Group 2 Oligopoly Market Structure

8/10/2019 Group 2 Oligopoly Market Structure

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FACULTY OF COMPUTER &MATHEMATICAL SCIENCES

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Group 2 Market Structure (Oligopoly)

Fajratul Aini Binti Mohd. Razali 2014459148

NurAiniBinti Azhar 2014654272

Caroline Hendry 2014261072

Norsyuhada Binti Johan 2014260284


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Market Structure

Market structure identifies how a market is made upin terms of: The number of firms in the industry

The nature of the product produced The degree of monopoly power each firm has

The degree to which the firm can influence price

Profit levels

Firms behaviour (pricing strategies, non-price competition,

output levels) The extent of barriers to entry

The impact on efficiency

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Market Structure

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PerfectCompetition

PureMonopoly

The further right on the scale, the greater the degreeof monopoly power exercised by the firm.

Monopolistic Competition Oligopoly Duopoly Monopoly


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Characteristicsof Oligopoly


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Oligopoly

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Oligopoly is a market structure characterized by a few sellers,

homogenous or differentiated products, and difficult marketentry. In this market structure, a few large firms dominate the

market. They aggressively compete with each other, forexample, by engaging in heavy advertising. Example of an

oligopoly market is where there are only two sellers.


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Characteristic

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There are few large firms in this industry. They are solarge that they can affect the market price. Industries

which best fir the description of oligopoly areautomobiles, aircraft, steel industries and oilindustries.

Few sellers but large in size

Sometimes the product is homogenous; for example oilfrom Saudi Arabia is the same as from Indonesia andMalaysia. Automobiles, tires and airlines services aredifferentiated products sold by oligopolists.

Homogenous or differentiated products


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Oligopolistic Market Structures

Few Firms Consequently, each firm must consider the reaction of rivals to

price, production, or product decisions

These reactions are interrelated

Heterogeneous or Homogeneous Products

Example : Athletic Shoe Market

Nike has 33% of market

Adidas as 15% Reebok has 10%


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The market shares of oligopolists change. In 1985, the marketleader in cell phones was Motorola with 45% market share andNokiasecond with 22%

In 2005, leadership reversed: Nokia held 35% of the market andMotorola 15%

However, technology in phones is changing, bringing wirelessweb, photos, and other high-speed G3 technologies

Entry of other firms and new products, such as Dell, Palm, NEC,

Panasonic, and Apples iPhone pose threats to Nokias profitmargins

Nokia must decide whether or not to invest heavily in the 3Gtechnology for the future.

Being a leader in a oligopoly does not mean that you remain the

leader for long.

Nokias Challenge

In Cell Phones


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There are barriers to entry, which include exclusive financialrequirements, control over an essential resource, patent rights andother legal barriers. But the most significant barrier to entry underoligopoly is economies of scale. For example, larger automakers likeHonda or Toyota achieve a lower cost than those incurred by smaller

ones like Proton. In the USA due to economies of scale, theautomobile industry has been reduced to three major operators frommore than 60 firms previously.

Difficult entry

Because of the fewness of the oligopoly firms, one firmspricing and

output policies can affect the market price and output as well as otherfirms price and output. This situation is called mutualinterdependence amongst firms in oligopoly. Mutual interdependenceis a condition in which an action by one firm may cause a reaction onthe part of other firms. For example, if one firm reduces its price,other firms will soon reduce their prices as well.

Mutual interdependence

Characteristic


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Elasticity

The theory of the kinkeddemand curve is based on twoassumption:

First assumption:If an oligopolist reduces itsprice, its rivals will follow andcut their prices to prevent losingthe customers.

Second assumption:If an oligopolist increases itsprice, its rivals do not increasethe price and keep their pricesthe same, thereby they gaincustomers from the firm thatincreases the price.

Kinked Demand Curve


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Elasticity

Demand is elastic above thekink where an increase in priceabove P0 will lead to a largedrop in quantity as morecustomers switch to the rivals

with lower prices. (Secondassumption : If a firm increasesthe price, others will not follow.)

Demand is inelastic below thekink, where decreasing the price

will only reflect with smallincrease in quantity since allother firms reduce the pricesbelow P0 and customers doswitch. (First assumption : If afirm decreases the price, otherswill follow.)

Kinked Demand Curve


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PriceDetermination


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Price Determination

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A single firm sets industry price and the remaining firmscharge the same price as the leader

Firms in an oligopolistic market have to consider the reaction

of its rivals when taking decisions.

Firms in an oligopolistic market can make many possiblereaction to the price, non-price and output changes ofanother firm.

