|Section 3: Characteristics of an Oligopoly Industry|
|Microeconomics - Unit 8|
Four characteristics of an oligopoly industry are
Examples of Oligopoly Industries
Profit Maximization in an Oligopoly Industry
Firms in oligopoly industries maximize profits in the same way as firms in other industries. They maximize profits at the quantity where a rising marginal cost equals or approaches marginal revenue, as long as the price is greater than the average variable cost (otherwise, shut down).
The Kinked Demand Curve
Some economists claim that because of the interdependence between rival oligopoly firms, there are two demand curves to consider.
Let's suppose that the current price of a product sold by oligopoly firm X is $8, and the firm sells 5 products at this price. What will happen to the firm's quantity sold if it changes its price? The answer depends on what rival firm Y will do in response to the price change.
Let's assume that firm Y does not copy the price change of firm X. Then if firm X lowers its price, it will have a significant competitive advantage over firm Y, and its quantity sold will increase considerably. If it raises its price, the opposite will occur. Thus, firm X's price elasticity of demand is high, if firm Y does not copy its price change. This is shown in Table 1 below, and is illustrated by demand curve D1 in the graph below.
Let's now assume that firm Y does copy the price change of firm X. Then if firm X lowers its price, it will not have a significant competitive advantage over firm Y, and its quantity sold will not increase considerably (there is no substitution effect, only an income effect). If it raises its price, and firm Y copies the price change, then firm X will not lose much market share. In other words, firm X's price elasticity of demand is low, if firm Y does copy its price change. This is shown in Table 2 below, and is illustrated by demand curve D2 in the graph below.
Table 1 - Demand for firm X's product, if the rival firm does not copy a price change
Table 2 - Demand for firm X's product, if the rival firm does copy a price change
Some economists believe that rival firm Y will copy a price change of firm X, only if firm X lowers its price. However, they believe that rival firm Y will not copy a price change of firm X, if firm X raises its price. Thus, if firm X lowers its price below the current price of $8, demand D2 is relevant. This is illustrated by the green part of Table 2 and the green part of demand curve D2. If firm X raises its price above the current price of $8, demand curve D1 is relevant. This is illustrated by the green part of Table 1 and the green part of demand curve D1. We end up with two demand curves, depending on whether firm X lowers or raises its price. Therefore, the demand curve of firm X is kinked. This is illustrated by the green kinked demand curve in the graph below.
Because the demand curve is kinked, there is a gap in firm X's marginal revenue curve. As you can see from the calculations in the tables above, marginal revenue at quantity 5 is different depending on whether you use demand 1 or demand 2. The relevant marginal revenue portions of the kinked demand curve are illustrated by the blue curve above.
Not every economist believes in the kinked demand curve theory. Some economists believe that oligopolies behave just like other firms. In that case, the demand and revenue curves look similar to the demand and revenue curves of the monopoly and monopolistically competitive firms discussed before.
Profits of Firms in an Oligopoly Industry
Regardless of the shape of the demand curve, we can conclude that for oligopoly firms, economic (above-normal) profits are possible in the long run because of the more difficult entry into the industry. However, in the long run, extremely high profits are unlikely. If the price of the product is too high, competitors will enter eventually, undercut the existing firms' prices, and lower industry profits. Occasionally, gasoline prices increase, and people are concerned that oil companies are exploiting consumers. Not to say that this never happens, but the higher gasoline prices are usually a result of higher demand (for example, during the summer) or lower supply (because of deliberate cutbacks by OPEC, or a crisis in an oil-producing country). If oil prices are excessive for a considerable period of time, then, despite barriers, new competitors will enter the market. Consumers may also respond by reducing demand (purchasing more hybrid or fuel-efficient cars, turning to alternative sources of energy, living closer to work). These market forces will in the long run, make prices come down.
|Last Updated on Sunday, 31 August 2014 05:23|