ACKNOWLEDGEMENT

The materials used in unit 9, 10 & 11 are designed and developed by epg
Pathshala.
 BACHELOR OF ARTS (HONOURS)
ECONOMICS (BAEC)

BEC-08
Microeconomics II

BLOCK-4

OLIGOPOLY AND GAME THEORY

UNIT 9 OLIGOPOLY: NON-COLLUSIVE MODELS

UNIT10 NON–COLLUSIVE AND COLLUSIVE MODELS
UNIT11 GAME THEORITIC MODELS
UNIT 9: OLIGOPOLY: NON - COLLUSIVE
OLIGOPOLY

STRUCTURE
9.1 Learning Objectives
9.2 Introduction
9.3 Oligopoly market characteristics
9.4 Demand curve and pricing in oligopoly market
9.5 Oligopoly players market decision
9.6 Difference between oligopolistic market and monopolistic market
structure
9.7 Summary
9.8 Appendix

9.1 LEARNING OBJECTIVES

After studying this module, you shall be able to

 Know the meaning of oligopolistic market structure

 Learn the characteristics of oligopoly market
 Learn collusive and non collusive oligopolistic market structures
 Find out the difference between the oligopoly market and monopolistic
market structure
 Evaluate the demand curve and pricing decisions of the oligopoly
market players.

9.2 INTRODUCTION

Oligopoly is a market situation in which there are a few firms selling

homogeneous or differentiated goods. Though it is very difficult to identify the
number of sellers, but due to few sellers the actions and decisions of one seller
influence the others. Furthermore, under oligopoly market firms producing
homogeneous products are known as pure or perfect oligopoly and firms
selling the differentiated goods are known as imperfect or differentiated
oligopoly. For instance, pure oligopoly is found among the producers of
industrial goods like aluminum, zinc, copper, cement, steel, crude oil etc, and
imperfect oligopoly is found among the producers of consumer goods like
T.V., automobiles, typewriters, refrigerators etc.

9.3 OLIGOPOLY MARKET CHARATERISTICS

In addition to fewness of sellers, following are the common characteristics of

oligopolistic industries:
 Interdependence: There is complete interdependence among sellers in
this market. Since, there are few firms producing a considerable
fraction of the total output of the industry, so the actions taken by one
seller affect the others. By reducing or increasing the price for the
whole oligopolist market, one seller can sell more or less quantity and
can affect the profits of the other sellers. This also implied that in this
type of market, each seller is conscious of the price moves of the other
sellers and is aware of its impact on his profit. In addition to this he also
knows the action of rivals due to the influence of his price moves. Thus,
there is full interdependent among the sellers in this market with respect
to their price output policies/ decisions.

 Advertisement: Due to the interdependence of sellers in this market, it

becomes very important of each individual seller to highlight his
product and tell the consumers about the different features of his
product. Thus it becomes necessary for the firms in an oligopolistic
market to spend much on advertisements and customer services, so that
he can attract more market for his product and can give a tough
competition to his rivals.
 Competitions: since under oligopoly, there are a few sellers, thus a
move by one seller immediately affects the rivals and is followed by
their counter moves. Thus we can say that there exists a tough
competition among all the sellers in an oligopolistic market.

 Barriers to entry of firms: Due to the intense competition in an

oligopolistic market, there are no barriers to entry into the market or
exit from it. However, in the long run, the types of barriers to entry
which have a tendency to restrain new firms from entering into the
industry are economies of scale, high capital requirement, exclusive
patents and licenses etc. Thus, when entry is restricted/ blocked by such
natural and artificial barriers, the oligopolist industry can earn long run
super natural profits.

 Lack of uniformity: there exists lack of uniformity in the size of

oligopolist firms. It can be small or very large, such situation is also
known as asymmetrical with firms of a uniform size is rare.

 Demand curve: It is not easy to sketch the demand curve for the product
of an oligopolist seller because unless the exact behavior pattern of a
producer can be curtained with certainty, his demand curve cannot be
drawn accurately with definiteness. And since an oligopolist seller do
not show a unique pricing pattern/behavior, therefore, it is difficult to
trace the demand curve for an oligopolist seller. However, some of the
economists have sketched the demand curves based on certain
assumptions, which are explained in the following sections.

 No unique pattern of pricing behavior: Due to the rivalry arising fro m

interdependence among the oligopolist, each seller wants to be
independent and wants to earn the maximum possible profits and in
order to fulfill this motive they act and reach on the price - output
movements of other sellers with uncertainty for which he readies to
cooperate with his rivals in order to reduce or eliminate this element of
 uncertainty. For this, all rivals form a kind of formal agreement with
regard to their price - output changes, which in turn lead to a kind of
monopoly within oligopoly. They may also even identify one seller as a
leader at whose proposal all the other sellers raise or lower their prices.
Hence, due to these conflicting attitudes, it is not possible to predict any
unique pattern of pricing behavior in oligopolist markets.

9.4 DEMAND CURVE AND PRICING IN OLIGOPOLY MARKET

Price determination under oligopoly can be done under two models –

1) Non collusive oligopoly model of Sweezy (the kinked demand
curve)
2) The collusive oligopoly models related to cartel and price leadership

The Sweezy model of kinked demand curve (rigid prices)

In 1939, professor Sweezy has given the kinked demand curve analysis in
order to explain the price rigidities which are often seen in oligopolist markets.
In his model, Sweezy assumes that if the oligopolist firms lower its price, its
rivals will react by reducing their prices too in order to avoid losing their
customers. Thus the firm who has initially lowered the price in order to
increase its demand, will not be able to increase its demand much because his
rivals have also decreased the price of their good which is almost a substitute
for the consumers. Therefore, this portion of the demand curve of the initial
firm will be relatively inelastic. Whereas, on the other hand, if an oligopolist
firm increases its price, its rivals will not follow it and change their prices, and
thus the quantity demanded of this firm will fall considerably, as a good
number of customers may shift to the other firm which is selling the good at a
lower price. Hence, this portion of the demand curve of the initial firm will be
relatively elastic. Thus, in these two situations, the demand curve of oligopolist
firm will get a kink at the prevailing market price which in turn explains price
rigidity and the gap in the marginal revenue curve means that marginal costs
can fluctuate without changing equilibrium price and quantity. Thus prices tend
to be rigid according to this model in an oligopolist market.
Assumptions-
1. There are a few firms in oligopolistc market
2. Products of one firm are close substitute for other firms
3. No product differentiation
4. No advertising expenditures
5. Each sellers’ attitude depends on the attitude of his rivals
6. All the sellers are satisfied at the prevailing market price of the
product
7. A reduction in the price by any seller (to increase his sales) will be
followed by the other rivals in terms of reducing their prices as well.
8. An increase in the price of one seller will not be followed by the
other sellers and they will not increase their prices.
9. The marginal cost curve will pass through the dotted portion of the
marginal revenue curve so that even if the marginal costs would
change due to any reason, it will not affect the output and price.

