Cambridge International as and a level Economics Ebook

Behaviour of oligopolistic firms
Th
e diffi
culty in studying oligopoly is that the behaviour of 
fi rms can follow two diff erent routes – in some industries 
there may be cut-throat competition between aggressive 
fi rms, while in others, there may well be cooperation 
or tacit evidence of collusion. Consequently, just how 
one fi rm actually reacts will depend on how it expects 
competitors to react. All of this means that it is diffi
cult 
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Cambridge International A Level Economics

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to put forward one completely acceptable theory of 
oligopolistic behaviour. Nevertheless, there are two main 
theories that attempt to explain how oligopolists behave. 
Th
ese are the theory of the 
kinked demand curve
and 
game theory as referred to above.
Kinked demand curve: 
a means of analysing the 
behaviour of firms in oligopoly where there is no collusion.
KEY TERM
Oligopolists are price makers. Th
ey have the power to set 
their own prices but what they are unable to gauge is the 
reaction of their competitors. Th
is uncertainty means that 
fi rms may prefer non-price competition in the form of 
branding, customer service, location, range of products 
and so on. Th
e underpinning explanation for this is the 
kinked demand curve (see 
Figure 7.25
). Th
is can be used 
to explain why prices in oligopolistic markets are oft en 
rigid in so far as they are stable for relatively long periods 
of time.
In 
Figure 7.25
, it is assumed that a fi rm is producing at 
price 
P
and output 
Q
. If the fi rm increases its price above 
P
, other fi rms in the market will not follow. Th
is is because 
these fi rms will be able to sell more themselves, attracting 
customers from the fi rm that increased its price. So, the 
fi rm’s demand curve is 
AD
and its marginal revenue 
curve is MR. Th
is demand curve is relatively elastic to an 
increase in price. If the fi rm lowers its price, it assumes 
that other fi rms in the market will follow this lead so as 
not to lose market share. Th
is starts a price war, the result 
of which is likely to be that all fi rms lose out. Th
e demand 
curve below A is inelastic and indicated by 
AD
. Th
e 
marginal revenue curve is EF.
So, overall the oligopolist’s demand curve appears to be 
P
1
AD
. Price will be rigid at 
P
since there is no incentive for 
a fi rm to increase or decrease the price it charges. If it did, 
either way, it would lose out.
Th
e kinked demand curve is in some respects a useful 
way to explain the behaviour of oligopolists. Empirical 
evidence unfortunately does not always support what 
this model tells us. For example, prices in an oligopolistic 
market may be no more rigid than in other markets. Also, 
the reason for price rigidity may have more to do with 
commercial practices than the fi rm’s awareness of the 
kinked demand curve.
It is for this reason that, in recent years, game theory 
has increasingly been applied in order to understand the 
behaviour of oligopolists. Th
e ‘game’ is that fi rms have to 
make decisions about the price they charge and their level 
of output. Decisions are taken based on assumptions about 
the responses of rival fi rms; these decisions have particular 
implications for the profi ts earned.
Table 7.6
shows the game matrix facing two fi rms, 
A and B, that have large market shares in an oligopolistic 
market. Suppose at present there is no price competition 
and that each fi rm sells its product for £1. In order to 
increase market share, both fi rms are considering reducing 
their prices by 10% to 90p.
At £1, each fi rm is making an annual profi t of 
£2 million. If B decided to reduce its price to 90p, its 
profi ts would increase to £2.2 million. Th
is is not good 
news for A, which has left its price at £1 and seen profi ts 
fall to £1 million. Alternatively, A could cut its price 
to 90p, with B leaving its price at £1. A’s profi ts would 
increase to £2.2 million, with B’s falling to £1 million. 
In this situation both fi rms know what each other is 
considering – if prices are cut to 90p then both fi rms 
experience a fall in profi ts to £1.5 million. Both fi rms lose 
out so the obvious option is for them to collude to retain 
their prices at £1 in order to gain higher profi ts.