6. Kinked demand curve
Assumptions:
A few firms in a market, each of
which believes that if it raises its
price other firms will not, but if it
cuts its price, so will other firms.
Outcome:
 Discontinuity in the D and MR
curves.
 Prices and quantities are
“sticky” with respect to costs;
firms do not adjust to small
changes in cost
 Prices may be “sticky” with
respect to demand; firms might
not adjust prices to small
changes in demand, but will
change output.
6a: Kinked demand curve & Π max
Price, Cost
MC
P
Demand
Q
MR
Quantity
Starting at p:
 If you increase price (and none of
your rivals do) big fall in demand
 High PεD above p
Starting at p:
 If you decrease price (and all your
rivals do too) small increase in
demand
 Low PεD below p
6b. Kinked demand curve:
unresponsiveness to cost
changes
Price, Cost
MC2
MC1
P
D
Q
MR
Quantity
 MC of producing any given Q has ↑
 But Q and P remain unchanged.
Suggested to provide a theoretical
explanation for the real-world
phenomenon of price stability.
 What if MC ↑ further than MC2?
6c. Kinked demand curve:
Responsiveness to demand
changes
Price, Cost
D1
D2
P
MC
Q1
Q2
MR 1
MR 2
Quantity
 An exogenous change in demand
conditions such that D1 → D2
 Π max Q has increased
 But p remains unchanged
Limitation: model does not explain
how p determined in the first place.
7. Duopoly
Assumptions:
 Two firms in a market, producing
identical products.
 Identical cost structures.
 Restrictions on entry to the
industry.
Next lecture:
Modelling decision-making under
duopoly using game theory.