Given these assumptions, the price output relationship in the oligopolist market
is elucidated in the figure1 where KHD is the kinked demand curve and OP is
the prevailing market price for the OR quantity of one seller. Any increase in
the price above OP will reduce his sales because his rivals will not follow this
price increase. Therefore, the KP portion of the demand curve is elastic and the
corresponding portion KA of the MR curve is positive. Therefore, any price
increase will not only reduce his total sales but also his total revenue and
profits.
On the other hand if the seller reduces the price of the product below OP then
his rivals will also reduce their prices, so, the HT portion of his demand curve
is less elastic and the corresponding part of the MR curve below R is negative.
Therefore, this price decrease will increase his sales but his profit would be
less than before.
 Figure:1

Thus in both the price raising and price reducing situations, the seller will be
loser and hence he will stick to the prevailing market price OP for his product,
which remains rigid. Moreover, the MC curve will cut the MR curve in this
dotted gap which in turn means that it will give the same output and price. So,
this gap in the marginal revenue curve means that even if the marginal costs
changes/ fluctuates then this change in MC will not change the equilibrium
price and quantity. Thus prices will remain rigid as per this model. Moreover,
there also exist some other reasons for price rigidities, these reasons are given
in the appendix at the end.
Collusive Oligopoly Model
In collusive oligopoly, all firms of a particular industry join together as a single
entity in order to maximize their joint profits or to share the market in a certain
amount. This is also known as cartel. There is one more type of collusion
which is known as leadership, under which one firm acts as the price leader (or
dominant firm) and fixes the price for the product while other firms follow it.
A. Cartels

A cartel is an alliance of independent firms of the same industry which follows

common policies related to pricing, outputs, sales, profit maximization and
distribution of products. Cartels may be voluntary/ compulsory and open/
secret depending upon the policy of the government with regard to their
formation. Cartel provides a sort of incentive from uncertainty to the rival
firms in which firms producing a homogeneous product form a centralized
cartel board in the industry and all individual firms give up their price output
decisions to this central board and in return this board decides the output
quotas, price to be charged and the distribution of industry profits for all its
members which further aims to maximize the joint profits of the entire
oligopolist industry.
In the figure2, given the market demand curve and its corresponding MR
curve, joint profits will be maximized when the industry MR equals the
industry MC. The following figure illustrates this situation where D is the
market or cartel demand curve and MR is its corresponding marginal revenue
curve and MC is drawn by the lateral summation of the MC curves of firm A &
B so that MC = MCa+MCb. The cartel solution which maximizes joint profit is
determined at point E where MC intersects MR and thus the total output is OQ,
to be sold at OP prices. Now the cartel board will allocate the industry output
by equating the industry MR to the marginal cost of each firm. The share of
each firm in the industry output is obtained by drawing a straight line from E to
the vertical axis which passes through the curves MCb and MCa of firms B &
A at point Eb and Ea respectively. Thus the share of firm A is OQa and that of
firm B is OQb which equals the total output OQ. Here we can see that firm A
is having lower cost of production and thus it is selling a larger output as
compared to firm B, but this does not mean that A will be getting more profit
than B. the joint maximum profit is the sum of RSTP and ABCP earned by A
& B respectively. Thus this type of perfect collusion by oligopolist firms in the
form of cartels does not only avoids price wars among rivals but also
maximizes the joint profits of all firms, which is generally more than the total
profits earned by them if they were to act independently.

Figure: 2

However another type of perfect collusion in an oligopolist market relates to

market sharing by the member firms of the cartel. Under this the firms enter
into a market sharing agreement either through a non price competition or
through quota system, to form a cartel but keep a considerable degree of
freedom concerning the style of their output, their selling activities and other
decisions.
Under the non price competition cartel, the low cost firms insist for a low price
and the high cost firms for a high price but at the end, they agree upon a
common price below which they will not sell their product. In such case, the
firms compete with one another on a non price basis by varying the color,
design, shape, packing etc of their product and having their own different
advertisement and other selling activities and thus this type of cartel allow
them to earn some individual profit. However this type of cartel is unstable
because if one low cost firm cheats the other firm by charging a lower price
than the common price, then it will attract the customers of other member firms
too and earn larger profits. And when the other firm comes to know about it
then it will leave the cartel and a price war will then start in the industry.
Under market sharing by quota agreement, all firms in an oligopolist industry
enter into collusion and charge an agreed uniform price for sharing the market
equally among them so that each firm would earn and get its profit on its sale.
In the figure.3 D is the market demand curve and D/MR is its corresponding
MR curve ΣMC is the aggregate MC curve of the industry which intersects
D/MR curve at point E which determines OP price and OQ quantity for the
industry. This is also known as the monopoly solution in the market sharing
cartel. However, this industry output can also be shared equally between the
two firms. For this we assume that the D/MR is the demand curve of each firm
and mr is its corresponding MR curve. AC & MC are their identical costs curve
where the MC curve intersects the mr curve at point e so that the profit
maximization output of each firm is Oq. So that 2*Oq=OQ, it is equally shared
by the 2 firms as per the quota agreement between them. Thus each sells Oq
output at the same price OP and earns RP per unit profit, where the total profit
earned by each firm is RP*Oq and by both is RP*2*Oq or RP*OQ.

Figure: 3
B. Price Leadership
Price leadership is imperfect collusion among the oligopolist firms in an
industry when all firms follow the lead of one big firm. This is of three types:
 The low cost price leadership model –
In the low cost leadership model, an oligopolist firm having low cost than the
other firms sets the lower price which the other firms have to follow. Thus the
low cost firm becomes the price leader. The main assumption of this model is
that the cost of all the firms is different but they all have identical demands and
MR curves. As illustrated in the following figure 4, D is the industry demand
curve and D/MR is its corresponding MR curve which is the demand curve for
both the curves and mr is their marginal revenue curve. Here the cost curves of
the low cost firm A are ACa and MCa and of the high cost firm B are
ACb&MCb.

