Oligopoly

Unit 7 - Lesson 11
Learning outcomes:
● Define all the terms in orange bold for section 7.6. (AO1)
● Distinguish between collusive and non-collusive oligopoly. (AO2)
● Draw a diagram for collusive and non-collusive oligopoly. (AO4)
● Explain features of oligopoly including interdependence, risk of price war,
incentive to collude versus incentive to cheat. (AO2)
● Explain the relevance of price and non-price competition for firms in in
oligopoly. (AO2)
● Explain the presence of allocative inefficiency and Market Failure. (AO2)
● Explain the game theory payoff matrix
● Explain the meaning of market concentration and concentration ratio. (AO2)
● Discuss the advantages and disadvantages of oligopoly. (AO3)
Assumption of Oligopoly
Assumptions:
● There is a small number of large firms in the market
● There are high barriers to entry.
● Products produced in the oligopolistic market structure may be differentiated or
homogeneous.
● There is mutual interdependence
○ In perfect competition and monopolistic competition firms behave
independently due to the large number of firms in the market.
○ Since Oligopolistic markets have a small number of firms decisions made
by one firm will impact other firms in the market.
■ If any one firm changes its behaviour this can have a large impact on
the demand curve for the other firms.
■ Therefore, firms are very aware of the choices made by their rivals.
Strategic Behaviour and Conflicting Incentive
Mutual Interdependence has very important implications for the behaviour of
oligopolistic firms:
● Strategic Behaviour
○ Plans of action that take into account the rival firms’ possible course of
action.
○ The action of one firm is based on the expected actions and reactions of
the rival firm.
● Conflicting Incentives
○ Incentive to collude
■ Collusion refers to an agreement between firms to limit
competition usually by fixing price or limiting output produced.
○ Incentive to compete
■ Each firm has the incentive to compete in the hopes that it will
capture a portion of the rivals revenues and profits.
Game Theory
Game Theory, a mathematical
process, that is used to analyse
the strategic behaviour of
individuals and firms.

The illustration to the right

represents the Payoff Matrix that
is used to help explain the
strategic behaviour of two firms -
Coke and Pepsi
Game Theory
● The payoff matrix represents four
possible pricing strategies for coke
and pepsi and their corresponding profit
outcomes (payoffs).
○ If Coke and Pepsi collude and
both use a high pricing strategy
each firm would earn $40 million -
Box 4.
○ Pepsi realizing that if it lowers its
price that it will capture some of
the market demand for Coke and
its profits would increase to $70
million with Coke only making $10
million - Box 3.
Game Theory

● Likewise if Coke lowers its price

they will capture a higher profit of
$70 million and Pepsi only $10
million - Box 2.
● Both Coke and Pepsi recognizing
that lowering their price will result in
higher profits so they choose to
lower prices in the hopes of
capturing more profit.
● When each firm cheats on the
agreed upon price they end up only
making $20 million - Box 1.
Game Theory
● Nash Equilibrium
○ Occurs when both Coke and Pepsi
lower their prices and receive lower
profits.
○ Nash Equilibrium shows there is
sometimes a conflict between
pursuit of individual self-interest
and the collective market interest.
○ This conflict is known as
“Prisoner’s Dilemma”
○ Although a firm may be better off by
cooperating, each firm, trying to
make itself better off, ends up
making both itself and its rival worse
off.
Game Theory
Game Theory illustrates:

● Mutual Interdependence
○ What happens to the profits of Coke and Pepsi depends on the strategies
adopted by the other firm - this is known as strategic interdependence.
● Strategic Behaviour
○ Coke and Pepsi plan their actions based on guesses about what their
competitors will likely do.
● Conflicting Incentive
○ Coke and Pepsi face the incentive to collude (agree to set prices - Box 4)
○ Coke and Pepsi face the incentive to compete (cheat in the case of Coke
and Pepsi)
Game Theory
Game Theory illustrates:

● Coke and Pepsi become worse off as a result of price competition - trying
to capture sales from their rivals by cutting price.
○ Since rivals are likely to match the reduction in price, both Coke and
Pepsi will end up with lower profits - Box 1
■ This is referred to as a “Price War”.
● Coke and Pepsi have a strong interest in avoiding “price wars” because they
realize that everyone will worse off through price cutting.
○ Coke and Pepsi prefers to compete using non-price competition.
Game Theory
Watch the videos below on Prisoner’s Dilemma (Left) and a TV Game show illustrating Game
Theory and the Conflicting Incentive. Can you create a “Payoff Matrix” for the game show?
Concentration Ratio
Concentration Ratio

● Provides an indication of the percentage of output produced by the largest

firms in the industry.
● Provides an indication of the degree of competition in an industry.
○ Higher the concentration ratio the less competition in that industry.
○ Lower the concentration ratio the more competition in that industry.
● A rule of thumb
○ An industry is considered oligopolistic if the four largest firms control
40% of the output in that industry.
Weaknesses of Concentration Ratio

Weaknesses of Concentration Ratio:

