Oligopoly

Oligopoly market. Characteristics, indeterminate equilibrium. Paul Sweezy's kinked demand curvec

1. OLIGOPOLY
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. Oligopoly
•Most prevalent form of market organisation.
•Few firms in the market (3-9) so must take
into account what others will do.
•Interdependence among firms in an industry is
a key feature of oligopoly.
•The actions of one firm depend on and
influence the actions of another.
2
30/04/2016 Prabha Panth

3. Characteristics
1)Small number of firms (3-9). Duopoly only 2
firms.
2)Homogeneous products (cement, steel, petrol)
or Differentiated products (cars, airlines, soft
drinks)
3)Barriers to entry
4)High level of interdependence between firms
5)Price competition –Price Wars
6)Collusions and mergers
7)Equilibrium may be indeterminate.
8)Usual U-shaped cost curves
3
30/04/2016 Prabha Panth

4. Theories of Oligopoly
•No single theory of oligopoly, as there are many
variants.
•Not possible to define the demand curve, as P of
one firm depends on P fixed by other firms.
•To expand the market, one firm may lower its P.
But others also lower their prices.
•This goes on till many of the firms get into losses.
•Leads to Monopoly or Duopoly, or
•The oligopoly firms finally form mergers or
collusions, and act as a monopoly.
4
30/04/2016 Prabha Panth

5. Paul Sweezy’sKinked D-curve analysis
Assumptions:
1.Interdependence between firms
2.Differentiated goods, so each has some
monopoly over brand name.
3.Downward sloping D curves.
4.Analyse one firm (A) against all other firms (B, C,
D). No collusion.
5.Firms behave asymmetrically –if A decreases P,
others follow. If A increases P, no one follows, so
A has to decrease his own P.
6.All firms face the same U shaped cost curves.
5
30/04/2016 Prabha Panth

6. •Let Firm A have its own demand curve.
•Given by ddin the diagram.
•All other firms together have a demand curve = DD.
•ddis steeper than DD, has lower elasticity than DD.
•The two curves cut each other at K (the kink).
•If firm A raises its Price above the kink, other firms do
not raise their P, but remain on their own curve DD.
•If firm A reduces its P below the kink on its own
demand curve dd, then other firms also reduce their P
from DD to dd.
•At the kink K, firm A and all the other firms have the
same price.
30/04/2016 Prabha Panth

7. The Kinked D-curve
C,
R
0 Q
DD
dd
PA
PO
Q1
PO
PA1 Σall other
firms d
Firm A’s
demand
curve
If firm A fixes P = PA on
its own d-curve, other
firms fix P = PO on their
total D-curve.
Then A loses its
customers. So it has to
reduce its P to PO.
If A fixes P =PA1, then
other firms also reduce
their prices to PA1. So it
does not gain more
consumers
Kink
7
30/04/2016 Prabha Panth
DD
dd

8. •Sweezyremoves the top part of the ddcurve and the lower part of
the DD curve, as being irrelevant to the analysis, since no firm will
fix a price on those segments of their demand curve.
•Hence the shape of the AR curve will not be a smooth downward
sloping curve. The top part is the DD-curve, and from the point of
intersection of dd-DD, the curve now turns sharply as the lower
part of the dd-curve is taken.
•So the demand curve will be DD-K-dd.
•Because the demand curve has a kink in it at K, Sweezycalls it the
“Kinked” demand curve. It is actually made up of two demand
curves –the firm’s and the rest of the market.
•As the demand curve is also the AR curve, each of these has its own
MR curve.
•The MR curves are drawn for each of the demand or AR curves, and
there is a discontinuity or gap of these two MR curves at the kinked
point K.
•(See diagram on next page)
30/04/2016 Prabha Panth

9. The Kinked D-curve
C,R
0 Q
dd
Q1
P
DD
K
MR
MC
E
AC
C
ABNORMAL
PROFITS
A
B
9
30/04/2016 Prabha Panth
Assume that Firm A fixes its
price at the kink, K.
It produces OQ1 of output, and
fixes the price at P
TR = OPKQ1, and TC = OCEQ1.
The abnormal profits are CPKE.

