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Copyright Economics Department, King’s School, Chester
Theory of oligopolyTheory of oligopoly
““Competition amongst the few”Competition amongst the few”
Copyright Economics Department, King’s School, Chester
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
Copyright Economics Department, King’s School, Chester
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
Copyright Economics Department, King’s School, Chester
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
Copyright Economics Department, King’s School, Chester
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
Copyright Economics Department, King’s School, Chester
Kinked demand curve modelKinked demand curve model
D = AR
Output
Price
D = AR
What does the MR curve for the kinked demand curve look like?
P0
Q0
Copyright Economics Department, King’s School, Chester
Kinked demand curve modelKinked demand curve model
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
Copyright Economics Department, King’s School, Chester
Kinked demand curve modelKinked demand curve model
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
Copyright Economics Department, King’s School, Chester
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
Copyright Economics Department, King’s School, Chester
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)
Copyright Economics Department, King’s School, Chester
Confess
Deny
ConfessDeny
Freddie’s options
Will’s options
Copyright Economics Department, King’s School, Chester
High
Firm
Y’s
pric
ing
stra
tegy
Firm X’s pricing strategy
Low
High Low