● Concentration Ratios reflect concentration in a National Market. They do not
reflect competition from abroad.
● Do not provide any indication of the importance of firms in the global market.
○ May have small percentage of output domestically, but a dominant
position globally or vice versa.
● Do not account for competition from other industries which may be
important in the case of substitute goods.
● Does not distinguish between different possible sizes of the largest firms.
○ For example, if the three firm concentration ratio is 60% does that mean
each firm has 20% share of the market? No.
■ One firm may dominate and the others control a very small share.
Collusive Oligopoly

Collusion
● Refers to an agreement between firms to limit competition.
○ Common forms of collusion include:
■ Price-fixing - holding prices constant at the same level
■ Raising prices by a fixed amount
■ Fixing prices between different products

Collusion is illegal in most countries as the goal is to try and limit competition.

Open/formal collusion is referred to as a ‘cartel’

Cartels

Cartel:
● Formal agreement between firms in an industry to take action to limit
competition in order to increase profits.
○ Agreements include:
■ Fixing or limiting the quantity of output to be produced resulting in an
increase in price.
■ Fixing the price at which output can be sold.
■ Setting restrictions on non-price competition such as advertising
■ Dividing the market be geographical location.
■ Agreeing to set-up barriers to entry
Key objective of a cartel is to limit competition between members of a cartel in
order to maximize profits. Cartel members collectively behave like a monopoly.
Cartel Graph - Monopoly
To illustrate a collusive oligopoly - cartel -
we use a monopoly graph.

The graph to the right shows a profit making

collusive oligopoly making abnormal profit.

● Total Revenue earned is greater than

the total cost to produce the output.
● Total Revenue = A + B
● Total Cost = B

TR (A+B) > TC (B)

Therefore the monopolist firm makes a

profit of the area of A.
Cartels

Firms participating in a cartel have much to gain in terms of market power and
increased profits.
However, cartels or collusion is illegal in most countries as their aim is to restrict
competition and do not have consumers or societies best interest in mind.
Read the article below on the market for beer in India.
COLLUSIVE OLIGOPOLY
Consider these questions:
● What type of market structure is the beer industry in India? Justify your
answer.
● What type of collusion did the firms agree to?
● How does this type of practice negatively impact society?
Obstacles to Forming and Maintaining Cartels
Obstacles:
● Incentive to Cheat
○ Every firm faces the incentive to cheat on the agreement as this will
result in the cheating firm increasing market share thus profits. Refer to
the Payoff Matrix.
● Cost difference between firms
○ Ideally each firm would like to have a share of output where their profits
are maximized (MC = MR)
○ This is extremely difficult as each firms costs to produce (Marginal Cost)
and cost curves (Average Total Cost) are different.
■ Firms who have higher Average Cost will experience lower profits
● This may cause incentivize them to cheat in order to increase
profits.
Obstacles to Forming and Maintaining Cartels

Obstacles
● Firms face different demand curves
○ Firms are likely to experience different demand curves. Reasons:
■ Different market shares
■ Product differentiation
● Number of firms
○ Larger the number of firms the harder it is to reach an agreement
■ More incentive to cheat
● Industry lacks a dominant firm
○ Presence of a dominant firm helps to facilitate an agreement.
■ Lack of a dominant firm can lead to a power struggle
Tacit/Informal Collusion
The illegal nature of formal collusion sometimes make firms turn towards
Tacit/Informal Collusion.

● Tacit collusion refers to co-operation that is implicit or understood between

firms.
● No formal agreement exists between firms.

Price Leadership is a form of tacit collusion.

● Dominant firm in the firm in the industry sets the price and initiates any
price changes.
● Remaining firms in the industry become “price takers” and accept the price
set by the dominant firm.
Tacit/Informal Collusion
The informal agreement binds firms as far as price goes, however firms are free
to compete using non-price competition.
● Price changes tend to be infrequent and only take place if and when
demand or costs for the dominant firm changes.
Obstacles to tacit/informal collusion:
● Costs differences between firms vary greatly especially when there is
significant product differentiation makes it difficult to follow the leader.
● Some firms may follow and some may not leading to the leader/dominant
firm losing market share.
● Firms still face the incentive to cheat by lowering price to gain market
share.
● High industry profits may attract new firms that will cut into market share.
Non-collusive Oligopoly and the Kinked Demand Curve

In the real world, prices of oligopolistic

firms tend to be rigid or “sticky”.