Figure: 4

Now if the two firms act independently then the high cost firm B would charge
OP price per unit and sell OQb quantity as determined by point B where its
MCb curve cuts the mr curve. Similarly, the cost curve A will charge OP1
price unit and sell OQa quantity as determined by point A where its MCa curve
cuts the mr curve. Now since there is the formal agreement between the 2
firms, therefore, the high cost curve B has no choice but to follow the price
leader firm A. therefore, it will sell OQa quantity at a lower price OP1, even
though it will not be earning maximum profits. On the other hand, the price
leader A will earn much higher profits at OP1 price by selling OQa quantity.
Since both A & B sell the same quantity OQa, the total market demand OQ is
equally divided between the 2 firms but if firm B sticks to OP price then its
sales will be zero because the product is homogeneous and all its customers
will shift to firm A because it is selling the same product at a much lower price.
 The dominant firm price leadership model –

Under this model, there is one large dominant firm and a number of small firms
in the industry, where the dominant firm fixes the price for the entire industry
and the small firms sell as much product as they like and the remaining market
is filled by the dominant firm itself. In this case, the dominant firm will select
the price which will give it more profits. However, when each firm sells its
product at the price set by the dominant firm, then its demand curve is perfectly
elastic at that price and its marginal revenue curve coincides with the
horizontal demand curve and the firm will produce that output where its
MR=MC. Moreover, the MC curves of all the small firms combined laterally to
establish their

aggregate supply curve where all these firms behave competitively while the
dominant firm behaves passively by fixing the price and allowing the small
firms to sell all they wish at that price.
The figure5 explains the case of price leadership by the dominant firm where
DD1 is the market demand curve, SMC1 is the aggregate supply curve of all
the small firms. By subtracting SMC1 from DD1 at each price, we get the
demand curve faced by the dominant firm, PNMBD1 which can be drawn as
follows. Suppose the dominant firm sets the price OP then it allows the small
firms to meet the entire market demand by supplying PS1 quantity but the
dominant firm will supply nothing at this price OP. therefore, point P is the
starting point of its demand curve. Now take a price OP1 < OP, then at this the
small firms would supply P1C (or OQs) output, where their SMC1 curve cuts
their horizontal demand curve P1R at point C. since the total quantity
demanded at OP1 is OQ and the small firms supply P1C quantity. So, CR
quantity would be supplied by the dominant firm. Now by taking P1N=CR on
the horizontal line P1qR, the dominant firms supply becomes P1N (=OQd).
Since the small firms will not supply anything at prices below OP2 (because
their SMC1 curve exceeds this price) the dominant firms demand curve
coincides with the horizontal line P2B over the range MD and then with the
market demand curve over the segment BD1 and the dominant firms demand
curve will be PNMBD1.

Figure: 5

In addition to this, the dominant firm will maximize its profit at that output
where its marginal cost curve MCd cuts its MRd at point E at which the
dominant firm sells OQd output at Op1 price. The small firms will sell OQs
output at this price for SMC1, where the marginal cost curve of the small firms
equal the horizontal price line P1R at C. thus the total output of the industry
will be OQ=OQd+OQs. However, if OP2 price is set by the
dominant firm then the small firms would sell P2A and the dominant firm AB.
In case of price below OP2, small firms will sell zero and the dominant firms
will meet the entire industry demand. Hence this analysis shows that the price
quantity solution is stable because the small firms behave passively as price
takers.
 The barometric price leadership model -

Under this, there is no leader firm as such but one firm among the oligopolist
firm with the wisest management which announces the price change first which
is followed by other firms in the industry. Here the barometric price leader may
not be the dominant firm with the lowest cost or even the largest firm in the
industry, it is a firm which acts like a barometer in forecasting changes in cost
and demand conditions in the industry and economic conditions in the
economy as a whole.

4. OLIGOPOLY MARKET PLAYER’S DECISION

As has been discussed in the previous sections, the players decision in an
oligopolistic market structure depends upon the other existing firms in the
market. There exists complete interdependence of price and output decisions
of each firm due to the existence of a few firms in oligopoly market. It has
been discussed and showed in the previous section that each move by one firm
is followed by the counter moves of the other firms (rivals).
According to kinked demand curve model, the oligopoly market players
decision is based on the other players decision in such a way that a decrease in
the price is been followed by all the other players by reducing their prices of
products also but an increase in the price by one seller do not lead to an
increase in the price of the other sellers product.
In collusive oligopoly model, all firms form a sort of a tacit agreement under
whichthey all charge a common price and sells individual quantities so as to
maximize their joint profits of all firms. However, firms can also follow a
common price and can form a sort of agreement under which they decide each
player’s market share either through non price competition cartel or by quota
agreement.

Moreover, according to the price leadership model, each player’s decision is

based on the decision of the dominant or price leader firm. According to a price
leader firm, the low cost firm decides the price at which all other firms sell
their products and as per the dominant firm, a dominant or big size firm
decides the price for the other firms, which is followed by all the players of
oligopolist market.

Hence, in oligopoly market structure, each player’s decision is dependent on

the decision of the other players though in a different way according to
different models as has been discussed above, but the main characteristic is
that, their decisions are mutually interdependent and influence the decisions of
all other market participants and thus the entire oligopoly market.

9.6 DIFFERENCE BETWEEN OLIGOPOLY MARKET AND

MONOPOLISTIC MARKET STRUCTURE

The major difference between oligopoly and monopolistic competition is the

size and number of competing firms. Oligopoly refers to large firms having
small number of competitors while monopolistic competition is small firms
with large number of competitors. In other words, there exists many firms and
many buyers in monopolistic firms whereas, in oligopoly market there exists a
few big firms and many buyers. Another difference between the two is that
oligopoly has barriers to entry and exit in the market or industry, while
monopolistic competition has freedom for entry and exit of industries. An
oligopoly can produce either a homogeneous product or a differentiated
product but in Monopolistic competition only differentiated products are
produced. Moreover, there is full control of prices in oligopoly with complete
interdependence of all firms on each other, however, in monopolistic
competition each firm is independent and a competitor to other firms with
narrow or no price control and each decides its prices and quantities at its own
to maximize its profits. Monopolistic firms incur huge advertisement costs
whereas, oligopolist firms either incur less or no advertisement costs. Lastly, in
oligopolistic market, there exists a kinked demand curve and marginal revenue
curve is also not continuous and in monopolistic competition firm faces a
continuous downward sloping demand and marginal revenue curves.
9.7 SUMMARY

Oligopoly market is a market where there exist few big players who have full
control over prices and where all firms depend on the other for their price
output decisions. Several models (as has been discussed) been given for the
determination of prices and output in an oligopoly market where all models
shows the different demand curves of players with different price output
decisions.

