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Oligopoly

Oligopoly. Small number of firms Firms are interdependent - actions directly affect other firm’s profits. Barriers to entry Substitutes and Compliments impact markets Substitutes compete with each other, complements need each other ( coopetition – cooperative behavior among competitors)

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Oligopoly

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  1. Oligopoly • Small number of firms • Firms are interdependent - actions directly affect other firm’s profits. • Barriers to entry • Substitutes and Compliments impact markets • Substitutes compete with each other, complements need each other (coopetition – cooperative behavior among competitors) • Reactive pricing • price changes result from other firm price changes – typically match price cuts, not increases

  2. Industry Concentration • Size of oligopoly not clearly defined. Could be as small as 2 (duopoly) or as large as 10 firms. • Concentration ratio – percentage of sales accounted for by specified number of top firms in a market. • Usually reported as 4-firm, 8-firm, or 20-firm. • The higher the concentration ratio, the greater the degree of market dominance by small number of firms. • Can distinguish between market structures by concentration ratio

  3. Industry Concentration % of GDP

  4. Industry Concentration • Herfindahl-Hirschman Index (HHI) – sum of the squared market shares of all firms. • HHI = s12 + s22 + . . . .sn2 • Ranges from 10,000 for pure monopolist to zero for infinite number of small firms. • The more unequal the market share, the higher the HHI value. The greater the number of firms, the lower the HHI.

  5. Industry Concentration • Increases in concentration typically yield increased prices and profits, ceteris paribus. • Example: If there are five firms in a market with market shares of 40%, 30%, 16%, 10% and 4%: • HHI = 402 + 302 + 162 + 102 + 42 = 2,872

  6. Price Leadership (Dominant Firm Strategy) • Often one firm in oligopolistic market owns dominant market share. • Dominant firm can establish profit max price, then smaller firms behave competitively and take price, selling all they want. • Smaller firms produce Q where MC = P. • Dominant firm sets profit max Q and P from net demand curve (difference between total market demand and supply of smaller firms)

  7. Price Leadership Dominant Firm Strategy

  8. Price Leadership (Dominant Firm Strategy) • Assume total market demand is QD-MKT=248-2P. • Total supply curve for 10 smaller firms in market is QS-FIRMS = 48+3P. • MCDOM = .1Q • Dominant firm establishes optimal Q and P: • Net demand curve = QD-MKT – QS-FIRMS QDOM = (248-2P) – (48+3P) = 200 – 5P, or P = 40 - .2Q

  9. Price Leadership (Dominant Firm Strategy) • Assume total market demand is QD-MKT=248-2P. • Total supply curve for 10 smaller firms in market is QS-FIRMS = 48+3P. • MCDOM = .1Q • Dominant firm’s profit max, set MC = MR: • .1Q = 40 - .4Q • Q = 80 units • P = $24 • QS-FIRMS = 48+3P = 48 + 3(24) = 120. Smaller firms will provide 120 units total, or 12 units each. Total of 200 units will be produced.

  10. Price Rigidity (Kinked Demand) • Oligopolistic firms are interdependent – when one firm changes, others will have to consider whether action is required on their part. • Firms tend to match price cuts and NTO match price increases. • When firm cuts price, Q will increase – if other firms also cut price, increase in Q will be minimal (inelastic) • When firm raises price, Q will decrease. If other firms do not raise their price, increase in Q will be more substantial (elastic). • Difference in relative elasticity will cause kink in demand curve at current price.

  11. Price Rigidity Kinked Demand Profit max output is where the MR curve is discontinuous (where MC runs thru discontinuity). Marginal costs can increase or decrease without changing profit max output as long as MC stays in gap.

  12. Price Rigidity Kinked Demand Response by other firms tends to discourage this firm from changing price, keeping prices stable (price rigidity).

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