LECTURE 1OBJECTIVES:Students should be able to:Identify and explain the characteristics of oligopoly.

OLIGOPOLYImperfect Competition among the FEW

OLIGOPOLYDefinitionA market structure in which a few firms dominate the supply of an industrys output and compete with each other for markets.

Market StructureOligopoly Competition amongst the fewIndustry dominated by small number of large firmsMany firms may make up the industryHigh barriers to entryProducts could be highly differentiated branding or homogenousNonprice competitionPrice stability within the market - kinked demand curve?Potential for collusion?Abnormal profitsHigh` degree of interdependence between firms

OLIGOPOLYExampleCar industryAirline industryCigarettesCleaning productsElectrical appliance

CharacteristicsFew dominant firmsSupply is concentrated in the hands of a relatively few firms.Market domination of firms can be measured by concentration ratio.

OLIGOPOLYMeasuring Oligopoly:Concentration ratio the proportion of market share accounted for by top X number of firms:E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for 80% of market share3 firm CR of 72% - top 3 firms account for 72% of market share

OligopolyExample:Music sales The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this independents group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers.Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html

Market shares of thelargest brewers

In 1985 - 3 firm concentration ratio is 47.In 1985 5 firm concentration ratio is 68.In 2002 3 firm concentration ratio is 63.In 2002 5 firm concentration ratio is 83.

CharacteristicsImplication of market dominationStrong mutual interdependence among dominant firms in their price and output decisions.

CharacteristicsHomogeneous or Differentiated ProductsHomogeneous product- pure oligopoly eg. Raw materials (oil, petrol, tin)Differentiated product- imperfect/ differentiated oligopoly eg. Cars, detergent

CharacteristicsBarriers to EntrySubstantial barriers, similar to monopoly but not as restrictive eg. Petroleum industry

CharacteristicsNon-price competitionCompete not through price but other methods (advertising, after-sales service, free gifts)

NON-PRICE COMPETITIONPracticed by oligopoly and monopolistic competition.Various forms:Competitive advertising to reinforce product differentiation and harden brand loyalty.Promotional offers eg. Household detergent, toothpaste, shampoo (buy 2 get 1 free), (25% extra at no extra cost).Extended guarantees/after sales service esp. for consumer durables, by offering free spare parts, labour guarantee.Better credit facilityAttractive gift wrappings

Price RigidityPrices are very inflexibleDespite changes in underlying costs of production, firms are often observed to maintain prices at a constant level.

CollusionMake agreement amongst themselves so as to restrict competition and maximise their own benefit.

LECTURE 2OBJECTIVES:Students should be able to:Identify oligopoly models.Identify the practices of oligopoly- collusion and price leadershipExplain the equilibrium of oligopoly ie. the kinked demand curve theory.Examine advantages and disadvantages of oligopoly.

1.PRICE DETERMINATION MODELSCARTELS

PRICE LEADERSHIP

2. PRICE RIGIDITY MODELS KINKED DEMAND CURVE THEORY

1.PRICE DETERMINATION MODELSCARTELSCollusive model- an agreement between firms to fix prices or mutually divide the market.Firms work together and act like a profit maximising monopolist.Collusion may be FORMAL (collusive oligopoly) or TACIT (non-collusive oligopoly).

Disadvantages of collusionHigher pricesOutput restrictedProducer sovereigntyProductive InefficiencyAllocative Inefficiency

1. PRICE DETERMINATION MODELSPRICE LEADERSHIPUsually there is a price leader in oligopoly collusion (esp. tacit) to determine price.The dominant firm will emerge as the leader.

2. PRICE RIGIDITY MODELTHE KINKED DEMAND CURVE THEORY(reaction model) Paul Sweezy 1930sThis model recognises that demand for a firms product is determined both by the market demand for a product as well as by rival firms behaviour

Kinked demand for a firm under oligopolyQOCurrent priceand quantitygive one pointon demand curve

fig

Stable price under conditions of a kinked demand curveQOP1Q1D = AR

KINKED DEMAND CURVE THEORYIf the firm lowers its price below OP1, its rivals will follow.Its demand will expand along the relatively inelastic section of the demand curve below OP1 and total revenue will fall.

KINKED DEMAND CURVE THEORYIf the firm raises its price above OP1, none of its competitors will follow. Its demand for prices above OP1 will contract along the relatively elastic section of the demand curve and total revenue will fall.

As a result of action and non-reaction to price changes, an oligopolist is faced with a kinked demand curve at OP1.Price rigidity is due to the kinked demand curve and the resulting discontinuity in the MR curve.

Note: An oligopolistic firm faces a relatively more ELASTIC DDcurve at prices ABOVE a given market price and a relatively more INELASTIC DD curve at prices BELOW a given market price.

Changing cost conditionsEven though MC may be rising or falling, MC=MR in the portion of discontinuity will leave price and output unchanged at OP1 and OQ1.Ie. Changes in costs has no effect on profit maximising price and out put because the firm is still producing where MC=MR.

ADVANTAGES OF OLIGOPOLYWhen firms collude monopoly supernormal profit extra profit extra capital to fund R&D benefit to consumer.Product differentiation non-price competition greater variety to consumers.Price stability/rigidity helps in planning, reduce uncertainty.

DISADVANTAGES OF OLIGOPOLYCollusive oligopolyif they agree upon output no variety and improvement in quality bad for consumers.Acting like a monopolyRestrict output and charge a higher priceProducer sovereigntyConsumer sovereignty not respectedGreater inequality in income (supernormal profits)

PQD1P0Q0PLD2 (Rival matches your price change)PH(Rival holds itsprice constant)

DDemand if Rivals Match Price Reductions but not Price Increases

Key InsightThe effect of a price reduction on the quantity demanded of your product depends upon whether your rivals respond by cutting their prices too!The effect of a price increase on the quantity demanded of your product depends upon whether your rivals respond by raising their prices too!Strategic interdependence: You arent in complete control of your own destiny!

Sweezy (Kinked-Demand) ModelFew firms in the marketEach producing differentiated products.Barriers to entryEach firm believes rivals will match (or follow) price reductions, but wont match (or follow) price increases.Key feature of Sweezy ModelPrice-Rigidity

Sweezy Marginal RevenuePQD1P0Q0D2 (Rival matches your price change)(Rival holds itsprice constant)

MR1MR2DMR

Sweezy Profit-MaximizationPQP0Q0DMRMCMCHMCL