FACULTY OF COMPUTER &

MATHEMATICAL SCIENCES

Group 2

Market Structure (Oligopoly)

Fajratul Aini Binti Mohd. Razali

2014459148

NurAini Binti Azhar

2014654272

Caroline Hendry

2014261072

Norsyuhada Binti Johan

2014260284

Market Structure
Market structure identifies how a market is made up
in terms of:

The number of firms in the industry

The nature of the product produced
The degree of monopoly power each firm has
The degree to which the firm can influence price
Profit levels
Firms behaviour (pricing strategies, non-price competition,
output levels)
The extent of barriers to entry
The impact on efficiency

Market Structure
Pure
Monopoly

Perfect
Competition
Monopolistic Competition

Oligopoly

Duopoly

Monopoly

The further right on the scale, the greater the degree

of monopoly power exercised by the firm.

Characteristics
of Oligopoly

Oligopoly

Oligopoly is a market structure characterized by a few sellers,

homogenous or differentiated products, and difficult market
entry. In this market structure, a few large firms dominate the
market. They aggressively compete with each other, for
example, by engaging in heavy advertising. Example of an
oligopoly market is where there are only two sellers.

Characteristic
Few sellers but large in size
There are few large firms in this industry. They are so
large that they can affect the market price. Industries
which best fir the description of oligopoly are
automobiles, aircraft, steel industries and oil
industries.
Homogenous or differentiated products
Sometimes the product is homogenous; for example oil
from Saudi Arabia is the same as from Indonesia and
Malaysia. Automobiles, tires and airlines services are
differentiated products sold by oligopolists.

Oligopolistic Market Structures

Few Firms
Consequently, each firm must consider the reaction of rivals to
price, production, or product decisions
These reactions are interrelated

Heterogeneous or Homogeneous Products

Example : Athletic Shoe Market

Nike has 33% of market
Adidas as 15%
Reebok has 10%

Nokias Challenge
In Cell Phones

The market shares of oligopolists change. In 1985, the market

leader in cell phones was Motorola with 45% market share and
Nokia second with 22%

In 2005, leadership reversed: Nokia held 35% of the market and

Motorola 15%

However, technology in phones is changing, bringing wireless

web, photos, and other high-speed G3 technologies

Entry of other firms and new products, such as Dell, Palm, NEC,
Panasonic, and Apples iPhone pose threats to Nokias profit
margins

Nokia must decide whether or not to invest heavily in the 3G

technology for the future.

Being a leader in a oligopoly does not mean that you remain the
leader for long.
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Characteristic
Difficult entry
There are barriers to entry, which include exclusive financial
requirements, control over an essential resource, patent rights and
other legal barriers. But the most significant barrier to entry under
oligopoly is economies of scale. For example, larger automakers like
Honda or Toyota achieve a lower cost than those incurred by smaller
ones like Proton. In the USA due to economies of scale, the
automobile industry has been reduced to three major operators from
more than 60 firms previously.

Mutual interdependence
Because of the fewness of the oligopoly firms, one firms pricing and
output policies can affect the market price and output as well as other
firms price and output. This situation is called mutual
interdependence amongst firms in oligopoly. Mutual interdependence
is a condition in which an action by one firm may cause a reaction on
the part of other firms. For example, if one firm reduces its price,
other firms will soon reduce their prices as well.
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Elasticity
The theory of the kinked
demand curve is based on two
assumption:

First assumption:
If an oligopolist reduces its
price, its rivals will follow and
cut their prices to prevent losing
the customers.
Kinked Demand Curve

Second assumption:
If an oligopolist increases its
price, its rivals do not increase
the price and keep their prices
the same, thereby they gain
customers from the firm that
increases the price.

Elasticity
Demand is elastic above the
kink where an increase in price
above P0 will lead to a large
drop in quantity as more
customers switch to the rivals
with lower prices. (Second
assumption : If a firm increases
the price, others will not follow.)

Kinked Demand Curve

Demand is inelastic below the

kink, where decreasing the price
will only reflect with small
increase in quantity since all
other firms reduce the prices
below P0 and customers do
switch. (First assumption : If a
firm decreases the price, others
will follow.)

Price
Determination

12

Price Determination

A single firm sets industry price and the remaining firms

charge the same price as the leader

Firms in an oligopolistic market have to consider the reaction

of its rivals when taking decisions.

