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1 OLIGOPOLY We have thus far observed that a certain portion of our market is characterized as competitive, monopolistically competitive and monopolies. However, we also know that some firms that exist today do not fall into any of the above categories. There are industries in which only a few sellers operate. This is market structure is known as oligopoly. Characteristics of this market structure are: 1. large scale production is necessary to attain a low per unit cost. 2. recognized interdependence exists between firms in oligopolistic industries. 3. substantial barriers to entry exist. 4. produce either a homogeneous of differentiated product. This model actually takes into consideration both the actions and needs of each firm in the industry and the industry itself. If left to their own devices each firm in an industry would be forced to compete with other firms. This competition means that millions of dollars have to be spent in advertising campaigns. That is millions of dollars that could be used for other purposes if the competition was not so intense. One way to lower this cost is to get your fellow producers to agree to one set price for the industry. If that price is high enough maybe everyone could realize above average rates of return. Getting producers to agree to maintain one set price is what we economists call collusion. Collusion is an agreement among firms to avoid various competitive practices, particularly price reductions. When firms join together to control prices and output we call the group a cartel. Collusion is most likely when: Few sellers are present in the industry or a homogeneous product is being produced. The fewer the number of oligopolists the easier it is to agree on the actions required to keep prices high. It is also easier to monitor each other when the cartel consists of few members. There at least five contributing factors that make collusion least likely: the number of oligopolists is fairly large; secret price cuts are

2 difficult to detect; barriers to entry are low; market demand conditions are unstable; and anti-trust action is vigorous. If we are talking about an industry in which only a few sellers operate then we are talking about an oligopoly. The characteristics of this industry are: Large scale production is necessary to attain a low per unit cost. Automobile are a good example of this. Automotive experts has estimated that to build a basic car from the ground up by collecting all your own material and machining the parts would cost in excess of $50,000. Mass production of automobiles has provided firms the ability to realized economies of scale which lower production costs. A recognized interdependence exists between firms. This characteristic simply means that producers in oligopolistic industries must watch each other carefully because of the limited number of producers. If firms in the industry did not respond to favorable changes, either to the product or in the production process, then one firm could attract more consumers to his product. Industries with high operating costs cannot afford to lose a large portion of their customer base. A third characteristic is that substantial barriers to entry exist. The substantial barriers are the high start up costs. Before any new producer can enter the automotive industry, for example, he will need to invest in buildings and machinery to produce on the same scale as the existing competition. This initial cost represents a significant barrier to entry. Oligopolists produce either a homogeneous or differentiated product. This model is like a hybrid of all the others we have examined in this regard. The oil industry is a good example of an oligopolistic industry where a homogeneous product is being produced. Notice that in the model for the firm that the demand curve is relatively more elastic than the demand curve for the industry. Firms in this market structure may be few in number, but nevertheless they do represent potential competition. Therefore, individual firms will be price sensitive and this is implied with a relatively elastic demand curve. Now the demand curve for the industry assumes that some collusion has occurred. As we group together we eliminate some of the competition from the industry. Accordingly, the demand curve becomes

3 less elastic. With less competition we can charge higher prices and earn higher profits. Although there is a strong incentive to collude there is also reason to cheat on your agreements. Each oligopolist realizes that their individual demand curve must be more elastic than the industry demand curve. Therefore, if they were to decrease price below the agreed price they could expect quantity demanded to increase and also their profits. However, if one firm decreases prices the other oligopolists in the industry will also, and so no one firm will increase its share of the market. Conversely, if we increase price we know that our competitors will not follow our lead and, therefore, we will lose a portion of the market. Given these observations we can note the following: 1. the demand curve is elastic above the set price. 2. the demand curve is inelastic below the set price. 3. therefore oligopolists tend to be price rigid. 4. hence we know that a kinked demand curve exists.

4 On the first graph: Df= the demand curve for the firm. Di= the demand curve for the industry. MRf= the marginal revenue curve for the firm. MRi= the marginal revenue for the industry. In this first graph we are demonstrating the incentives that exist for cheating on collusive agreements. According to our agreement the industry will produce q5 levels of output and charge price p7. However, by looking at my relatively more elastic demand curve I realize that by lowering the price just a little I can increase the quantity demanded and therefore earn higher profits. Higher profits can be a great incentive!

5 The second graph (above) indicates that if I do cheat on our agreement I should expect some retaliation. The essential idea of the kinked demand curve is that the oligopolist s will maintain their prices when other firm s raise theirs, thus the demand curve will be very elastic for a price increase; but, very inelastic for a price decrease because other firms will respond by also reducing their prices. This all implies that prices in oligopolistic industries are quite stable because we are watching each other so closely. Given the model of oligopolistic industries many economists predicted that the Organization of Petroleum Exporting Countries (OPEC Cartel) would fail soon after its creation. Although that prediction was not realized OPEC did eventually circum to the logic of the model. The

6 following graphic demonstrates changes in their output and pricing levels over a 22 year period.

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