Bài giảng topic 7(b) oligopoly

 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

Topic 7(b)

OLIGOPOLY Contents

 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.

Oligopoly

 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

Characteristics of Oligopoly

 Small mutually interdependent number of firms controlling the market

 Significant market power

 One firm cut the prices => others are affected

 Homogenous or differentiated products

 High barriers to entry

 Examples

Non-price competition…

 is common in oligopoly, such as:

 advertising, product innovation,

improvement of service to customers

 is preferred to price wars which usually bring losses to all parties

product range, customer groups etc

model to help analyse this behaviour.

2 Game Theory –

a two-firm Payoff matrix

 Two airlines competing for the domestic air travel market

 Vietnam Airlines

 Jetstar

 Assume two airlines choose their strategy

 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

B

VA’s profit = $20m JS’s profit = $5m

Low

fare

C

VA’s profit = $5m JS’s profit = $20m

D

VA’s profit = $8m JS’s profit = $8m

2 Game Theory –

MAXIMIN strategy

 For Vietnam Airlines:

 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

 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

B

VA’s profit = $15m JS’s profit = $2m

Low

fare

C

VA’s profit = $12m JS’s profit = $8m

D

VA’s profit = $10m JS’s profit = $5m

2 Game Theory –

MAXIMIN strategy

 Low Fare: Min $10m profit ; Max $15m profit

 High Fare: Min $12m profit; Max $20m profit

=> VA choose High Fare option

 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

 D1: When the firm changes prices => other firms react similarly

 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

 There is substitution effect

 Change in demand more sensitive to price changes

 Relatively elastic curve

Rivals ignore

Rivals match

Kinked demand curve for a firm

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

Kinked Demand Curve Model

 Assumptions:

 Rivals match price decreases and ignore price increases

 Implication of Kinked Demand Curve: Stable Price

 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

 It does not explain the determination of current price

 Sometimes prices rise substantially during inflation period, which is

3 Oligopoly Models

 Assumes implicit collusion

 Follow the leader

 dominant firm makes prices changes

 most efficient, oldest, most respected, largest

 others follow

 Usually

 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

3 Oligopoly Models

open or secret agreement to

 fix price

 divide up or share the market

 or other ways of restricting competition b/w themselves

Collusion (contd.)

 Difficulties:

 Difference in cost structures

 Large number of firms in the market

 Cheating

 Falling demand

 Legal barriers

3 Oligopoly Models

d) Cost-plus pricing

 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