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

Macroeconomics: multiplier and crowding out effects

Multiplier effect: whenever   any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures. The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy. The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS. The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP. The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate. This increase in interest ...
Post a Comment
Read more

Microeconomics: Factor Markets

Definition: Factor markets: markets for the factors of production (example: labor and capital). Markets are formed whenever consumers and producers meet to exchange goods or services. Deriving factor demand: the demand for goods or services in the product markets creates demand for the factors of production.  An increase (decrease) in demand for good X leads the suppliers to increase their production thereby increasing (decreasing) the demand for the factors of production.   Marginal revenue product: The demand for the factor of production is formed by multiplying a firm's marginal revenue by its marginal product.  Remember that by taking the derivative of the TR function with respect to Q we are able to find the MR. Marginal product on the other hand is found by taking the derivative of the production function with respect to a factor of production (L or K for example). Marginal revenue product (MRP): the change in total revenue when one more input is employed. It decrea...
Post a Comment
Read more

A short interlude...

Hello all, it's been quite some time since I have made any major announcements since the creation of this blog about a year and a half ago. I am currently in graduate school and will soon take a portion of my comprehensive examination (i.e exams in Micro, Macro, and Metrics that will allow me to continue my studies in my graduate program), wish me luck! Thus, I will not be able to post consistently until at least mid-June. The roadmap is as such, if I pass, I will start introductory lessons in Econometrics and Statistics (if not, then I'll have to study until I can retake the comps in August). I hope that once I am done, I will be able to add more advance materials to the blog, such as general equilibrium, indirect utility functions, and game theory/mechanism design for Micro. The Solow, Ramsey, RBC, New Keynesian models, permanent income hypothesis (PIH) and more for Macro. By the way I think I still need to add notes on the IS-LM curves, so I will do that before jumping to t...
Post a Comment
Read more