Interdependence in Oligopolistic Markets

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  • Interdependence in Oligopolistic Markets
    • Game theory
      • Two players are working out how to further their interests
        • Fate of the players depends on their own decisions and the decisions of the others
        • Players are interdependent
    • Prisoners' dilemma
      • Used to understand how interdependent firms act in an oligopolistic market
      • The choices of the different firms is summarised using a payoff matrix
      • Example: 2 firms --> Choice of high level of output or low level of output
        • Both firms choose low output: Firm A makes a profit of 200, Firm B makes a profit of 200
          • If both firms cooperate and restrict output to low levels, the outcome will be better for both than if they both output at high levels
            • However, only works well if both firms can be trusted
        • Firm A low output, Firm B high output: Firm A makes a profit of 100, Firm B makes a profit of 300
          • It is in the interests of each firm to stop cooperating and raise output
            • However, this will only work if they do this before the other firm
            • If one firm raises output, it is in the interests of the other firm to keep output low and take the reduced profit
              • First mover advantage
              • Cartels are unstable as any firm can have an advantage if they break the agreement before the others
        • Both firms choose high output: Firm A makes a loss of 100, Firm B makes a loss of 100
          • If both firms cooperate and restrict output to low levels, the outcome will be better for both than if they both output at high levels
            • However, only works well if both firms can be trusted
    • Kinked demand curve
      • Assumptions
        • If one firm raises prices, the others will not raise theirs
          • Price = increased, demand = price elastic
          • Customers are likely to switch to buying goods from other firms
          • Any firm that raises price will lose out
            • The fall in demand will more than cancel out the gains from charging a higher price
          • A firm which raises prices will see quite a large drop in demand
        • If one firm lowers price, the others will also lower theirs
          • Price = decreased, demand = price inelastic
          • A firm which lowers prices will not gain any market share
          • Any firm that reduces price will lose out
            • The average price for their products will fall but they will not gain market share
      • However, only shows one type of interdependence
        • Does not explain behaviour in every oligopoly
        • If assumptions are not appropriate, the model will not predict behaviour correctly
          • Other models may be needed
      • The outcome
        • Firms have no incentive to change prices
          • Firms will lose out as a result of changing prices
        • Prolonged periods of price stability
    • First mover disadvantage
      • If the first mover overestimates demand for product, they make losses
      • Competitors can use technology developed by the first firm, reducing their costs
        • They can charge a lower price than the first mover
      • Potential profits or losses depend on the numbers in the payoff matrix
        • Different decisions are needed for different situations

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