368
Chapter 9
Oligopoly
cost could decrease without changing the firm’s optimal price. (Small shifts in demand that retain the kink at P* would also leave the firm’s optimal price unchanged.) In short, each firm’s price remains constant over a range of changing market conditions. The result is stable industry-wide prices. The kinked demand curve model presumes that the firm determines its price behavior based on a prediction about its rivals’ reactions to potential price changes. This is one way to inject strategic considerations into the firm’s decisions. Paradoxically, the willingness of firms to respond aggressively to price cuts is the very thing that sustains stable prices. Price cuts will not be attempted if they are expected to beget other cuts. Unfortunately, the kinked demand curve model is incomplete. It does not explain why the kink occurs at the price P*. Nor does it justify the price-cutting behavior of rivals. (Price cutting may not be in the best interests of these firms. For instance, a rival may prefer to hold to its price and sacrifice market share rather than cut price and slash profit margins.) A complete model needs to incorporate a richer treatment of strategic behavior. CHECK STATION 2
An oligopolist’s demand curve is P ⴝ 30 ⴚ Q for Q smaller than 10 and P ⴝ 36 ⴚ 1.6Q for Q greater than or equal to 10. Its marginal cost is 7. Graph this kinked demand curve and the associated MR curve. What is the firm’s optimal output? What if MC falls to 5?
Price Wars and the Prisoner’s Dilemma Stable prices constitute one oligopoly outcome, but not the only one. In many markets, oligopolists engage in vigorous price competition. To this topic we now turn. A surprising number of product lines are dominated by two firms, so-called duopolists. Some immediate examples are Pepsi versus Coke, Nike versus Reebok (running shoes), Procter & Gamble versus Kimberly-Clark (disposable diapers), and Disney-MGM versus Universal (movie theme parks). When the competing goods or services are close substitutes, price is a key competitive weapon and usually the most important determinant of relative market shares and profits. A PRICE WAR As a concrete example, consider a pair of duopolists engaged in price competition. To keep things simple, suppose that each duopolist can produce output at a cost of $4 per unit: AC MC $4. Furthermore, each firm has only two pricing options: charge a high price of $8 or charge a low price of $6. If both firms set high prices, each can expect to sell 2.5 million units annually. If both set low prices, each firm’s sales increase to 3.5 million
