Oligopoly and Game Theory

Oligopoly

 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.
Interdependence between firms
 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 price).

 Therefore, each firm’s decisions influence the decisions

made by the other firms.

 In other words, firms’ decisions are interdependent.

 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
 Airlines
 Telecom companies
 Beer
 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.
 2. Game Theory
 A model of strategic moves and countermoves of rivals.
 Firms chooses strategies based on their assumptions
about competitors likely behaviour or response.
 Strategies could relate to pricing, advertising, product

range, customer groups etc.

 Game theory provides a framework or model to help
analyse this behaviour.
The Prisoner’s Dilemma as a Model for Oligopoly Behaviour

Two men are in custody for a crime they may or may not have
committed: armed robbery. The police have the men in separate
cells so they can’t communicate and have told them the following:

If A confess’ to the crime,

but B doesn’t.
A will get out of jail.
B will get twenty years in jail.

If A remains silent and B confess’

A will get 20 years in jail, and
B will get out of jail

If both confess, they will get five

years in jail.

However, if both remain silent,

They will get one year in jail.
Nash Equilibrium
The Nash Equilibrium is the solution to a game in which two or more
players have a strategy, and with each participant considering an
opponent’s choice, he has no incentive, nothing to gain, by switching
his strategy.

In the Nash Equilibrium, each player’s

strategy is optimal when considering
the decisions of other players.
 Duffka School of Economics

Game Theory
The study of how people behave in strategic
situations

An understanding of game theory helps

firms in an oligopoly maximize profit.
 Duffka School of Economics

A Duopoly Example
Suppose there are only two gas stations in a small rural town of
Boonetuckey.
These gas stations, Margaret’s Gas Stop and Pam’s Station, are
duopolists in the gasoline market and they each sell 50% of all of
the gas in town.
The demand schedule for gasoline in Boonetuckey is given in
the following table. We will assume that the marginal cost of
selling a gallon of gas is $1.
 Duffka School of Economics

A. A Duopoly Example
If these station
owners operated in a
perfectly competitive
world, P=MC=$1.

In this case, the firms

would split $1400 of
total revenue, so
each would earn
$700.
 Duffka School of Economics

A. A Duopoly Example
But two sellers do not need
to behave as perfectly
competitive firms.
They could decide to
collude and charge a price
of $4 per gallon and each
would sell 800/2 = 400
gallons.
At this collusive price, each
firm would earn $3200/2 =
$1600 of total revenue.
 Duffka School of Economics

A. A Duopoly Example
But would such an
agreement (to not
compete) last?

Probably not
2. Game Theory – a two-firm Payoff matrix

 Two airlines competing for Vietnam’s domestic

air travel market
 Vietnam Airlines
 Jetstar

 Assume two airlines choose their strategy independently

(ie. No collusion)

 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

High fare Low fare
Jet Star’’s options

A B
High
VA’s profit = $15m VA’s profit = $20m
fare
JS’s profit = $15m JS’s profit = $5m

C D
Low VA’s profit = $5m VA’s profit = $8m
fare JS’s profit = $20m JS’s profit = $8m
 Firms maximise the minimum expected payoff.

 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.

 Game Theory – MAXIMIN strategy
 For Jetstar:
 if they choose a Low Fare option, they will receive either $8m or
$20m profit, depending on the option chosen by VA – so the worse
Jetstar 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
JS will also choose the Low Fare option.

 Both firms choose the Low Fare option if act independently.

 There is an incentive to collude
 Game Theory – a two-firm Payoff matrix (2)

Vietnam Airlines’ options

High fare Low fare
Jet Star’s options

High A B
fare VA’s profit = $20m VA’s profit = $15m
JS’s profit = $10m JS’s profit = $2m

C D
Low VA’s profit = $12m VA’s profit = $10m
fare
JS’s profit = $8m JS’s profit = $5m
For Vietnam Airlines :

 Low Fare: Min. $10m profit ; Max. $15m profit
 High Fare: Min. $12m profit; Max. $20m profit

 Vietnam Airlines will choose High Fare option

For Jetstar:
 Low Fare: Min. $5m profit; Max. $8m profit

 High Fare: Min. $2m profit; Max. $10m profit

 Jetstar will choose Low Fare option

Possibly, they cater for different market segments.

