Oligopoly

Oligopoly Oligopoly: is an industry with relatively few firms producing either homogenous or differentiated products Example; Steel, aluminum, and electrical appliances Since each firm makes up a considerable part of the market, there is a mutual interdependence between oligopolists in the industry The behavior and actions of one firm effects all firms in the industry Oligopolists face two conflicting motives, The first is to collude and act together as a monopoly to maximize profits of the group The second is to compete fiercely as rivals in order to gain greater market share in the industry

There are also several barriers to entry in the industry, Economies of scale Control of patents or strategic resources Ability to engage in retaliatory pricing Oligopolies may result from internal growth of firms, mergers or both

Collusive Oligopoly Oligopolies may collude and form a cartel in order to reduce the uncertainty in the industry and the losses that would come about if they competed with each other. Collusion: a situation in which firms act together in agreement (collude) to fix prices, divide a market, or otherwise restrict competition Cartel: a formal agreement among firms in an industry to set the price of a product and establish the outputs of the individual firms Cartels are often illegal because they do not promote efficiency or public welfare Firms may break the law and risk being fined or they may collude tacitly Tacit collusion: an unspoken, unwritten agreement by an oligopolist to set prices and outputs that does not involve outright (or overt) collusion One key form of tacit collusion is price leadership,

Price leadership: involves one firm (the leader) announcing a change in price, and the other firms (the followers) soon making similar to identical changes A collusive oligopoly will behave like a monopoly and it will produce where MR = MC The industry MC curve is the sum of each firms marginal costs at each price

Difficulties of Collusion Collusion among oligopolists is difficult because, Demand and cost differences among sellers Complexity of output coordination among producers Potential for cheating Tendency for agreements to break down during recessions Potential entry of new firms Antitrust laws

Non-Collusive Oligopoly Cartels keep higher prices than they would be if the firms were in competition There is a temptation of a single firm to cheat, and undercut its competitors to gain market share. We make two assumptions 1) If a firm increases its price, the rivals will not follow 2) If a firm decreases its price, the rivals will follow Consequently, there is relative price stability in the market because of the fear of a price war Price war: each firm lowers its price below rival’s prices, hoping to increase its sales and revenues at its rivals expense

Demand Curve for Oligopolist Kinked demand curve model: is a model of oligopoly in which the demand curve facing each individual firm has a “kink” in it The kinked demand curve has two segments: one fairly flat and one steep The kink results from the assumption that rival firms will follow if a single firm cuts price but will not follow if a single firm raises price

Basis of the kinked demand curve model of oligopoly, Each firm faces a demand curve kinked at the current price PE Above PE, demand is very elastic. If P > PE, other firms will not follow Below PE, demand is very inelastic. If P < PE, other firms will follow

Marginal Revenue for Oligopolist The kink in the demand curve generates a break in the oligopolists marginal revenue curve shown by the gap between the two curves,

Profit Maximization for Oligopolists Oligopolists must follow the profit-maximizing output rule, MR = MC As long as marginal cost (MC) is in the vertical region of the marginal revenue curve, price and output will remain constant A whole range of costs between MC1 and MC2 will lead to the profit maximizing output and price

Example; Oligopolist Example; Gabbie’s Auto-parts We can use the table to calculate the profit maximizing level of output and the corresponding price Price Quantity Total Revenue (TR) Marginal Revenue (MR) Marginal Cost (MC) Average Cost (AC) 40 - 35 10 350 15 30 20 600 25 500 -20 19 300 -40

This results in a supernormal profit given by, Profit = (P – AC) × Q The equilibrium price is $30 and the corresponding quantity produced is 20 units. This results in a supernormal profit given by, Profit = (P – AC) × Q = (30 – 20) × 20 =$200