Vicky Novikova
IB2 Economics B2
8/23/11
Oligopoly Chapter 10 Notes
I.
II.
Definition of an Oligopoly
a. A market in which a few large firms produce homogenous or differentiated
products (Welkers).
i. Homogenous Products: identical products produced by a number of
firms
1. Examples:
a. Steel
b. Cement
ii. Differentiated Products: when certain features or capabilities are
different between the product produced
1. Examples:
a. Lap tops
b. Automobiles
Assumptions of an Oligopoly
a. Firms are mutually interdependent:
i. A firm take into consideration the reactions of the other firms in response
to changes in their own output and prices when trying to determine their
own pricing strategy.
b. Significant Barriers to Entry Exist (examples listed below):
i. Economies of Scale which may be present due to a firm having a large
market share or advanced technology and this may in turn cause the initial
capital investment to enter this market to be rather large and therefore
effectively keeping many firms out and therefore allowing the firms in the
oligopoly to earn supernormal profits in the long run.
1. Non-price competition: advertising, special features, sales
promotion, publicity, and sponsorship deals,
2. This may lead to brand loyalty, hence many customers may
already be loyal to a particular brand that is already producing in
the oligopoly and therefore if a new firm tries to enter the industry
their sales may suffer due to this preexisting brand loyalty, since it
makes the demand of the firm already in the oligopoly less elastic.
a. Short run: a time period in which producers are able to
change the quantities of some but not all of the resources
that they use; a period in which resources (usually the plant
in which they operate) are fixed while others are variable.
b. Long run: a time period that is long enough to allow
producers of a product to change the quantities of all of the
resources that they use; period in which all of the resources
and costs are variable and non are fixed.
c. Normal Profits: this is equal to the opportunity cost of a
firm leaving to go to another industry, and therefore is
enough to retain a firm in a particular industry, but not
enough to attract one to enter (unless it is experiencing
losses). It is also the average returns expected anywhere in
the economy and occurs when a firms profit is equal to its
average total costs.
d. Supernormal Profits: This is a profit that is greater than
the average return elsewhere in the economy. This is excess
profit greater than the normal profit and greater than the
opportunity cost of leaving to go to another industry. It is
enough to lure firms into an industry. Also, this occurs
when the firm has profit left over after covering its average
total costs. However, this can only be maintained in certain
market structures in the long run including monopolies and
oligopolies.
e. Losses: This is a return that is less than what is expected
elsewhere in the economy. This is also less than the
opportunity cost of leaving a particular industry in order to
enter another. This is a sum below the normal profit and
therefore does not cover average total costs of a firm and
may cause them to leave their industry in pursuit of at least
normal profits.
ii. Legal Barriers may also include copyrights, patents, and trademarks.
iii. If the raw materials necessary to produce the products that the firms in
the oligopoly produce are controlled by said firms, then other firms will be
unable to enter the industry as the will not have access to these materials.
iv. Preemptive and Retaliatory Pricing may also be used to push firms out of
the market by outcompeting them.
1. Preemptive Pricing: when firms temporarily sell their products at
a price that is below normal in order to inhibit new firms from
entering the market.
2. Retaliatory Pricing: often occurs during price wars, and this is the
act of cutting prices in order to push competitors out of the market.
v. Mergers of firms already in the oligopoly may occur if these firms would
like to increase market power, and this can further prevent firms trying to
enter the oligopoly from attaining significant market power. Also, mergers
allow for these firms to gain more control over the output and price in the
market.
c. If the largest four firms in an industry control at least 40% of the market, then
this market is categorized a being oligopolistic.
i. Concentration is measured using the concentration ratio.
1. “The four-firm concentration ratio: the percentage of total industry
sales accounted for by the largest four firms” (Welkers)
2. However, it is important to keep in mind that the concentration
ratio does not provide insight into the actual performance of the
different industries, specifically about the competition that exists
between these firms.
III.
d. There exists imperfect information in an oligopoly, since perfect information only
exists in theory in perfect competition. Since some firms know more than others,
this also serves as a barrier to entry since firms trying to enter the market may be
unable to do so if they do not know enough about certain laws or regulations or
methods of obtaining resources and technology. This may inhibit them from
producing as efficiently as the other firms that already exist in the oligopoly.
Game Theory: “A means of analyzing the pricing behavior of oligopolists that uses
the theory of strategy associated with games such as bridge and chess” (McConnell
and Brue)
a. For instance if two competing firms such as Coca-Cola and Pepsi compete, and
their profit is determined by the pricing strategy it chooses and the one that its
rival does as well.
