Oligopoly Market Structure

Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
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CHAPTER

12
Oligopoly

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DEFINITION OF AN
OLIGOPOLY

Definition
A market structure in which there are
only a few firms selling either
standardized or differentiated products
and it restricts the entry into and exit
from the market
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CHARACTERISTICS OF AN
OLIGOPOLY
Characteristics
• Few numbers of firms: The number of firms is small
but size of the firms is large.
• Homogeneous or differentiated products: These
products can be standardized products such as steel,
zinc or copper which is price based. Other industries
such as electronics automobiles offer different products
where emphasis is on non-price competition, such as
advertisirs.
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OLIGOPOLY (CON’T)

• Mutual interdependence: Firms in an
oligopoly market always considers the
reaction of their rivals when choosing
price, sales target, advertising budgets
and other business policies.

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OLIGOPOLY (CON’T)

• Barriers to entry: Restricts new entrants
into the market through various types of
barriers of entry such as the control of
certain resources, ownership of patents
and copyrights, exclusive financial
requirements and legal barriers.

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PRICE AND OUTPUT DECISIONS
FOR AN OLIGOPOLIST
Non-Price Competition
• Firms compete with each other using
advertising and product differentiation
techniques.
• Firms try to capture the market from rivals
through better advertising campaigns and
produce high-quality products instead of
reducing prices.
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FOR AN OLIGOPOLIST (CON’T)
• Besides advertising, research and
development activity is important for
oligopoly firms to invent new products
and improve the quality of the existing
products.

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FOR AN OLIGOPOLIST
Price Rigidity and Kinked Demand Curve
• Since there is mutual interdependence between
oligopoly firms, the prices in the market are more
stable. This is called price rigidity in oligopoly market.
• The price rigidity explains the behaviour of an
oligopoly firm that has no incentive to increase or
decrease the price. The theory of the kinked demand
curve is based on two assumptions.
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ASSUMPTIONS OF A KINKED
DEMAND CURVE
1. First assumption: If an oligopolist reduces its
price, its rivals will follow and cut their prices to
prevent losing the customers.
2. Second assumption: If an oligopolist increases
its price, its rivals would not increase their prices
and keep their prices the same, thereby they gain
customers from the firm that increases the price.

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KINKED DEMAND CURVE
Price (RM) An oligopoly firm faces two demand
curves that is an individual demand
curve (dd) and an industry demand
curve (DD).

According to the second assumption,
when a firm increase the price (P*), no
P* other firms will follow. Above P*, the firm
will follow dd curve.
If the firm decrease the price, other firms
dd will follow. Below P*, the firm follow DD
curve.

DD Because of this assumption, an
oligopolist faces kinked demand curve.

Q*
Quantity

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KINKED DEMAND CURVE

Price (RM)
The kinked demand curve below
point E creates a gap in the MR,
which is indicated by the dotted
line ab.
MC1
MC2
E At this range of MR, any change in
P* the MC does not reflect changes in
the profit maximizing price and
output.
a
b DD This shows price rigidity in the
oligopoly market.

Q*
MR Quantity

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PROFIT MAXIMIZATION USING
THE EQUATION METHOD
Athletic footwear faces the following demand curve:
P1 = 600 − 0.5Q1 for price increase
P2 = 700 − 0.75Q2 for price decrease

The firm’s marginal cost is RM150. What is the
price and output at the kink? At what range of value
will the marginal cost shift without changing price
and output.

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PROFIT MAXIMIZATION USING
THE EQUATION METHOD (CON’T)
Solution
At the kink, P1 = P2
600 – 0.5Q = 700 – 0.75Q
0.25Q = 100
Q = 400
P = RM400
To find the range of MC, the upper limit and lower limit of
MR needs to be found out.
MR1 = 600 − Q1 = 600 – 400 = 200
MR2 = 700 − 1.5Q2 = 700 −600 = 100
The range for MC to shift is between 100 and 200
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GAME THEORY (CON’T)
A game theory is a model of analyzing
strategic behaviour of rivals.
Strategic behaviour refers to the
actions taken by firms to consider the
expected movement of rivals and the
mutual recognition of interdependence
between these firms.
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Strategies are the important actions
for each player.

The score obtained by each player
in this game is called payoff.

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The payoff refers to the profits and losses of
players, which is determined by strategies
and constraints faced by the players.
Constraints faced by the players come from
the consumers who determine the demand
curve for the product in this industry.

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PRISONERS’ DILEMMA

In order to understand how the game
theory works, we can start with a
simple non-economic example called
the prisoner’s dilemma.

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PRISONERS’ DILEMMA (CON’T)

• The strategy is to separate the partners
in different rooms to make sure they
cannot communicate with each other.
Four combinations of strategies that
might be possible in this game are given
below.

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PRISONERS’ DILEMMA (CON’T)
1. Both Gavin and Tan confess
2. Neither Gavin nor Tan confesses
3. Gavin confesses and Tan does not
4. Tan confesses and Gavin does not
Based on the four possible outcomes, we
can tabulate of these outcomes. This is
called the payoff matrix.
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PAYOFF MATRIX
If both of them confess for TAN If Gavin confess for murder
murder offence; they will get offence and Tan does not; 3-
15-year sentence. year sentence for Gavin and
Confess Do not confess 25-year sentence for Tan.

Tan:
Tan:
Confess 15 years
25 years
GAVIN

Gavin : Gavin :
15 years 3 years

Tan: Tan:
3 years 5 years

Do not confess
Gavin : Gavin :
25 years 5 years

If Tan confess for murder A payoff matrix is a table that shows a listing If both of them does not
offence and Gavin does of payoffs that each player will get for each confess for murder offence;
not; 3-year sentence for possible combination of strategies that the they will get 5-year sentence
Tan and 25-year sentence two partners might choose. for bank robbery.
for Gavin.

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PRICE LEADERSHIP
Price leadership means the pricing strategy in
which the firms in an oligopolistic industry
follow the price set by the leading firm.
Price leadership is one form of collusion under
oligopoly.
There is no formal or tacit agreement.
There are two types of price leadership.

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TYPES OF PRICE LEADERSHIP
1. Dominant price leadership
- The dominant price leadership firm may be the largest
firm that dominates the overall industry.
- The dominant price leadership firm can act as a
monopoly where it sets its price to maximize profits;
other firms will set their prices at the same level.
2. Barometric price leadership
- One firm will be the first to announce price change.
This firm does not dominate the industry.
- Its price will be followed by others.
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CARTEL
A cartel is a group of firms whose objective
is to limit the scope of competitiveness in the
market.
Cartel arises because firms want to eliminate
uncertainty and improve profits by stabilizing
market shares and prices, reducing
competitiveness and eliminating promotional
cost.
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CARTEL (CON’T)
• The most famous cartel is Organization of
Petroleum Exporting Countries (OPEC).
• Cartel agreement is an arrangement among
the oligopoly firms to cooperate with one
another to act together as a monopoly.
• An ideal cartel will be powerful to establish
monopoly price and earns supernormal
profits.
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CARTEL (CON’T)

• Profits are divided among firms based on
their individual level of production.
• Each firm sells different quantities and
obtains different profits depending on the
level of AC at the point of production

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