● Once a price is reached in the

market, it tends to stick at that price
for a long period of time.
● The kinked demand curve is a
model that helps to explain price
rigidity among non-collusive
oligopolistic firms.
● The pricing behaviour of firms is
strongly correlated to the
expectations of the rival firms.
Non-collusive Oligopoly and the Kinked Demand Curve

The graph to the right illustrated the kinked

demand curve and will help us explain price
rigidity among non-collusive oligopolistic
firms.
DON”T PANIC!!!!!!
Careful with your language!!
How we are going to approach understanding
this graph:
1. How to draw it effectively
2. Refresher on PED and Total Revenue
3. Explaining what happens when price
changes.
Non-collusive Oligopoly and the Kinked Demand Curve
How to draw the kinked demand
curve:
Step 1:
● Label your axes - price and
quantity
● You will now begin drawing your
D=AR=P
○ Draw a line representing
relatively elastic demand
○ The line should be
approximately half of your
quantity axis.
Non-collusive Oligopoly and the Kinked Demand Curve

Step 2:
● Draw a second line that starts at
the end of your previous line.
● This line should be relatively
inelastic compared to the first
line.
○ Be careful to not make it too
steep.
Non-collusive Oligopoly and the Kinked Demand Curve

Step 3:
● Draw a dotted line from where
your two lines “kink:
○ One dotted line to the
quantity axis
○ One dotted line to the price
axis
Non-collusive Oligopoly and the Kinked Demand Curve
Now that you have drawn you D=AR=P it
is now time to draw your Marginal
Revenue curve for the first Demand
curve.

Step 4:

● Draw a line that starts at your

relatively elastic demand curve.
● Remember that Marginal Revenue
falls away from D=AR=P
● Stop at the dotted line your created.
Non-collusive Oligopoly and the Kinked Demand Curve
Step 5:

● Now it is time to draw the Marginal

Revenue (MR) curve for your relatively
inelastic D=AR=P curve.
○ Leaving a space, go down your dotted line a
little bit.
○ With a few dots left, draw a line down ensuring
the line crosses the quantity axis.
○ Be careful!!!
■ Remember that Marginal Revenue falls
away from D=AR=P.
■ This line should NOT be parallel to the
D=AR=P nor move closer to it.
Non-collusive Oligopoly and the Kinked Demand Curve
Final step!!!

● Draw a Marginal Cost curve that

touches the upper Marginal Revenue
curve.
● Finally draw an additional Marginal
Revenue (MC1) that touches the
start of the second Marginal
Revenue curve.

You have successfully drawn an

accurate kinked demand curve!
Non-collusive Oligopoly and the Kinked Demand Curve
What does this all mean?
● To explain price rigidity and the fact
that non-collusive oligopolistic firms
do not compete using price, but
non-price competition.
● There are two Demand (D=AR=P)
○ One above price (P)
■ This Demand curve is
relatively elastic
○ One below price (P)
■ This Demand curve is
relatively inelastic.
Non-collusive Oligopoly and the Kinked Demand Curve

We also have two Marginal Revenue

Curves (MR)

● The Marginal Revenue curve (MR)

above MC correlates with the
relatively elastic demand curve.
● The Marginal Revenue curve (MR)
below MC1 correlates with the
relatively inelastic demand curve.

Knowing this we now need to review

PED and total revenue (TR).
Non-collusive Oligopoly and the Kinked Demand Curve

Total Revenue change when PED > 1

Total Revenue at (P4, Q3)

● Total Revenue = D + E

Total Revenue at (P3, Q4)

● Total Revenue = C + D

Which is bigger? (D+E) or (C+D)

(D+E) is bigger

So an increase in price when PED > 1 will

result in a decrease in Total Revenue
Non-collusive Oligopoly and the Kinked Demand Curve
Total Revenue change when PED < 1

Total Revenue at (P2, Q2)

● Total Revenue = A + B

Total Revenue at (P1, Q1)

● Total Revenue = B + C

Which is bigger? (A + B) or (B + C)

(A + B) is bigger

So an decrease in price when PED < 1 will

result in a decrease in Total Revenue
Explain why prices do not change in non-collusive oligopoly.
If a firm A considers increasing price to gain
more profit, what will firm B do?
● Firm A considers increasing the price
above P.
● Firm A will be operating on the elastic
portion of the demand curve.
○ Firm B will leave their price
unchanged in the hopes of gaining
Firm A’s customers.
● If Firm A increases their price and Firm B
does not change their price customers
from Firm A will leave and buy from Firm
B.
Explain why prices do not change in non-collusive oligopoly.
So what happens if Firm A increases their price
and Firm B does not change their price?
● Firm A will be operating on the elastic
portion of their Demand curve.
○ Increase in Price when demand is
elastic will result in a decrease in
revenues.
■ % increase in price is less than
the % decrease in quantity
demanded.
Thinking this Firm A will not increase their
price for fear of losing revenues and market
share.
Explain why prices do not change in non-collusive oligopoly.
So what happens if Firm A decreases their
price?
● Firm B is also likely to decrease their
price for fear of losing market share
and revenue.
● With both firms decreasing prices
therefore demand is inelastic.
○ A decrease in price when demand
is inelastic results in a decrease in
revenue.
○ % decrease in price is greater than
the % increase in quantity
demanded.
Explain why prices do not change in non-collusive oligopoly.
So what should Firm A do?

● Firm A should not change their price and

should continue selling at price (P).
● This is the same line of reasoning for Firm B.

The Kinked Demand Curve Model illustrates:

1. Firms that do not collude are forced to take

into account the actions of their rivals.
2. Even though firms do not collude their is price
stability.
3. Firms do not compete based on price. They
compete using non-price competition.