The kinked demand curve model states that businesses might reach stable profit maximising equilibrium at price P and output Q with a small incentive to alter prices. Furthermore the model predicts the periods of relative price stability under an oligopoly with businesses focusing non-price competition to increase their supernormal profits. Even in this model price wars can occur, so that a firm gets an advantage in the short term over the other firms and gains some extra market shares. Recently the major UK supermarkets had this kind of competition war.
Another prediction which allows the kinked demand curve is, that changes in variable cost might not lead to a rise or fall in the profit maximising price and output. In figure 2 it is assumed that a rise in cost such as raw material prices leads to an upward shift in the marginal cost curve from MC1 to MC2. The equilibrium price and output though remains still at Q. If the costs are again rising, the marginal cost curve would even reach MC3 (upper 2), although this would then lead to a change in output as well as in price.
However this model is mainly only a theory with limited real-world evidence.
More important is the non-price competition under oligopolies. These are advertising methods and strategies to increase demand and develop brand loyalty among consumers. Some of these strategies include longer opening hours for retailers, discounts on product upgrades, better quality of the service and contractual relationship with suppliers, which means that a few top firms make an agreement to increase their firms’ output. Here advertising is also very well-known as millions of euros, pounds and dollars are pumped in persuasive advertising, which mostly leads to an outward shift in demand and consumers are willing to pay more for each unit consumed. This type of strategy is also needed for opening a new business, to make the people get to know the new product and more important the new brand in the market.
Although this all is very useful a sometimes even more important component are price collusion in oligopolies. One major type is tacit collusion. Hereby is meant if there is one leading firm, which establishes new prices, usually other firms will accept these new prices and adopt them. This is known as price leadership. There the price leader will tend to set the price high enough that the least cost-efficient firm in the market may earn returns above the competitive level. Examples are major mortgage lenders and petrol retailers. Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting. So when a market is dominated by a few large firms, there is always the potential for businesses to seek reduce uncertainty and engage in collusive behaviour. When this occurs, existing firms are forming price fixing cartels, which is in most countries deemed illegal, although it is hard to prove that a group of firms have deliberately joined together to change the market circumstances to their advantage.
Collusion is often explained through the greed to achieve joint-profit maximisation or to prevent price and revenue instability. Therefore price fixing gets introduced, so that suppliers can control the supply and fix the prices close to the price levels of monopoly concepts. To collude on price, producers must be able to exert some control over the market supply. In figure 4 it is show that a producer cartel is assumed to fix the cartel price at price Pm. Here there might be an output quota to distribute the cartel’s output.
In contrast the individual firm’s output quota is unlikely to be at the profit maximising point, because for any one firm expanding output and selling at a price that slightly undercuts the cartel price, extra profits can be achieved. The problem here is that it shouldn’t be to such an extent that every firm is doing that with the result of excess supply in the market and a fall in price.
Furthermore there are a few circumstances, which make it easier for firms in a market to collude. The market demand shouldn’t be too variable and only a small, limited number of firm are in the industry, the demand should be fairly inelastic, each firm’s output can be easily monitored and the information are incomplete. In turn there are also factors, which could be reasons for cartels break-downs. So if there is a falling demand and successful entry of non-cartel firms into the industry, the exposure of illegal price fixing by market regulators and if there are enforcement problems, it is very likely that cartels won’t exist for a long time period. One of the most recent cartels was pricing by tobacco firms in 2008.
Despite all that Oligopolies are representing a problem in which decision makers must select strategies to be flexible to the responses of their rivals, which can only be predicted. A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes these possible actions into account is called a strategic choice. Here is one major term the important factor of all predictions and actions. This term is called Game theory, which is an analytical approach through which strategic choices can be assessed.
This game theory analysis has a direct relevance to the study of the conduct and behaviour of firms in oligopolistic markets. An example would be money invested in research and development. If one firm will spend loads of money on the development of their product, the other firms have to follow them in their behaviour, because otherwise it could be, that they are becoming less competitive over a longer time period. On the other hand, it could be that the investment on development didn’t pay off, so that this firm made a loss at the end, therefore in game theory is always a risk to win high or lose. This is also shown in the example with the development investment, because if all firms now want to spend their money on development and there are only a few patents available, it could again end that only one firm, which optimised their product successfully would gain more returns and the other firms would be worse off than before. So it all depends on the reactions from others on actions from one.
The classic and most famous example for game theory is called the prisoners’ dilemma. This is a situation where two prisoners are being asked, whether they are guilty or innocent about a crime. Here they have the choice to either confess that they are guilty, to deny everything or to blame the partner to be guilty. Their actions will have different reactions and consequences. Both prisoners have to predict their partners reactions and then have to decide what they are doing – confess or deny. In this situation the pay-off is measured in terms of years the prisoners arising from their choices, which is summarised in the table below. There exists no communication between the prisoners and both are in separate rooms. They both have to take into account each others’ likely behaviour.
Again as in the example of the firms, here the prisoners can take the risk, that both are denying everything, so win high, but they can also lose when one of them confesses and the other one denies.
The equilibrium for both happens when each player takes a decision to maximise their outcomes. Here the best outcome would be when they either both confess or deny the crime, so when they work together – collusion. The problem is only, that both have an incentive to cheat and if they take just the best possible action for themselves they will have the worst outcome, but the dominant strategy for both prisoners’ unique best strategy is regardless of the other players’ action, therefore they selfishness will have the worst outcome for both at the end and both have to be 10 years in prison.
In the classic prisoner’s dilemma both have chosen the best for them and instead of cooperating together with the best outcomes, they have decided to follow their own interests with the consequence of bad outcomes. If we now apply the game theory to real business decisions, we can use the example of 2 firms with different output outcomes when different decision been made.
Here the reward for both firms choosing to limit supply and thereby keep the price high is that each of them earns $10m. In turn if they would just follow their own interests again, each of them would gain only $5m. If they will both decide for having a high output, the consequence will be less revenue – this example illustrates the breakdown of price-fixing agreements, which can lead to price wars.
The game theory once again analysis the behaviour of both parties, to evaluate the risk of the actions from one firm and the consequences of the reactions from the other firm. As a conclusion sentence it could be said that everything in oligopolies depend on the prediction of the firms’ likely behaviour and through which concept they might react. This means whether they will have a collusion and work together for greater outcomes or price wars to prevent, that the other firm will be more competitive than they are.