Coca-Cola’s Pricing Strategy
Pepsi’s
Pricing
Strategy
IV.
b. This illustrates all of the possible outcomes if one firm acts one way and it
demonstrates the way the other firm will respond.
i. If Coke chooses a high pricing strategy and Pepsi does too then they drive
price up and make greater profits.
ii. If Coke chooses a high pricing strategy, Pepsi may choose a low pricing
strategy, and therefore would gain consumers due to a high price elasticity
of demand.
iii. If Coke chooses a low pricing strategy, Pepsi may choose a low pricing
strategy in order to not lose business to Coke.
iv. If Coke chooses a low pricing strategy, it is unlikely that Pepsi would
choose a high pricing strategy since it would then lose profits.
Collusive Oligopoly:
a. Example: 2 firms in the West Bloomfield Gasoline Market: BP and Shell
b. Formal Collusion: when firms in an oligopoly agree to charge the same price in
advance
i. A cartel is also considered an example of a collusive oligopoly since it is
defined as a formal agreement among firms or countries in an industry to
set the price of a product and establish the outputs of the individual firms
or countries or to divide the market for the product geographically
(McConnell and Brue). The Organization of Petroleum Exporting
Countries (OPEC), specifically when they had to ration out oil to various
companies.
c. Tacit Collusion: when firms in an oligopoly charge the same price without
formally agreeing to do so.
d. The result is the same because the firms act as a monopolist and therefore charge
a monopoly price and make monopoly profits, and spread them across the market
in accordance with market share of each firm. This is done usually be restricting
supply and therefore driving price up.
e. Any form of collusion causes price rigidity because the firms may be
supernormal profits in the long run and in order to sustain them may keep the
price stable.
f. Below is a graph for a single firm that exists in a collusive oligopoly.
V.
Non-Collusive Oligopoly
a. Example: Novi fast food market - Burger King and McDonalds
b. This is an oligopoly where the firms do not decide together on prices or
outputs and instead make these decisions on the foundation of the decisions that
their rival firms make.
c. Firms tend to operate at one output in order to maximize profits in order to
achieve productive efficiency (the production of a good in the least costly way)
where MC=MR and this in turn determines the price that they charge, this is Point
A.
d. Below is a graph for a single firm that exists in a non-collusive oligopoly.
e. Kinked Demand Curve: if a firm raises its price, then the rival firms are unlikely
to raise their prices, and thus the firm would lose a lot of demand, since there
would be viable alternatives that would be cheaper. Since the greater the number
of substitutes, the greater the price elasticity of demand. Thus demand above
point A is rather elastic because a small change in price can result in a rather
large drop in demand. However, if a firm lowers its prices, then the rival firms
would as well in order not to lose business to the first firm. Thus, demand below
point A is rather inelastic because a small decrease in price will not likely result
in a large increase in demand, if in any. Therefore, the graph is kinked at point A
(current market.
i. Price Rigidity:
1. Firms are afraid that raising their prices above the current market
price would cause them to lose business to others and therefore
profits as well.
2. Firms are afraid to lower prices below the current market price
because the other firms will too and try and undercut their price,
and thus engage in a price war, which may cause every firm
involved to lose out on profits.
3. The market may also remain stable because if MR were to rise, it
could still be equal to MC, and thus the firms would continue
charging P1 and producing Q1, hence the would not change their
prices or outputs. Thus if the firm is operating at MC1, it would
still be charging P1 and producing Q1, and even if MC1 were to rise
to MC2, the firm would still be charging P1 and producing P2.
Thus, although MC changed, prices remained the same.
f. Structure of the Graph:
i. Marginal revenue is below price because when a firm reduces its price in
order to get people to buy more, it reduces its price on all of the units, and
therefore loses revenue on each additional unit that they could have sold at
a higher price had they not reduced it.
ii. The demand curve (which also represents price and average revenue)
is downward sloping because of the income and substitution effects.
iii. The MC curve and the ATC curve have a relationship as well. At first MC
is below ATC due to fixed costs, but as marginal costs begin to increase if
output increases and more workers are needed, and since it is factored into
ATC, after they intersect, which occurs when MC allows for the lowest
average total cost, MC begins to pull the ATC curve up with it. Thus,
when there are increasing marginal costs the ATC curve will always reach
a minimum when it intersects with the MC curve.
iv. The MR curve is not appears to be vertical when it reaches MC1 all the
way to MC2 because as mentioned above there exists a rage of marginal
costs over which the firm will not change its price (price rigidity).
VI.
Normal Profits:
VII.
a. The graph to the right illustrates the firm making normal profits in a non-collusive
oligopoly while the one on the left demonstrates the industry in which that firm
operates. It demonstrates that there are no changes in supply or demand in the
industry, and hence a stable price in the oligopoly when the firms are making
normal profit.
b. These are demonstrated in the non-collusive oligopoly graph seen above (this is
the model most commonly used when discussing an oligopoly). This is when
price determined by the quantity produced which is first determined by
MC=MR, hence demand as seen on the graph, is equal to the average total
cost. On the graph this occurs when the ATC curve is tangent to the demand
curve (which also determined price) at the quantity when MC=MR.
c. Therefore since the firm is making just enough to stay in the market, instead of
going to a different one, it is unlikely that this will cause new firms to enter or
existing firms to leave, unless they find another market in which they can make
supernormal profits.
