Oligopoly: Pricing and Game Theory

Topics: Pricing, Oligopoly, Economics Pages: 8 (2507 words) Published: August 29, 2013
Key characteristics
The main characteristics of firms operating in a market with few close rivals include: Interdependence
Firms that are interdependent cannot act independently of each other. A firm operating in a market with just a few competitors must take the potential reaction of its closest rivals into account when making its own decisions. For example, if a petrol retailer like Texaco wishes to increase its market share by reducing price, it must take into account the possibility that close rivals, such as Shell and BP, may reduce their price in retaliation. An understanding of game theory and the Prisoner’s Dilemma helps appreciate the concept of interdependence. Strategy

Strategy is extremely important to firms that are interdependent. Because firms cannot act independently, they must anticipate the likely response of a rival to any given change in their price, or their non-price activity. In other words, they need to plan, and work out a range of possible options based on how they think rivals might react. Oligopolists have to make critical strategic decisions, such as: * Whether to compete with rivals, or collude with them.

* Whether to raise or lower price, or keep price constant. * Whether to be the first firm to implement a new strategy, or whether to wait and see what rivals do. The advantages of ‘going first’ or ‘going second’ are respectively called 1st and 2nd-mover advantage. Sometimes it pays to go first because a firm can generate head-start profits. 2nd mover advantage occurs when it pays to wait and see what new strategies are launched by rivals, and then try to improve on them or find ways to undermine them. Barriers to entry

Oligopolies and monopolies frequently maintain their position of dominance in a market might because it is too costly or difficult for potential rivals to enter the market. These hurdles are called barriers to entry and the incumbent can erect them deliberately, or they can exploit natural barriers that exist. Natural entry barriers include:

Economies of large scale production.
If a market has significant economies of scale that have already been exploited by the incumbents, new entrants are deterred. Ownership or control of a key scarce resource.
Owning scarce resources that other firms would like to use creates a considerable barrier to entry, such as an airline controlling access to an airport. High set-up costs.
High set-up costs deter initial market entry, because they increase break-even output, and delay the possibility of making profits.  Many of these costs are sunk costs, which are costs that cannot be recovered when a firm leaves a market, and include marketing and advertising costs and other fixed costs. High R&D costs

Spending money on Research and Development (R & D) is often a signal to potential entrants that the firm has large financial reserves. In order to compete, new entrants will have to match, or exceed, this level of spending in order to compete in the future. This deters entry, and is widely found in oligopolistic markets such as pharmaceuticals and the chemical industry. Artificial barriers include:

Predatory pricing.
Predatory pricing occurs when a firm deliberately tries to push prices low enough to force rivals out of the market. Limit pricing.
Limit pricing means the incumbent firm sets a low price, and a high output, so that entrants cannot make a profit at that price.  This is best achieved by selling at a price just below the average total costs (ATC) of potential entrants. This signals to potential entrants that profits are impossible to make. Superior knowledge

An incumbent may, over time, have built up a superior level of knowledge of the market, its customers, and its production costs. This superior knowledge can deter entrants into the market. Predatory acquisition

Predatory acquisition involves taking-over a potential rival by purchasing sufficient shares to gain a controlling interest, or by a complete...
Continue Reading

Please join StudyMode to read the full document

You May Also Find These Documents Helpful

  • Oligopoly and Game Theory Essay
  • Game Theory Essay
  • Cartel Theory of Oligopoly Essay
  • Game Theory and Oligopoly Fall Essay
  • oligopoly Essay
  • Oligopoly Essay
  • Game Theory Essay
  • Game Theory and Profit Essay

Become a StudyMode Member

Sign Up - It's Free