OLIGOPOLY. Nature of Oligopoly. What Causes Oligopoly?

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1 CH 11: OLIGOPOLY 1 OLIGOPOLY When a few big firms dominate the market, the situation is called oligopoly. Any action of one firm will affect the performance of other firms. If one of the firms reduces the price, the sale of other firms will suffer unless they also reduce the price. If one of the firms advertizes, its sale may increase, but the sale of the other firms will go down. This happens simply because the total demand in relation to the total production by a firm is not very high. Market for cereals, autos, soft drink and fast foods are few examples of oligopoly market. Even though some of them are increasingly becoming monopolistically competitive markets; never the less, a few of them dominate the whole market. Nature of Oligopoly Oligopoly market has the following characteristics Few sellers selling homogeneous or differentiated products How many firms? It is difficult to answer, how many. Two or more than two dominating the industry enough to set the price can be considered as an oligopoly market. EXAMPLES o AUTOMOBILE industry is in oligopoly market. Big three used to dominate the market until the seventies. (Still they are, but not much dominating to set the prices by themselves. They have tough competition from the imports.) o CEREALS, SOFT DRINKS, TOBACCO Interdependent o Each firm knows that other firms will react to its changes in prices, quantities and qualities. What Causes Oligopoly? o o o There should be some sort of barrier as in case of monopoly. Economy of scale is one of the major causes to exist oligopoly in the market. Only a few firms will be able to provide the product at lowest unit cost. That is, to say minimum efficient scale is high with respect to the market demand. Mergers Horizontal merger of the firms where companies producing/selling similar products, merge. (Not the vertical merger where firms that supply/produce inputs for other firms merge) Example 11.1 Suppose the total demand for carpets in a market is 50,000 units at certain price. Also, suppose that producing more than 30,000 carpets will revoke diseconomy of scale, and producing less than 15,000 carpets cannot utilize the economy of scale fully. So, one firm will not produce more than 30,000 carpets nor it produces less than 15,000 carpets so as to utilize the production at lowest possible cost per unit. If a firm produces 30,000 carpets, then there will be no room for producing more than 20,000 carpets for another firm. If one firm increases its production, the other must reduce it. In this market there can be minimum of two firms and maximum of three firms. If two firms produce 15,000 each, the third may be able to produce 20,000 carpets so that the market demand will be fulfilled at the lowest per unit cost of production. This is the kind of situation that an oligopoly market faces.

2 CH 11: OLIGOPOLY 2 Industry concentration We stated that oligopoly is a situation in which a few interdependent firms control a large part of total output in an industry. This is called the industry concentration and is measured by concentration ratio. The concentration is defined as Concentration Ratio = Total sales by major four firms Total sales in the industry If this is high, say 90% then the firms are in oligopoly market. (This is widely used four firms concentration ratio; sometimes eight firms (or other numbers) concentration ratio is calculated.) No concentration 0% means perfect competition or at the very least monopolistic competition. If for example CR 4=0 %, the four largest firm in the industry would not have any significant market share. Total concentration 100% means an extremely concentrated oligopoly. If for example CR 1= 100%, there is a monopoly. Low concentration 0% to 50%. This category ranges from perfect competition to oligopoly. Medium concentration 50% to 80%. An industry in this range is likely an oligopoly. High concentration 80% to 100%. This category ranges from oligopoly to monopoly. (From Wikipedia, the free encyclopedia) We can look at the US domestic concentration ratio for various industries. Note that definition of picking up % is arbitrary. (Similarly the concept of industry is arbitrary) If we pick up 80% four firms concentration ratio for oligopoly, then motor vehicles, breakfast cereals, soft-drink and tobacco products fall into oligopoly industry in the US. Efficiency in Resource Allocation in Oligopoly Just as in monopoly, there will be some inefficiency in resource allocation in oligopoly as well. Industry will produce less than what perfectly competitive market would produce. If the firms in this market produce less, it will charge more and will end up with some deadweight loss to the society. Pricing policy in oligopoly will be little more complicated than in other types of markets. Prisoner s dilemma We take here an example of prisoner s dilemma. Sam and Carol are two suspects in a bank robbery case. An investigator hints their sentences as given in the table, and asks them separately

3 CH 11: OLIGOPOLY 3 What will be the best strategy for SAM? Confess or not confess? Whether Carol confesses or not, he will be better off if he confesses. What will be the best strategy for Carol? Confess or not confess? Whether Sam confesses or not, she will be better off if she confesses. That is best strategy with no cooperation is that both will confess and get 5 years of sentence each. Better would have been if they cooperated each other and both did not confess. However this strategy will not work in general. What if one of them cheats? What has to do with this example in economics? o A lot. A similar situation is confronted by the firms in oligopoly market in their pricing strategies. Example: Pay offs of two firms with two different strategies are given in the table below. With no cooperation, both firms will choose to pursue low price strategy and each of the firms will earn $4 Million. If they were cooperating to each other, both of them would have received higher

