Oligopoly Pricing: A Game Theory Overview

   Oligopoly pricing behavior has characteristics of a specific game of strategy. Like chess or poker. The best way to play such a game depends on the way opponent play. Oligopolists (in our case players) must pattern their action according to actions and reactions of rivals. The study of oligopolists behave in this strategic situations is called game theory. We will use game theory model to analyze and explain the pricing behavior of oligopolists. Let’s assume that in our oligopolistic market system are only two firms that produce CDs simply called “A” and “B”. Each firms- “A” and “B”- has a choice of two pricing strategies: increase the price or lower it. The profit of each firm depends on what strategy it chooses and what strategy its rival chooses.
   There are four combinations of strategies possible for these two firms, and letter cells in the table below express them. For example, cell W represents low-price strategy of firm “B” and high-price strategy of firm “A”. This table is called payoff matrix because its cells represent the profit(payoff) each firm makes that result from combination of strategies of firms “A” and “B”. Cell W represents that after firm “A” chooses to adopt high-price strategy and firm “B” chooses to adopt low-price strategy, then firm “B” will make 4 million dollars and firm “A” will make only 1 million.

Mutual Interdependence
   The Data in the payoff matrix are just hypothetical one, but relationship is very realistic. Remind the fact that oligopolistic firms can increase their revenues, and influence rival’s profits, by changing its price strategies. Each firm’s payoff depends on its own pricing policy and that of its rival. This mutual interdependence in economics is very well demonstrated by figure above. If both firm “A” and firm “B” adopt a high-price strategy then revenue of each one will be 3 million of dollars. If firm “A” uses a low-price strategy while firm “B” uses a high-price strategy then firm “A” will increase its market share and profit from 3 to 4 million of dollars, however firm “B” will lose 1 million of dollars, since its revenues will decrease from 2 million to 1 million of dollars. So, firm “B” high-price policy will be efficient only if firm “A” will also choose to employ a high-price strategy.
Collusive Tendency
   The figure above suggests that oligopolists will benefit from collusion, or better said cooperation with rivals. An example of benefit can be when both firms are following high-price strategies, so each firm will get a profit of 3 million of dollars (cell X).
   Note that either firm “A” or firm “B” can increase its profit by switching from high-price to lo-price policy. So, the profit can become 4 million of dollars, but the firm that keeps high-price policy will get only 1 million of dollars as revenue. If the firm that right now employs high-price strategy switches to low-price strategy will increase its revenues by 1 million so it will be able to collect 2 million (cell Z). The effect of all this will be switching the profits from 3 million (cell X) to ones which worth 2 million (cell Z).
   In real situation, however independent actions of oligopolists may lead to competitive low-price strategies, which clearly will be beneficial to consumers but not also to oligopolists whose profits will decrease.
   How can oligopolists avoid low-profit outcome of cell Z? They may collude, rather that installing independent and competitive price. Each firm will increase its profits from 2 to 3 million dollars (from cell Z to cell X).
Cheating
   The payoff matrix explains why oligoplists may be tempted to cheat on a collusive agreement. Suppose that our firms “A” and “B” agree to maintain high-price policy, both of them earning 3 million of dollars (cell X). Both firms are tempted to cheat so that they will be able to increase their revenues to 4 million of dollars. If firm “A” cheats and diminishes its prices then it will increase its revenues from 3 to 4 million of dollars (cell Y), while if firm “B” cheats secretly and moves to low-price policy while firm “A” keeps high-price policy then firm “B” will increase its revenues by 1 million of dollars moving from cell X to cell W.

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Pure Monopoly

   Pure monopoly happens when one firm is the single supplier of a product for which there are not substitutes. Some of the main characteristics of pure monopoly are:

• Single Seller– A pure monopoly is an industry in which a sole producer is the single supplier of a specific good or service in this market model.
• No Close Substitutes– A pure monopoly’s product is unique and there aren’t any close substitutes for it, so that consumer has to choose to buy or not to buy the product.
• Price-maker– The pure monopolist controls the quantity supplied of good and service, so that it controls the price.  This kind of firm or industry is called price-maker, unlike pure competitors which are price-taker, because they can’t control the price, since quantity produce by them is very small relative to total quantity output. The pure monopolist confronts downward-sloping curve.  So it can change the product’s price by changing the quantity of good that it produces. The monopolist can use this advantage to maximize its profits.
• Blocked entry– A pure monopolist doesn’t have any competitors because there are some barriers that keep competitors away from entering the industry. These barriers may be technological, economical or some other types, but the fact remains that no other firms may enter in our pure monopoly market.

 There are very rare examples of pure monopoly, but there are examples of some less pure forms of it. In many countries many government-owned or government regulated public utilities (gas, water, electricity) may be monopolies. Also, some professional sport teams are thought to be monopolies, because they are suppliers of unique service in large geographic areas. Examples may serve some major football matches like between Real Madrid and Barcelona in Spain, which serve as representative of large cities in Spain.  In some small towns airline service or train-transport may be pure monopolies if they are represented only by one firm in these regions. Also, in some very small areas banks, pharmacies or theaters may be examples of pure monopolies.

