M10: OLIGOPOLY

• Oligopoly

  • A market dominated by a few large producers of a homogeneous or differentiated product.
  • Because of their “fewness,” oligopolists have considerable controlover their prices, but each must consider the possible reaction ofrivals to its own pricing, output, and advertising decisions.
• A FEW LARGE PRODUCERS:

  • Big Three
  • Big Four
  • Big Six
• Homogeneous or Differentiated Products

  • Differentiated oligopolies typically engage in considerable nonprice competition supported by heavy advertising.
• Strategic behavior => self-interested behavior that takes into account the reactions of others.
• Mutual interdependence => a situation in which each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms.
• Large expenditure for capital => is an entry barrier of oligopoly that represents the cost of obtaining necessary plant and equipment
• Mergers

  • The merging, or combining, of two or more competing firms may substantially increase their market share, and this in turn may allow the new firm to achieve greater economies of scale.
  • Another motive underlying the “urge to merge” is the desire for monopoly power.
• THREE OLIGOPOLY MODELS:

  1. The Kinked-Demand Curve
  2. Collusive Pricing
  3. Price Leadership
• Kinked-Demand Theory: Non-collusive Oligopoly

  • It is assumed that the firms are “independent,” meaning that they do not engage in collusive price practices.
  • "What does the firm’s demand curve look like?"
• Mutual interdependence and the uncertainty about rivals’ reactionsmake this question hard to answer:

  • Match the price changes
  • Ignore price changes
• Criticisms of the Model

  • When the macroeconomy is unstable, oligopoly pricesare not as rigid as the kinked-demand theory implies.
  • During the inflationary periods, many oligopolists haveraised their prices often and substantially.
  • During downturns (recessions), some oligopolists have cutprices.
• Price war is a successive and continuous rounds of price cuts by rivals as they attempt to maintain their market shares.
• Collusion occurs whenever firms in an industry reach an agreement to fix prices, divide up the market, or otherwise restrict competition among themselves.
• Disadvantage of kinked-demand curve: PRICE WAR
• However, by controlling price through collusion, oligopolists may be able to reduce uncertainty, increase profits, and perhaps even prohibit the entry of new rivals.
• How can they avoid the less profitable outcomes associated with either higher or lower prices?

  • They can collude
  • They can get together, talk it over, and agree to charge the sameprice.
  • In addition to reducing the possibility of price wars, this will give each firm the maximum profit.
• Overt => open to view

  Covert => illegal
• Cartel => is a group of producers that typically creates a formal written agreement specifying how much each member will produce and charge.
• Organization of Petroleum Exporting Countries (OPEC) => produce about 40% of the world’s oil and 60% of the oil sold in world’s market.
• Demand and Cost Differences => When oligopolists facedifferent costs and demand curves, it is difficult for them toagree on a price.
• Number of Firms => Ceteris paribus, the larger the number offirms, the more difficult it is to create a cartel of some otherform of price collusion.
• Cheating => collusive oligopolists are tempted to engage insecret price cutting to increase sales and profit.
• Recession => Slumping markets increase ATC => excess capacity,sales are down, unit costs are up, profits are being squeezed.
• Potential Entry => The greater prices and profits that result fromcollusion may attract new entrants, including foreign firms.
• Legal Obstacles => Anti-trust Law
• Price leadership => entails a type of implicit understanding by which oligopolists can coordinate prices without engaging in outright collusion based on formal agreements and secret meetings.
• PRICE LEADERSHIP TACTICS:

  • Infrequent Price Changes
  • Communications
  • Limit Pricing
• Infrequent Price Changes

  • Because price changes always carry the risk that rivals will not follow the lead, price adjustments are made only infrequently.
  • The price leader does not respond to minuscule day-to-day changes in costs and demand.
  • Price is changed only when cost and demand conditions have been altered significantly and on an industry wide basis as the result of: wage increases, an increase in excise taxes, or an increase the price of basic inputs such as energy.
• Communications

  • The price leader often communicates impending adjustments to the industry through speeches by major executives, trade publication interviews, or press releases.
  • By publicizing “the need to raise prices,” the price leader seeksagreement among its competitors regarding the actual increase.
• Limit Pricing

  • The price leader does not always choose the price that maximizes short-run profits for the industry because the industry may want to discourage new firms from entering.
  • The price leader may keep price below the short-run profit-maximizing level. The strategy of establishing a price that blocks the entry of new firms is called limit pricing.
• Breakdown in Price Leadership

  • Price leadership in oligopoly occasionally breaks down, at leasttemporarily, and sometimes results in a price war.
• Oligopoly and Advertising

  • Prevalent in monopolistic competition and oligopoly
  • Capture market share
  • Better than a price cut
  • Information for consumers
  • Manipulation
• EFFICIENCY IN OLIGOPOLY

  • Neither productive efficiency (P= minimum ATC) nor allocativeefficiency (P=MC) is likely to occur under oligopoly.