9.8 APPENDIX

Other reasons for price stability

There are a number of reasons for price rigidity in certain oligopoly markets.
FIRST, individual sellers in an oligopolist industry might have learnt through
experience the futility of price wars and thus prefer price stability. SECOND,
they may be content with the current prices, outputs and profits and avoid any
involvement in unnecessary insecurity and uncertainty. THIRD, they may also
prefer to stick to the present price level to prevent new firms from entering the
industry. FOURTH, the sellers may intensify their sales promotion efforts at
the current price instead of reducing it. They may view non price competition
better than price rivalry. FIFTH, after spending a lot of money on advertising
his product, a seller may not like to raise his price to deprive himself of the
fruits of his hard labor. SIXTH, if a stable price has been set through
agreement or collusion, no seller would like to disturb it, for fear of unleashing
a price war and thus engulfing himself into an era of uncertainty and insecurity.
LASTLY, it is the kinked demand curve analysis which is responsible for price
rigidity in oligopolist markets.
UNIT 10: NON-COLLUSIVE AND
COLLUSIVE MODEL

STRUCTURE
10.1 Learning Objectives
10.2 Introduction
10.3 Collusive Models
10.4 Non Collusive Models
10.5 Summary

10.1 LEARNING OBJECTIVES

After studying this module, you shall be able to

 Know the concept of Oligopoly

 Understand Collusive models.
 Know the concept of cartel.
 Know the concept of Cournot, Stackelberg, Bertrand, Price leadership
firm
 Distinguish between collusive and no collusive models.

10.2 INTRODUCTION

An oligopoly is an industry characterized by few dominant firms. Oligopoly is

said to prevail when there are few firms in the market producing or selling a
product. Oligopoly is also referred to as “competition among the few”. A
special case of oligopoly is duopoly where two firms are competing with each
other. Under oligopoly each firm has enough market power to prevent itself
from being a price taker but each firm is facing inter firm rivalry which is
preventing it to consider the market demand curve as its own demand curve.
Competition among oligopolistic firms is so severe those economists call it as a
‘cut-throat competition’. Examples of oligopolistic industries include
computer, soft-drinks, steel, aluminum etc.
The oligopolistic market structure is different from perfect competition,
monopoly and monopolistic competition in terms of strategic behavior. The
behavior of oligopolistic firm is strategic because it takes into account the
impact of its decision on other competing firms and their reactions in response
to its decision. On the other hand firms in perfect competition and monopolistic
competition have non-strategic behavior because before taking their price and
output decision they do not consider any possible reaction from their
competitors. They behavior of monopolist is also non-strategic as monopolist
has no competitor to complete with.
In some oligopolistic market, some or all the firms are earning substantial
profits in the long run because entry of barriers making it to impossible for a
new firms to enter the market.
Models of Oligopoly
Economists have developed a large number of models by taking different
assumptions regarding the behavior of the oligopolistic firms (that is, whether
they would cooperate or compete with each other), regarding the objective they
seek to
achieve (that is , whether they seek to maximize profit, joint profit, sales etc)
and regarding different reaction patterns of the rival firms to price and output
changes by one firm. There are two types of models advanced by economists
are as follows:
(i) Collusive Models

 Cartel: Profit Sharing and Market Sharing

 Price Leadership

(ii) Non Collusive Models

 Cournot Model
 Stackelberg Model
 Bertrand Model
  Sweezy Model or Kinked Demand Curve

10.3 COLLUSIVE MODELS

(i) Cartel: OPEC- A Case Study of a Cartel

Cartel is an organization created from a formal agreement between groups of
producers of a good or service to regulate the supply in an effort to regulate
prices. Under cartel, producers or countries act together as a single producer
and by controlling production and marketing influencing the prices. The cartel
is successful in creating an oligopoly. Though cartel has market power but not
as like in monopoly.

OPEC-Organization of Petroleum Exporting Countries was set up in 1973. The

behavior of OPEC provides an example of cartelization of an industry that
contained a large number of competitive firms most of which were price-
takers. Before 1973, the oil industry was not perfectly competitive. There was
several oil producing countries, so no country by withholding his output in the
market influences the prices. But OPEC attracted attention in 1973 when its
members voluntarily agreed to restrict their outputs by negotiating quotas for
the first time. During 1973, OPEC countries accounted for about 70 percent of
the world oil exports. As a result of this output restriction, OPEC countries
succeed in raising prices of oil in the world market.

OPEC exports were about 31 million barrels per day in 1973. And in order to
raise prices from $3.37 per barrel to an average of $11.25 a barrel, exports had
only to be rusticated to 28.5 million barrels per day. So a reduction in OPEC’s
exports of less than 10 percent was sufficient to more than triple the world
price.
The higher prices were maintained for the remainder of the decade. And as a
result there is a tremendous increase in the wealth of the OPEC countries.
OPEC’s policy was successful because of several reasons-

I. The member countries of the OPEC provided a large proposition of

the total world supply i.e. nearly 70 % of the world’s supply of crude oil.
II. Non OPEC countries were not able to increase their supplies in
response to price increase.
III. The world demand for crude oil was relatively inelastic in the short
run.

OPEC as a Successful Cartel

How OPEC was successful in restricting output and influencing prices is
shown in Figure 1. Price is measured on X-axis and quantity on Y axis. Sw is
the world supply curve. SN is the non OPEC supply curve of oil. S’wis also the
world supply curve after fixation of production by OPEC. PW is the world
price. And DD is the world’s demand curve for oil.
When the OPEC countries were prepared to supply all that was demanded at
the world price PW, the world supply curve was SW. The world’s supply cuts
the world’s demand curve for oil DD at point E. At price PW, the total quantity
of oil produced is OQ out of which OQ1 was produced by non- OPEC
countries and Q1Q [OQ- OQ1] by OPEC.
 Figure:1

Now suppose OPEC by fixing its production quota, OPEC shifted the world
supply curve to S’W. And the horizontal difference between SN and S’W
shows the production by OPEC. Now the new world supply curve S’W
intersects demand curve DD at E1. The new world higher price is now P’W. At
price P’ W, the total quantity of oil produced is OQ2 out of which OQ3 is
produced by non-OPEC and Q3 Q2 [OQ2-OQ3] by OPEC.