There is no incentive to collude
Kinked Demand Curve Model
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
Rivals
ignore
 D2: When the firm changes
price => other firms don’t
follow.
Rivals  There is substitution effect
match  Change in demand more
sensitive to price changes
 Relatively elastic curve
Kinked demand curve for a firm under oligopoly
$

Assumptions:
• Independence among firms
(ie. no collusion)
A
• Rivals will match price decreases
and ignore price increases
B
P1

O Q1 Q
fig
 The MR curve
$

B
P1

MR

a
D = AR

O Q1 Q
 $
The MR curve

P1

a
D = AR
b

O Q1 Q
MR
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
So the MC curve can increase or decrease
$ between this discontiuity, without
necessitating a change in the profit
maximising output OQ1 or price OP1 - the
oligopolist will absorb the higher costs.

MC2

P1 MC1
According to normal
demand and supply
analysis, an increase in
costs would cause a fall
in output and an
increase in price.
a
D = AR
b

O An example of cost absorption in practice is when the price of crude oil rises
Q
Q1
and petrol companies wish to increase price, but do not as no company wants
to be the first to do so. MR
 Kinked Demand Curve Model
Assumptions:
 All firms are independent (ie. no collusion)
 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
contrary to the stable price conclusions of Oligopoly
Oligopoly Models -Price Leadership Model

 This type of price leadership occurs where a firm, probably by virtue of its
size comes to dominate an industry in terms of its power to influence
market supply.

 The dominant firm sets a price to suit its own needs and the smaller firms
then adjust their planned output in line with the market price that has been
set for them.

Assumes implicit collusion

 Follow the leader
 dominant firm makes prices changes
 most efficient, oldest, most respected, largest

 others follow
Price leader aiming to maximise profits for a given market share

AR = D market

O Q
fig
 Price leader aiming to maximise profits for a given
$ market share

Assume constant
market share
for leader

AR = D market

AR = D leader

O Q
fig
 Price leader aiming to maximise profits for a given
$ market share

AR = D market

AR = D leader

MR leader
O Q
fig
 Price leader aiming to maximise profits for a given
$ market share

MC

AR = D market

AR = D leader

MR leader
O Q
fig
 Price leader aiming to maximise profits for a given
market share
$

MC

l
PL
AR = D market

AR = D leader

MR leader
O QL Q
fig
 Price leader aiming to maximise profits for a given
$ market share

MC

l t
PL
AR = D market

AR = D leader

MR leader
O QL QT Q
fig
Oligopoly Models c) Collusion

Definition: when an industry reaches an open or secret

agreement to

 fix price
 divide up or share the market
 or other ways of restricting competition between
themselves.
The most common type of formal collusion is through the cartel;
• a small number of rival firms,
• selling a similar product,

The cartel members come to the conclusion that it is in their joint interests to
formally collude rather than compete, they may establish a cartel arrangement
in which they agree to set an industry price and output which enables them to
achieve a common objective.

This is likely to involve the setting of agreed output quotas for each member in
order to maintain the agreed price.

A successful cartel arrangement, from

the point of view of the participating firms,
would be one in which the cartel acts like
a single monopolist to maximise profits of
individual members.
Why collude?
 removes uncertainty

 no price wars

 increase profits

 barrier to entry

Types of collusion
 Explicit
 centralised cartel (OPEC)

 Implicit
 price leadership model
 Collusion
Difficulties:
 Difference in cost structures

 Large number of firms in the market

 Cheating

 Falling demand

 Legal barriers

In practice, cartels may tend to be rather fragile and may not last for very long.

• individual members may have an incentive to renege on the agreement

• necessity to limit output to keep price high will tend to leave individual firms
with spare productive capacity, and provide the temptation to increase profits
by expanding output.

• Such an expansion would not only generate profit on the additional sales, but
would also increase the profits on existing sales, as average fixed costs would
fall as output expanded.
 Oligopoly Review

 Oligopoly: a market structure in which only a few sellers offer

similar or identical products.

 Strategic behavior in oligopoly:

A firm’s decisions about P or Q can affect other firms and cause
them to react.
 The firm will consider these reactions when making

decisions.

 Game theory: the study of how people behave in strategic

situations.