Example:

If Maxis decrease the price of their internet plan, the otherfirms in the same industry such as Celcom and Digi also hadto decrease their price in order not to lost customers


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Price Determination Model Of Oligopoly :Price Leadership Model

Under price leadership, one firm assumes the role of a price leaderand fixes the price of the product for the entire industry.

The other firms in the industry simply follow the price leader andaccept the price fixed by him and adjust their output to this price.

The price leader is generally a very large or dominant firm or a firm

with the lowest cost of production. It often happens that price leadership is established as a result of

price war in which one firm emerges as the winner.

In oligopolistic market situation, it is very rare that prices are setindependently and there is usually some understanding among the

oligopolists operating in the industry. This agreement may beeither tacit or explicit.

There are various models concerning price-output determinationunder price leadership on the basis of certain assumptionsregarding the behaviour of the price leader and his followers.

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This is a system of price-output determination we sometimessee in oligopolistic market structures in which there is onefirm that is clearly dominant.

General Motors was once the price leader in the U.S. autoindustry.

Other dominant firms include Du Pont in chemicals, US

Steel (now USX), Phillip Morris, Fedex, Boeing, GeneralElectric, AT&T, and Hewlett Packard.

Dominant Firm

Price Leadership


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The Model

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1. The dominant firm sets the market price and remaining firmssell all they wish at this price

2. The demand curve for the price leader is found bysubtracting the market demand curve from the supply curveof the remaining sellers in the market


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FIGURE10.1: DOMINANTFIRMPRICELEADERSHIP

P'

P*

d Lneader ' set demand

I ndust r y demand

Supply cur vef or small f ir ms

D

S

d

M C M R

Q* Qs

Dollar s per Unit of O ut put

O ut put

D

P* is the price

established by

the dominant

firm

Q* + QS


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Example :

Let the market demand curve be given by:

QD= 2482P

The supply curve for 10 small firms in the market is given by:

QS= 48 + 3P

The dominant firms residual or net demand curve is given

by the market demand curve minus the supply of the 10 other

firms, or:

Q = QDQS= 2482P(48 + 3P) = 2005P

The inverse (residual) demand curve facing the dominant firm

is given by:

P = 40 - .2Q


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Assume the dominant firm has a marginal cost function given

by:

MC = .1QThe dominant firm would maximize its own profits by setting

MR = MC. To derive the MR, find the revenue (R) function and

take the first derivative with respect to Q:

R = P Q = (40 - .2Q)Q = 40Q - .2Q2

MR = dR/dQ = 40 - .4Q

Now set MR = MC and solve for Q

40 - .4Q = .1Q.5Q = 40 Q = 80 UnitsP = 40(.2)(80) = $24

At the price established by the dominant firm, the remaining 10

firms collectively supply 120 units (or 12 units each).


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Price Rigidity &Kinked Demand


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Price Rigidity

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Since there is mutual interdependence between oligopolyfirms, the prices in the market are more stable which is calledprice rigidity in oligopolistic market.

This can be explained by kinked demand curve.

The price rigidity explains the behavior of an oligopoly firmthat has no incentive to increase or decrease the price.

The theory of kinked demand curve is based on two

assumptions. If an oligopolist reduce its price, its rival will follow and cut

their prices to prevent losing the customers. If an oligopolist increases its price, its rival do not increase

the price and keep their prices the same, thereby gaincustomers from the firm that increases the price


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Kinked Demand Curve Model

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1. A combination of two demand curves

2. Show a situation where the best situation for players is tomaintain current prices and that prices remain stable in spiteof firms with different cost structures


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Elasticity

Demand is elastic above thekink where an increase inprice above P0 will lead to alarge drop in quantity as more

customersswitch to the rivalswith lower prices.

Demand is inelastic below thekink, where decreasing the

price will only reflect withsmall increase in quantitysince all other firms reduce theprices below P0and customersdo not switch.

Kinked Demand Curve


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"Kinked" demand curves and traditional demand curves are similar inthat they are both downward-sloping. They are distinguished by ahypothesized concave bend with a discontinuity at the bend - the"kink." Therefore, the first derivative at that point is undefined and

leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producerwith some market power (either due to oligopoly or monopolisticcompetition) will set marginal costs equal to marginal revenue. Thisidea can be envisioned graphically by the intersection of an upward-

sloping marginal cost curve and a downward-sloping marginal revenuecurve (because the more one sells, the lower the price must be, so theless a producer earns per unit).

In classical theory, any change in the marginal cost structure (howmuch it costs to make each additional unit) or the marginal revenue

structure (how much people will pay for each additional unit) will beimmediately reflected in a new price and/or quantity sold of the item.

This result does not occur if a "kink" exists. Because of this jumpdiscontinuity in the marginal revenue curve, marginal costs couldchange without necessarily changing the price or quantity.