As a result, with higher prices OPEC increased its oil revenues. Though there
was decline in the sale by the OPEC countries but price rises more than a fall
in sales. Non-OPEC countries also gain because they were also selling at new
higher world price.
(ii) Price Leadership
Price leadership is an important form of Collusive oligopoly. Under price
leadership, the leader firm sets the price and other firms follow it. The price
leader firm has major share of total sales, and a group of smaller firms supply
the remainder of the market. The large firm acts as a dominant firm which sets
a price that maximizes his own profit. The other firms have no option but to
take the price set by the dominant firm as given and maximize their profits
accordingly. These other firms have very small share of total sales, so
individually other firms would have very little influence over the price. Thus,
other firms act as perfect competitors and take price decided by dominant firm
as given. Now let us take the case of dominant firm and see how it sets the
price to maximize its profit.
When leader firm maximizes its profit it takes into account how the output of
the other firms depends on the price it sets. It is shown in figure 2.

Figure:2
In the figure, price is measured on Y-axis and quantity on X- axis. D is the
market demand curve which is negatively sloped. SS is the supply curve which
is the aggregate marginal cost curve of the follower firms. DD is the demand
curve of dominant firm. The demand curve of the dominant firm is the
difference between market demand and the supply curve of followers firm. At
price OP1,the market demand is equal to the supply by the followers firm, so
the dominant firm can sell nothing at this price. At price OP2 or less, the
follower firm will not supply any good. So, at price OP2 or less the dominant
firm faces the market demand curve D. And between prices OP2 and OP1, the
dominant firm faces the demand curve DD. Corresponding to demand curve
DD faced by the dominant firm, the dominant’s firm is facing marginal
revenue MRD. MCD is the marginal cost faced by the dominant firm. The
dominant firm in order to maximize profit should produce a level of output
where marginal revenue is equal to marginal cost. The dominant firm is
maximizing profit at point E where marginal revenue is equal to marginal cost.
The equilibrium price is OP* and the equilibrium quantity produced by the
dominant firm is OQD. At this price, follower firms sell a quantity OQS. The
total quantity that is sold at price OP* is OQT which is the sum of the quantity
produced by dominant firms (OQD) and the quantity produced by the small
firms (OQs).

10.4 NON-COLLUSIVE MODEL

(i) Cournot Duopoly Model

Augustin Cournot, a French Economist, published his theory of duopoly in
1938. We begin with a simple model of duopoly where two firms are
competing with each other. It is assumed that the products produced by the two
firms are homogeneous and they are aware of the market demand curve. The
market demand curve is assumed to be linear i.e. straight line. Each firm need
to decide how much to produce and two firms are taking their decisions at the
same time. It is also assumed that cost of production is taken as zero. It is only
the demand side that is considered. It is also assumed that each firm believes
that the rival firm will keep its output constant regardless of its action and their
effect upon the market price of the product. In other words, each firm treats the
output level of its competitors as fixed and then decides how much to produce.
It is shown in figure 3.

In figure 3, price is measured on X-axis and quantity on Y-axis. We are taking

a special case of duopoly where two firms are competing with each other. The
demand curve faced by the two rival firms is the straight line DD1. The total
output that both firms produce is OA+AD1=OD1.The maximum output
produced by firm 1 is OA and by firm 2 is AD1. When the total output OD1 is
offered for sale in the market then the market price is zero. We are assuming
that there is no cost of production. Let us suppose that firm 1 starts the business
first and then followed by firm 2. Firm 1 would behave like a monopolist as he
is starting first. Firm 1 will produce maximum output OA to maximize profit.
The price is OP that is charged by firm 1 to produce OA units of output. Firm1
is facing no cost of production so its entire revenue would be its profits. The
profit that is earned by firm1 by producing OA units of output is OAEP. Now
suppose firm 2 also enters the market and starts operating his business. Firm 2
knows that firm 1 is already operating in the market and producing OA units of
output. Firm 2 believes that firm 1 will continue to produce OA units of output
irrespective of what output he decides to produce. So, the firm 2 can take ED1
portion of the demand curve and produce half of AD1 units of output. Firm 2 is
now producing AB units of output. The total output that is produced by firm 1
and firm 2 is OA+AB=OB. The new price would be OP1 which is less than the
price that is charged by firm 1 when he is the only firm that is operating in the
market. The total profits earned by both firms are OBCP1. This profit OBCP1
that is earned by both firms is less than OAEP. Out of OBCP1 total profits,
profits earned by firm 1 are OAFP1 and profits earned by firm 2 is AFCB.
Figure: 3
The profit earned by firm 1 is reduced from OAEP to OAFP1 as firm 2 is
producing AB units of output. Now firm 1 assumes that firm 2 will continue to
produce AB units of output, the best that firm 1 can do is to produce half of
(OD1-AB). Now that firm 2 has been surprised by the reduction of output
produced by firm 1 and his reduced share of profits in comparison to firm1, he
will reappraise his situation. This process of adjustment and readjustment by
each producer will continue, firm 1 being forced gradually to reduce his output
and firm 2 being able to increase his output gradually until each is producing
the same amount of output equal to one third of OD1 units of output.
Throughout this process each firm assumes that the other firm will keep its
output constant irrespective of what he decided to produce.
The profit earned by firm 1 is reduced from OAEP to OAFP1 as firm 2 is
producing AB units of output. Now firm 1 assumes that firm 2 will continue to
produce AB units of output, the best that firm 1 can do is to produce half of
(OD1-AB). Now that firm 2 has been surprised by the reduction of output
produced by firm 1 and his reduced share of profits in comparison to firm1, he
will reappraise his situation. This process of adjustment and readjustment by
each producer will continue, firm 1 being forced gradually to reduce his output
and firm 2 being able to increase his output gradually until each is producing
the same amount of output equal to one third of OD1 units of output.
Throughout this process each firm assumes that the other firm will keep its
output constant irrespective of what he decided to produce.
(ii) Stackelberg Model

