Oligopoly. What Is Oligopoly? What is Oligopoly?

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1 CHAPTER 13B After studying this chapter you will be able to Oligopoly Define and identify oligopoly Explain two traditional oligopoly models Use game theory to explain how price and output are determined in oligopoly Use game theory to explain other strategic decisions PC War Games In some markets there are only two firms. Computer chips are an example. The chips that drive most PCs are made by Intel and Advanced Micro Devices. How does competition between just two chip makers work? Do they operate in the social interest, like the firms in perfect competition? Or do they restrict output to increase profit, like a monopoly? What Is Oligopoly? The distinguishing features of oligopoly are Natural or legal barriers that prevent entry of new firms A small number of firms compete What is Oligopoly? Barriers to Entry Either natural or legal barriers to entry can create oligopoly. Figure 13.9 shows two oligopoly situations. In part (a), there is a natural duopoly a market with two firms. 1

2 What is Oligopoly? In part (b), there is a natural oligopoly market with three firms. A legal oligopoly might arise even where the demand and costs leave room for a larger number of firms. What is Oligopoly? What is Oligopoly? Small Number of Firms Because an oligopoly market has a small number of firms, the firms are interdependent and face a temptation to cooperate. Interdependence: With a small number of firms, each firm s profit depends on every firm s actions. Cartel: A cartel and is an illegal group of firms acting together to limit output, raise price, and increase profit. Firms in oligopoly face the temptation to form a cartel, but aside from being illegal, cartels often break down. Examples of Oligopoly Figure shows some examples of oligopoly. Four largest firms Next four largest firms Next 12 largest firms An HHI that exceeds 1,000 is usually an oligopoly. An HHI below 1,000 is usually monopolistic competition. The Kinked Demand Curve Model In the kinked demand curve model of oligopoly, each firm believes that if it raises its price, its competitors will not follow, but if it lowers its price all of its competitors will follow. 2

3 Figure shows the kinked demand curve model. The firm believes that the demand for its product has a kink at the current price and quantity. Above the kink, demand is relatively elastic because all other firm s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firm s prices change in line with the price of the firm shown in the figure. The kink in the demand curve means that the MR curve is discontinuous at the current quantity shown by that gap AB in the figure. This slide helps to envisage why the kink in the demand curve puts a break in the marginal revenue curve. 3

4 Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profitmaximizing quantity and price unchanged. For example, if costs increased so that the MC curve shifted upward from MC 0 to MC 1, the profitmaximizing price and quantity would not change. The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact. If MC increases enough, all firms raise their prices and the kink vanishes. A firm that bases its actions on wrong beliefs doesn t maximize profit. Dominant Firm Oligopoly In a dominant firm oligopoly, there is one large firm that has a significant cost advantage over many other, smaller competing firms. The large firm operates as a monopoly, setting its price and output to maximize its profit. The small firms act as perfect competitors, taking as given the market price set by the dominant firm. Figure shows10 small firms in part (a). The demand curve, D, is the market demand and the supply curve S 10 is the supply of the 10 small firms. 4

5 At a price of $1.50, the 10 small firms produce the quantity demanded. At this price, the large firm would sell nothing. But if the price was $1.00, the 10 small firms would supply only half the market, leaving the rest to the large firm. The demand curve for the large firm s output is the curve XD on the right. The large firm can set the price and receives a marginal revenue that is less than price along the curve MR. The large firm maximizes profit by setting MR = MC. Let s suppose that the marginal cost curve is MC in the figure. The profit-maximizing quantity for the large firm is 10 units. The price charged is $

6 The small firms take this price and supply the rest of the quantity demanded. In the long run, such an industry might become a monopoly as the large firm buys up the small firms and cuts costs. THE END 6

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