Oligopoly and Strategic Behavior

Oligopoly and
Strategic Behavior
Oligopoly and Strategic Behavior
● Oligopoly
 A market situation in which there are

very few sellers
 Each seller knows that the other
sellers will react to its changes in prices
and quantities
WHAT IS AN OLIGOPOLY?
● Duopoly
If there are only two sellers
● Pure Oligopoly
Product is homogeneous
e.g. steel and aluminum
● Differentiated Oligopoly
Product is differentiated
e.g. automobiles, cigarettes, breakfast cereals, soaps, and
detergents.
● Characteristics of Oligopoly
Small number of firms

Interdependence
 Strategic dependence
A situation in which one firm’s actions with respect to price,
quality, advertising, and related changes may be
strategically countered by the reactions of one or more
other firms in the industry
An oligopoly—a market with just a few firms—occurs for

seven reasons:
1 Economies of scale in production.
• Large capital investment required
• Patented production process
• Brand loyalty
• Control of raw material or resource
• Government franchise
1 Limit Pricing
Measures of Oligopoly
● Concentration ratio
The percentage of the market output produced by the 4, 8. 12
largest firms in the industry
● Herfindahl-Hirschman
An alternative measure of market concentration is the Herfindahl-
Hirschman Index (HHI). It is calculated by squaring the market
share of each firm in the market and then summing the resulting
numbers.
● Theory of contestable market

If entry is absolutely free and exit is entirely costless then firms
will operate as if they are perfectly competitive
KINKED DEMAND CURVE MODEL
• Proposed by Paul Sweezy
• If an oligopolist raises price, other firms will not follow,

so demand will be elastic
• If an oligopolist lowers price, other firms will follow, so

demand will be inelastic
• Implication is that demand curve will be kinked, MR will

have a discontinuity, and oligopolists will not change
price when marginal cost changes
KINKED DEMAND CURVE MODEL
The demand curve facing

the oligopolist is D or ABC and has
a kink at the prevailing market price
of ＄ 6 and quantity of 40 units
(point B), on the assumption that
competitors match price cuts but not
price increases. The marginal
revenue curve is MR or AGEHJ. The
best level of output of the oligopolist
is 40 units and is given by point E at
which the MC curve intersects the
discontinuous portion of the MR
curve. At Q=40. P= ＄ 6 (point B on
the D curve). Any shift in the MC
curve from MC' to MC'' would leave
price and output unchanged.
CARTEL ARRANGEMENTS
● Collusion
Cooperation among firms to restrict competition in order to
increase profits
● Market-sharing Cartel
Collusion to divide up markets
● Centralized Cartel
Formal agreement among member firms to set a monopoly price
and restrict output.
Incentive to cheat.
THE CENTRALIZED CARTEL
D is the total market demand cruve, and MR is the corresponding marginal

revenue curve for the two-firm centralized cartel. The ∑MC for the cartel is obtained by
summing horizontally the MC curves of the two member firms. The centralized authority
will set P= ＄ 8 and sell Q=50 units (given by point E at which the ∑MC curve intersects
the MR curve). If firm 1 sells 20 units at a profit of ＄ 1 per unit and ＄ 20 in total (the
shaded area) and firm 2 sells 30 units at a profit of ＄ 2 per unit and ＄ 60 in total, we
have the monopoly solution. The share of profits of each firm could, however, be
determined by bargaining.
PRICE LEADERSHIP
• Implicit Collusion
• Price Leader (Barometric Firm)
→ Largest, dominant, or lowest cost firm in the
industry.
→ Demand curve is defined as the market demand
curve less supply by the followers
→ A system under which one firm in an oligopoly takes
the lead in prices.
• Followers
→ Take market price as given and behave as perfect
competitiors
PRICE LEADERSHIP
DT (ABCFG) is the market
demand curve for the product,
and ∑MCF is the marginal cost
curve of all the follower firms in
the industry. Since the followers
always produce where P=∑MCF,
DT - ∑MCF = DL (HNFG) is the
demand curve faced by the
dominant leader firm, and MRL
is the corresponding marginal
revenue curve. WIth MCL as the
marginal cost curve of the
leader, the leader will set
P= ＄ 6 (given by point N at
which MCL=MRL ) in order to
maximize its total profits. At
P= ＄ 6, the followers will supply
JR=40 units of the product and
the leader RC = RN = 20 units.
THE SALES MAXIMIZATION MODEL
• Proposed by William Baumol
• Managers seeks to maximize sales, after

ensuring that an adequate rate of return has been
earned, rather than to maximize profits
• Sales (or Total Revenue, TR) will be at a