OLIGOPOLY 40
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q  Smalltown has 140 residents
$0 140
 The “good”: cell phone service with
5 130
unlimited anytime minutes and free
10 120 phone
15 110
20 100
 Smalltown’s demand schedule
25 90  Two firms: T-Phone, V-Phone
30 80 (duopoly: an oligopoly with two firms)
35 70  Each firm’s costs: FC = $0, MC = $10
40 60
45 50
OLIGOPOLY 41
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q Revenue Cost Profit Competitive
$0 140 $0 $1,400 –1,400 outcome:
5 130 650 1,300 –650
P = MC = $10
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000 Monopoly
outcome:
25 90 2,250 900 1,350
P = $40
30 80 2,400 800 1,600
Q = 60
35 70 2,450 700 1,750
Profit = $1,800
40 60 2,400 600 1,800
45 50 2,250 500 1,750
We can estimate MR at Q=60 as follows:
42
Increase output from 50 to 70, dR = $200, dQ=20, MR = dR/dQ = $200/20 = $10.
EXAMPLE: Cell Phone Duopoly in Smalltown
 One possible duopoly outcome: collusion
 Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
 T-Phone and V-Phone could agree to each produce
half of the monopoly output:
 For each firm: Q = 30, P = $40, profits =

$900
 Cartel: a group of firms acting together,
e.g., T-Phone and V-Phone in the outcome with
collusion

OLIGOPOLY 43
Collusion vs. self-interest

P Q Duopoly outcome with collusion:

$0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = $900.
反悔
10 120 If T-Phone reneges on the agreement and
15 110 produces Q = 40, what happens to the
20 100 market price? T-Phone’s profits?
25 90 Is it in T-Phone’s interest to renege on the
30 80 agreement?
35 70
If both firms renege and produce Q = 40,
40 60 determine each firm’s profits.
30 30
44
ACTIVE LEARNING 1
Answers
P Q If both firms stick to agreement,
each firm’s profit = $900
$0 140
5 130 If T-Phone reneges on agreement and
produces Q = 40:
10 120
Market quantity = 70, P = $35
15 110
T-Phone’s profit = 40 x ($35 – 10) = $1000
20 100
T-Phone’s profits are higher if it reneges.
25 90
30 80 V-Phone will conclude the same, so
both firms renege, each produces Q = 40:
35 70
Market quantity = 80, P = $30
40 60
Each firm’s profit = 40 x ($30 – 10) = $800
25 40 45
Collusion vs. Self-Interest
 Both firms would be better off if both
stick to the cartel agreement.
 But each firm has incentive to renege
on the agreement.
 Lesson:
It is difficult for oligopoly firms to form
cartels and honor their agreements.

OLIGOPOLY 46
The oligopoly equilibrium

P Q If each firm produces Q = 40,

$0 140 market quantity = 80
5 130 P = $30
10 120
each firm’s profit = $800
15 110 Is it in T-Phone’s interest to increase its
20 100 output further, to Q = 50?
25 90 Is it in V-Phone’s interest to increase its
30 80 output to Q = 50?
35 70
40 60
45 50 47
Answers

P Q If each firm produces Q = 40,

$0 140 then each firm’s profit = $800.
5 130 If T-Phone increases output to Q = 50:
10 120 Market quantity = 90, P = $25
15 110 T-Phone’s profit = 50 x ($25 – 10) = $750
20 100 T-Phone’s profits are higher at Q = 40
25 90 than at Q = 50.
30 80
The same is true for V-Phone.
35 70
40 60
45 50 48
 CONCLUSION
 Oligopolies can end up looking like monopolies or like
competitive markets, depending on the number of firms and
how cooperative they are.

 The prisoners’ dilemma shows how difficult it is for firms to

maintain cooperation, even when doing so is in their best
interest.

 Policymakers use the antitrust laws to regulate oligopolists’

behavior. The proper scope of these laws is the subject of
ongoing controversy.

OLIGOPOLY 49
CHAPTER SUMMARY

 Oligopolists can maximize profits if they form a

cartel and act like a monopolist.
 Yet, self-interest leads each oligopolist to a higher
quantity and lower price than under the monopoly
outcome.
 The larger the number of firms, the closer will be
the quantity and price to the levels that would
prevail under competition.

50