Losses:
a. Once again the non-collusive oligopoly model is used and can be seen below and
the graph to the left illustrates a single firm operating in a non-collusive oligopoly
and experiencing losses.
b. In this model ATC curve is above the demand curve (hence price) at the
quantity determined by MC=MR, illustrating that the firm is unable to cover
the average total costs and therefore is experiencing losses.
c. This may cause firms to leave that industry in the long run in pursuit of at least
normal profits elsewhere in the economy, decreasing supply in the industry,
increasing price, and thus allowing for the firms in the oligopoly to once again
make normal profits. However, this may not occur because many firms in a
oligopoly have made tremendous investments in capital and in obtaining
resources, which may not be used to produce other products other than the
ones already being made, and thus will not leave as they would no be able to
easily transition to another industry. Therefore the scenario demonstrated
above with the shift in supply in the industry and the increase in price would NOT
occur.
VIII. Supernormal profits
a. Once again the non-collusive oligopoly model is used and can be seen below and
the graph to the left illustrates a single firm operating in a non-collusive oligopoly
and experiencing supernormal profits.
b. In this model ATC curve is below the demand curve (hence price) at the
quantity determined by MC=MR, illustrating that the firm is able to cover
the average total costs and has excess profits left after is has done so, and
therefore is experiencing supernormal profits.
c. This may cause firms to try and enter that industry in the long run in pursuit of
these supernormal profits (as this is enough lure firms experiencing normal profits
or losses into the industry). However, due to the high barriers in entry, it is
unlikely that even in the long run many firms if any will be able to enter the
industry and therefore increase supply, thus drive price down, and therefore
eliminate supernormal profits. Thus supernormal profits are sustainable in an
oligopoly in the long run. Therefore the scenario demonstrated above with the
shift in supply in the industry and the decrease in price would NOT occur.
Review of Oligopolies Quiz:
1. Which of the following is not a characteristic of the oligopoly market structure?
a) mutual interdependence
b) a perfectly elastic demand curve
c) high barriers to entry
d) imperfect information
2. Which of the following firms would most likely operate in an oligopoly?
a) DTE Energy
b) a local agricultural market
c) Speedway Gas Station
d) hairdressers in a big city
3. Where will the firm produce in order to maximize its profit?
a) AR=MC
b) MR = MC
c) ATC=D
d) ATC=MC
4. When a firm is experiencing losses in an oligopoly, where is the ATC curve on the graphical
model at the market price?
a) equal to the demand curve
b) below the demand curve
c) above the demand curve
d) it has no relation to the demand curve
5. Which of the following is a cause of price rigidity in a non-collusive oligopoly?
a) firms are afraid to lower their prices below the current market price because they fear that
other firms may undercut their price
b) there is a range of marginal costs over which the firms will not raise their price
c) firms are afraid to lower their prices below the current market price because their fear that
they will lose profits to other firms
d) all of the above
6) Which of the following is not a significant barrier to entry?
a) low start-up costs
b) non-price competition
c) legal restrictions
d) control of resources by firms already in the oligopoly
7) What occurs during formal collusion?
a) firms charge the same prices without formally agreeing to do so
b) firms react to one another changes in prices and outputs in order to determine their own
pricing strategy
c) firms charge the same prices due to an agreement created beforehand
d) none of the above
8) Oligopolies can produce which of the following types of products:
a) homogenous
b) differentiated
c) a and b
d b only
9) Define a non-collusive and a collusive oligopoly, use a graphical model to illustrate what
occurs when a firm experiences supernormal profits in a non-collusive oligopoly in the long run
and explain how this is possible.
10) Explain why there exists a kinked demand curve to represent a non-collusive oligopoly and
why there is a gap (vertical portion) in the marginal revenue curve on the same model as well as
other causes of price rigidity.
Works Cited
Blink, Jocelyn, and Ian Dorton. "Oligopoly." Economics: Course Companion. Oxford: Oxford
UP, 2007. Print.
"Characteristics of Oligopolies." Welcome to Welker's Wikinomics Page - Welker's Wikinomics
Page. Wet Paint, 20 Nov. 2007. Web. 29 Aug. 2011.
<http://welkerswikinomics.wetpaint.com/>.
McConnell, Campbell R., and Stanley L. Brue. Economics: Principles, Problems, and Policies.
New York: McGraw-Hill, 1996. Print.
ibeconreview.pbworks.com