Oligopoly

Features of Oligopoly
 An industry which is dominated by a few firms.
o UK definition of an oligopoly is a five firm concentration ratio of more than 50% (this
means they have more than 50% of the market share)
 Interdependence of Firms, firms will be effected by how other firms set price and output
 Barriers To Entry, but less than Monopoly
 Differentiated Products, advertising is often important
 Most Common Market Structure
Definition of Concentration Ratios:
This is a tool for measuring the market share of the 5 biggest firms in the industry. E.g. the 5 firm
concentration ratio for supermarkets is about 58%

How Firms In Oligopoly are Expected to behave

There are different possible ways that firms in oligopoly will compete and behave this will depend upon:

 the objectives of the firms e.g. profit max or sales max

 the degree of contestability i.e. barriers to entry
 government regulation

The Kinked Demand Curve Model

The Kinked Demand Curve Graph

 This assumes that firms seek to maximise profits

 If they increase price, then they will lose a large share of the market because they become
uncompetitive compared to other firms, therefore demand is elastic for price increases.
 If firms cut price then they would gain a big increase in Market share, however it is unlikely that
firms will allow this. Therefore other firms follow suit and cut price as well. Therefore demand will only
increase by a small amount: Demand is inelastic for a price cut
 Therefore this suggests that prices will be rigid in Oligopoly
The below diagram suggests that a change in Marginal Cost still leads to the same price, because of the
kinked demand curve( remember profit max occurs where MR = MC

Essay: Discuss how firms in Oligopoly are likely to compete with each
other
Oligopoly is a market structure in which a few firm dominate the industry, it is an industry with a 5 firm
concentration ratio of greater than 50%.

In Oligopoly, firms are interdependent; this means their decisions (price and output) depend upon how the
other firms behave:

 Barriers to entry are likely to be a feature of Oligopoly

 There are different models to explain how firms may behave
The kinked demand curve model suggest firms will be profit maxi misers.

Kinked Demand Curve Diagram 

At p1 if firms increased their price, consumers would buy from the other firms therefore they would lose a
large share of the market and demand will be elastic. Therefore, firms will lose revenue from increasing
price

If Firms cut Price then they would gain a big increase in Market share, however it is unlikely that firms will
allow this. Therefore, other firms follow suit and cut price as well. Therefor,e demand will only increase by
a small amount: Demand is inelastic for a price cut and revenue would fall.

This model suggests price will be rigid because there is no incentive for firms to change the price
 If prices are rigid and firms have little incentive to change prices they will concentrate on non price
competition. This occurs when firms seek to increase revenue and sales by various methods other than
price.

For example, a firm could spend money on advertising to raise the profile of their product and try and
increase brand loyalty, if successful this will increase market sales. Advertising is a big feature of many
oligopolies such as soft drinks and cars. Alternatively they could introduce loyalty cards or improve the
quality of their after sales service. When buying a plane ticket price is not the only factor consumers look
at, they may prefer airlines with more leg room, airmiles e.t.c.

Non price competition depends upon the nature of the product. For example, advertising is very important
for soft drinks but less important for petrol.

However, in reality this model doesn’t always occur. Often the objectives of firms is not to maximise profit.
For example, they may wish to increase the size of their firm and maximise sales. If this is the case, they
may be willing to take part in a price war, even if this does lead to lower profits. Price wars involve firms
selling goods at very low prices to try and gain market share. For example, newspapers such as the
Times and the Sun have recently been sold very cheaply. Price wars are more likely if:

1. A big firms is able to cross subsidise one market from profits elsewhere
2. In a recession markets are more competitive as firms seek to retain customers

However, price wars may only be short term

A firm may engage in predatory pricing, this occurs when the incumbent firm seeks to force a new firm out
of business by selling at a very low price so that it cannot remain profitable.

Under certain circumstances firms may be able to collude with each other and avoid any form of price
competition. Collusion involves firms agreeing to raise prices and restricting output in order to increase
profits of the industry. Collusion will be possible if:

1. A small number of firms, who are well known to each other make it easier to stick to output quotas
2. A dominant firm, who is able to have a lot of influence in setting the price
3. Barriers to entry, this is important to stop other firms entering to take advantage of the high profits
4. Effective communication and monitoring of output and costs
5. Similar production costs and therefore will want to raise prices at the same rate
6. Effective punishment strategy’s for firms who cheat
7. No effective govt legislation, collusion is illegal in the UK

Conclusion:

There is no certainty in how firms will compete in Oligopoly; it depends upon the objectives of the firms,
the contestability of the market and the nature of the product

Economics of Game Theory

Is the study of strategic interaction where one player’s decision depends on what the other player does.
What the opponent does also depends upon what he thinks the first player will do

1. Both players have a dominant strategy.

A DOMINANT strategy occurs when there is an optimal choice of strategy for each player no matter what
the other does.
  

                                                            P2
                                                LEFT               RIGHT
                        UP                   8,3                  5,4
P1                    DOWN            7,5                  2,6

If P2 chooses left  P! will choose  UP

If p2 chooses right P1 will choose  UP
Therefore UP is a dominant strategy for P1

P2 will always choose right no matter what P1 does

The unique equilibrium is (up, right). This is despite the fact that (down, left ( is pareto superior

2. One player has a dominant strategy

PIGLET
                                                Push lever                     wait for swill
            Push lever                     8,-2                              1,7
PIG
            Wait for swill                10,-2                            0,0

1. piglet will always wait

2. Pig will have to push
 

Nash Equilibrium
There are many games which don’t have a dominant strategy.

Definition: A Nash equilibrium occurs when the payoff to player one is the best given the other’s choice.
And player’s 2 choice is the best given the other’s choice.

                                                            P2
                                          LEFT                           RIGHT
                  UP                   5,4                               3,10
P1
                  DOWN            9,2                               0,1

If P1 goes UP, P2 prefers right since 10>4. But if P1 goes down then P2 prefers left since 2>1. If P2 goes
left then P1 goes down since 9>5. If P2 goes right then P1 goes UP since 3>0

Nash Equilibrium and the Prisoners Dilemma

There are 2 outcomes which are stable (UP,RIGHT) and (DOWN, LEFT) which are “stable”: neither
player would wish to change his action given the action of the other player. This is a NASH equilibrium 
Prisoners dilemma

 
                                                      Player B
                                          Confess            Deny
                  Confess            -3,-3                0,-6
Player A     
                  Deny                -6,0                  -1,-1

 
Repeated Games and Game Theory
      If games are repeated then there is the poss. Of punishing people for cheating, this will provide an
incentive for sticking to the pareto optimal approach.

However if they are repeated a finite number of times then there will be an incentive to cheat. If the game
is played 10 times then the player will defect on the 10th round so why cooperate. So therefore you may
as well defect on round 9 and so round  8 as well

If it is played an infinite number of times then it will be different. The best strategy then is to play tit for tat.
If a player defects in one round you retaliate in the next round. In other words you do what ever your
opponent does and this is an incentive to enforce the cartel.

Game Theory: A game of entry deterrence

If a new firm enters the market then the payoff will depend on whether the incumbent fights or accepts. If
the incumbent fights they both get 0. If it does not fight then the incumbent gets 1 and the entrant gets 2.
Therefore the equilibrium is for the new firm to enter and the incumbent to accept.

However, if the incumbent can give a credible threat that he will fight then he may be able to persuade the
entrant to stay out. He could do this by investing in extra capacity, which would give him a bigger payoff in
a price war. This would deter entry. So although the monopolist would never use this he would prevent
entry