Short Run Production Costs

   Production information must contain resource prices in order to determine total and per unit price of diverse amount of output. It’s known that in short run prices are associated with plant’s variable resources. Its capital resources are limited so we shouldn’t consider them. Short run costs can be either variable or fixed. So let’s describe them:
Fixed Cost: these costs don’t vary with changes in output. These costs must be paid even if the firm doesn’t produce anything. Such costs may be: rental payments, interests of firm’s debts, money paid for insurance. These costs are paid even when the firm has zero output, so firm can’t avoid paying these costs.
Variable Cost:
 These costs vary with the change in output. They include payment for raw material, fuel, wages, transportation prices, fuel etc. These payments vary directly with output. As the production begins variable costs will increase by a decreasing amount, but after a point they will rise by an increasing amounts (as a result of law of diminishing marginal returns) also this reason lies in the shape of Marginal Product (MP) curve, which is increasing with smaller and smaller amounts and when diminishing returns are encountered marginal product begin to decline, so larger and larger amounts of variable resources are needed to produce a successive unit of output. Total variable cost then is increasing by an increasing amount.
Total Cost:
Economists call sum of fixed costs and variable costs as total costs. At zero unit of output total costs are equal with fixed costs. Graphically, amount of vertical Total Fixed Cost (TFC) summed with vertical value of Total Variable Cost (TVC) should result in Total Cost (TC).
For business manager these distinctions between fixed and variable costs are very important. Variable costs can be controlled or changed by changing production levels in short-run. However, fixed costs are beyond control of business manager, because they are included in short run and must be paid regardless the output level. In short run firms can’t get out of industry and leave the market.

 Per-unit and Average Costs:
 Average fixed cost (AFC) is found by dividing total fixed cost by output quantity (Q):

Because Total fixed Cost by definition is the same regardless of output, then AFC curve will decline as output increases,because as output quantity increases Total Fixed Cost (TFC) is spread over a larger output produced. Q≠0.

Average Variable Cost (AVC): for any output quantity (Q≠0) is calculated by dividing Total Variable Cost (TVC) by Quantity output (Q):

As added more variable resources increase output, average variable cost (AVC) declines initially, reach a minimum and then increases again, so AVC curve is U shaped. It can be explained by the fact that AVC (also TVC) curve reflects law of diminishing returns.

  To explain in simple terms, at very low levels of output, production is inefficient because of high-costs and low quantity produced. Initially, since firm is understaffed, average variable cost is relatively high. As output expands greater level of specialization, greater division of labor and better use of firm’s capital occurs. However, when we still add more variable resources, a point is reached when diminishing returns are incurred. Also the firm is being overstaffed so each additional unit of variable resource doesn’t increase marginal product (MP) as before.

ATC
    Average Total Cost (ATC) for any output level is found by dividing Total Cost (TC) by output (Q) or by adding average variable cost (AVC) and average fixed cost (AFC):

Graphically ATC can be found by adding vertically average variable cost (AVC) and average fixed cost (AFC). Q≠0. 

Marginal Cost
  Marginal Cost is the additional cost of producing one more unit of output. Marginal cost can be found by following formula:

Marginal Cost is important for firm’s managers because a firm can control it immediately. It is used to find the cost of production of an additional product, so it helps to save some money if the firm doesn’t produce this unit (because of the loss that may occur at production).

Capital Goods,Specialization…

Technology and Capital Goods
   Market system needs extensive use of capital goods. Supplier’s self-interest, competition, willingness for high-revenue and freedom of choice create a motivation for using technological advantage. In order to have high income an economic unit should grow very fast and have a high efficiency at output production, that’s why suppliers are building capital goods like: machineries, tools that create facilities for goods storage and transportation.
The only way to acquire a high efficiency at production is to rely on roundabout production.

  Division of labour
   Human specialization, which is also called division of labour, contributes society’s output in several ways.

• Specialization helps us to take advantage of our differences. For example one which are better at math will be an accountant, so this person will do his/her job faster than one which is good at writing poems.
• Specialization helps to improve our abilities by doing. If we devote our time to a single task, we will be able to do it faster and more efficient than if we would do multiple actions in the same period of time.
• Specialization saves time. By using all our time to a single task we don’t have losses in time, in contrast to when we shift among more jobs.

Because of this reasons specialization help a society to create more output from the same scarce resources.

   Money
   In economics money has diverse functions, but the most important of them is using it as a medium of exchange. It makes trade easier.
Let’s take a case in which money doesn’t exist. So the only way some countries can exchange their goods is by barter-exchange of one good by another one. But, here some problems arise. One of them is coincidence of wants between demanders and suppliers. Let’s take one case. Country one (excess potatoes, needs carrots), country two (excess carrots, needs apples), country three (excess apples, need potatoes). In this case trade can occur, but what if country three had excess potatoes and demanded apples? For sure, barter would be very difficult or even impossible. That’s why using money is so convenient. One important property of money is that it should be accepted by sellers in exchange for their goods. The fact that different countries have different currencies makes international trade a little bit difficult, but we shouldn’t forget that there are right now currency exchangers that are very useful if we want to buy some goods from a country that has a different currency. Money helps countries to get some amount of goods that are even impossible without international trade, because that point lies outside of PPC.

Key Terms:
Roundabout Production-The construction and use of capital to aid in the produc­tion of consumer goods.
Specializa­tion-The use of the resources of an individual, a firm, a region, or a nation to produce one or a few goods and services.
Division of Labour-Divid­ing the work required to produce a product into a number of different tasks that are per­formed by different workers.
Barter- The exchange of one good or service for another good or service.