Oligopoly Oligopoly Oligopoly is an industry with relatively

Oligopoly

Oligopoly �Oligopoly: is an industry with relatively few firms producing either homogenous or differentiated products o 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 o The behavior and actions of one firm effects all firms in the industry �Oligopolists face two conflicting motives, o The first is to collude and act together as a monopoly to maximize profits of the group o The second is to compete fiercely as rivals in order to

�There also several barriers to entry in the industry, o Economies of scale o Control of patents or strategic resources o 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

�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 o The industry MC curve is the sum of each firms marginal costs at each price

Difficulties of Collusion �Collusion among oligopolists is difficult because, o Demand cost differences among sellers o Complexity of output coordination among producers o Potential for cheating o Tendency for agreements to break down during recessions o Potential entry of new firms o 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 o 1) If a firm increases its price, the rivals will not follow o 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, o Each firm faces a demand curve kinked at the current price PE o Above PE, demand is very elastic. If P > PE, other firms will not follow o 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 MC 1 and MC 2 will lead to

Example; Oligopolist �Example; Gabbie’s Auto-parts Price Quantity Total Revenue (TR) Marginal Revenue (MR) Marginal Averag Cost e Cost (MC) (AC) 40 0 0 - - - 35 10 35 15 30 30 20 600 25 10 20 20 25 500 -20 15 19 10 30 300 -40 25 20 �We can use the table to calculate the profit maximizing level of output and the corresponding price

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