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Lecture/chapter objectives
SEEG 5013 Managerial Economics
o Examine oligopoly and firm architecture. o Discuss the meaning and sources of oligopoly. o Examine various models of oligopoly pricing and output and evaluating the profitability and efficiency implications of oligopoly. o Discuss sales maximization model and the growth of global oligopolists. o Examine the architecture of the ideal firm, the evolution of the creative company and the virtual corporation and relationship enterprises.
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Chapter 9: Oligopoly and Firm Architecture

Dr. Hj. Mohd Razani Hj. Mohd Jali FE 0.55 (Economics Building) College of Arts and Sciences razani@uum.edu.my 04-928 3524

Oligopoly
The form of market organization in which there are few sellers of a homogeneous or differentiated product. If there are only two sellers duopoly. If the product is homogeneous pure oligopoly. If product is differentiated differentiated oligopoly. Entry into oligopoly is possible but not easy. That is why there are only a few firms in this industry.
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Oligopoly
Most prevalent form of market organization in manufacturing sector of industrial nations. Examples are automobiles, primary aluminum, steel, electrical equipment, telecommunication, durable equipment, airlines, cigarettes and soaps. Oligopoly also exists when transportation costs limit the market area.
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Oligopoly
Since there are only a few firms in the industry, the action of each firm will affect other firms in the industry and vice versa. Example when Pepsi mounted a major advertising campaign, Coca-cola responded by having major advertising campaign of its own. Thus one of the characteristics of oligopoly is the interdependence or rivalry among firms in the industry.
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Oligopoly
Before making any decision, an oligopolist must consider a few things:
Possible reaction of competitors in deciding its pricing policies, The degree of product differentiation to introduce, The level of advertising to undertake, The amount of service to provide. Since they are interdependence, decision making is much more complex under oligopoly.
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Sources of Oligopoly
Economies of scale.
May operate over sufficiently large range of output that only a few firms supplying the entire market.

Sources of Oligopoly
Brand loyalty.
Loyal following of customers based on product quality and service that new firm cannot match.

Large capital investment required.

Specialized input required to enter the industry, which acts as natural barrier to entry.

Control of a raw material or resource.

Control of entire supply of raw material required in the production of the product.

Patented production processes.

No other firm can produce the commodity that a firm has exclusive right under the law.
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Sources of Oligopoly
Government franchise.
Form a barrier for entry in the long run. Without restriction, other firm can enter the industry and it could not remain as oligopolistic.

Measures of Oligopoly
Concentration Ratios
The degree by which an industry is dominated by a few large firms. Gives the percentage of total industry sales of the 4, 8, or 12 largest firms in an industry. Industry with four-firm concentration ratio is close to 100 which is quite oligopolistic.

Limit pricing.
Existing firm charge a price low enough to discourage entry into the industry. They sacrifice short-run profits in order to maximize long-run profits.
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Herfindahl Index (H)

H = Sum of the squared market shares of all firms in an industry. The higher the Herfindahl index, the greater is the degree of concentration in the industry.

Theory of Contestable Markets

If entry is absolutely free and exit is entirely costless then firms will operate as if they are perfectly competitive
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Oligopoly Models
Some most important models the Cournot model, the kinked demand curve model, cartel arrangements and the price leadership model. each model focuses on one particular aspect of oligopoly but overlooks other. Thus, they have limited applicability and are more or less unrealistic.
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The Cournot Models

Introduced by French economist, Augustin Cournot. The first formal oligopoly model. Useful in highlighting the interdependence that exists among oligopolistic firm. Cournot assumed there were duopolist selling identical spring water, and consumers use their own containers to by the water. Thus, MC of production was zero for the firms. While trying to max. profit the firm assumes other duopolist holds its output constant at the existing level. The result is a cycle of moves and countermoves by firms until each sells one-third of total industry output. Firms maximize profits under the assumption that market rivals will not change their rates of production.
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The Cournot Models

Example
Two firms (duopoly) Identical products Marginal cost is zero Initially Firm A has a monopoly and then Firm B enters the market

The Cournot Models

Adjustment process
Entry by Firm B reduces the demand for Firm As product Firm A reacts by reducing output, which increases demand for Firm Bs product Firm B reacts by increasing output, which reduces demand for Firm As product Firm A then reduces output further This continues until equilibrium is attained
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The Cournot Models

Equilibrium
Firms are maximizing profits simultaneously. The market is shared equally among the firms. Price is above the competitive equilibrium and below the monopoly equilibrium.

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The Kinked Demand Curve Models

Introduced by Paul Sweezy in 1939 to explain price rigidity that was often observed in many oligopolistic models. Sweezy postulated that if an oligopolist raise price it would lost most of its customers because other firms will not follow, so demand is elastic. On the other hand, if oligopolist lower price, other firms will follow, so demand will be inelastic. Implication is that demand curve will be kinked, MR will have a discontinuity, and oligopolists will not change price when marginal cost changes.
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The Kinked Demand Curve Models

According to Sweezy, oligopolist face a demand curve that has a kink at the prevailing price
highly elastic for price increase much less elastic for price cuts.

