13-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Chapter 13

Oligopoly

13-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Learning objectives• Define oligopoly in greater detail than in

Chapter 8, assess its occurrence and note the reasons for its existence

• Examine the behaviour of oligopoly in terms of a simple game theory framework

• Survey four models of the possible courses of price–output behaviour that oligopolistic industries might follow

13-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Learning objectives (cont.)• Discuss the role of non-price competition;

that is, competition on the basis of product development and advertising in oligopolistic industries

• Provide some comments on the economic efficiency and social desirability of oligopoly

13-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Characteristics of oligopoly• ‘Fewness’: few firms dominate the market

– Firms are mutually interdependent and must consider the possible reactions of rivals to its price and product development decisions

– Firms may collude or act independently

13-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Characteristics of oligopoly (cont.)

• Product differentiation?– Homogeneous or differentiated product– Examples

Petroleum products Aluminium Insurance Motor vehicles

• Concentration ratios: the percentage of total industry sales accounted for by a given number of the largest firms in each industry

13-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Characteristics of oligopoly (cont.)

High barriers to entry• Causes

– Economies of scale– Mergers

The combining of two or more competing firms, with a resulting increase in size, market share and economic power

– Ownership of patents, copyrights– Control of strategic raw materials– Technological progress

13-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Oligopoly behaviour: a game theory approach• Compare the behaviour of oligopolists to

a simple duopoly game of strategy, actions and pay-offs as shown in the profit pay-off matrix

• Mutual interdependence– The fate of one firm lies partially or wholly with

the performance or decisions of other firms in that same industry

13-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Oligopoly behaviour: a game theory approach (cont.)• Incentives to collude through some formal

or informal arrangement to coordinate pricing strategies or fix prices

• Incentive to cheat on a collusive agreement

13-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Profit payoffs for a duopolyGiant’s pricing strategy

High Low

Big

’s p

rici

ng

str

ateg

y

Hig

hL

ow

$12m

$12m

$6m

$6m

$8m

$8m$15m

$15mA

C

B

D

13-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Maximum strategies and optimal pricing strategy

Maximum strategies• Strategies chosen by players in a game

to maximise their minimum expected pay-off from the game

• The equilibrium pair of strategies under this rule will result in a Nash equilibrium, which is for each firm to charge a low price, regardless of the choice the other firm makes

13-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Price–output behaviour in four models• Four models of oligopoly

– The kinked demand curve– Collusive pricing– Price leadership models– Cost-plus pricing

• No standard model of oligopoly due to:– Diversity – Interdependence

13-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Kinked demand: non-collusive oligopoly model• Output occurs where MR = MC• Price remains stable over a variety of cost

scenarios– Avoiding price wars– Firms ignore price increases– Firms match price decreases

• Criticisms– How is the current price set?– Prices may not be as inflexible as model suggests

13-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The kinked demand curveP

QD1

MR1

The firm’s demandand marginal

revenue curves

13-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The kinked demand curve P

QD1

MR1

The rival’s demandand marginal

revenue curves

MR2

D2

13-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The kinked demand curve (cont.)P

QD1

MR1

MR2

D2

Rivals tend tofollow a price cut

13-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The kinked demand curve (cont.)P

QD1

MR1

MR2

D2

Rivals tend tofollow a price cut

or ignore aprice increase

13-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The kinked demand curve (cont.)P

QD1

MR1

MR2

D2

Effectively creating…

13-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

The kinked demand curve (cont.)P

QD1

MR1

Effectively creatinga kinked demand

curve

P

X

Q

D2

MC2

MC1

MR2

13-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Collusion and cartels• Overt or covert agreements to fix prices, divide

up or share the market or limit competition between firms

• Output and price: same as a monopolist • Forms

– Cartels Groups of firms that agree either formally or

informally to set prices and output levels of a product among members

– Gentlemen’s agreements Groups of firms agree verbally to set prices and

output levels, usually in an informal setting such as a golf course

13-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Economicprofit

Collusion and profit maximisation

Q

MC

ATCP

MR

Pri

ce

Q

MR = MC

D

13-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Obstacles to collusion• Demand and cost differences between firms• Numbers of firms• Cheating• Recession• Legislative obstacles: Trade Practices Law

13-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Price leadership: tacit collusion modelPrice leadership: tacit collusion• A type of gentlemen’s agreement in which

oligopolists automatically follow the price initiatives of the dominant firm in an industry

13-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Price leadership: tacit collusion model (cont.)• Infrequent price changes by price leader• Price announcements often made through

indirect channels such as trade publications• Price leader may choose strategies to block

potential entrants: limit-pricing or price blocking

13-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Cost-plus pricing model• An oligopolist uses a standard formula

to estimate cost per unit of output and adds a mark-up to determine price

• Advantages for multi-product firms• Consistent with outright collusion

13-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Non-price competition• Oligopolists dislike competing on price• Oligopolists must rely on non-price competition

– Advertising– Product development

• Oligopolists typically have substantial resources to support non-price competition

13-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Oligopoly and economic efficiency• Productive inefficiency

– Minimum ATC is not necessarily chosen Under-allocation of resources

• Allocative inefficiency– Price does not necessary equal MC

Output is restricted

13-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Oligopoly and economic efficiency (cont.)

Dynamic efficiency• Long-term improvements in product quality

and production methods may occur– Competitive view– Schumpeter–Galbraith view

Oligopolists have both the incentive and financial and technical resources to be more technologically progressive than competitive firms

13-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Oligopoly and economic efficiency (cont.)• Technical advance — what is the evidence?

– Giant corporate oligopolies are probably not the leaders in technological advance

– In Australia in the 1980s and 1990s more than half of the research and development efforts were supported by government rather than business

– The private sector has imported much of the technology through parent overseas companies

– Technological advances in Australian industry is science- based and research-orientated ratherthan market driven

13-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Microeconomics 8e, by Jackson & McIverBy Muni Perumal, University of Canberra, Australia

Next chapter:

The demand for economic resources