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Our primary technology for analyzingoligopoly behaviour will be gametheory. As we will see, these aremethods designed to focus onstrategic considerations. Before wedo that though, let's look at a simplemodel which combines the profitmaximization model we know wellwith some simple strategicconsiderations.

Consider the two demand curvesshown to the right. An oligopolistmight not know which of thesedemand curves it faces. Suppose afirm knows that any time it raises or

lowers its prices all other firms in theindustry will do the same. In this caseit faces DI, the inelastic curve. If allfirms change prices together, theeffect of a price change won't have alarge effect on the sales of any one of

the firms.


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If no other firms follow its changes inprices the firm will instead find itselfon DE, a much more elastic demandcurve. If the firm is the only one to raise

prices it will experience a large drop insales. Likewise, if it is the only one tolower prices it will find sales increaserapidly. So DE is the relevant demandcurve if others don't follow the firmsprice changes.

Before it can set profit maximizing priceand quantity the firm must determinewhich is the appropriate demand curve.The kinked demand curve model isbased on the idea that, if the firm raises

prices other firms won't follow becausethey don't worry about losing marketshare to a firm which is raising price.However, if the firm lowers its pricesother firms will respond by lowering theirprices also since they don't want to lose

market share.


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If price increases are ignored by otherfirms but price decreases lead tolowering of prices by competitors thefirm will face a kinked demandcurve as shown to the right, with thekink at the current market price of P*.

Keep in mind that the firm's belief thatit faces a kinked demand curvecomesfrom basic strategic considerations. Itbelieves that competitors won'trespond to price increases but thatthey will respond to price decreases.This in turn, means that the elasticity

of the demand curve it faces dependson the direction of a price change.From here we use the simple logic ofprofit maximization to analyzebehaviour.


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If the demand curve is kinked asshown to the right the marginalrevenue curve will have an unusualshape.

As always the marginal revenuecurve lies below the relevantdemand curve and is steeper, so it

makes sense that the MR curveshown here has two segments withvery different slopes. What isunusual is the gap in the MR curve,shown by the dashed line. Simplyput, if the firm lowers price

below P* a strong reaction fromcompetitors occurs in the form ofindustry wide price drops. Thiscauses MR to drop dramatically,causing a gap in the curve.


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If marginal costs fall anywherebetween MC1and MC2 the firm willchoose to leave price and outputunchanged. Because of its belief

about how other firms will respondto a price change the firm is betteroff not altering price even in theface of rather significant changesin production costs.

As we will see, strategicconsiderations can causebehaviour that varies considerablyfrom the simple mechanisticresponses predicted by profitmaximization. Not that there is

anything wrong with the profitmaximizing model in otherindustrial structures, but it doesn'tcapture the rich strategiccomplexity that we must allow forin our study of oligopoly.


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An analysis using the kinked-demand curve to explain rigid pricesoften found with oligopoly.

The kinked-demand curve contains two distinct segments whichare one for higher prices that is more elastic and one for lowerprices that is less elastic.

Key to this analysis is that the corresponding marginal revenue

curve contains three segments :a) associated with the more elastic segmentb) associated with the less elastic segmentc) associated with the kink.

A profit-maximizing firm can then equate marginal cost to a wide

range of marginal revenue values along the vertical segment of themarginal revenue curve. This suggests that marginal cost mustchange significantly before an oligopolistic firm is inclined tochange price.

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The kinked-demand curve analysis of oligopoly builds on the

notion of interdependent decision-making to explain why pricestend to be relative stable or rigid.

The key to this analysis is that competing firms do not respond inthe same way when one firm increases or decreases its price.

Competing firms match price decreases, but not price increases.This means a firm is likely to lose market share for price increases,but does not gain market share for price decreases.

A firm has little to gain from reducing prices and much to loseform raising prices. As such, the firm is inclined to keep pricesstable.

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Profit Maximization

Example :Athletic footwear faces the following demand curve:

P1 = 600 - 0.5Q1 for price increaseP2 = 7000.75Q2 for price decrease

The firms marginal cost is RM150

a) What is the price and output at the kink?

At the kink,


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b) At what range of value will the marginal cost shift withoutchanging price and output?

To find the range of MC, the upper limit and lower limit of MRneeds to be found out.

Firstly, derive the demand curve.

Price increase (upper limit) : Price increase (lower limit) :

The range for MC to shift is between 100 and 200


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c) What is the profit maximizing price and quantity if the marginalcost is RM250?

For profit maximization to take place, we use MR=MC rule.

We equate to MC because MC is more than the upper limit

Group 2 Oligopoly Market Structure

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