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 firms own price
and the prices and quantities sold by the
other firms.
The response of other firms to a firms
price and output influence the firms
profit-maximizing decision.

Oligopoly
The Kinked Demand Curve Model
In 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 firms prices
remain unchanged.
Below the kink,
demand is relatively
inelastic because all
other firms 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 quantityshown
by the gap AB in the
figure.

Oligopoly
Fluctuations 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 fact
If MC increases enough,
all firms raise their
prices and the kink
vanishes. A firm that
bases its actions on
wrong beliefs doesnt
maximize profit.

Oligopoly
Dominant Firm Oligopoly
In 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

Oligopoly
The 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 firms 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. Lets
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 Dilemma
The 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 1year 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
himcan work out his payoffin 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.

Payoff
Matrix

Oligopoly Games

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.

Bobs
view
of the
world

Bobs
view
of the
world

Arts
view
of the
world

Arts
view
of the
world

Equilibrium