OligopolyCharacteristicsOligopoly 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.

CollusionCollusion 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, Firm’s 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 industryo 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 costso 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 TheoryGame 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.