maximum when the firm produces a quantity that
sets marginal revenue equal to zero (MR = 0)
THE SALES MAXIMIZATION MODEL
TR, TC, and π refer, respectively,

to the total revenue, total cost, and
total profits of the oligopolistic firm.
π = TR - TC and is maximized at
＄ 90 when Q=40 and TR= ＄ 240.
On the other hand, TR is maximum
at ＄ 250 when Q=50 and π
= ＄ 70. A minimum profit
requirement above ＄ 70 would be
binding, and the firm would
produce less than 50 units of
output. For example, if the
minimum profit requirement were
＄ 80, the firm would produce,
47.50 units of output with TR of
nearly ＄ 250.
STRATEGIC BEHAVIOR AND GAME
THEORY
Strategic Behavior
● Decisions that take into account the
predicted reactions of rival firms.
Game Theory
● Concerned with the choice of the best or
optimal stratefy in conflict situations.
● Shows how an oligopolistic firm makes

strategic decisions to gain a competitive
advantage over a rival or how it can minimize
the potential harm from a strategic move by a
rival.
THEORY
Game theory model includes:
● Players
The decision makers (managers of the oligopolist firms) whose
behavior we are trying to explain and predict.
● Strategies
Choices to change price, develop new products, undertake a
new adveritising campaign, build new capacity, and all other such
actions that affect the sales and profitabilit of the firm and its
rivals.
● Payoffs
Outcome or consequence of each strategy.
THEORY
● Payoff matrix
A matrix or table that shows, for each possible outcome of a
game, the consequences for each player.
● Dominant strategy
An action that is the best choice for a player, no matter
what the other player does.
● Nash equilibrium
A situation in which each player chooses his or her optimal
strategy, given the strategy chosen by the other player.
Advertising Example 1
Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
What is the optimal strategy for Firm A if Firm B chooses to advertise?
Firm B
Advertise (4, 3) (5, 1)
Firm A

If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The
optimal strategy is to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
What is the optimal strategy for Firm A if Firm B chooses not to advertise?
Firm B
Advertise (4, 3) (5, 1)
Firm A
If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 3.
Again, the optimal strategy is to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
Regardless of what Firm B decides to do, the optimal strategy for Firm A is to
advertise. The dominant strategy for Firm A is to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
What is the optimal strategy for Firm B if Firm A chooses to advertise?
Firm B
Advertise (4, 3) (5, 1)
Firm A

If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The
Firm B
Advertise (4, 3) (5, 1)
Firm A
What is the optimal strategy for Firm B if Firm A chooses not to advertise?
Firm B
Advertise (4, 3) (5, 1)
Firm A
If Firm B chooses to advertise, the payoff is 5. Otherwise, the payoff is 2.
Firm B
Advertise (4, 3) (5, 1)
Firm A
Regardless of what Firm A decides to do, the optimal strategy for Firm B is to
advertise. The dominant strategy for Firm B is to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
The dominant strategy for Firm A is to advertise and the dominant strategy for
Firm B is to advertise. The Nash equilibrium is for both firms to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
Firm B
Advertise (4, 3) (5, 1)
Firm A
Firm B
Advertise (4, 3) (5, 1)
Firm A

If Firm A chooses to advertise, the payoff is 4. Otherwise, the payoff is 2. The
Firm B
Advertise (4, 3) (5, 1)
Firm A
Firm B
Advertise (4, 3) (5, 1)
Firm A
If Firm A chooses to advertise, the payoff is 5. Otherwise, the payoff is 6. In
this case, the optimal strategy is not to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
The optimal strategy for Firm A depends on which strategy is chosen by Firms
B. Firm A does not have a dominant strategy.
Firm B
Advertise (4, 3) (5, 1)
Firm A
Firm B
Advertise (4, 3) (5, 1)
Firm A

If Firm B chooses to advertise, the payoff is 3. Otherwise, the payoff is 1. The
Firm B
Advertise (4, 3) (5, 1)
Firm A
Firm B
Advertise (4, 3) (5, 1)
Firm A
If Firm B chooses to advertise, the payoff is 5. Otherwise, the payoff is 2.
Firm B
Advertise (4, 3) (5, 1)
Firm A
Regardless of what Firm A decides to do, the optimal strategy for Firm B is to
advertise. The dominant strategy for Firm B is to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
The dominant strategy for Firm B is to advertise. If Firm B chooses to

advertise, then the optimal strategy for Firm A is to advertise. The Nash
equilibrium is for both firms to advertise.
Firm B
Advertise (4, 3) (5, 1)
Firm A
The Prisoner's Dilemma
• A situation in which each firm adoptsf its

dominant strategy but each could do better (i.e.,
earn larger profits) by cooperating.
The Prisoner's Dilemma Example
• You and your partner rob a bank and get caught.

