4.2: Price Discrimination, Oligopoly, and Game Theory

Price discrimination

• Price discrimination: the practice of selling the same products to different buyers at different prices

  • Eg. airplane tickets (eg. first v. business class), coupons, sporting event tickets (eg. adult v. senior)

• Seeks to charge each consumer what they are willing to pay in an effort to increase profits → those with inelastic demand are charged more than those with elastic demand

  • Seeks to eliminate consumer surplus

• Requires the following conditions:

  1. Must have monopoly power
  2. Must be able to segregate the market
  3. Consumers must not be able to resell product

Characteristics Of Oligopolies

• <10 Large Producers
• Identical Or Differentiated Products
• High Barriers To Entry
• Control Over Price (price Maker)
• Mutual Interdependence
  • Firms Use Strategic Pricing
• Eg. OPEC, Cereal Companies, Car Producers

How Do Markets Become Oligopolies?

• High Barriers To Entry Prevent Others From Entering

  Types Of Barriers To Entry

  1. Economies Of Scale

     1. Eg. The Car Industry Is Difficult To Enter Because Only Large Firms Can Make Cars At The Lowest Cost

  2. High Start-up Costs

  3. Ownership Of Raw Materials

Game Theory

• Game Theory: The Study Of How People Behave In Strategic Situations
• An Understanding Of Game Theory Helps Firms In An Oligopoly Maximize Profit

Why Learn About Game Theory?

• Oligopolies Are Interdependent Since They Have To Anticipate And React To The Decision Of Competitors

• In An Oligopoly, Pricing And Output Decisions Must Be Strategic As To Avoid Economic Losses

• Game Theory Helps Determine The Best Strategy

• dominant Strategy: The Best Move To Make Regardless Of What Your Opponent Does

  ==Firm One==

  ^^Firm Two^^

• Firm One Has A Dominant Strategy To Go High
• Firm Two Does Not Have A Dominant Strategy

1. Oligopolies Must Use Strategic Pricing (they Have To Worry About The Other Firms)

2. Oligopolies Have A Tendency To Collude To Gain Profit

   1. Collusion Is The Act Of Cooperating With Rivals In Order To “rig” A Situation

3. Collusion Results In The Incentive To Cheat

4. Firms Make Informed Decisions Based On Their Dominant Strategies

Price Leadership

• Collusion Is Illegal → Firms Cannot Set Prices
• Price Leadership Is A Strategy Used By Firms To Coordinate Prices Without Outright Collusion

General Process:

1. “Dominant Firm” Initiates A Price Change
2. Other Firms Follow The Leader

• Breakdowns In Price Leadership

  • Temporary Price Wars May Occur If Other Firms Don’t Follow Price Increases Of Dominant Firm
  • Each Firm Tries To Undercut Each Other

• Cartels Are Colluding Oligopolies

  • Cartel: A Group Of Producers That Create An Agreement To Fix Prices High
  1. Cartels Set Price And Output At An Agreed Upon Level
  2. Firms Require Identical Or Highly Similar Demand And Costs
  3. Cartels Must Have A Way To Punish Cheaters

Kinked Demand Curve Model

• The Kinked Demand Curve Model Shows How Non-collusive Firms Are Also Interdependent

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