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St. Michael, Earl of Bensalem.

WHY OLIGOPOLISTIC FIRMS ARE AFFECTED BY BOTH INTERDEPENDENCE AND UNCERTAINTY WHEN SELLING THEIR PRODUCT?

An oligopoly is when there are a small number of dominant firms in a market structure, a firm inside an oligopoly is called an oligopolistic firm. An example is the UK Oil industry which is dominated by the likes of BP, Exxon and Shell among a few others. Interdependence is when a firm competing in a market might have to consider the actions of consumers and other producers when setting their own price and output. They are some way or another connected. For example, if a firm raises its price (then not all firms will follow) and thus the firm will lose out on customers and market share, as the price elasticity of demand is inelastic. However if price cutting starts a price war then the independence on all the competing firms means that the price elasticity of demand is now elastic and thus the firm will lose out on revenue. This can be demonstrated on the kinked demand curve;

elastic

inelastic

In the above diagram, the price and quantity are both at P*, Q*. Any price above this, then the theory assumes that the firm will experience elastic demand (and other firms may not follow meaning that the quantity bought by the consumer will be reduced. This will lower revenue and profits for the firm. Whilst any price below this, the theory assumes that the firm will experience inelastic demand and other competitors may follow in a price war and the effects of the quantity sold may be only marginally greater. As the quantity sold is only marginally increased whilst the price that they are sold at is decreased then the revenue and profits will not be increased by as much hoped for and may even be worse. Therefore firms have a problem in that they are uncertain about what price to charge, since higher prices will reduce demand if other firms dont follow whilst lower prices might start a price war with the other firms. (Since firms dont know what the other firms will do, they are linked to unknown parameters of interdependence with the other firms, which is the uncertainty that they experience from choosing a profitable price level. (Firms usually change their price level to boast their profits). This is the reason of why they usually compete on non-price competition like advertising. Collusion is assumed to be banned). Of course the uncertainty in oligopolies can be explained with the help of game theory. Oligopolies dont know which level to set their price, and that is the uncertainty in the market. (The kinked demand curve can only go so far but it is not very accurate and reliable). For example, Apples and Bananas are both competing for customers and their money. At the beginning both are charging 2 for each apple or banana, however that doesnt make them much money, so one of them could potentially drop to 1 for each fruit (so that they undercut the competitor and make more money). But the uncertainty lies in whether this will make one of the

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St. Michael, Earl of Bensalem.


companies more profitable or not since if apples drops their price to 1, banana might follow and possibly undercut it.

Apple
Price = 2 10 each. Apple - 7.50. Banana - 15. Price = 1 Apple - 15. Banana - 7.50 5 each.

Banana

Price = 2 Price = 1

In the game theory matrix above, the uncertainty is that if one firm charges 1 and the other 2 then the one charging 2 would lose out of the profit i.e. they would get the 7.50 instead of the 15. However if they both charge the 1 both profits are reduced from 10 to 5. This shows that profitability levels and price levels are uncertain since the actions of the rival firms are unknown and could potentially change, which is when many oligopolistic firms collude. (It also means that the actions on one firm can influence the actions of another firm, which also means that game theory shows the independence of firms.)

To avoid this oligopolists often compete on non-price competition or collude. In collusion, however oligopolists are usually afraid of cheating firms (i.e. price undercutting or above quota production) and also the ratting out by the competitors (the competitor usually gets off Scott-free whilst the other firms involved get huge fines).

2 E-mail; smebthewizard@outlook.com Twitter; @SMEBtheWizard

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