The stackelberg model is named after the German economist Heinrich Freiherr
von Stackelberg who published Market Structure and Equilibrium in 1934
which described the model. The Stackelberg leadership model is a strategic
game in economics in which the firm moves first and then the follower firms
move sequentially. In this model, suppose firm 1 sets its output first, and then
followed by firm 2 after observing firm1’s output , makes its output decision.
Firm 1 before setting output must consider how firm 2 will react. The
stackelberg model is different from Cournot model where neither firm has any
opportunity to react. The Stackelberg and Cournot models are similar because
in both models competition is based on quantity.
 Figure: 4
However the first move gives the leader in Stackelberg a crucial advantage.
The very important assumption in the stackelberg model is perfect information.
The follower must observe the quantity chosen by the leader, otherwise the
model would reduce to Cournot. The aggregate Stackelberg output and
consumer surplus is greater than the aggregate Cournot output. And the
Stackelberg price is lower than the Cournot price.
In figure 4, BR1 and BR2 are the best response curves. The frown-shaped
curves are firm1’s isoprofits. Point N is the Nash equilibrium where two
reaction curves intersect each other. The Stackelberg equilibrium point is S, the
point at which the highest isoprofit for firm 1 is reached on firm 2’s best
response function. At point S, firm 1’s isoprofit is tangent to firm 2’s best
response function. If firm 1 cannot commit to its output, then the output
function unravels, following the arrow from S back to C.

(iii) Bertrand Model

The bertrand model was formulated in 1883 by Bertrand in a review of Antoine
Augustin Cournot’s (1838) book in which Cournot had put forward the
Cournot Model. According to Cournot, firms compete with each other and
choose quantities, the equilibrium outcome would result in prices which are
more than marginal cost. According to Bertrand if firms choose prices rather
than quantities, then the competitive outcome would occur with price equal to
marginal cost.
The Bertrand model assumes that products produced by firms are
homogeneous. Suppose that two duopoly firms are competition by
simultaneously choosing a price instead of quantities. We know that products
produced by firms are homogeneous then the consumer will only purchase
from the lowest price seller. If the two firms charge different prices, the lower
price firm will supply the entire market and higher priced firm will sell
nothing. The entire market is covered by lowest price seller. If both firms
charge the same price then the consumers would be indifferent as to which firm
they buy from. In this case we may assume that each firm would supply the
market equally. The Nash equilibrium is the competitive output because of
incentive to cut prices.
(iv) Kinked Sweezy Model

The two seminal papers on kinked demand were written nearly simultaneously
in 1939 on both sides of the Atlantic. Paul Sweezy of Harvard College
published "Demand under Conditions of Oligopoly”. According to Sweezy, an
ordinary demand curve does not apply to oligopoly markets and promotes a
kinked demand curve. The price rigidity is the basis of the “kinked demand
curve” model of oligopoly.
 Figure: 5

According to Sweezy, each firm faces a demand curve kinked at the currently
prevailing price say P*. Any price above (below) P*, the demand curve is
elastic (inelastic). It implies that if the firm raises its price above P*, other
firms would not follow him and as a result it would lose sales and market
share. On the other hand, if the firm lowers its price below P*, other firms
would follow him else they would lose market share. Thus, an ordinary
demand curve does not apply to oligopoly markets and promotes a kinked
demand curve.
10.5 SUMMARY

An oligopoly is an industry characterized by few dominant firms. Oligopoly is

said to prevail when there are few firms in the market producing or selling a
product. Oligopoly is also referred to as “competition among the few”. A
special case of oligopoly is duopoly where two firms are competing with each
other.Under oligopoly each firm has enough market power to prevent itself
from being a price taker but each firm is facing inter firm rivalry which is
preventing it to consider the market demand curve as its own demand curve.
Competition among oligopolistic firms is so severe those economists call it as a
‘cut-throat competition’.

Economists have developed a large number of models by taking different

assumptions regarding the behavior of the oligopolistic firms (that is, whether
they would cooperate or compete with each other), regarding the objective they
seek to achieve (that is , whether they seek to maximize profit, joint profit,
sales etc) and regarding different reaction patterns of the rival firms to price
and output changes by one firm. The collusive models are cartel: profit sharing
and market sharing and Price Leadership. On the other hand, the non collusive
models are Cournot model, Stackelberg model, Bertrand model and Kinked
Sweezy model.

In collusive oligopoly, cartel is an organization created from a formal

agreement between groups of producers of a good or service to regulate the
supply in an effort to regulate prices. Under cartel, producers or countries act
together as a single producer and by controlling production and marketing
influencing the prices. Whereas in non collusive models firms are competing
with each other by choosing prices, quantities etc.
UNIT 11: GAME THEORITIC MODELS

STUCTURE
11.1 Learning Outcomes
11.2 Introduction
11.3 Oligopoly as a Game
11.4 Game Theory applied to Oligopoly
11.5 Prisoner’s Dilemma
11.6 Summary

11.1 LEARNING OUTCOMES

After studying this module, you shall be able to

 Know the concept of Oligopoly
 Understand Nash equilibrium
 Know the concept of games
 Know how the concept of game theory can be applied to
Microeconomics.

11.2 INTRODUCTION

An oligopoly is an industry characterized by few dominant firms. Oligopoly is

said to prevail when there are few firms in the market producing or selling a
product. Oligopoly is also referred to as “competition among the few”. A
special case of oligopoly is duopoly where two firms are competing with each
other. Under oligopoly each firm has enough market power to prevent itself
from being a price taker but each firm is facing inter firm rivalry which is
preventing it to consider the market demand curve as its own demand curve.
Competition among oligopolistic firms is so severe those economists call it as a
‘cut-throat competition’.
All the firms under oligopoly industry are behaving strategically. But when
firms are behaving strategically, the oligopolistic firm faces a basic dilemma
i.e.
(i) To cooperate with other firms or
(ii) To compete with other firms.

