Market Structure

Oligopoly

Characteristics of Oligopoly

• The government does not intervene into the operations of the oligopolistically competitive firm in the market unless the oligopolist violates the laws of the land.

• The industry has a few large sells and a large number of buyers.

• The market structure has strong barriers to entry.

• The firms operating in this oligopolistically competitive product group may or may not produce homogenous good. The good may be differentiated.

• For simplicity we assume perfect knowledge exists.

Collusive Behavior (Non price competition)

• Collusion exist when the firms agree on prices and other factors such as output levels and market share. A cartel is a formal collusive agreement between firms in an industry.

• This gives rise to monopoly power as seen in the Organization for Petroleum Exporting Countries (OPEC).

Collusive Behavior (Non price competition)

The total market demand curve is shown with the corresponding market MR curve. The cartel’s MC curve is the horizontal sum of the MC curves of its members (since we are adding the output of each of the cartel members at each level of marginal cost). Profits are maximised at Q1 where MC = MR. The cartel must therefore set a price of P1 (at which Q1 will be demanded). Having agreed on the cartel price, the members may then compete against each other using non-price competition, to gain as big a share of resulting sales (Q1) as they can.

Collusive Behavior (Non price competition)

• Alternatively, the cartel members may somehow agree to divide the market between them. Each member would be given a quota. The sum of all the quotas must add up to Q1. If the quotas exceeded Q1, either there would be output unsold if price remained fixed at P1, or the price would fall. But if quotas are to be set by the cartel, how will it decide the level of each individual member’s quota? The most likely method is for the cartel to divide the market between the members according to their current market share. This is the solution most likely to be accepted as ‘fair’.

£

Q O

P1

Q1

D

D

Kinked demand for a firm under oligopoly

Non Collusive Behavior – The Kinked Demand Curve

The theory is based on two asymmetrical assumptions:

(1) If an oligopolist cuts its price, its rivals will feel forced

to follow suit and cut theirs, to prevent losing customers to the first firm.

(2) If an oligopolist raises its price, however, its rivals will not follow suit since, by keeping their prices the same, they will thereby gain customers from the first firm.

Non Collusive Behavior – The Kinked Demand Curve

On these assumptions, each oligopolist will face a demand curve that is kinked at the current price and output . A rise in price will lead to a large fall in sales as customers switch to the now relatively lower-priced rivals. The firm will thus be reluctant to raise its price. Demand is relatively elastic above the kink. On the other hand, a fall in price will bring only a modest increase in sales, since rivals lower their prices too and therefore customers do not switch. The firm will thus also be reluctant to lower its price. Demand is relatively inelastic below the kink. Thus oligopolists will be reluctant to change prices at all.

£

Q O

P1

Q1

MC2

MC1

MR

a

b D = AR

Stable price under conditions of a kinked demand curve

Kincked Demand Curve

• When the demand curve is kincked, the MR Curve has a discontinuous segment shown in the diagram. Price stickiness refers to the tendency for prices to remain rigid or fixed under oligopolistic market structure even though cost may vary. This is as a direct result of the kinked demand curve and the discontinuous marginal revenue curve.

Kincked Demand Curve

• In the diagram the knicked demand curve is presented with two different MC curves. At intial cost MC1 the firm achieves output Q at price P1. As MC curve shifts upwards to MC2 into the discontinous region of the MR curve, the firm’s output and price remains unchanged at Q and P. Conclusively the diagram demonstrates that even though the firm’s MC curve varies, its price remains stuck at the same level, thus prices under oligopoly are describe as sticky.

Industrial Concentration

• The degree of oligopolistic industries is often measured using concentration ratios.

• A concentration ratio reveals the percentage of total output produced and sold by an industry’s largest firms (McConnell & Brue 2002).

• A four firm concentration ratio will measure the percentage of total output produced and sold by the top four companies in a particular industry

Concentration Ratio Formula

Example In this example the four firm concentration ratio is 70% . This means that the four largest firms in the industry collectively control 70% of the market share

Limitations of Concentration Ratios

– The concentration ratios focus on domestic production and do not include import competition. Therefore the four largest firms may account for a large percentage of domestic production but that does not mean that they have significant control over price because imports may be large

– Lastly markets may be localized where the production by a dominant firm is restricted to a particular town or metropolitan society.

Herfindahl Index

• It is the sum of the squared percentage market shares of all firms in the industry.

• To generalize the larger the index, the greater the market power within an industry.

Herfindahl Index • The Herfindahl index (HI), also known as the concentration index, It is commonly used to

support antitrust claims. The index can be large or small, but decreases are indicative of a loss in pricing power and/or increased competition while increases suggest the opposite.

The Herfindahl-Hirschman Index (HHI), a commonly accepted measure of market concentration, measures industry concentration by summing the squared market shares of the firms in the industry. The HHI index is calculated as follows:

where si is the market share of firm i in the market, and n is the number of firms.

• It is calculated by squaring the market share of each firm competing in the market and then

summing the resulting numbers, where the market shares are expressed as fractions. The result can range from 0 to 1.0. Equivalently, if percents are used as whole numbers, as in 75 instead of 0.75, the index can range up to 1002, or 10,000.

• An HHI index below 0.01 (or 100) indicates a highly competitive index. An HHI index below 0.15 (or 1,500) indicates an unconcentrated index. An HHI index between 0.15 to 0.25 (or 1,500 to 2,500) indicates moderate concentration. An HHI index above 0.25 (above 2,500) indicates high concentration

• Increases in the HHI generally indicate a decrease in competition and an increase of market power, whereas decreases indicate the opposite.