A2 Revision – Oligopoly and the kinked demand curve – download

Getting onto market structures with my A2 class and here is a note on the kinked demand curve. 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 to 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.
Oligopoly

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Most Premier League clubs make as much money as a branch of IKEA

Really enjoyed the David McWilliams podcast entitled ‘The Economics of Football’ in which he interviews Simon Kuper of Soccernomics fame. What he basically says is that the vast majority of clubs are not businesses and are not trying to make profits. They are pursuing trophies and with this intention spend what money they do make on buying the best players. If you look at the teams in the four English Divisions in 1921 there has been little change even when some clubs go bankrupt. As they are fan based institutions they seem to be unaffected by things like debt in a normal business. For example if a club (limited company) goes bankrupt you discard the old company and form a new limited company changing the name of the club (ABC City to ABC United) but playing at the same ground with the same strip etc. To put it in perspective a typical Premier League club is the size of a branch of IKEA.

Football clubs are huge emotional brands but not very big businesses. For example in 2019 Barcelona was the first club to made over $1bn in revenue but that equates to 0.02% of what Walmart made that year. The problem that football clubs have is how to monetise that passion for the club without affecting their fan base.

Bundesliga should be the richest league in Europe?
When you look at the economic indicators of the German economy – population size, income levels, GDP growth etc – it should be the league with the most money. Why is this not the case? The German FA doesn’t want foreign money coming into their clubs like Chelsea, Manchester City, Paris Saint-Germain etc. Also the German Bundesliga has a rule that over 50% of a club must be controlled by its supporters.

New breed of foreign owners and European Super League
The owners of Manchester United, Tottenham and Arsenal are more focused on making money out of the football club compared to others – Man City, Chelsea, PSG – whose owners want success at the expense of profit. This new breed of owner has come under a lot of pressure from the club’s supporters in that some are borrowing money to buy the club and then taking money out. Take for instance Man United – in the 5 years up to 2020, no owners in the Premier League have taken out more money than Man Utd £133m (dividends £112m, share buy back £21m). In stark contrast, some owners have put in significant funds: Everton £348m, Aston Villa £337m and Chelsea £255m – see graphic.

Source: SwissRamble

You can therefore see why some owners were keen on the European Super League. The proposed ESL was all but free-market capitalism with an American style franchise system with 12 teams guaranteed a place in the competition – significant barriers to entry and not conducive to competition. So much for Joseph Schumpeter’s creative destruction with a group of elite clubs protecting their market and the owners being rentier capitalists. The ESL’s proposed move is similar to what has been happening in the market place – a structure of businesses taking huge debt and taking little interest in competition as long as they are making money. Manchester United, probably the most famous club in the world, got knocked out of the Champions League in the group stage in 2021 but are still making a lot of money for the owners. It seems that the desire to win trophies has been superseded by profit – the proposed ESL avoids competition as member clubs are protected against the risk of failure. Not to say this is not already happening as the EPL and many other leagues in Europe are dominated by a small number of clubs which have significant funds available.

A2 Economics – Oligopoly Revision


More revision material for A2 students as the CIE exam approaches. Below is a useful mind map which summarises the topic. Quite a popular essay question at A2 which can be linked in with other market structures in imperfect competition.

Oligopoly
Firms that are interdependent cannot act independently of each other. A firm operating in a market with just a few competitors must take the potential reaction of its closest rivals into account when making its own decisions. For example, if a petrol retailer like Z (Shell in the UK) wishes to increase its market share by reducing price, it must take into account the possibility that close rivals, such as Mobil, Caltex and BP, may reduce their price in retaliation.

It is a mistake to believe that ALL oligopolists face a KINKED DEMAND CURVE. Oligopolists may either:

a) COMPETE VIGOROUSLY or
b) COLLUDE (e.g. in cartels) or
c) PLAY SAFE (as in Kinked Demand Curve Theory)

The amount an oligopolist sells depends on the prices charged by other producers and their reactions to changes in his own price and output. Therefore, there are several possible solutions. In practice, prices may not vary much in response to changes in costs and demand: hence the kinked demand curve phenomenon.

