Economics Micro & Macro (CliffsAP)

Oligopolies

Oligopoliesare interdependent, meaning that each firm takes into account and reacts to what its rivals are doing. Rivalry
and competition can be intense in an oligopolistic market. Because of a variety of behavior, the safe way to label an
oligopolistic firm’s behavior is strategic.

Strategic behavior occurs when what is best for Y depends on what X does and what is best for X depends on what
Y does. This behavior is such a variable that economists have applied what is called game theoryto an oligopolistic
market. Game theory describes oligopolistic behavior as a series of moves that involve strategy and assumptions.

The Kinked Demand Curve

The law of demand applies to all firms. A firm knows that if it decreases its price, quantities sold should increase. But
the firms in an oligopoly may not know the shape of the demand curve for their product because it depends on the reac-
tion of their rivals. They have to predict how their competitors will react to a price change in order to know what the de-
mand curve will look like.

Consider this example with Coke and Pepsi in the beverage industry. Suppose Coke’s costs have fallen and the company
is deciding whether or not to lower the price of its products. If Coke did not have to consider how Pepsi would respond, it
would lower the price to be sure that the new MC curve intersected the new MR curve. But Coke suspects that lowering
its prices will not reflect a true gain because Pepsi will soon follow with a price adjustment. If Pepsi does lower its price,
the substitution effect will not occur for Coke, thereby eliminating a gain it would have experienced by lowering its price.
Ultimately, Coke’s strategy is to do nothing because a shift in price could trigger long-run inefficiencies.

Figure 10-9 illustrates an oligopolistic firm’s demand curve when firms follow price changes and when they do not fol-
low price changes, respectively.

Figure 10-9

Game Theory

Game theory is a common way of explaining oligopolistic behavior. It examines the strategic moves oligopolies make
in their decisions regarding pricing, output, and advertising.

Q^1 Q^2

Competition Follows Price Change Competitors Who Do Not

Follow A Price Change

D

Quantity Quantity

D

MC

MC^1

P^1

P^1

P^2

Price/Cost Price/Cost

MC^1

MC

MRMR

Part III: Microeconomics