Lecture 20
OLIGOPOLY

1. Characteristics of the industry

• Market dominated by a few sellers
• Recognized mutual interdependence
• Products may be identical (steel) or differentiated (cars)
• Moderate to high entry barriers

2. Difficulty in analyzing oligopolies

• Individual firm's actions affect the market as a whole
• One firm's demand curve is affected by another firm's actions

3. The kinked demand curve model

• If a firm lowers its price, other firms match it
• But, if it raises its price, other firms do not
• Example: The airline industry

4. Collusion

• Firms collude on pricing and output decisions
• The industry is a shared monopoly
• Examples: OPEC, diamond cartel (DeBeers)

• "Thou shalt cheat and make bigger profits."
• By lowering the price slightly below the agreed-on price, a producer can increase its profits substantially.

5. Price leadership

• Tacit collusion
• The price leader sets prices; followed by other firms

• Could lead to price wars
• Good for consumers

6. Game theory

• Strategic decision-making by firms
• Payoffs and strategies

• Two firms in the industry
• Each firm's profits (payoffs) are determined by its price and the rival's price (strategy)
• Both firms charge the lower price and make smaller profits
  
  
• Example: In the figure below, each firm's profits are given, corresponding to each of the 4 possible pairs of strategies. Ideally, they would like to go with High price-High price and thus make profits of $1,800 each.

Analysis:

If Firm B chooses High price, what should Firm A choose? Low price, since it makes a profit of $2,000 compared with $1,800 otherwise.

If Firm B chooses Low price, what should Firm A choose? Low price, since it makes a profit of $1,600 compared with $1,500 otherwise.

So, no matter what B does, A should choose Low Price.

Similarly for Firm B. No matter what A does, B's best reponse is to choose the Low Price strategy.

Therefore, they each end up choosing the Low price strategy. And each will make profits of $1,600. This is the Nash equilibrium.

7. Contestable markets

• Fixed costs are not sunk; they can be recovered
• Freedom of entry and exit by firms
• Threat of potential entrants ensures competitive behavior by oligopolistic firms