Solutions to Class questions Topic 11 - Oligopolies

Questions and Solutions for Topic 11: Oligopolies

1.       What does the Kinked demand curve model tell us about prices in an Oligarchic market?

Prices are rigid, tend not to change frequently

2.       Do Ologopolies optimize output where MC=MR? Draw a diagram to support your answer.

Yes, draw diagram from slide 9 in your notes

3.       How might an Oligopoly increase its market share?

By using non-price competitive strategies .e.g product innovation, marketing, quality enhancements

Game theory – steps

1.       Understand the rules

2.       Identify the choices/strategies

3.       Tabulate the pay-off matrix

4.       First: column outcomes, then row outcomes

5.       Look for a common choice / strategy

4         Prisoner’s Dilemma Question

Soapy Inc. and Suddies Inc. are the only producers of soap powder. They collude and agree to share the market equally. If neither firm cheats on the agreement, each makes $1 million profit. If either firm cheats, the cheat makes a profit of $1.5 million, while the complier incurs a loss of $0.5 million. If both cheat, they break even. Neither firm can monitor the other’s actions.

a)      What are the strategies in this game?

Both agree: Soapy = $1 m and Suddies = $1 m

Both cheat: Soapy = $0 profit and Suddies = $0

Soapy cheats and Suddies agree :  Soapy = $1.5 million profit, and Suddies = $0.5 million loss;

Suddies cheats and Soapy agree :  Suddies = $1.5 million profit, and Soapy = $0.5 million loss.

Construct a payoff matrix

		Soapy Inc
		Agree	Cheat
Suddies Inc	Agree	$1 m      S1m	-$5m           $1.5m
	Cheat	$1.5m     -$5m	$0                $0

b)      Is the equilibrium a dominant strategy/ Nash equilibrium? Explain.

Yes, The equilibrium is a dominant strategy equilibrium because for each firm, regardless of the opponent’s choice, the best strategy is to cheat.

If Suddies agrees, the best strategy for Soapy is to cheat = $1.5 million rather than $1 million.

If Suddies cheats, the best strategy for Soapy is to cheat = $0 rather than incur a loss of $0.5 million.

5         How does Prisoner’s dilemma substantiate the kinked demand curve model?

Prisoner’s dilemma shows the difficulty of cooperating. Firms need trust eachother if they are to get the best outcome.  The dilemma or nash equilbiruim is not the best solution for each of the firms, if they cooperated with and trusted each other they could select an outcome which was better for both of them.

The kinked demand curve also shows how, in an interdependent oligarchic market, the firm selects a strategy erroneously, believing that they know what the other firms’ response will be.  E.g. Firm does not raise prices, because no-one will follow.