Theory of oligopoly

Copyright Economics Department, King’s School, Chester

Theory of oligopolyTheory of oligopoly

““Competition amongst the few”Competition amongst the few”


Characteristics of oligopolyCharacteristics of oligopoly

The market is dominated by a few large firms concentration ratios are high

There is a high degree of interdependence between firms

Firms supply products which are heavily branded or differentiated

Entry barriers exist so that profits are abnormal in the long run


Features of oligopoly marketsFeatures of oligopoly markets

There is a great deal of non-price competition between firms

Price rigidity is the norm Aggressive price wars break out periodically Firms may collude to fix prices, agree not to

compete in each others’ ‘patch’, carve up the market, follow a leader’s price changes

Firms may exercise control over the supply chain through ‘vertical restraints’, controlling the distribution and sale of the product


Why non-price competition?Why non-price competition?

Advertising and marketing are used to raise demand, develop brand loyalty and command a ‘premium’ price

Often the emphasis of corporate strategy is on increasing market share (service quality, longer opening hours) rather than maximising profit

Incumbent firms may use advertising and marketing to restrict entry


Kinked demand curve modelKinked demand curve model

This model takes as its starting point the idea that oligopolistic firms are highly interdependent

So, if one firm lowers its price others will follow for fear of losing market share

But, if one firm raises its price others will not in order to gain market share

Firms in oligopoly, therefore, face two demand curves - one relatively elastic curve for a price rise and one relatively inelastic for price reductions

The firm’s demand curve ‘kinks’ around the original price



D = AR

Output

Price

D = AR

What does the MR curve for the kinked demand curve look like?

P0

Q0



MR

MR

Each AR curve has its own MR curve but only up to the output sold at P0 - ie output Q0

Output

Price

D = AR

P0

Q0

D = AR



MROutput

Price

P0

Q0

D = AR

The MR curve has a vertical discontinuity at output Q0.

The consequence is that MC can vary between MC1 and MC2 yet the price will not change - it is rigid.

What if the MC curve is MC3?

Does the firm maximise profit?

MC1

MC2

MC3


The nature of collusionThe nature of collusion

Collusion is an attempt to maximise joint profits of the group by acting together as a monopolist

Price fixing requires a quota system to divide the market output between the members of the cartel

Collusion is easiest / most successful when: there are a small number of firms in the industry there is a way of ‘policing’ firms’ output and prices there is no dominant buyer entry barriers prevent new firms from undercutting the

incumbents’ agreed price demand is stable and price inelastic


Problems with collusionProblems with collusion

Collusion is not stable and cartels break down Although joint profits are maximised through price

fixing, each firm is not maximising profit Each firm has an incentive to cheat on the agreement

by producing more than its quota or discounting its prices

Cartels run foul of competition policy BA / Virgin

http://news.bbc.co.uk/1/hi/business/6925397.stm http://news.bbc.co.uk/1/hi/business/5105454.stm

Bus service operators, Kingston upon Hull (1998)


Confess

Deny

ConfessDeny

Freddie’s options

Will’s options


High

Firm

Y’s

pric

ing

stra

tegy

Firm X’s pricing strategy

Low

High Low

Theory of oligopoly

Technology

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