13.3 Oligopoly

Characteristics of an Oligopoly

1. High barriers to entry 2. Fewer firms 3. Firms are interdependent, a price change in one firm can be expected to be met by a price change its competitors.

Models of Oligopoly Pricing

1. Kinked demand curve model 2. Cournot duopoly model 3. nash equilibrium model 4. Stackelberg dominant firm model

Nash Equilibrium

A Nash equilibrium is reached when the choices of all firms are such that there is no other choice that makes any firm better off (increases profits or decreases losses). The firms could, however, collude.

Cartel

An example of a collusive agreement is the OPEC cartel. collusive agreements to increase price in an oligopoly market will be more successful (have less cheating) when: 1. There are fewer firms. 2. Products are more similar (less differentiated). 3. Cost structures are more similar. 4. Purchases are relatively small and frequent. 5. Retaliation by other firms for cheating is more certain and more severe. 6. There is less actual or potential competition from firms outside the cartel.

Kinked Demand Curve model

Base on the assumption that an increase in a firm's product price will not be followed by its competitors, but a decrease in price will. A firm believes that if it raises its price above PK, its competitors will remain at PK, and it will lose market share because it has the highest price if a firm decreases its price below PK, other firms will match the price cut, and all firms will experience a relatively small increase in sales relative to any price reduction. Therefore, Q K is the profit-maximizing level of output. The profit-maximizing level of production is located at Qk.

Dominant Firm Model

In this model, there is a single firm that has a significantly large market share because of its greater scale and lower cost structure—the dominant firm (DF). In such a model, the market price is essentially determined by the dominant firm, and the other competitive firms (CF) take this market price as given.

Stackelberg Model

One firm is the "leader" and chooses its price first, and the other firm chooses a price based on the leader's price. In equilibrium, under these rules, the leader charges a higher price and receives a greater proportion of the firms' total profits.

Dominant Firm Oligopoly

The dominant firm believes that the quantity supplied by the other firms decreases at lower prices, so that the dominant firm's demand curve is related to the market demand curve as shown. Based on this demand curve (DDF) and its associated marginal revenue (MRDF) curve, the firm will maximize profits at a price of P*. The competitive firms maximize profits by producing the quantity for which their marginal cost (MCCF) equals P*, quantity QCF . A price decrease by one of the competitive firms, which increases QCF in the short run, will lead to a decrease in price by the dominant firm, and competitive firms will decrease output and/or exit the industry in the long run. The long-run result of such a price decrease by competitors below P* would then be to decrease the overall market share of competitor firms and increase the market share of the dominant firm.

Collusion vs. Perfect Competition

the resulting price will be somewhere between the price based on perfect collusion that would maximize total profits to all firms in the market (actually the monopoly price, which is addressed next) and the price that would result from perfect competition and generate zero economic profits in the long run.

Cournot Model

two firms with identical marginal cost curves each choose their preferred selling price based on the price the other firm chose in the previous period The equilibrium for an oligopoly with two firms (duopoly), in the Cournot model, is for both firms to sell the same amounts and same quantities, splitting the market equally at the equilibrium price The equilibrium price is less than the price a single monopolist would charge, but greater than the equilibrium price that would result under perfect competition. Firms determine their quantities simultaneously each period and, under the assumptions of the Cournot model, these quantities will change each period until they are equal

Gap in Marginal Revenue Curve

with a kink in the market demand curve, we also get a gap in the associated marginal revenue curve For any firm with a marginal cost curve passing through this gap, the price at which the kink is located is the firm's profit maximizing price