Skip to main content

Microeconomics: Oligopolistic firms

Definition of Oligopoly:

  • An oligopoly is a market structure where there is a limited number of firms that are allowed to enter in the market.
  • New firms face barriers to entry to access an oligopoly market:
    • Economies of scale give the already existing firms a low cost advantage over smaller entrants into the market.
    • Existing firms may work together to prevent new firms from accessing the market.
    • Older firms have name recognition that newer firms do not have.
  • A firm's best choices are influenced by one another's decisions. Thus, each firm needs to have strategy in order to make the best decision possible.
    • In an oligopoly market, firms can change their production and prices in reaction to a competitor's production (or pricing) decision.
    • Firms may be of unequal size, thus, one firm may be seen as the price leader, and the other firms set their prices in response to the leading firm.
Collusion and Cartels:
  • Oligopolistic firms have an incentive to collude, to set prices and productions.
  • If unregulated, collusion among firms may result in a cartel, which can be defined as an agreement not to compete, instead this group of firms behave like a monopoly by determining collectively the price and quantity to produce.
  • Cartels have a hard time subsisting in the long run due to the incentive to cheat. For example, one firm can decide to produce more, or lowering its price in order to increase their profit. 
Modeling Oligopolistic Behavior:
  • An oligopoly market can be modeled via a payoff matrix. A payoff matrix is simply a matrix that shows the possible outcomes when two agents make a decision (see game theory).
  • Assume that two firms form a oligopoly market and both try to maximize their profit. The payoff matrix below shows the daily profit given their choice to set a high or low price. 
Payoff Matrix: Firm A: high prices Firm A: low prices
Firm B: high pricesA: $1000
B: $1000		A: $1200
B: $500
Firm A: low pricesA: $500
B: $1200		A: $750
B: $750
  • If the firms compete, they will both earn a daily profit of $750. Low price is the dominant strategy, both firms will always choose the low price option as it is always the best response no matter what the other firm chooses.
    • Firm A is always better off by choosing a low price strategy. If firm B sets a high price then A makes an even bigger profit by choosing low price. If firm B sets a low price, then firm A still makes a bigger profit than if it had chosen to set at a high price. 
    • Choosing a low price is also the dominant strategy for firm B. This is not always the case, in some cases there can be no dominant strategy or only one firm has a dominant strategy.
  • If the firms decide to collude, they would both decide to charge a high price and earn each a $1000 daily profit. Both firms would rather earn a $1000 daily profit rather than $750. Also, notice that both have an incentive to cheat and earn $1200 by deciding to charge a low price while to other firm charges a high price. In the long run this will result in both earning a $750 daily profit.
Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 119-122. 
Labels:
Location: New York, NY, USA

Comments

Post a Comment

Popular posts from this blog

Microeconomics: Firms and cost in the short run

In Economics, the term short run refers to a time period where at least one variable of interest does not change . In our case, the short run for a firm is when at least one input  (labor, land, capital) stays fixed. Usually land and capital are considered fixed in the short run.  If an input is fixed during a period time, no matter how much the total product a firm produces, its cost stays the same. This cost is commonly known as fixed cost (FC). Examples of fixed costs: rent, property taxes, loan payments. Labor is often considered to be a part of the  variable cost (VC) . Variable cost can be defined as the cost a firm has control over during the short run. Unlike fixed cost, variable cost increases (decreases) as a firm's total product increases (decreases). Examples of variable costs include: utility bills, wages, raw materials A firm's total cost (TC) is the sum of its variable and fixed costs. As you can see, the fixed cost...
Post a Comment
Read more

Microeconomics: Shift in Supply

We recently talked about the factors that cause a shift in the demand. It is now time to discuss the factors that shift the supply curve which cause the equilibrium price and demand to change. Determinants of Supply: changes in supply are caused by changes in the price of inputs, the number of firms in the market, technology, changes in the price of related goods and services, and changes in expected prices. An increase (decrease) in the price of an input results in less (more) supply as per unit production costs rise (fall). More competition increases supply, and less competition leads to less supply. If a new firm enters the market for good X, then the supply of good X increases. Improvement in technology can result in an increase in the ability of producers to supply their products. For example, the invention of the printing press increased the supply of books. An increase (decrease) in the price of a related good leads to an increase (decrease) in the supply of the other...
Post a Comment
Read more

Macroeconomics: measuring the inflation rate and its impact on the economy

Inflation and deflation: Inflation: an increase in the average price level of a nation's output over time. If a country is experiencing inflation, the inflation rate must be positive. Inflation rate is the percentage change in the price level between one period and a previous period. Deflation: a decrease in the average price level of a nation's output over time. deflation means that the inflation rate must be negative.  Inflation as a macroeconomic indicator: Inflation reduces real incomes of households, thereby reducing their standard of living. Deflation reduces the incentive for firms to invest, it negatively impact borrowers (both firms and households). By knowing the rate of change in price level, policy-makers can implement targeted policies to keep the price level stable. Shortcomings of inflation as an economic indicator: Inflation is derived from a price index (e.g CPI), which estimates a change in prices based on a particular selection of goods. If the index fails to...
Post a Comment
Read more