I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.
In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.
With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.
Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.
If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
This is a market structure in which there are a large number of firms selling commodities which are very close substitutes. There are weak barriers to entry and firms may enter the industry with ease. Notice on the diagram that the firm initially makes supernormal profit at Q0 – at MC=MR Price = P0 and Cost = AC0. However with weak barriers to entry these profits are competed away and they now produce at Q1 where at MC=MR and the Price and Cost = AC1
Modern capitalism is characterised by a large number of ‘limited’ monopolies. They are sole suppliers of branded goods, but other firms compete with them by selling similar goods with different brand names. This is the market structure described as monopolistic competition. Thus the commodities produced by any one industry are not homogeneous; the goods are differentiated by branding and the use of trade marks. The individual firm has a monopoly position, but it faces keen competition from firms supplying very similar goods. It has, therefore, only a limited degree of monopoly power – how much depends upon the extent to which firms are free to enter the industry. Product differentiation is emphasised (some would say, created) by the practice of competitive advertising which is, perhaps, the most striking feature of monopolistic competition.
Advertising is employed to heighten in the consumer’s mind the differences between Brand X and Brand Y. It is important to realise that we are concerned with the differentiation of goods in the economic sense and not in the technical sense. Two branded products may be almost identical in their technical features or chemical composition, but if advertising and other selling practices have created different images in the consumer’s mind, then these products are different from our point of view because the consumer will be prepared to pay different prices for them.
Here is something I picked up from Scoop.it that explains Oligopoly markets in an amusing way. Useful for CIE A2-Unit 2.
The German competition regulator (the Bundeskartellamt) has fined five breweries €106.5 for illegally agreeing prices for bottled and draft beer between 2006 and 2008.
The breweries involved were:
Most of the agreements were communicated by phone and detail included the agreement between all parties to raise the price of draft beer by between €5 and €7 per 100 litres, and the price of a crate of 20 beer bottles by about €1. See news clip below from CNN
Here is one of my favourite clips from Seinfeld which shows how a monopoly is broken.
The Soup Nazi makes delicious soup—so good there’s always a line outside his shop. He refuses service to Elaine, and by a stroke of luck she comes across his stash of soup recipes. She visits his shop and informs him that his soup monopoly is broken, while waving his recipes in his face. Also in this clip, George gets charged $2 for a roll that everyone else gets for free. This example of price discrimination shows that in order to charge different customers different prices, you must have market power. Source: Seinfeld Economics
No doubt you have come across the movie documentary “Black Gold” which looks at the global coffee industry focusing on the plight of coffee farmers in Southern Ethiopia. The Indian onion market has similar characteristics and it is the farmers that lose out the most. Here are some of the issues that they have encountered:
* Higher rural wages have pushed up farmer’s costs
* Farms are small and therefore lack potential economies of scale
* The supply chain involves 5 middlemen who take their cut on the way through
* The onion is loaded, sorted or repacked at least 4 times
* Retail prices are double what farmers get
* Poor quality onions get dumped as there is no modern food-processing industry in India where they could be put to use.
* Little stock of onions is held in reserve so prices can vary greatly
Foreign food companies, including Walmart, Carrefour and Tesco, have been keen to make inroads into the Indian market. This would undoubtedly reduce the number of middlemen who take their cut on the way through and the development of modern storage facilites would assist in stabilising onion prices.
You should note the following from the graphs:
• to sell an additional unit of a commodity, the monopolist must reduce the price of all units sold. This therefore means the AR curves falls.
• as the price on all units must be lowered to sell the higher output, MR is lower than the price of the marginal unit(AR)
• TR at first increases with output but as price is reduced to sell more goods and services, eventually falls.
• where MR = 0 TR is at a maximum.