Source: CIE A Level Economics Revision – Susan Grant

Oligopoly – Game Theory and Dominant Strategy

Been covering this topic with my A2 class and found Jason Welker’s video very good at explaining Prisoner’s Dilemma and the dominant strategy.

In recent years game theory has become a popular way of examining the strategies that oligopolists may adopt in a market. Game theory involves studying the alternative strategies oligopolists may choose to adopt depending on their assumptions about their rivals’ behaviour. Put at its simplest, if a firm is considering reducing its price, in making its decision it will need to take into account how its rival oligopolists might react and how it will affect them. Firms can choose high risk or low risk strategies in what is very similar to a game of poker between four or five players.

Although game theory strategy involves some extremely difficult maths the A2 Economics course concentrates on relatively straightforward two-player zero-sum games where one player’s gain must equal the other player’s loss.

Tacit Collusion at Martha’s Vineyard petrol stations.

The Economist ‘Free Exchange’ had an article about tacit collusion and the role of algorithms in setting prices. Martha’s Vineyard, a popular holiday retreat for the wealthy in the US, has four petrol stations who had a price-fixing suit brought against them for what was seen as extremely high petrol prices when compared to those at nearby Cape Cod. The judges found no evidence that there was agreement between petrol stations to raise prices although they did note that the market encouraged tacit (silent) collusion amongst the four petrol stations. Whereas explicit collusion over prices is illegal, tacit collusion is not. The conditions conducive for tacit collusion include:

  1. The market is concentrated and there are strong barriers to entry from competitors. Martha’s Vineyard is cut off from the mainland.
  2. Prices are transparent in a way that renders any attempt to steal business by lowering prices self-defeating. A price cut posted outside one petrol station will soon be matched by the others. And if one station raises prices, it can always cut them again if the others do not follow.
  3. The product is a small-ticket and frequent purchase, such as petrol. Markets for such items are especially prone to tacit collusion, because the potential profits from “cheating” on an unspoken deal, before others can respond, are small.

Petrol Price App

Although the consumer maybe able to find out the price of petrol at various stations through a smartphone app but this app makes it easier for the petrol stations to monitor and match each others’ prices. A retailer would have little incentive to cut prices and as other competitors would be able to match their prices instantly leaving everyone worse off.

Collusion in oligopoly

It is often observed that oligopolistic firms are torn between two conflicting desires: The wish to compete on one hand, and the wish to collude on the other. The hope of winning any price war tempts some firms (particularly those with significant advantages, such as lower costs) but collusion is an attractive proposition given the desire to remove the uncomfortable uncertainty that interdependence brings to the market. Collusion reduces the fear of competitive price cutting or retaliatory advertising which could reduce industry profits.

Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development.

A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. In the graph below the total market or industry demand curve is shown as D and the corresponding marginal revenue curve is MR. The cartel’s marginal cost curve (MC) is the horizontal sum of the marginal cost curves of the members of the cartel. The cartel will set a price of p1 (MC = MR) where profits are maximised. Alternatively the cartel could set output at q1 by giving each cartel member an output quota. This would produce the same price (p1).

By contrast, p2 shows the marginal cost price which would be the price under perfect competition, with q2 showing the corresponding output. This means that the cartel will operate with a higher price and lower output when compared to perfect competition.

Cartel with Monop Price

Cartel with a monopoly price

Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.

Collusion between firms whether formal or informal is more likely when:

• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.

• they have similar costs of production and methods of production making any agreement on price easier to reach.

• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.

• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.

• the laws against collusion in a country are weak or ineffective.

Collusive agreements often prove difficult to sustain. Most are illegal as they raise prices to the detriment of the consumer. They cannot, therefore, be enforced by contract, even if cheating could be detected. Each and every party to the collusive agreement has an incentive to cheat by producing more than agreed. This will suppress price slightly, but the firm can still take advantage of artificially high prices as long as the other firms do not cheat as well. However, stable market conditions (a small number of firms; similar costs of production; similar products; high barriers to entry; easy detection of cheating on the agreement) make joint profit maximisation feasible.