[MUSIC] A second model of oligopoly, the price leadership model, provides insight into how firms in an industry might tacitly collude. As well as how firms which refuse to collude might be punished. In the price leadership model. The policing or enforcement mechanism used is often punishment by the price leader. Usually the biggest or dominant firm in the industry. With price leadership, executives within the industry don't have to slip off to a secret rendezvous in Vegas to set prices. Rather, a practice evolves where the dominant firm, usually the largest firm, initiates a price change. And all other firms more or less automatically follow that price change. Moreover, if one or more firms refuse to follow suit, the price leader may choose to back down. Alternatively. And they punished the non-cooperative firms by significantly lowering prices for a while, forcing the followers to incur losses. In the way, the oligopoly can maintain price discipline. A classic case of such price leadership involves the cigarette industry. The Big three firms Reynolds, American, and Liggett and Meyer, evolved a highly profitable practice of price leadership. Which resulted in virtually identical prices over the entire period between 1923 and 1941. During that period, the companies averaged a whopping 18% rate of return after taxes. Roughly double the rate earned by American manufacturing as a whole. In more recent time, other industries such as farm machinery, anthracite coal, cement, copper, gasoline. Newsprint, tin cans, lead, sulfur, rayon, fertilizer, glass containers, steel, automobiles. And nonferrous metals have likewise practiced some type of price leadership. Still a third interesting model of oligopoly involves the kinked demand curve. This model helps to explain why prices are sticky in oligopolistic industries, that is, why prices don't rapidly adjust to changes in supply and demand. In doing so, the model also helps explain why prices may be high relative to the perfect competition outcome. Even if there is no collusion. Imagine then an oligopolistic industry with three firms A, B and C. Each of which have one third of the total market. Further assume that each firm sets its price independently, meaning that there is no collusion. This situation is depicted in this figure. Now, the question is what does the firm's demand curve look like? And what makes this an interesting question is their mutual independent of the three firms. Coupled with the uncertainty of each rival's reaction to the pricing moves of the other. Let's look at the possibilities. If Firm A raises its price, and the firm believes that the other firms won't go along. Its perceived demand curve for increasing price will be very elastic. In particular, because of its fear of losing business to its rivals. Firm A's demand curve looks like D1 in the figure. While the relevant portions of the demand curve and its marginal revenue curve are shown in blue. Alternatively, suppose firm A decides to lower it's price. What might it most logically expect its rivals to do? That's right, the most logical response of form A's rivals to a price decrease would be for the firms to match that decrease. Otherwise, they will lose market share to firm A. Under this strategic assumption, a large drop in price by firm A would yield only a small, if any increase in sales. So demand under this scenario is very inelastic. This is represented by the curve D2. While the relevant portions of this demand curve and the marginal revenue curve, are shown in red in the figure. Thus, and here's the punch line [SOUND] the firm's perceived demand curve has a kink in it. That is, when we draw the relevant marginal revenue curve for this kink demand curve. We see that it has a gap in it. Therefore the relatively large shifts in marginal costs between points c and d as indicated by the shaded area. Will not change the price or the output that maximizes profits since they do not change the intersection of marginal cost and marginal revenue. Hence, in this industry, prices will tend to be sticky. And if they are set high to begin with, they will tend to remain high, even in the absence of collusion. You can see from these traditional models of oligopoly behavior. How important the strategic behavior of rivals can be in determining the eventual outcome in an industry. Let's take a deeper look at these strategic interactions through the lens of game theory. A subject which may sound frivolous from its name, but which in fact is fraught with economic