In this model, oligopolist recognize their interdependence but act without collusion in keeping their price constant. They prefer to compete on the basis of quality, advertising, service and other form of nonprice competition.
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The Kinked Demand Curve Models

When kinked demand curve model was first introduced, it was hailed as a general theory of oligopoly. However, two important criticisms were raised against the model. Stagler found no evidence that oligopolist readily matched price cuts but not price increase, thus questioning the existence of kink.
It may be applicable in short run when firms have no clear idea as to how competitors might react to price change.

It was also criticized that while demand curve model can rationalize the existence of rigid prices, it cannot explain or predict what price the kink will occur in the first place.
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Cartels
Collusion.
Cooperation among firms to restrict competition in order to increase profits. Firms restrict entrance into their respective markets to ensure monopoly profits for their members.

Cartels
Two types of cartels:
Market-Sharing Cartel Collusion to divide up markets. Gives each member the exclusive right to operate in a particular geographical area. Centralized Cartel Formal agreement among member firms to set a monopoly price and restrict output. It determines how profits are to be shared. Incentive to cheat.
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Price Leadership
Firm that is recognized as price leader initiates price change, followed by other firms in the industry. Price leader is usually the largest or dominant firm. It could also be the low-cost firm or any other firm (called barometric firm), recognized as barometer of changes in industry demand and cost conditions warranting a price change. An orderly price change is then accomplished by other firms following the leader.

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Price Leadership
In dominant-firm price leadership model, the dominant firm sets product price that maximizes its total profits, allowing the followers to sell all they want at that price. The follower firms behave as perfect competitors or price takers, and the dominant firm acts as residual monopolistic supplier of the product. Example of price leadership is in automobile industry. With one firm sets certain incentive, i.e. cash rebate, other firms soon follows in a matters of days. The role of price leader can also shift from one firm to another over time.
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Porters Strategic Framework

What is the relationship between profitability and efficiency for firms in oligopoly markets? Porters strategic framework.
Developed by Michael Porter, Harvard University Business School conceptual framework for identifying the five structural determinants of the intensity of competition and of the profitability of firms in oligopolistic industries.

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The threat from substitute products. The threat of entry. The bargaining power of buyers. The bargaining power of suppliers. The intensity of rivalry among existing competitors.
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Porters Strategic Framework

Firm tend to earn higher than average industry profits
if it does not face much threat from substitute products if it does not face threat from entry of potential competitors if buyers and suppliers do not exert much market power if there is low intensity of rivalry and competition among existing firms.

The greater the differentiation and uniqueness of the product and the greater the brand loyalty for firm's product, the higher is the markup that the firm can apply and the greater are its profits.

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Porters Strategic Framework

Profitability of a firm is also affected by bargaining power of buyers and suppliers. The smaller concentration (and market power) of buyers and sellers, the higher is the profitability of the firm. Tesco can squeeze lowest price from its suppliers, thus can sell at lower price than it competitors but earn higher profit. It sells to unorganized consumers with little individual market power. Oligopolists profit depends on intensity of rivalry with other firms. Rivalry tend to be less (hence profits higher) the greater The degree of concentration in the market. Nonprice versus price competition. Exit barriers. The ratio of fixed to total costs. Switching costs. The grow rate of the industry.

Efficiency Implications of Oligopoly

In short run, just as in other forms of market structure, an oligopolist can earn a profit, break even or incur a loss. Even if incurring a loss, it pays for an oligopolist to continue to produce in the short run as long as P > AVC. In long run oligopolist will leave the industry unless it can earn a profit or break even by constructing the best scale of plant to produce anticipated best long-run level of output. This is more difficult in oligopoly compare to other market structure.
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Efficiency Implications of Oligopoly

In long run oligopoly may lead to harmful effects:
As in monopoly, price exceeds LAC so profits in oligopolistic market can persist in long run because of restricted entry. Oligopolist usually do not produce at lowest point on their LAC curve as perfectly competitive firms do. Because demand curves are negatively sloped, P > LMC at the best level of output, thus, there is an underallocation of resources. When oligopolists produce differentiated product, too much may be spent on advertising and model changes.

Efficiency Implications of Oligopoly

On positive side:
For technological reasons, many product (automobiles, steel, etc.) could not possibly be produced under perfect competition (the cost will be prohibitive). Oligopolists spend much of their profits on R & D, which leads to much faster technological advance and higher standards of living. Some advertising is useful because it informs consumers, and some product differentiation has economic value in satisfying different consumers tastes.
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Sales Maximization Model

Proposed by William Baumol. Managers of modern corporations seek to maximize sales, after ensuring that an adequate rate of return has been earned, rather than to maximize profits. Larger firms may feel more secure, get better deal in the purchase of input and lower rates of borrowing money and have better image with consumers, employees and suppliers. There is strong correlation between executives salaries and sales, but not between sales and profits.
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Sales Maximization Model

Sales maximization model is particularly relevant in oligopolistic markets. Sales (or total revenue, TR) will be at a maximum when the firm produces a quantity that sets marginal revenue equal to zero (MR = 0).

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Questions or comments?

Reference: Salvatore (2008), Ch. 9

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