10. Kinked D curve
•Sweezy’smodel explains Price rigidity in
oligopoly.
•As long as the firms fix their Q and P at the kink K,
there will be no price wars.
•All firms’ prices remain constant at P, and each
firm can sell Q1,
•They can each make abnormal profits.
•Even if AC increases, but lies within A and B, price
and quantities will not change.
•Only if AC increases above A, or below B, will it
affect P and Q.
10
30/04/2016 Prabha Panth

11. 1. Collusion
•Explicit agreements among firms to fix output
and prices and act as a monopolist.
•Informal agreements between firms to avoid
price wars, and act together as monopolists.
•Examples are OPEC, Electrical Conspiracy
(Econ USA), Shipping Cartel.
•Banned by laws –Anti Trust Law in USA, but
oligopolies can evade them.
11
30/04/2016 Prabha Panth

12. Collusion in Oligopoly
1.Tacit Collusion: done secretly, higher P lower
output.
But:-
oDifficult to control members.
oA firm may increase its Q and lower P to get larger
market share.
oNo action can be taken by the organisation, as it is
illegal.
oThe collusion breaks up, resulting in price wars,
control over markets.
12
30/04/2016 Prabha Panth

13. Price leadership
•Price wars leads to huge losses to oligopoly firms.
•Firms are not of uniform size, so small firms lose
out during price wars.
•They collude and agree to let the largest firm be
the price leader.
•The leader fixes the price, and other firms also fix
the same price.
•He makes sure that all firms earn profits.
•Smaller firms get lower profits, but are saved
from frequent price wars and expenditure.
13
30/04/2016 Prabha Panth

14. Price leadership
C,R
C,R
C,R
0
0
0
Leader Firm A
Firm B
DD
MR
Da
MR
Db
MR
ACL
MCL
P R
CC1
ACA
C1
C
ACB
P
14
30/04/2016 Prabha Panth

15. •Large firm is the price leader
•It has lower AC. Fixes the P at 0P, with its MC =
MR, MC .
•It makes large abnormal profit = C1PRC.
•Firms A and B have to accept this price.
•A and B have higher AC, and smaller size.
•Given the price by the leader (0P), both A and
B sell at the same price.
•But with higher AC they earn some abnormal
profit, but less than what they could get
individually.
15
30/04/2016 Prabha Panth

16. Collusion
2. Cartels:open collusion (OPEC).
They decide together about the Price and
Quantity to be produced.
Inelastic D, no substitutes, homogeneous
products (oil, aluminium, copper).
But,
•possible to cheat and break the cartel.
•Retaliation by other firms –price wars.
•Banned by law.
16
30/04/2016 Prabha Panth

17. 3. Mergers
•Vertical Merger –merging with a firm that
supplies inputs, e.g. book publisher acquiring a
paper mill.
•Horizontal Merger –merging with a competitor
(Coca cola with Parle, Kingfisher with Deccan
airways, Anglo-Dutch steelmaker Corus takeover
by Tata Steel, Jaguar)
•Conglomerate Merger –merging with firms that
are not related, e.g. airlines acquiring jewellery
shop.
17
30/04/2016 Prabha Panth

18. Questions
I.Short answer questions:
1.What are the chief characteristics of oligopoly?
2.Why is equilibrium indeterminate in oligopoly?
3.What is Merger? How does it help an oligopoly
firm?
18
30/04/2016 Prabha Panth

19. II. Essay Questions:
1.Explain Paul Sweezy’skinked demand curve
model of oligopoly.
2.What is meant by Price leadership? Explain
with the help of a diagram.
3.What are the advantages and disadvantages
of a) Collusion, b) Cartels, and c) Mergers?
19
30/04/2016 Prabha Panth