Lesson 7.3: Oligopoly PDF

Lesson 7.3. Oligopoly Oligopoly is a market structure which lies between pure competition and monopoly. In this market structure, there is a small number of firms and a great deal of interdependence is highly observed among the oligopolists. Each oligopolist formulates his economic policies in relat...

Lesson 7.3. Oligopoly Oligopoly is a market structure which lies between pure competition and monopoly. In this market structure, there is a small number of firms and a great deal of interdependence is highly observed among the oligopolists. Each oligopolist formulates his economic policies in relation to the policies of his competitors in the market. Because there are only small number of firms under oligopoly, any change in the company’s prices or marketing strategies may influence the sales and profits of the other oligopolists. An example of oligopoly in the country is the oil industry. Only 6 to 8 companies are competing in the oil and gasoline. Each oil company usually considers the competitors when they formulate policies regarding the price to be set and the output. In the country, a uniform price is charged by different firms in the oil industry. To increase their sale and create loyalty, oil companies advertise their products and services to consumers. They use sales promotions, discounts, earning points, raffles and other free services to gain more customers. Characteristics of Oligopolistic Market 1. Few Sellers The producers or sellers are few in the oligopolistic market and the customers are many. There are few big firms dominating the market and they enjoy a considerable control over the price in the market. 2. Interdependence The firms under this type of market depend on each other. The action of one firm has noticeable effect on the other firm. 3. Advertising Every firm advertises their products and services on a frequent basis in order to reach more customers and to increase their profits. 4. Competition There is an intense competition since there are only few sellers and producers in the market. Any move done by one oligopolist will have an impact on its competitors, so every producer or seller has always an eye over its competitors. 5. Entry and Exit barrier The firms can easily exit in the industry, however they have to face a lot of barriers when they enter the oligopolistic market. Classification of Oligopoly 1. Pure Oligopoly This exists when products produced by oligopolists are similar in all aspects. This can be seen in most capital goods industries like producing cement and oil. There is a great mutual interdependence among firms when products produced are identical. 2. Differentiated Oligopoly This exists in industries when the products produced are not homogeneous. This can be seen in manufacturing consumer goods like cars and appliances. Consumers can choose from different models of car and different brands of appliances. Kinked demand curve A kinked demand curve occurs when the demand curve is not a straight line but has a different elasticity for higher and lower prices. One example of a kinked demand curve is the model for an oligopoly. This model of oligopoly suggests that prices are firm or fixed and that oligopolist face different effects when price increase or decrease. The kink in the demand curve occurs because rival firms will behave differently to decrease and increase in prices. (Pettinger, 2020). Effect of Price Increase: If a firm increases the price, the products or service of the firm is more expensive than its competitors and therefore, the consumer will buy the competitor’s products or services. In an increased price, there will be a decrease in demand. Demand therefore is price elastic. When firm’s increase price, they will lose revenue since the percentage in quantity demanded is greater than the percentage in price. Effects of Price Decrease: If the firm decreases its price, it will cause a big increase in the demand of the product or service and will cause an increase in revenue. The firm will increase its market share. When competitors respond by also decreasing their price to follow the first firm, the net effect is that when all firms decrease their prices, the individual firm will only see a small increase in the demand. Price war is happening among oligopolists, demand is price inelastic since there will be smaller percentage in the increase in demand. If demand is inelastic and price decreases, then revenue will decrease. Example of a kinked demand Curve The market of oil industry. The products are homogeneous and consumers are price sensitive. If one gasoline station increases the price, consumers will shift to other gasoline stations. If one gasoline station decreases its price, other firms may follow to decrease its price also. Therefore, decrease in price would be self-defeating for the first company which decrease their price. In many oligopolistic industries, most firms have a degree of brand differentiation. Mobile companies can increase their price but consumers are still willing to pay because price for them is not the dominant factor. Perfect and Imperfect Collusion Collusion is a secret agreement between two or more persons or organizations to achieve certain objectives among the firms in the industry. It involves direct negotiation and agreements among the oligopolists themselves. There are at least three incentives leading oligopolistic firms toward collusion: (1) they can increase profit if they can decrease the amount of competition among themselves (2) collusion can decrease oligopolistic uncertainty (3) collusion among the firms already in an industry will facilitate blocking newcomers from that industry Once a collusive arrangement is in existence, any single firm has a profit incentive to break away from the group and act independently, thus, destroying the collusive arrangement (Pagoso, et.al., 2010). Perfect Collusion A cartel or a formal organization of the producers within a given industry, is an example of perfect collusion among sellers in an industry. A cartel’s purpose is to transfer certain management decisions and functions of individual firms to a central association in order to improve the profit positions of the firms. Cartels, in order to be successful and effective, must have the following characteristics: (1) All the producers or sellers in the industry are included in the agreement. (2) The agreement is definite and enforceable. (3) It covers both the price to be charged and the quantity of outputs to be produced by the agreeing parties. (4) A formula is used in distributing the profits among the agreeing parties. (5) All parties follow rigorously all the terms of agreement. Imperfect Collusion Imperfect collusion is made up mostly of informal arrangements under which the firms of an industry seek to establish prices and outputs. Imperfect collusion happens when there is failure to meet one or more of the characteristics of perfect collusion. Some of the characteristics of imperfect collusion (1) incompletely observed collusion (2) collusion with indefinite terms of agreement among sellers affecting prices or outputs (3) collusion with incomplete participation of the sellers in the industry (4) Interdependent action without agreement (Pagoso, et.al., 2010). The Centralized Cartel  An example of collusion in its most complete form. Its purpose is monopolistic maximization of industry profits by the few firms in the industry. In a centralized cartel, individual firms in the industry have surrendered the power to make price and output decisions to a central association. Quotas to be produced and distribution problems are determined by the association. Maximization of industry profits is the ultimate goal and policies adopted are geared towards this objective (Pagoso, et.al, 2010).