The concept of interdependence in oligopolies

In oligopolistic markets, a small number of firms dominate, and their actions are closely linked. This interdependence means that each firm's decisions, such as on pricing or output, are influenced by how competitors might respond, making strategic planning complex.

Key features of interdependence

• Mutual influence - A change in one firm's strategy, like altering prices, prompts reactions from rivals, affecting market outcomes for all.
• Strategic decision-making - Firms must anticipate competitors' moves, often leading to models like the kinked demand curve or game theory to predict behaviour.
• Market implications - This can result in price stability or aggressive competition, depending on how firms perceive and react to each other's actions.

The kinked demand curve model and price stability

The kinked demand curve model explains why prices often remain stable in competitive oligopolies, despite interdependence among firms. It highlights how firms' reactions to price changes create a demand curve with a distinctive shape, discouraging price adjustments.

Assumptions of the kinked demand curve model

• Price increases - If one firm raises its price, competitors do not follow, leading to a significant loss of customers to cheaper rivals. Demand becomes price elastic above the current price.
• Price decreases - If one firm lowers its price, competitors match it to avoid losing market share, resulting in minimal gain for the initiator. Demand becomes price inelastic below the current price.

Structure of the kinked demand curve

The model produces a demand curve with a kink at the prevailing price and output level:

• Elastic section - Above the kink, the curve is relatively flat, showing a large drop in quantity demanded if prices rise.
• Inelastic section - Below the kink, the curve is steeper, indicating little increase in quantity demanded if prices fall.

This shape means firms lose revenue whether they increase or decrease prices, promoting long-term price stability.

Consequences for oligopolistic firms

• No incentive to change - Raising prices leads to lost market share without matching from rivals, while lowering prices fails to expand share but reduces overall revenue.
• Prolonged stability - Prices often stay constant for extended periods, even in competitive environments, as firms avoid triggering unfavourable reactions.

Limitations of the kinked demand curve model

While useful, the kinked demand curve model does not apply universally to all oligopolies, as its assumptions may not hold in every scenario.

Reasons the model may not fit all markets

• Inaccurate assumptions - Not all oligopolies follow the pattern where rivals ignore price rises but match cuts; some may collude or react differently.
• Limited explanatory power - It describes price stability in specific cases but fails to predict behaviour in markets with different dynamics, requiring alternative models for better analysis.
• Narrow focus - The model addresses one aspect of interdependence, overlooking factors like non-price competition or varying market conditions.

Game theory and its application to oligopolies

Game theory provides a mathematical framework for analysing strategic interactions in oligopolies, where firms' outcomes depend on mutual decisions.

Core principles of game theory

• Player interdependence - Firms act as players, each choosing strategies (e.g., output levels) while considering rivals' potential responses.
• Outcome analysis - It examines scenarios where decisions lead to varying payoffs, helping predict behaviour in competitive settings.
• Economic relevance - Widely used in economics to model situations like pricing wars or output choices, where self-interest drives actions but collective results matter.

Applications to oligopolistic markets

• Predicting strategies - Helps firms anticipate rivals' moves, such as in decisions on advertising or product launches.
• Payoff evaluation - Outcomes are often shown in matrices, illustrating profits or losses from different strategy combinations.

The prisoners' dilemma and first-mover advantage

The prisoners' dilemma illustrates interdependence through a scenario where two firms decide on output levels, revealing the tension between cooperation and self-interest. It demonstrates how first-mover advantage can destabilise agreements.

Setup of the prisoners' dilemma in oligopolies

Two firms (A and B) choose between high or low output, knowing their profits depend on the other's choice. Results are summarised in a payoff matrix showing profits for each combination:

If both choose low output, each earns moderate profits (e.g., 190), avoiding market flooding.

Analysis of decisions and first-mover advantage

• Incentive to cheat - A firm gains higher profits (e.g., 310) by switching to high output while the rival stays low, but if both switch, both suffer losses (e.g., -90).
• First-mover advantage - The first firm to increase output secures a temporary edge, but this risks retaliation, showing why cooperative agreements like cartels often break down.
• Strategic implications - Firms may prefer low output for mutual benefit, but fear of being undercut leads to instability.

Potential disadvantages of being the first mover

While first-mover advantage can yield benefits, it carries risks, especially in innovative or uncertain markets:

• High risk of failure - Launching first, such as with a new product, may result in losses if demand is overestimated or technology proves flawed.
• Competitor benefits - Rivals can learn from the pioneer's efforts, adopting similar technologies at lower cost and undercutting prices.
• Market uncertainty - Early movers bear development expenses without guaranteed rewards, potentially allowing later entrants to dominate with refined strategies.