Two Alternative Theories of Pricing Behavior 13A

Previously… Oligopoly –A market structure in which there are a small number of firms –Firms interact strategically –Can be competitive or collusive Game theory helps determine when cooperation among oligopolists is most likely –In many cases, cooperation fails to materialize because decision-makers have dominant strategies that lead them to be uncooperative.

Two Alternate Theories Two alternative theories argue that oligopolists will form long-lasting cartels. –Kinked demand curve –Price leadership

The Kinked Demand Curve Kinked Demand Curve Theory –A group of oligopolists has established an output level and price –Firms will mostly ignore a rival’s price increases Firms hold their prices steady to capture rival’s customers who don’t want to pay more Rival who raised price will see a big sales decrease –Firms have a greater tendency to respond aggressively to a rival’s price cuts A price decrease by a rival will be matched by competitors No one firm is able to pick up very many new customers

The Kinked Demand Curve

Price Leadership Kinked Demand Theory –Doesn’t explain price changes Price leadership –A dominant firm sets the price that maximizes profits and the smaller firms follow –Explains price changes –Not illegal since it does not involve explicit collusion –Involves tacit collusion where there is an understanding among firms that attempts to fight the changes made by the leader that will lead to lower profits for everyone

Price Leadership Example: airlines –Leader airline sets the fare for a given route, and others follow –Each firm knows that lowering the price will hurt everyone, so the price stays where it was set by the leader