Oligopoly 14 The Four Types of Market Structure

Oligopoly 14

The Four Types of Market Structure Number of Firms? Many firms Type of Products? One firm Monopoly • Tap water • Cable TV Few firms Oligopoly • Tennis balls • Crude oil Differentiated products Monopolistic Competition • Novels • Movies Identical products Perfect Competition • Wheat • Milk

Oligopoly • An oligopoly is a form of industry (market) structure characterized by a few dominant firms. Products may be homogeneous or differentiated. • The behavior of any one firm in an oligopoly depends to a great extent on the behavior of others. • Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. • Substantial barriers to entry Copyright © 2004 South-Western

Ten Highly Concentrated Industries Percentage of Value of Shipments Accounted for by the Largest Firms in High. Concentration Industries, 1992 SIC NO. INDUSTRY DESIGNATION FOUR LARGES T FIRMS EIGHT NUMBER LARGEST OF FIRMS 2823 3331 3633 2111 2082 3641 2043 3711 3482 Cellulosic man-made fiber Primary copper Household laundry equipment Cigarettes Malt beverages (beer) Electric lamp bulbs Cereal breakfast foods Motor vehicles Small arms ammunition 98 98 94 93 90 86 85 84 84 100 99 99 100 98 94 98 91 95 5 11 10 8 160 76 42 398 55 3632 Household refrigerators and freezers 82 98 52 Copyright © 2004 South-Western

Collusion and Competition Oligopoly firms may collude (act as a monopoly) and earn positive profits. OR Oligopolists may compete with each other and drive prices down to where profits are zero. Copyright © 2004 South-Western

Duopoly • A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. • The duopolists may agree on a monopoly outcome. • Collusion • An agreement among firms in a market about quantities to produce or prices to charge. • Cartel • A group of firms acting in unison. Copyright © 2004 South-Western

Oligopoly Models • • The important models of non-collusive oligopoly are: (a) Cournot Duopoly model (b) Kinked Oligopoly demand curve models. The two major theories of collusive oligopoly are: (a) Joint profit maximization - Cartels (b) Price leadership. Copyright © 2004 South-Western

Cournot Duopoly model • The Cournot model is in terms of duopoly (two sellers) but it can be easily extended to an oligopolistic situation. • This model analyses the process of equilibrium in a duopoly situation when each duopolist assumes that his rival will not react when he changes his output to maximize profits. Copyright © 2004 South-Western

Assumptions • There are two sellers in the market. • The products sold by these two sellers are homogeneous. • The market, or total demand curve, is known and it is a straight line. • Each duopolist assumes that his rival’s output will remain constant when he changes his output. Thus, each duopolist assumes his rival will not react to his action. • Each duopolist produces output of which the profits are at the maximum. • The cost of production is zero for both the sellers. • The average and marginal costs for each seller are zero and these curves coincide with the X-axis. Copyright © 2004 South-Western

Cournot Duopoly model Copyright © 2004 South-Western

Cournot Duopoly model Firm & Industry Output: - Copyright © 2004 South-Western

Cournot Duopoly Equilibrium Copyright © 2004 South-Western

Cournot Duopoly Equilibrium The Total Industry output is given as: The average market share of each firm in the industry is: Copyright © 2004 South-Western

The Kinked Demand Curve Model • The kinked demand model is a model of oligopoly in which the demand curve facing each individual firm has a “kink” in it. The kink follows from the assumption that competitive firms will follow if a single firm cuts price but will not follow if a single firm raises price. Copyright © 2004 South-Western

The Kinked Demand Curve Model • Above P*, an increase in price, which is not followed by competitors, results in a large decrease in the firm’s quantity demanded (demand is elastic). • Below P*, price decreases are followed by competitors so the firm does not gain as much quantity demanded (demand is inelastic). Copyright © 2004 South-Western

Kinked Demand Curve Model • Sweezy’s kinked demand curve model explains the rigidity or stickiness in oligopolistic prices in the face of short-term increases or decreases in variable input costs. When costs of raw materials or labour rise, profits will get squeezed and when these costs fall, the benefit of lower input costs will not be passed on to the consumers. • The Sweezy model of kinked demand curve under oligopoly explains why prices of oligopolistic firms are inflexible and fail to reflect short-run changes in variable costs of raw materials and wages. Copyright © 2004 South-Western

Cartel • A cartel is a formal collusive organization of the oligopoly firms in an industry. There may either be an open or secret collusion. • A perfect cartel is an extreme form of collusion in which member firms agree to abide by the instructions from a central agency in order to maximise joint profits. • The profits are distributed among the member firms in a way jointly decided by the firms in advance and may not be in proportion to its share in total output or the costs it incurs. Copyright © 2004 South-Western

Theory of Cartels • Objectives: • 1) minimize industry costs for any given output (produce where all firms have the same MC). • 2) restrict output and maximize industry-wide profits. Sum MC curves to find industry-wide S curve. Equate that to MR, and sell from the related demand curve. Each firm produce the quota where short-run industry MC = industry MR Copyright © 2004 South-Western

Motivations for Collusion a) Decrease competition, achieve monopoly-like behavior b) Decrease uncertainty c) Decrease of entry Copyright © 2004 South-Western

Cartels Decision making is carried on by the central organization. It sets price and output. $ Firm A $ MCa Firm B $ Industry MC ACa MCb ACb MR 0 Qa X 0 Qb X 0 Qc Objective: Minimize industry costs for any given output. Allocate quotas to members so the MC of each producing firm at its quota output is equal to MC of every other firm. D X

The Price-Leadership Model • Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller firms in the industry follow its pricing policy. • It may become monopolist but compromises with the small rival firms which in turn accept the dominant firm as the price setter and behave as if they are firms under perfect competition i. e. price takers. Copyright © 2004 South-Western

The Price-Leadership Model • Assumptions of the price-leadership model: • • It is assumed that the dominant firm knows the aggregate market demand. It finds its own demand curve by setting a price and deduct from the market demand the quantity supplied jointly by the small firms. It also knows the supply curve of the small firms through a knowledge of their individual MC curves. The part of the market demand not supplied by the small firms will be its own share. Given a price, the market share of the dominant firm equals the market demand less the share of small firms. Copyright © 2004 South-Western

Dominant Firm The large firm can set the price and receives a marginal revenue that is less than price along the curve MR. Dominant Firm’s Demand Curve Residual Demand Copyright © 2004 South-Western

Dominant Firm As long as the dominant firm has lower costs, it can act like a monopolist over the residual demand. Copyright © 2004 South-Western

The Price-Leadership Model • Outcome of the price-leadership model: 1. The quantity demanded in the industry is split between the dominant firm and the group of smaller firms. 2. This division of output is determined by the amount of market power that the dominant firm has. 3. The dominant firm has an incentive to push smaller firms out of the industry in order to establish a monopoly. Copyright © 2004 South-Western