Diploma in Management Studies

Microeconomics ECO001
Lecture 11 Oligopoly
Topics to be discussed:
Features of Oligopoly
The Kinked Demand Curve Model
Features of Game Theory
Prisoners Dilemma Game
Ref: Parkin, Chapter 13
1

Learning Outcomes

After this lecture, students should be able to:

Define and identify oligopoly
Explain the Kinked Demand Curve Model
Use game theory to explain how price and
output are determined in oligopoly
Define a prisoners dilemma game
Use game theory to explain other strategic
decisions
2

Features of Oligopoly
The distinguishing features of oligopoly are
Natural or legal barriers that prevent entry
of new firms
A small number of firms compete

Small Number of Firms

Because an oligopoly market has a small number

of firms, the firms are interdependent and face a
temptation to cooperate.
Interdependence: With a small number of firms,
each firms profit depends on every firms actions.
Cartel: A cartel and is an illegal group of firms
acting together to limit output, raise price, and
increase profit.
Firms in oligopoly face the temptation to form a
cartel, but aside from being illegal, cartels often
break down.
4

Kinked Demand Curve Model

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.

Kinked Demand Curve Model

The figure shows the
kinked demand curve
model.
The firm believes that
the demand for its
product has a kink at
the current price and
quantity.
There is a gap in the
MR curve
6

Kinked Demand Curve Model

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.

Kinked Demand Curve Model

The kink in the
demand curve
means that the MR
curve is
discontinuous at the
current quantity
shown by that gap
AB in the figure.

Fluctuations of MC
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.
11

Kinked Demand Curve Model

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.
12

Games Theory
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.
The Prisoners Dilemma
The prisoners dilemma game illustrates the
four features of a game.
Rules
Strategies
Payoffs
Outcome
13

Rules of Games
Rules
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 each other.
14

Prisoners Dilemma Game

Each is told that both are suspected of
committing a more serious crime.
If one of them confesses, he will get a 1-year
sentence for cooperating while his accomplice
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.
15

Strategies
Strategies are all the possible actions of each
player.
Art and Bob each have two possible actions:
1. Confess to the larger crime.
2. Deny having committed the larger crime.
With two players and two actions for each player,
there are four possible outcomes:
1. Both confess.
2. Both deny.
3. Art confesses and Bob denies.
16
4. Bob confesses and Art denies.

Payoffs and Payoff Matrix

Payoffs
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.
17

Prisoners Dilemma Game

18

Nash Equilibrium
Outcome
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 equilibriumfirst
proposed by John Nash.
The following slides show how to find the
Nash equilibrium.
19

Equilibrium

20

Duopoly
A duopoly is a market in which there are only
two producers that compete.
Suppose that the two firms enter into a
collusive agreement.
A collusive agreement is an agreement
between two (or more) firms to restrict output,
raise the price, and increase profits.
Such agreements are illegal in the United
States and are undertaken in secret.
Firms in a collusive agreement operate a
cartel.
21

Duopoly: Comply or Cheat

The strategies that firms in a cartel can pursue
are to
Comply
Cheat
Because each firm has two strategies, there are
four possible combinations of actions for the
firms:
1. Both comply.
2. Both cheat.
3. Trick complies and Gear cheats.
4. Gear complies and Trick cheats.
22

Payoff Matrix
If both comply, each firm makes $2 million a
week.
If both cheat, each firm makes zero economic
profit.
If Trick complies and Gear cheats, Trick incurs an
economic loss of $1 million and Gear makes an
economic profit of $4.5 million.
If Gear complies and Trick cheats, Gear incurs an
economic loss of $1 million and Trick makes an
economic profit of $4.5 million.
23

Payoff
Matrix

24

Equilibrium

25

Duopoly Game
The Nash equilibrium is that both firms
cheat.
The quantity and price are those of a
competitive market, and the firms make
zero economic profit.

26

Exercise 11.1
The common feature in monopoly, oligopoly,
and monopolistic competition is

A)
the absence of close substitutes.

B)
blocked entry.

C)
interdependent decision making by
firms.

D)
price discrimination.

E)
downward sloping demand.

27

Answers to Exercise 11.1

The correct answer is (e).
In monopoly, monopolistic competition
and oligopoly, firms have at least some
market power and can set price over a
range of output.
Thus the demand curve is downward
sloping.

28

Exercise 11.2
Firm B
Firm A

High Price

Low Price

High Price

$100 for A
$75 for B

$200 for A
$50 for B

Low Price

$50 for A
$400 for B

$150 for A
$300 for B

Refer to the table above which shows the payoff matrix

of two firms, Firm A and Firm B, each has two
strategies, to set high price or low price. The figures in
the matrix show the profits earned by each firm.
(a) Solve for the Nash equilibrium in this game.
(b) Is this game a prisoners dilemma game? Justify
29
your answers.

Answers to Exercise 11.2

(a) The Nash equilibrium is both firm set
high price and that the payoff to Firm A is
$100 and pay off to Firm B is $75.
(b) This is a prisoners dilemma game. The
reason is that the Nash equilibrium is not
the best outcome. The best outcome is in
fact both firms set low price so that Firm A
gets $150 and Firm B gets $300
30

Exercise 11.3

The table below show the payoff matrix for

players A and B to strategies X and Z.
P la y e r B

P la y e r A

X
Z

$ 7 0 0 fo r B $ 3 0 0 fo r A
$ 4 0 0 fo r B $ 5 0 0 fo r A

$ 3 0 0 fo r B $ 2 0 0 fo r A
$ 6 0 0 fo r B $ 1 ,0 0 0 fo r A

Player A finds that

A)
strategy Z is a dominated strategy.

B)
strategy X is a dominant strategy.

C)
strategy Z is a dominant strategy.

D)
he has no dominant strategy.

E)
his best strategy depends on what
player B chooses.

31

Answers to Exercise 11.3

The correct answer is (c)
If Player B chooses X, Player A will choose
Z since $500 is better than $300.
If Player B chooses Z, Player A will choose
Z since $1000 is better than $200.
Thus strategy Z is a dominant strategy for
Player A.

32

Exercise 11.4
(1) Why is there no incentive for a firm
in the kinked demand curve model to
change its price?
(2) Is the price always remain rigid in
the kinked demand curve model?

33

Answers to Exercise 11.4

(1) In the kinked demand curve model, the
price is stabilized at the kink level. If the
firm charge a higher price, its demand
becomes elastic and its revenue drops. If it
charges a lower price, its demand becomes
inelastic and its revenue drops. Thus it has
no incentive to change the price.
If there is a large change in the marginal
cost such that the MC shifts by a larger
amount than can be accommodated by the
gap of MR, then the equilibrium price will
change.
34

Kinked Demand Curve Model

No change in price for
MC1 to MC3

Price
MC5

Price drops for MC4

Price rises for MC5

MC3

P1

MC1
MC2
MC4

MR
Q1

D
Quantity