When an oligopolistic firm is cooperating with other firms, it gives rise to

cooperative solution but if firms compete with each other, it gives rise to non-
cooperative equilibrium.
i. The Cooperative Solution: If the firms in an industry cooperate
among themselves to produce the monopoly output then they can maximize
their joint profits. The cooperation among firms may be either tacit or formal.
A formal cooperation among firms is one when all the firms under oligopolistic
industry after consultation and discussion agree to observe certain rules of
conduct with respect to price, output etc. This formal cooperation is also
known as collusive oligopoly. On the other hand, the tacit cooperation among
firms occurs when all the firms under oligopolistic industry without
consultation and discussion have developed some understanding between them
and pursues a uniform policy with regard to price,

output etc. So, if the firms tacitly or formerly cooperate they will reach
to a cooperative solution.

ii. The Non-Cooperative Equilibrium or Nash Equilibrium: The non-

cooperative equilibrium is an equilibrium that is reached by firms when they
proceed by calculating only their own gains without cooperating with others. It
is called non-cooperative equilibrium or a Nash Equilibrium.
The concept of Nash equilibrium was first explained by Mathematician John
Nash in 1951 and received the Nobel Prize in Economics for his work. Nash
Equilibrium in which each firm’s best strategy is to maintain its present
behavior, given the present behavior of the other firms. The concept of Nash
equilibrium is widely used in game theory.

11.3 OLIGOPOLY AS GAME

In 1994, Mathematician John Von Neumann and Economist Oskar

Morgenstern published a work in which they analyzed a set of problems or
games in which two or more people pursues their own interests and in which
no one of them can dictate the outcome. In an oligopolistic market, each
individual firm is faced with a problem of choosing rational course of action
from many possible actions while keeping in view the possible reactions of his
rivals whose counter moves would affect him. Game theory analyzes the
oligopolistic behavior as a series of strategic moves and reactive counter moves
among rival firms. A strategy is a course of action which a player in a game
will choose during the play of the game. Players are choosing strategies
without knowing with certainty what strategy its rival is going to play. Here it
is assumed that firms are anticipating rival reactions. Each player’s aim is to
maximize their own payoff by choosing specific actions, but the actual
outcome also depends upon what other players are doing. The payoff matrix
shows the profit of each players given its decision and the decision of its
competitors.

Types of Games: In normal (or strategic) form games, players are moving
moves simultaneously whereas in extensive form games, players are moving
moves in some order overtime. ‘One shot’ game is a game that is played only
once and super game that is repeated an infinite number of times.
11.4 GAME THEORY APPLIED TO OLIGOPOLY

When game theory is applied to oligopoly, the players are firms, their game is
played in a market, their strategies are their price and output decisions and their
payoffs are profits. Let us explain the concept of equilibrium with the help of
an example.
We are taking the case of two firms who are producing a homogeneous product
and each firm has two possible strategies i.e.
 Each firm can produce an output equal to one half of the monopoly
output (the passive strategy) and jointly sharing the monopoly profit.
 Each firm can produce an output equal to two-third of the monopoly
output (the aggressive strategy).

The strategic form of the game can be written as:

Players: There are two players- Firm A and Firm B.
Game: Botha and B is producing output in the market.
Strategy: Each firm can produce an output equal to either one-half of the
monopoly output or two thirds of the monopoly output.
Payoff Matrix: Profit of each firm given its decision of its competitors.
The Payoff Matrix is given in Table 1.
In Table 1, the figure in the four boxes show the profit of firm A and firm B.
Let us explain these payoffs.

 The upper left hand corner of the payoff matrix tells us that if both
firms are producing one-half of the monopoly output, both firms would
make a profit of Rs 20 each.
 The upper right hand corner tells us that if firm B produces one half of
monopoly output and firm A produces two-third of monopoly output,
firm B would make a profit of Rs 15 and firm A Rs 22.
 The lower left hand corner tells us that if firm B produces two-third of
monopoly output and firm A produces one-half of monopoly output,
firm B would make a profit of Rs22 and firm A Rs15.
 The lower right hand corner tells us that if firm B produce two-third of
monopoly output and firm A also choose to produce two-third of
monopoly output, both would make a profit of Rs17 each.
Now the question is what the two firms would do to i.e. to cooperate with each
other or compete with each other. The possible solution could be:
i. The Passive (or Cooperative) Solution: If both firms cooperate with
each other i.e. both are producing one-half of the monopoly output then they
both are getting a profit of Rs 20 each. Under cooperative solution both are
jointly producing the monopoly output and sharing profit equally among them.
The cooperative solution is achieved by playing strategy (one half monopoly
output, one half monopoly output).

ii. The Aggressive (Non-Cooperative) or Nash Equilibrium: Nash

Equilibrium is the equilibrium where each firm is doing the best it can give
what its competitors are doing and each firms proceed by calculating only their
own gains without cooperating with others.
Definition: A strategy 𝑠𝑖∗is a best response to a strategy vector 𝑠−𝑖∗ of the
other player if
(𝑠𝑖∗,𝑠−𝑖∗)≥𝜋(𝑠𝑖,𝑠−𝑖∗)For all𝑠𝑖.
Here 𝑠𝑖∗ is a “dominant strategy” in the sense that it is a best strategy to play
provided the other players do in fact play the strategy combination𝑠−𝑖∗. There
must be a condition to ensure that player i is correct in his inference that the
other players are correct in their inferences. This gives us the following
definition.
The strategy vector 𝑠∗=𝑠1∗,2∗,……….,𝑠𝑛∗ is a Nash equilibrium if
(𝑠𝑖∗,𝑠−𝑖∗)≥𝜋(𝑠𝑖,𝑠−𝑖∗)For all 𝑠𝑖 and all𝑖.

There is one Nash equilibrium in Table 1. The best decision for each firm is to
produce two-third of the monopoly output where each firm is earning a profit
of Rs 17. Here neither firm has an incentive to depart from this position except
through cooperation with the other firm. In any other cell each firm has
incentive to change its output, given the output of the other firm. In Table 1,
suppose if firm A chooses to produce one half of the monopoly output then
firm B would choose to produce two-third of the monopoly output. This is so
because the profit earned by firm B when producing two-third of the monopoly
output is Rs 22 which is more than Rs 20 (when producing one half of the
monopoly output).