4 CH 11: OLIGOPOLY 4 sales revenues. Say, if they both chose to charge higher prices, they both end up with $6 million. [But there is no guarantee that they will not be cheating because of the temptation of getting higher revenue.] Price rigidity & Kinked demand curve d1 d2 P0 d2 d1 q0 If we assume about the reaction on price change from the rival is such that the rivals will follow the price reduction but not the price increase. Then we end up with a kinked demand curve. Suppose the market was at its equilibrium at price P0. The demand curve faced by any firm in this oligopoly market is d1 d1. The quantity supplied at the equilibrium price is q0.. Now, if one of the firms in this market increases the price of its product, no other firms will follow this price increase. Other firms will continue producing same amount as they were doing before. But this firm has to reduce its sell moving along the demand curve d1d1. But, if the firm reduces the price, all other firms in the industry follow the suit. With reduced price there will be higher quantity demand in the market. Every firm will start producing higher amount not only the firm who in the first place reduced the price. The firm cannot

5 CH 11: OLIGOPOLY 5 produce and sell as faced in the original demand curve. That means that the firms will not be able to remain in the original demand curve. The firms will be facing other steeper demand curve d2d2. Thus the market demand curve faced by the firms in oligopoly market will be kinked or bent at P0. The bent demand curve will also make the marginal revenue curve look very different. Up to quantity Q0, MR curve will follow d1d1 demand curve, after that it will follow d2d2 demand curve. Exactly at price P0, there will be discontinuity in the MR curve as shown in the figure. MC and AC curves are determined by the technology, so they will remain same in all types of markets, whether it is competition, monopoly or oligopoly. If the cost increases (MC Shifts) still the price will remain same (MR = MC for max profit). That is, the price remains fairly rigid, even when cost changes. CRITICISM Where is the p0 to start with? (Where does the kink start?) Practically, price has been observed changing and not staying same as predicted by the model. Price Leadership Model Sometimes, firms actually do not collide but indirectly they do so by following the leader. Usually leader raises the price; other smaller firms do the same. Kellogg s, GM and Chase Manhattan Bank are some examples. Assumption is Leader takes rest of the market that other firms do not serve. Then the main point is the construction of demand curve faced by the leader. Consider the market demand curve D and the supply curve is S, received by adding all the MC curves (All other firms only) Suppose the leader sets the price P1, the leader will supply the quantity Q, rest of the market demand (Qt Q1) will be supplied by rest of the forms. If the leader sets the price P0, very high and very attractive to the rest of the firms, the leader will supply nothing, all the quantity will be supplied by rest of the forms. If the leader sets the price P2, the leader

6 CH 11: OLIGOPOLY 6 will supply the quantity Q, very low and the rest of the firms will not be able to supply any and hence, at this low price all the quantity demanded by the market has to be supplied by the leader. If Price > P0, all quantity is supplied by other firms. If price is below p2, all quantity has to be supplied by this leader. Thus the line AB can be considered as the demand curve faced by the leader. The leader then tries to maximize its own profit given this newly constructed demand curve. Then setting MC = MR, the leader sets the price at P1 and supplies Q1 quantity, the rest of the quantity demanded by the market at that price is supplied by the rest of the firms. Problems It is not clear always who would be the leader in this market. It may end up with price wars o If there is no clear leader, sometimes firms engage in the price wars to establish themselves as the leader in that market. o This may be good for consumers for a while but may not be good in the long run. Cartel If there are few firms and all the firms in the market join hands to behave and produce the amount that resembles monopoly, it is called a cartel. They jointly restrict the production and charge higher price just as a monopoly does. That way they can share the monopoly profit. The firms forming the cartel set the production level where MR=MC, so that the profit will be maximum. Suppose there are two firms A and B with two differing MC curves. Differing MC curve basically means that they have different costs of production. If it were a perfect competition, MR curve would be horizontal and firm A would produce OQA amount; at this level MCA = MR=Pe. Similarly, firm B would produce OQB amount; at this level MCB=

7 CH 11: OLIGOPOLY 7 MR=Pe. Market would produce a total of OQe (=OQA + OQB) amount. But suppose they join to form a cartel to act as monopolist. That is, their MR curve is no longer horizontal, and, the MR curve is downward sloping as shown below. Here MCA+B refers to the combined marginal cost curve. Given the market demand D, the marginal revenue is MR. The cartel will then produce Qc amount so that it will charge the price of Pc and get the highest profit from this action. If the market were in perfect competition, the price charged by the firms would be Pe and consumers would be buying Qe amount. But due to cartel, the producers will produce only Qc amount. Cartel is based on trust. If monopoly price is kept in the market, supply has to be reduced at monopoly quantity. But if only one firm reduces its price to sell more, it can snatch profit from others' share and hence there will be a temptation to cheat, assuming that no other cartel members are aware of its cheating behavior and stay on their monopoly pricing and quantity. One of the best known cartels is The Organization of Petroleum Exporting Countries (OPEC). The petroleum producing countries join hands each other to set the price of oil in the world market. In most countries, including USA, forming of cartel within the country is illegal.

