All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 1

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 2 Oligopoly CHAPTER 12

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 3 Definition A market structure in which there are only a few firms selling either standardized or differentiated products and it restricts the entry into and exit from the market DEFINITION OF AN OLIGOPOLY

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 4 Characteristics Few numbers of firms: The number of firms is small but size of the firms is large. Homogeneous or differentiated products: These products can be standardized products such as steel, zinc or copper which is price based. Other industries such as electronics automobiles offer different products where emphasis is on non-price competition, such as advertisirs. CHARACTERISTICS OF AN OLIGOPOLY

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 5 Mutual interdependence: Firms in an oligopoly market always considers the reaction of their rivals when choosing price, sales target, advertising budgets and other business policies. CHARACTERISTICS OF AN OLIGOPOLY (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 6 Barriers to entry: Restricts new entrants into the market through various types of barriers of entry such as the control of certain resources, ownership of patents and copyrights, exclusive financial requirements and legal barriers. CHARACTERISTICS OF AN OLIGOPOLY (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 7 PRICE AND OUTPUT DECISIONS FOR AN OLIGOPOLIST Non-Price Competition Firms compete with each other using advertising and product differentiation techniques. Firms try to capture the market from rivals through better advertising campaigns and produce high-quality products instead of reducing prices.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 8 Besides advertising, research and development activity is important for oligopoly firms to invent new products and improve the quality of the existing products. PRICE AND OUTPUT DECISIONS FOR AN OLIGOPOLIST (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 9 PRICE AND OUTPUT DECISIONS FOR AN OLIGOPOLIST Price Rigidity and Kinked Demand Curve Since there is mutual interdependence between oligopoly firms, the prices in the market are more stable. This is called price rigidity in oligopoly market. The price rigidity explains the behaviour of an oligopoly firm that has no incentive to increase or decrease the price. The theory of the kinked demand curve is based on two assumptions.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – First assumption: If an oligopolist reduces its price, its rivals will follow and cut their prices to prevent losing the customers. 2. Second assumption: If an oligopolist increases its price, its rivals would not increase their prices and keep their prices the same, thereby they gain customers from the firm that increases the price. ASSUMPTIONS OF A KINKED DEMAND CURVE

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 11 An oligopoly firm faces two demand curves that is an individual demand curve (dd) and an industry demand curve (DD). Price (RM) Quantity dd Q* P* DD According to the second assumption, when a firm increase the price (P*), no other firms will follow. Above P*, the firm will follow dd curve. If the firm decrease the price, other firms will follow. Below P*, the firm follow DD curve. Because of this assumption, an oligopolist faces kinked demand curve. KINKED DEMAND CURVE

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 12 Price (RM) The kinked demand curve below point E creates a gap in the MR, which is indicated by the dotted line ab. This shows price rigidity in the oligopoly market. Quantity MR Q* P* E DD MC 1 At this range of MR, any change in the MC does not reflect changes in the profit maximizing price and output. MC 2 a b KINKED DEMAND CURVE

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 13 Athletic footwear faces the following demand curve: P 1 = Q 1 for price increase P 2 = Q 2 for price decrease The firms marginal cost is RM150. What is the price and output at the kink? At what range of value will the marginal cost shift without changing price and output. PROFIT MAXIMIZATION USING THE EQUATION METHOD

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 14 Solution At the kink, P 1 =P – 0.5Q = 700 – 0.75Q 0.25Q =100 Q =400 P=RM400 To find the range of MC, the upper limit and lower limit of MR needs to be found out. MR 1 = 600 Q 1 = 600 – 400 = 200 MR 2 = Q 2 = = 100 The range for MC to shift is between 100 and 200 PROFIT MAXIMIZATION USING THE EQUATION METHOD (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 15 GAME THEORY (CONT) A game theory is a model of analyzing strategic behaviour of rivals. Strategic behaviour refers to the actions taken by firms to consider the expected movement of rivals and the mutual recognition of interdependence between these firms.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 16 Strategies are the important actions for each player. The score obtained by each player in this game is called payoff. GAME THEORY (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 17 The payoff refers to the profits and losses of players, which is determined by strategies and constraints faced by the players. Constraints faced by the players come from the consumers who determine the demand curve for the product in this industry. GAME THEORY (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 18 PRISONERS DILEMMA In order to understand how the game theory works, we can start with a simple non-economic example called the prisoners dilemma.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 19 The strategy is to separate the partners in different rooms to make sure they cannot communicate with each other. Four combinations of strategies that might be possible in this game are given below. PRISONERS DILEMMA (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 20 1.Both Gavin and Tan confess 2.Neither Gavin nor Tan confesses 3.Gavin confesses and Tan does not 4.Tan confesses and Gavin does not Based on the four possible outcomes, we can tabulate of these outcomes. This is called the payoff matrix. PRISONERS DILEMMA (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 21 PAYOFF MATRIX Gavin : 15 years Tan: 15 years Gavin : 3 years Tan: 5 years Gavin : 25 years Tan: 3 years Gavin : 5 years Tan: 25 years GAVIN TAN A payoff matrix is a table that shows a listing of payoffs that each player will get for each possible combination of strategies that the two partners might choose. Confess If both of them confess for murder offence; they will get 15-year sentence. Do not confess If Gavin confess for murder offence and Tan does not; 3- year sentence for Gavin and 25-year sentence for Tan. Do not confess If Tan confess for murder offence and Gavin does not; 3-year sentence for Tan and 25-year sentence for Gavin. If both of them does not confess for murder offence; they will get 5-year sentence for bank robbery.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 22 PRICE LEADERSHIP Price leadership means the pricing strategy in which the firms in an oligopolistic industry follow the price set by the leading firm. Price leadership is one form of collusion under oligopoly. There is no formal or tacit agreement. There are two types of price leadership.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 23 1.Dominant price leadership - The dominant price leadership firm may be the largest firm that dominates the overall industry. - The dominant price leadership firm can act as a monopoly where it sets its price to maximize profits; other firms will set their prices at the same level. 2.Barometric price leadership - One firm will be the first to announce price change. This firm does not dominate the industry. - Its price will be followed by others. TYPES OF PRICE LEADERSHIP

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 24 CARTEL A cartel is a group of firms whose objective is to limit the scope of competitiveness in the market. Cartel arises because firms want to eliminate uncertainty and improve profits by stabilizing market shares and prices, reducing competitiveness and eliminating promotional cost.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 25 The most famous cartel is Organization of Petroleum Exporting Countries (OPEC). Cartel agreement is an arrangement among the oligopoly firms to cooperate with one another to act together as a monopoly. An ideal cartel will be powerful to establish monopoly price and earns supernormal profits. CARTEL (CONT)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, – 26 Profits are divided among firms based on their individual level of production. Each firm sells different quantities and obtains different profits depending on the level of AC at the point of production CARTEL (CONT)