But if firm A choose to produce two-third of the monopoly output then firm B
would also choose to produce two-third of the monopoly output as it is giving a
profit of Rs 17 which is more than Rs 15 (when he is producing one half of the
monopoly output). So there is one Nash Equilibrium when both firms are
producing two-third of the monopoly output. Neither firm has an incentive to
depart from this position.

iii. Strategic Behavior: When each firm is behaving strategically i.e. choosing
its optimal strategy taking into account what the other firm may do, we attain
Nash equilibrium. What would firm A would do if it knows what firm B is
doing? Firm B can do two thing i.e. either he can produce one half of the
monopoly output or two third of the monopoly output. First, suppose firm B is
producing one half of the monopoly output then what would be the best
decision for firm A. When firm B is producing one half of the monopoly output
and firm A also chooses the same then firm A will get a profit of Rs 20. But if
firm A chooses to produce two-third of the monopoly output then firm A will
get a profit of Rs 22.Secondly, suppose firm B is producing two third of the
monopoly output and firm A also chooses the same then firm A will get a
profit of Rs 17 But if firm A chooses to produce one half of the monopoly
output then firm A will get a profit of Rs 15.In either case, the best strategy for
firm A is to produce two-third of the monopoly output. Aggressive behavior is
the dominant strategy. A dominant strategy is a strategy that is best no matter
what the rival does. In this game, both firms have a dominant strategy which is
to produce two-third of the monopoly output. Firm B will reason in the same
way. So, as a result both end up by jointly producing one and third times the
monopoly output and earning a profit of Rs 17.

iv. Break Down of Cooperation: Nash equilibrium is attained when

firms are behaving strategically but then why tacit cooperation tends to break
down. Suppose both firms are cooperating with each other and producing one-
half of the monopoly output and earning a profit of Rs 20 each. If firm A
cheats by increasing its output its profit will increase but firm B’s profit will
decline.

This behavior of firm A drives down the price in industry so firm B earns less
from its unchanged output. This cheating by firm A causes a fall in the joint
profits by taking firms away from the joint maximizing monopoly output. So
firm B’s profits would fall by more than the rise in firm A’s profit.
The similar consideration also applies to firm B, so both firms A and B have an
incentive to depart from the joint profit maximizing level of output. So when
either firm does depart from the joint maximizing output, the other has an
incentive to do so as well. When each follows this selfish strategy, they reach
towards non-cooperative equilibrium which has profits lower than that at the
cooperative solution. At the non-cooperative equilibrium both firms are jointly
producing one and a third times of monopoly output.
11.5 PRISONER’S DILEMMA

Here in this section we study the prisoner’s dilemma game where the non-
cooperative equilibrium makes both players worse-off than if they were able to
cooperate. The problem with the Nash equilibrium is that it does not
necessarily lead to Pareto efficient outcomes. Suppose there are two persons,
prisoner A and prisoner B and both have been caught for committing a bank
robbery. In order to procure confession from them, they are interrogated
separately so that they cannot communicate with each other. The payoff matrix
for this game is given in table2.

The upper left hand corner of the payoff matrix tells us that if both
prisoners confess the crime, both would get an imprisonment of 5 years each.
 The upper right hand corner tells us that if prisoner A confesses and
prisoner B not confesses then prisoner A would get 10 years of
imprisonment and prisoner B would go free.
 The lower left hand corner tells us that if prisoner A not confesses and
prisoner B confesses, then prisoner A would get no imprisonment and
prisoner B would get 10 years of imprisonment.
 The lower right hand corner tells us that if prisoner A not confesses a
crime and prisoner B also not confesses than both get 8 years of
imprisonment each.
Here each prisoner faces an uncertainty regarding how the other person will
behave i.e. whether he will confess or not confess. So each person has to make
an independent choice whether to confess or not to confess a crime.
Prisoner A reasons as follows

First: If prisoner B confesses a crime, and prisoner A also chooses the same
then prisoner A will get 5 years of imprisonment. But if prisoner A chooses not
to confess then prisoner A will get no imprisonment. Thus, the best strategy of
Player A is not confess a crime. So, person A claimed my best strategy is not to
confess.
Secondly: If prisoner B not confesses a crime and prisoner A also chooses the
same then prisoner A will get 8 years of imprisonment. But if prisoner A
chooses to confess then prisoner A will get 10 years of imprisonment. Thus,
the best strategy of Player B is not confess a crime. So, person B claimed my
best strategy again is not to confess. Prisoner B will also reason in the same
way. As a result they both end up by not confessing a crime and getting 8 years
of imprisonment. This is the Nash Equilibrium. But if they had been able to
communicate with each other, they would both have confessed the crime and
get 5 years of imprisonment. Once again, the non-cooperative equilibrium
makes both prisoners worse off than if they were able to cooperate i.e. if both
are making decisions they end up by not confessing a crime.

11.6 SUMMARY

An oligopoly is an industry characterized by few dominant firms. Oligopoly is

said to prevail when there are few firms in the market producing or selling a
product. Oligopoly is also referred to as “competition among the few”. When
an oligopolistic firm is cooperating with other firms, it gives rise to cooperative
solution but if firms compete with each other, it gives rise to non-cooperative
equilibrium. If the firms in an industry cooperate among themselves to produce
the monopoly output then they can maximize their joint profits. The
cooperation among firms may be either tacit or formal. A formal cooperation
among firms is one when all the firms under oligopolistic industry after
consultation and discussion agree to observe certain rules of conduct with
respect to price, output etc. This formal cooperation is also known as collusive
oligopoly. On the other hand, the tacit cooperation among firms occurs when
all the firms under oligopolistic industry without consultation and discussion
have developed some understanding between them and pursue a uniform
policy with regard to price, output etc. So, if the firms tacitly or formerly
cooperate they will reach to a cooperative solution. The non-cooperative
equilibrium is an equilibrium that is reached by firms when they proceed by
calculating only their own gains without cooperating with others. It is called
non-cooperative equilibrium or a Nash Equilibrium.

In an oligopolistic market, each individual firm is faced with a problem of

choosing rational course of action from many possible actions while keeping in
view the possible reactions of his rivals whose counter moves would affect
him. Game theory analyzes the oligopolistic behavior as a series of strategic
moves and reactive counter moves among rival firms. A strategy is a course of
action which a player in a game will choose during the play of the game.
Players are choosing strategies without knowing with certainty what strategy
its rival is going to play. Here it is assumed that firms are anticipating rival
reactions. Each player’s aim is to maximize their own payoff by choosing
specific actions, but the actual outcome also depends upon what other players
are doing. The payoff matrix shows the profit of each players given its decision
and the decision of its competitors. We have seen how under the prisoner’s
dilemma game the non-cooperative equilibrium makes both players worse-off
than if they were able to cooperate. The problem with the Nash equilibrium is
that it does not necessarily lead to Pareto efficient outcomes.