Oligopoly

Oligopoly

Oligopoly is a market in which a small number of firms compete.In oligopoly, the quantity sold by one firm depends on the firm’s own price and the prices and quantities sold by the other firms.The response of other firms to a firm’s price and output influence the firm’s profit-maximizing decision.

Oligopoly

The Kinked Demand Curve ModelIn the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow.

Oligopoly

Figure 13.6 shows the kinked demand curve model.The demand curve that a firm believes it faces has a kink at the current price and quantity.

Oligopoly

Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged.Below the kink, demand is relatively inelastic because all other firm’s prices change in line with the price of the firm shown in the figure.

Oligopoly

The kink in the demand curve means that the MR curve is discontinuous at the current quantity—shown by the gap AB in the figure.

OligopolyFluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.For example, if costs increased so that the MC curve shifted upward from MC0 to MC1, the profit- maximizing price and quantity would not change.

Oligopoly

The beliefs that generate the kinked demand curve are not always correct and firms can figure out this factIf MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesn’t maximize profit.

Oligopoly

Dominant Firm OligopolyIn a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms.The large firm operates as a monopoly, setting its price and output to maximize its profit.The small firms act as perfect competitors, taking as given the market price set by the dominant firm.

Oligopoly

Figure 13.7 shows a dominant firm industry. On the left are 10 small firms and on the right is one large firm.

S10

OligopolyThe demand curve, D, is the market demand curve and the supply curve S10 is the supply curve of the 10 small firms.

S10

Oligopoly

At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing.

S10

Oligopoly

But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm.

Oligopoly

The demand curve for the large firm’s output is the curve XD on the right.

Oligopoly

The large firm can set the price and receives a marginal revenue that is less than price along the curve MR.

Oligopoly

The large firm maximizes profit by setting MR = MC. Let’s suppose that the marginal cost curve is MC in the figure.

Oligopoly

The profit-maximizing quantity for the large firm is 10 units. The price charged is $1.00.

Oligopoly

The small firms take this price and supply the rest of the quantity demanded.

Oligopoly

A dominant firm oligopoly can arise only if one firm has lower costs than the others.

Oligopoly

In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs.

Oligopoly Games

Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected behavior of others and the mutual recognition of interdependence.

What Is a Game?All games share four features: Rules Strategies Payoffs Outcome

Oligopoly Games

The Prisoners’ DilemmaThe prisoners’ dilemma game illustrates the four features of a game.The rules describe the setting of the game, the actions the players may take, and the consequences of those actions. In the prisoners’ dilemma game, two prisoners (Art and Bob) have been caught committing a petty crime. Each is held in a separate cell and cannot communicate with the other.

Oligopoly Games

Each is told that both are suspected of committing a more serious crime.If one of them confesses, he will get a 1-year sentence for cooperating while his accomplice (partner in crime) get a 10-year sentence for both crimes.If both confess to the more serious crime, each receives 3 years in jail for both crimes.If neither confesses, each receives a 2-year sentence for the minor crime only.

Oligopoly Games

In game theory, strategies are all the possible actions of each player.Art and Bob each have two possible actions: Confess to the larger crime Deny having committed the larger crime

Because there are two players and two actions for each player, there are four possible outcomes: Both confess Both deny Art confesses and Bob denies Bob confesses and Art denies

Oligopoly Games

Each prisoner can work out what happens to him—can work out his payoff—in each of the four possible outcomes.We can tabulate these outcomes in a payoff matrix.A payoff matrix is a table that shows the payoffs for every possible action by each player for every possible action by the other player.The next slide shows the payoff matrix for this prisoners’ dilemma game.

Oligopoly GamesPayoff Matrix

Oligopoly Games

If a player makes a rational choice in pursuit of his own best interest, he chooses the action that is best for him, given any action taken by the other player.If both players are rational and choose their actions in this way, the outcome is an equilibrium called Nash equilibrium—first proposed by John Nash.The following slides show how to find the Nash equilibrium.

Bob’s view of the world

Bob’s view of the world

Art’s view of the world

Art’s view of the world

Equilibrium