Download Chapter 8.4

THEORY OF THE FIRM & MARKET STRUCTURE
CHAPTER 8
Chapter 8.4 ::: OLIGOPOLY
DEFINITION OF OLIGOPOLY
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Come from the Greek word “Oligos” means “ a little”
A market structure with a few no of large firms producing & supplying all output in the market
Closed to monopoly eg: Petroleum industry & steel industry, Automobile manufacturers, Personal Care Products,
Cigarette Manufacturers
If there is only two firms in the market, it’s known as “Duopoli”
CHARACTERISTICS
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A few large firms
Mutual interdependence
Price rigidity(stable)
homogenous or differentiated product
Difficult to entry
A few large firms
 The number of firms is small but the size of the firm is large.
 The market share is large enough to dominate the market.
 such as petroleum industry (Shell, BP, Caltex, PETRONAS), cement, television [TV1, TV3, ASTRO]
Mutual interdependence
 Makes a decision based on the reaction of other firms in the industry.
 The changes, in price or output by one firm can have a direct effect on another firm.
 Eg: if General Motor increase it price, the cars will be more expensive than Ford’s. The consumer will choose
Ford’s cars and this will make General Motor lose. So, GM will reduce the price.
Price rigidity
 Price is rigid [stable] when it changes very slowly over a period of time.
 There’s no incentive to either increase or decrease the price of its product.
 When 1 oligopolist firm increase price, the others not follow because they can steal the market share from the
firm.
– The firm will incur loss & has to decrease P to avoid loss.
– Due to price interdependency, P can’t change.
Homogenous & differentiated product
 Some maybe have the same function but different in brand name, shape, quality, etc..
 Eg: PETRONAS vs. Shell  this firm give the same function (petrol) but differ in brand name & quality.
Difficult to entry
 Legal barriers such as government franchises, licenses & patents
TYPES OF OLIGOPOLY
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There have 2 types:
– Perfect oligopoly  All firms produced identical product eg: steel industry
– Imperfect oligopoly  All firms produced differentiated product eg: automobile product
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KINKED DEMAND CURVE
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Known as collusive oligopoly and use the “Sweezy’s Model”
Sweezy’s Model
– There 2 situations:
i) There are only 3 firms (A, B & C)
ii) They are interdependent (There is no collusion between them)
– There 2 assumptions:
i) The rivals will follow the price if one of the oligoplist reduces the price
ii) The rivals will not follow the price if one of the oligoplist increases the price
– The shape of the oligopolists demand curve depend on how the firm’s rival will react to a price change introduce
by firm A.
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Rivals will match a P , but ignore a P
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Without any collusion
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Make P decision(price maker)
There are two possible reactions
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MATCH PRICE CHANGES
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if A reduce the P  B & C follow
 so, the increase in sales for A is small,
because B & C also will gain the mkt share
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If A increase in P  B & C follow
 its sales will loss modestly
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Thus, Demand curve is steep & demand curve
is inelastic
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IGNORE PRICE CHANGES
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Another possibility is B & C ignore A’s price
changed
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If A reduce price, B & C do not changed the
price
 A will gain higher mkt share (sales
increase substantially)
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If A increase price, and B & C do not changed
the price
 A will lose big mkt share (sales drop
substantially)
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So, demand curve is less steep & elastic
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A Combined Strategy
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D1 MR1 is an inelastic demand curve. D2 MR2 is an elastic demand curve. Pe & Qe are equilibrium price & eqb Qty
respectively.
If the firm raises the price from Pe to P1, other firm will not follow, and the firm will lose a market share where
qty Dd decrease from Qe to Q1.
This is shown on elastic Dd curve D2 (Rivals tend to follow a price cut or ignore a price increase).
If the firm lowers its price from Pe to P2, other firms will follow to avoid losing a share market to the firm which
lowers its price. Lowering the price will increase the Qty Dd from Qe to Q2.
This is the small increase because other firm will also lower the price & they manage to attain the same share in
the mkt. the situation is shown on elastic Dd curve D1 (Rivals tend to follow a price cut).
So the actual Dd curve of the firm combination of D1 & D2. so the demand curve is kinked (Effectively creating a
kinked demand curve)
THE FIRM’S EQUILIBRIUM
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To maximize profit, the oligopolist firm will not involve in price competition (price rigid).
They will try to minimized cost of production as lower as possible.
Means the price is still fixed or same but to get the maximum profit, they will minimize cost as lowest as they can
afford to do it.
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At higher Marginal cost, C1, the output produced is Qe and the price at Pe.
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THEORY OF THE FIRM & MARKET STRUCTURE
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CHAPTER 8
Profit maximization MR = MC occurs at the kink.
The profit is area A.
If the frim becomes more efficient, MC will decrease MC1 to MC2.
The output produced is still at Qe at the same price, Pe . MC2.
The profit has increased to area A + B.
So, without changing the price, the firm can maximize profit by reducing cost efficiency in production.
Example I
 Profit is maximized when MR = MC
 As long as the curve intersect at the vertical gap of MR curve, the profit maximizing quantity & price will be at
kinked.
 If the amount of MC is within RM 8 to RM 25, the equilibrium output will be 40 units and price will be RM 50
Qe = 40 units
Pe = RM 50
TR = P x Q
=
=
TC = AC x Q
=
=
∏ = TR - TC
=
=
 In order to maximized, firm will try to minimize cost since there is no competition in terms of price.
Example II
What happen when MC is AT kinked point???
Qe =
Pe =
TR = P x Q
=
=
TC = AC x Q
=
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∏ = TR - TC
=
=
Example III
When MC is ABOVE kinked point???
Qe =
Pe =
TR = P x Q
=
=
TC = AC x Q
=
∏ = TR - TC
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Additional notes: Characteristics of Market Structures
Market Structure
Characteristics
Perfect Competition
Oligopoly
Very large number
Monopolistic
Competition
Many
Number of firms
Barriers to entry
None
Low
High
Market power (control over
price
Type of product
None
Some
Substantial
Standardized
Differentiated
Standardized
differentiated
Few
or
Market Structure
Characteristics
Perfect
Competition
Duopoly
Monopoly
Number of firms
Very large
number
Two
One
Barriers to entry
None
High
High
Market power (control
over price
None
Substantial
Substantial
Type of product
Standardized
Standardized or
differentiated
Unique
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