LECTURE 1OBJECTIVES:Students should be able to: Identify and explain the characteristics

of oligopoly.

Imperfect Competition among the FEW

OLIGOPOLY• DefinitionA market structure in which a few firms

dominate the supply of an industry’s output and compete with each other for markets.

Market StructureOligopoly – Competition amongst the few

Industry dominated by small number of large firms Many firms may make up the industry High barriers to entry Products could be highly differentiated – branding or

homogenous Non–price competition Price stability within the market - kinked demand curve? Potential for collusion? Abnormal profits High` degree of interdependence between firms

OLIGOPOLYExampleCar industryAirline industryCigarettesCleaning productsElectrical appliance

CharacteristicsImplication of market dominationStrong mutual interdependence among

dominant firms in their price and output decisions.

CharacteristicsHomogeneous or Differentiated ProductsHomogeneous product- pure oligopoly eg.

Raw materials (oil, petrol, tin)Differentiated product- imperfect/

differentiated oligopoly eg. Cars, energy drinks.

CharacteristicsBarriers to EntrySubstantial barriers, similar to monopoly but

not as restrictive eg. Petroleum industry

Characteristicso Non-price competitionCompete not through price but other methods

(advertising, after-sales service, free gifts)

NON-PRICE COMPETITIONPracticed by oligopoly and monopolistic

competition. Various forms: Competitive advertising – to reinforce product

differentiation and harden brand loyalty. Promotional offers – eg. Household detergent,

toothpaste, shampoo (buy 2 get 1 free), (25% extra at no extra cost).

Extended guarantees/after sales service – esp. for consumer durables, by offering free spare parts, labour guarantee.

Better credit facility Attractive gift wrappings

Price RigidityPrices are very inflexibleDespite changes in underlying costs of

production, firms are often observed to maintain prices at a constant level.

CollusionMake agreement amongst themselves so as to

restrict competition and maximise their own benefit.

1.PRICE DETERMINATION MODELSCARTELS

PRICE LEADERSHIP

2. PRICE RIGIDITY MODELS KINKED DEMAND CURVE THEORY

1.PRICE DETERMINATION MODELSCollusive modelsNon Collusive models

Collusive models assumes that there is an agreement between firms to fix prices or mutually divide the market.

Firms work together and act like a profit maximizing monopolist.

There are two types of collusion-1. cartel2. Price leadership

Cartel is is an agreement between firms to fix prices or mutually divide the market.

1. PRICE DETERMINATION MODELSPRICE LEADERSHIP Usually there is a price leader in oligopoly collusion

to determine price. Price leadership is of various types- 1. Price leadership of dominant firm- this firm is

producing large proportion of the total production in the industry and has great influence over the market. This firm estimates its own demand curve and fixes the price which maximizes its own profits.

2. Price leadership of barometric firm- this is an old experienced, largest and most respected firm assumes the role of a custodian who protects the interest of all. This firm fixes price which are the best from the point of view of all the firms in the industry.

3. Price leadership of Exploitative firm- this firm is very large and establishes its relationship by following aggressive price policies and thus compel the other firms in the industry to follow him in respect of prices.

2. PRICE RIGIDITY MODELTHE KINKED DEMAND CURVE THEORY(reaction model) Paul Sweezy 1930’sThis model recognises that demand for a

firm’s product is determined both by the market demand for a product as well as by rival firm’s behaviour

fig

£

QO

P1

Q1

Current priceand quantity

give one pointon demand curve

£

QO

P1

Q1

MC2

MC1

MR

a

bD AR

KINKED DEMAND CURVE THEORYIf the firm lowers its price below OP1, its

rivals will follow.Its demand will expand along the relatively

inelastic section of the demand curve below OP1

and total revenue will fall.

KINKED DEMAND CURVE THEORYIf the firm raises its price above OP1, none

of its competitors will follow. Its demand for prices above OP1 will contract

along the relatively elastic section of the demand curve and total revenue will fall.

As a result of action and non-reaction to price changes, an oligopolist is faced with a kinked demand curve at OP1.

Price rigidity is due to the kinked demand curve and the resulting discontinuity in the MR curve.

Note: An oligopolistic firm faces a relatively more ELASTIC DDcurve at prices ABOVE a given market price and a relatively more INELASTIC DD curve at prices BELOW a given market price.

Changing cost conditionsEven though MC may be rising or falling,

MC=MR in the portion of discontinuity will leave price and output unchanged at OP1 and OQ1.

Ie. Changes in costs has no effect on profit maximising price and out put because the firm is still producing where MC=MR.

ADVANTAGES OF OLIGOPOLYWhen firms collude – monopoly –supernormal

profit – extra profit – extra capital – to fund R&D – benefit to consumer.

Product differentiation – non-price competition– greater variety to consumers.

Price stability/rigidity – helps in planning, reduce uncertainty.

DISADVANTAGES OF OLIGOPOLYCollusive oligopoly if they agree upon output – no variety and

improvement in quality – bad for consumers.o Acting like a monopolyRestrict output and charge a higher priceProducer sovereigntyConsumer sovereignty not respectedGreater inequality in income (supernormal

profits)