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s
P
r
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S
t
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a
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g
y
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
2 competitors
2 price strategies
Each strategy has a
payoff
Greatest combined
profit
Independent actions
stimulate a response
Oligopoly and Game
Theory: Example
LO: 9-4
9-10
RareAirs Price Strategy
U
p
t
o
w
n
s
P
r
i
c
e
S
t
r
a
t
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g
y
A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low
Independently
lowered prices in
expectation of
greater profit leads
to the worst
combined outcome
Eventually low
outcomes make
firms return to
higher prices
There is a gain from
collusion
Oligopoly and Game
Theory: Example
LO: 9-4
9-11
Kinked-Demand Model of
Oligopoly
In the kinked-demand model, oligopolists face
a demand curve based on the assumption that
rivals will ignore a price increase and follow a
price decrease.
An oligopolists rivals will ignore a price increase
above the going price but will follow a price decrease
below the going price.
The demand curve is kinked at this price and the
marginal-revenue curve has a vertical gap.
Price and output are optimized at the kink.
This model helps explain why prices are generally
stable in noncollusive oligopolistic industries.
LO: 9-5
9-12
P
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P
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a
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C
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s
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Quantity Quantity
0 0
P
0
MR
2
D
2
D
1
MR
1
e
f
g
Rivals Ignore
Price Increase
Rivals Match
Price Decrease
Q
0
Competitors and rivals strategize versus each other
Consumers effectively have 2 partial demand curves
and each part has its own marginal revenue part
MR
2
D
2
D
1
MR
1
Q
0
MC
1
MC
2
P
0
e
f
g
Kinked-Demand Model of
Oligopoly
LO: 9-5
9-13
Collusion
Collusion, through price control, may allow oligopolists to
reduce uncertainty, increase profits, and possibly block
potential entry.
If oligopolistic firms produce an identical product and have
identical cost, demand, and marginal-revenue curves, then
each firm can maximize profit using the MR = MC Rule.
Firms will choose the price and quantity according to the MR
= MC Rule, because it is the most profitable price-output
combination.
One form of collusion is the cartel.
A Cartel is a formal agreement among producers to set the price
and the individual firms output levels of a product. One example is
OPEC.
LO: 9-6
9-14
P
r
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a
n
d
C
o
s
t
s
Quantity
D
MR=MC
ATC
MC
MR
P
0
A
0
Q
0
Economic
Profit
Effectively Sharing
The Monopoly Profit
Profit Maximization by a
Cartel
Cartel-type oligopoly is inefficient
LO: 9-6
9-15
Obstacles to Collusion
Anti-trust law prevents cartels from forming
Demand and costs may be different across firms
There may be too many firms to coordinate
There are strong incentives to cheat
If rivals charge prices lower than P
o
, then the demand curve of
the firm charging P
o
will shift to the left as its customers turn to
its rivals, and its profits will fall.
The firm can retaliate and cut its price, too. However, all firms
profits would eventually fall.
Recessions increase excess capacity and
strengthen incentives to cheat
High profits attract potential entry.
LO: 9-6
9-16
Oligopoly and Advertising
Positive Effects of Advertising
Enhances competition
Reduces consumers
search time, direct costs,
and indirect costs
Facilitates the introduction
of new products
Negative Effects of Advertising
Alters consumers
preferences in favor of the
advertisers product
Brand-loyalty promotes
monopoly power
Oligopolists have sufficient financial resources to
engage in product differentiation through product
development and advertising.
LO: 9-7
9-17