OLIGOPOLY

Definition and characteristics Price and Output Decisions for an Oligopoly:

Non-price Competition Price Rigidity and Kinked Demand Curve Price Leadership Model Cartel Game theory

Definition: Oligopoly = the market where there are only a few firms (more than two firms) in the industry producing either identical or differentiated products.

Characteristics:1. Few numbers of firms: • Small number of firms but size of firm is large. The

market share of each firm is large enough to dominate the market. Few firms control the overall industry.• The main criterion is the mutual interdependence

between these firms. Firms will consider the reactions of its rivals/competitors in decision making .

2. Homogeneous or differentiated product: For example cement or electrical appliances produced by one firm are identical to another firm. On the other hand, automobiles produced by major automakers are different in term of design, technology, performance and price.

3. Mutual interdependence: A condition in which an action by one firm may cause a reaction from other firms. Changes in price or output by one firm can have direct effect on another firm. (Firms will consider the reactions of its rivals/competitors in decision making) .

4. Barriers to entry: Oligopoly firms will restrict new entrants into market. These barriers include control over certain resources, patent rights, exclusive financial requirements and other legal barriers.

Price and Output Decisions for an Oligopolist

Mutual interdependence among firms in an oligopoly makes this market structure more difficult to analyze. Firms have to consider the reaction of its rivals when taking decisions.Some well-known oligopoly models:• non-price competition• the kinked demand curve• price leadership• the cartel• Game theory

Nonprice Competition:Firms will compete with each other by using better advertising and product differentiation (producing new products and improve the quality of the existing product). These strategies will attract more customers to the firm, and give consumers more choice.

Note: Oligopolists would compete through non-price competition, rather than price competition. If a firm reduces the price of a product, its rivals/competitors will easily and quickly reduce their prices.There is a risk of price war if the price reduction continues.

Price Rigidity and Kinked Demand CurveKinked Demand Curve = a demand curve facing an oligopolist that assumes rivals will match a price decrease, but ignore a price increase.

Ep >1

Ep <1

Po

Qo

F

E

D

If a firm ↑P, competitors will not follow. Customers switch to rivals.

If a firm ↓P, competitors will follow.Customers do not switch

Price

Quantity

Price Rigidity

EP*

Q*

MC0

MC1

Quantity

Price

F

D

MR

a

b

The kinked dd curve below point E creates a gap in the MR (dotted line ab). Any change in MC between ab, equilibrium price and quantity will be constant.The stability in price and quantity is called price rigidity.

Example:

Athletic footwear faces the following demand curve:P1 = 600 – 0.5Q1 for price increaseP2 = 700 – 0.75Q2 for price decreaseThe firm’s marginal cost is RM150.(a) What is the price and quantity at the kink?(b) At what range of value will the marginal cost shift without

changing price and output?(c) What is the profit maximizing price and quantity if the

marginal cost is RM250?

Solution:(a) At the kink, Q1 = Q2 or P1 = P2

P1 = P2

600 – 0.5Q = 700 – 0.75Q0.25Q = 100, Q = 400Substitute Q = 400 into P1 or P2

P = 600 – 0.5(400) = 400Hence, at the kink the price is RM400 and the quantity is 400 units(b) To find the range of MC, the upper limit and lower limit of MR need to be calculated.For price increase (upper limit): For price decrease (lower limit):P1 = 600 – 0.5Q1 P2 = 700 – 0.75Q2

MR1 = 600 – Q1 = 600 – 400 MR2 = 700 – 1.5Q2 = 700 – 1.5(400)

MR1 = 200 MR2 = 100

The range for MC to shift is between 100 and 200

(c ) For profit maximization to take place, we use the MR=MC rule. We equate MR1 to MC because MC is more than the upper limit.

MR1 = MC

600 – Q1 = 250

Q1 = 350

Substitute Q1 = 350 into P1

P1 = 600 – 0.5(350) = 425

Hence, the profit maximization price is RM425 and quantity is 350 units.

Price Leadership Model: • A pricing strategy in which a dominant firm sets the price for an industry, and the other firms follow.• The dominant firm may be • The largest firm that dominates the overall industry• Due to lower costs of production• Being economically powerful• Being able to forecast the market condition accurately.

• Hence, the dominant price leader firm can act as a monopoly. The firm sets its price to maximize profits and other firms will set the prices at the same level.

CARTEL:

Cartel is a group of firms that formally agree to control the price and the output of a product.

The objective is to get monopoly profits by replacing competition with cooperation.

The best known cartel is the Organization of Petroleum Exporting Countries (OPEC).

MR2

MR1

8 105 ‘000 barrels per day0

150

200

160

Price per barrel (RM) LRAC

LRMC

Assume each firm has the same cost curve.Before cartel is formed, in the long-run equilibrium: P = RM150 per barrel and Q = 8,000 barrels per day and each firm earns normal profit.Now assume the cartel is formed, each firm agrees to reduce output to 5000 barrels per day and charged RM200. Demand curve is MR2.Profit = (200 – 160) X 5000 = RM200,000.If a firm decides to cheat by stepping up its production to 10,000 barrels (MR2 = LRMC), Profit = RM400,000.If all firms cheat, the initial long-run equilibrium will be established.

GAME THEORY = A model of the strategic moves and countermoves of rivals.

High fare Low fare

High fare MAS profit = RM8 millionAir Asia profit = RM8 million

MAS profit = RM10 millionAir Asia profit = - RM2 million

Low fare MAS profit = - RM2 millionAir Asia profit = RM10million

MAS profit = RM5 millionAir Asia profit = RM5 millionAi

r Asi

a Ai

rline

s’

Opti

ons

Malaysian Airlines’ options

A Two-Firm Payoff Matrix

Both rivals are mutually interdependent.The payoff matrix demonstrate why both rivals using a low-price strategy that does not maximize mutual profits. Consumers benefit from not paying high fares.

How can these firms avoid the low-price outcome?• Price leadership: informal agreement, the leader

sets the profit maximizing high price & other competitor follows.• Form cartel: an agreement among firms to

cooperate with one another to act together as a monopoly. Cartels will establish monopoly price and earns supernormal profit.