8 CH 11: OLIGOPOLY 8 Questions for discussion 1. What are the assumptions of an oligopoly market? 2. What is a price leadership model? Who will decide who the leader in the market is? 3. What are the assumptions of a kinked demand curve? How is the price and quantity determined in kinked demand curve model? Does the model guarantee the profit for a firm? Multiple Choice Questions 1. One key characteristic that is distinctive of an oligopoly market is that: a. the demand curve facing each firm is downward sloping, with a marginal revenue curve that lies below the firm's demand curve. b. the decisions of one seller often influences the price of products, the output, and the profits of rival firms. c. there is only one firm that produces a product for which there are no good substitutes. d. there are many sellers in the market and each is small relative to the total market. 2. The industry that most closely approximates the conditions of the oligopoly model is: a. Restaurant. b. Retail clothing. c. Home construction. d. Airlines. 3. In which of the following market structures must the price and output decisions of an individual firm include the possible price and output reactions of the firm's rivals? a. Monopoly. b. Oligopoly. c. Perfect competition. d. Cartel. 4. A characteristic of an oligopoly is: a. mutual interdependence in pricing decisions. b. independent pricing decisions. c. lack of control over prices. d. none of these. 5. A major characteristic of the theory of oligopoly is that: a. there are no real-world examples. b. the reactions of each firm depends on how the firm believes rivals will react. c. in reality few oligopolies survive more than 10 years. d. none of these. 6. Nonprice competition, price leadership, and cartels are models in the market structure(s). a. perfectly competitive b. monopolistically competitive c. oligopoly d. monopoly e. perfectly competitive and monopolistically competitive

9 CH 11: OLIGOPOLY 9 7. Which of the following statements is always true with respect to oligopolists? a. They react slowly to actions taken by other firms b. They lower prices together c. They raise prices together d. They know with certainty what they other firms will do e. They take into consideration how other firms might react. 8. A kink in the demand curve facing an oligopolist is caused by: a. rapidly rising marginal revenues. b. excessive advertising. c. the belief that competitors will follow price increases but not match price decreases. d. the tendency of competitors to follow price reductions but not price increases. 9. Suppose an oligopoly has a dominant firm that sets the price for the entire industry. In this situation, the oligopoly has: a. nonprice competition. b. a kinked demand curve. c. price leadership. d. a cartel. 10. According to the kinked demand theory, when one firm raises its price, other firms will: a. also raise their prices. b. refuse to follow. c. increase their advertising expenditures. d. exit the industry. Exhibit 11-1 Kinked demand curves 11. In Exhibit 11-1, in a kinked-demand oligopoly model, D 1 represents the: a. demand curve applicable to any price increase above $50. b. demand curve applicable to any price decrease below $50. c. demand curve facing firms when a cartel is formed. d. market demand curve. e. demand curve facing the price leader. 12. In Exhibit 11-1, the exhibit represents a kinked-demand oligopoly model. Suppose the current price is $50. If one firm in the oligopoly now attempts to raise price, all firms will: a. follow along demand curve D 1. b. follow along demand curve D 2. c. ignore this price increase and cause the price-raising firm to move along D 1. d. ignore this price increase and cause the price-raising firm to move along D 2. e. lower their prices. 13. In Exhibit 11-1, the exhibit represents a kinked-demand oligopoly model. Suppose the current price is $50. If one firm in the oligopoly now attempts to lower price, all firms will: a. follow along demand curve D 1. b. follow along demand curve D 2. c. ignore this price decrease and cause the price-raising firm to move along D 1. d. ignore this price decrease and cause the price-raising firm to move along D 2. e. raise their prices.

10 14. The conclusion arrived at from a kinked-demand oligopoly model is that: a. oligopoly firms cannot maximize their profits. b. oligopoly firms should keep prices at their current level. c. all oligopoly firms should raise prices. d. all oligopoly firms should lower prices. e. oligopoly market structure will lead to lower prices than more competitive industries. CH 11: OLIGOPOLY Suppose that R. J. Reynolds raises the price of cigarettes by 10 percent. Although they have no requirement or agreement to do so, the other cigarette firms decide to raise their prices accordingly. This situation is best described as: a. price leadership. b. a cartel. c. monopolistic competition. d. a market with kinked demand. 16. The purpose of a cartel is to: a. promote product innovation. b. increase market competition. c. act like a monopoly. d. diversify operations. e. decrease market concentration. 17. A cartel maximizes industry profit by: a. eliminating quotas. b. producing at the kink in its demand curve. c. producing where MR = MC. d. giving secret price concessions. e. producing more output than a monopoly would. 18. Game theory is an especially useful model for analysis in the following types of markets: a. perfect competition. b. monopolistic competition. c. oligopoly. d. monopoly. 19. A dominant strategy is a. a strategy that every firm likes to choose. b. a strategy the rival firms do not choose. c. the only strategy a firm has. d. a strategy that produces the best results no matter what strategy the opposing player follows. e. None of these choices. 20. The most famous cartel is a. Walmart. b. OPEC. c. WTO. d. Microsoft. e. NAFTA.

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