Oligopoly

Characteristics
Oligopoly is a market structure in which small numbers of large firms dominate an industry.
Firm are mutually interdependent which means a decision by one firm will cause some
reaction from other firms in the same market. The firm in oligopoly might produce an
identical product and compete only on price, or they might produce a differentiated
product and compete on price, product, quality and marketing. Another characteristic
of oligopoly is high barriers to entry such as natural or legal barriers.
Kinked Demand Curve

Kinked demand curve is a demand curve facing an oligopolist that assumes rivals will
match a price decrease but ignore a price increase

If the firm increases its price other firms will not follow unless there is collusion. By not raising
their price the other firms hope to increase their market share by taking the customers of
the firm that increased its price. The firm that increased price goes up its elastic demand
curve and loses market share. This firm will quickly realize that it is losing market share and
will quickly return its price to that of its competitors.

If the firm decreases its price, then other firms will lose market share because their
customers switch to the lower price-product. Hence other firms will match the price and
then move down to the steeper inelastic industry demand curve. Eventually all firms will
realize that they are losing money and they will end the price war and prices will return to
normal levels.

As a result of this the price in non-collusive oligopoly tends to be sticky around the kink in
the demand curve. Firms will compete with non-price competition and avoid competing
on price or using discounting

The kink in the demand curve causes a discontinuity in the MR curve. This is because the
upper portion of the demand curve has a different MR curve to the lower portion. The
break in the MR curve helps to explain the inflexibility of prices in oligopolistic industries. As
the result of this gap, whenever there is a change in the cost of productions, there will be
no incentive to change price or output so long as the marginal cost curve moves up or
down within the gap.
Collusion
Collusion is an agreement, usually illegal and therefore secretive, which occurs between
two or more firms to limit open competition. It can be an agreement to divide the market,
set prices, or limit production. Firm may engage collusion to reduce uncertainly or to
increase profits or to create barriers to entry

Cartel is a formal agreement that sets price and shares production amongst firms or
restricts output to influence price. Cartel is illegal in Australia. OPEC is an example of a
cartel in the oil industry.

If there is a collusion amongst firm, there is no kink in demand curve and it enables
oligopoly earn supernormal in both short run and long run because the collusion between
firms can be considered as an obstacle that prevent other firm come into the industry.
The short run and long run revenue and cost diagrams are the same as monopoly. It is
because oligopolies cooperate in order to become a monopolist and to be able to
maximise profit by restricting output and setting the same price. Firm will maximise profit
by producing at the level of output where MC = MR. Firm sets price for Q at D curve which
equals to AR curve. At the price P, Firms economic profit equals to ABCP.


Tacit (spoken) collusion refers to oligopolies cooperate in the market without agreement.
It may take form of price leadership or cost plus pricing.

Price Leadership - one firm initiates a price change and all other firms follow
e.g. Banking industry
o price leader may be the firm with the largest market share or the most
efficient
use of a formula to determine price
o Competing firms may have similar costs
o e.g. after determining per unit cost of production a % mark up is added
to determine selling price
o the mark up implies that the firm has a target profit in mind

Game Theory
Game theory is the study of how firms make decisions in situations where achieving their
goals depends on their interactions with others. A business strategy is a set of actions
taken by a firm to achieve a goal

Pay off matrix is a tool to examine the interaction between oligopoly firms. The simplest
has 2 firms with identical costs, products and demand.

A payoff matrix is a table that shows the payoffs (profits) that each firm earns from every
combination of strategies by both firms


Mergers and take-overs are mechanisms to achieve external growth of a business and
raise market share.

Increase market power

There are various ways for oligopoly to rise its marker power in either price war or non-
price competition.

The combining of two or more competing firms by merger may increase their market
power because it allows new and larger production unit to achieve greater economies of
scale which leads to a lower price. Moreover, oligopoly may collude to restrict output to
influence the price. Those methods are used to create barriers to entry which may
increase oligopolies market power.

Firm may use non price competition such as product differentiation or advertising to
increase market power.