• You are separated and given these options:
 Both confess and get five years in jail
 Neither confess and get two years
 One confess and the other does not
→ Confessor goes free
→ One who does not confess gets ten years
Assume you are Sam reacting to the possible actions of

Carol.
The Prisoner's Dilemma Payoff Matrix
Confessing is better than not confessing.


Prisoners’ Dilemma
Application
• The conceopt of the prisoner's dilemma can be used to
anlyze price and non-price competition in oligopolistic
markets, as well as the incentive to cheat (i.e., the
tendency to secretly cut price or sell more than its
Confessing
allocated quota) is better than not confessing.
in a cartel
Application: Price Competition

Firm B
Low Price High Price
Low Price (2, 2) (5, 1)
Firm A
High Price (1, 5) (3, 3)
Application: Price Competition
Dominant Strategy: Low Price

Firm B
Low Price High Price
Low Price (2, 2) (5, 1)
Firm A
High Price (1, 5) (3, 3)
Application: Nonprice Competition

Firm B
Advertise (2, 2) (5, 1)
Firm A
Application: Nonprice Competition
Dominant Strategy: Advertise

Firm B
Advertise (2, 2) (5, 1)
Firm A
Application: Cartel Cheating

Firm B
Cheat Don't Cheat
Cheat (2, 2) (5, 1)
Firm A
Don't Cheat (1, 5) (3, 3)
Application: Cartel Cheating
Dominant Strategy: Cheat

Firm B
Cheat Don't Cheat
Cheat (2, 2) (5, 1)
Firm A
Don't Cheat (1, 5) (3, 3)
EXTENSION OF GAME THEORY
● Repeated Games
 Many consecutive moves and countermoves by each player
● Tit-for-Tat Strategy
 Do to your opponent what your opponent has just done to
you.
● Tit-for-Tat Strategy
 Stable set of players
 Small number of players
 Easy detection of cheating
 Stable demand and cost conditions
 Game repeatea large and uncertain number of times
● Threat Strategies
 Credibility
 Reputation
 Commitment
Entry Deterrence:
One important strategy that an oligopolist can use to deter market
entry is to threaten to lower its price and thereby impose a loss
on the potential entrant. Such a threat, however, works only if it
is credible.
ENTRY DETERRENCE
No Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (7, 2) (10, 0)
Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (3, 2) (8, 0)
THANK
YOU!

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Oligopoly and Strategic Behavior

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Oligopoly and

 A market situation in which there are

Small number of firms

An oligopoly—a market with just a few firms—occurs for

1 Economies of scale in production.

• Large capital investment required

• Patented production process

• Control of raw material or resource

● Theory of contestable market

• Proposed by Paul Sweezy

• If an oligopolist raises price, other firms will not follow,

• If an oligopolist lowers price, other firms will follow, so

• Implication is that demand curve will be kinked, MR will

The demand curve facing

D is the total market demand cruve, and MR is the corresponding marginal

• Proposed by William Baumol

• Managers seeks to maximize sales, after

• Sales (or Total Revenue, TR) will be at a

TR, TC, and π refer, respectively,

● Shows how an oligopolistic firm makes

What is the optimal strategy for Firm A if Firm B chooses to advertise?

What is the optimal strategy for Firm A if Firm B chooses to advertise?

What is the optimal strategy for Firm B if Firm A chooses to advertise?

What is the optimal strategy for Firm B if Firm A chooses to advertise?

What is the optimal strategy for Firm A if Firm B chooses to advertise?

What is the optimal strategy for Firm A if Firm B chooses to advertise?

What is the optimal strategy for Firm B if Firm A chooses to advertise?

What is the optimal strategy for Firm B if Firm A chooses to advertise?

The dominant strategy for Firm B is to advertise. If Firm B chooses to

• A situation in which each firm adoptsf its

• You and your partner rob a bank and get caught.

Assume you are Sam reacting to the possible actions of

Confessing is better than not confessing.

Confessing is better than not confessing.

Confessing is better than not confessing.

Application: Price Competition

Confessing is better than not confessing.

Application: Price Competition

Dominant Strategy: Low Price

Confessing is better than not confessing.

Application: Nonprice Competition

Confessing is better than not confessing.

Application: Nonprice Competition

Dominant Strategy: Advertise

Confessing is better than not confessing.

Application: Cartel Cheating

Confessing is better than not confessing.

Application: Cartel Cheating

Dominant Strategy: Cheat

Confessing is better than not confessing.

No Credible Entry Deterrence Firm B

Credible Entry Deterrence Firm B

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