Firms in an oligopolistic market can make many possible

reaction to the price, non-price and output changes of
another firm.
Example:

If Maxis decrease the price of their internet plan, the other

firms in the same industry such as Celcom and Digi also had
to decrease their price in order not to lost customers
13

Price Determination Model Of Oligopoly :

Price Leadership Model

Under price leadership, one firm assumes the role of a price leader
and fixes the price of the product for the entire industry.
The other firms in the industry simply follow the price leader and
accept the price fixed by him and adjust their output to this price.
The price leader is generally a very large or dominant firm or a firm
with the lowest cost of production.
It often happens that price leadership is established as a result of
price war in which one firm emerges as the winner.
In oligopolistic market situation, it is very rare that prices are set
independently and there is usually some understanding among the
oligopolists operating in the industry. This agreement may be
either tacit or explicit.
There are various models concerning price-output determination
under price leadership on the basis of certain assumptions
regarding the behaviour of the price leader and his followers.
14

Dominant Firm
Price Leadership

This is a system of price-output determination we sometimes

see in oligopolistic market structures in which there is one
firm that is clearly dominant.

General Motors was once the price leader in the U.S. auto
industry.

Other dominant firms include Du Pont in chemicals, US

Steel (now USX), Phillip Morris, Fedex, Boeing, General
Electric, AT&T, and Hewlett Packard.

15

The Model
1. The dominant firm sets the market price and remaining firms
sell all they wish at this price

2. The demand curve for the price leader is found by

subtracting the market demand curve from the supply curve
of the remaining sellers in the market

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FIGURE 10.1: DOMINANT FIRM PRICE LEADERSHIP

Dollars per Unit of Output
D Industry demand
S
Supply curve
for small firms

d Leader's
net demand
P'
P*

d
MC

P* is the price
established by
D the dominant
firm

MR
Q* Qs

Q* + QS

Output
17

Example :
Let the market demand curve be given by:

QD = 248 2P
The supply curve for 10 small firms in the market is given by:
QS = 48 + 3P
The dominant firms residual or net demand curve is given
by the market demand curve minus the supply of the 10 other
firms, or:

Q = QD QS = 248 2P (48 + 3P) = 200 5P

The inverse (residual) demand curve facing the dominant firm
is given by:

P = 40 - .2Q
18

Assume the dominant firm has a marginal cost function given

by:
MC = .1Q

The dominant firm would maximize its own profits by setting

MR = MC. To derive the MR, find the revenue (R) function and
take the first derivative with respect to Q:
R = P Q = (40 - .2Q)Q = 40Q - .2Q2
MR = dR/dQ = 40 - .4Q
Now set MR = MC and solve for Q

40 - .4Q = .1Q
.5Q = 40 Q = 80 Units
P = 40 (.2)(80) = $24
At the price established by the dominant firm, the remaining 10
firms collectively supply 120 units (or 12 units each).
19

Price Rigidity &

Kinked Demand

20

Price Rigidity

Since there is mutual interdependence between oligopoly

firms, the prices in the market are more stable which is called
price rigidity in oligopolistic market.

This can be explained by kinked demand curve.

The price rigidity explains the behavior of an oligopoly firm

that has no incentive to increase or decrease the price.

The theory of kinked demand curve is based on two

assumptions.
If an oligopolist reduce its price, its rival will follow and cut
their prices to prevent losing the customers.
If an oligopolist increases its price, its rival do not increase
the price and keep their prices the same, thereby gain
customers from the firm that increases the price
21

Kinked Demand Curve Model

1. A combination of two demand curves
2. Show a situation where the best situation for players is to
maintain current prices and that prices remain stable in spite
of firms with different cost structures

22

Elasticity
Demand is elastic above the
kink where an increase in
price above P0 will lead to a
large drop in quantity as more
customers switch to the rivals
with lower prices.

Kinked Demand Curve

Demand is inelastic below the

kink, where decreasing the
price will only reflect with
small increase in quantity
since all other firms reduce the
prices below P0 and customers
do not switch.

"Kinked" demand curves and traditional demand curves are similar in

that they are both downward-sloping. They are distinguished by a
hypothesized concave bend with a discontinuity at the bend - the
"kink." Therefore, the first derivative at that point is undefined and
leads to a jump discontinuity in the marginal revenue curve.

Classical economic theory assumes that a profit-maximizing producer

with some market power (either due to oligopoly or monopolistic
competition) will set marginal costs equal to marginal revenue. This
idea can be envisioned graphically by the intersection of an upwardsloping marginal cost curve and a downward-sloping marginal revenue
curve (because the more one sells, the lower the price must be, so the
less a producer earns per unit).

In classical theory, any change in the marginal cost structure (how

much it costs to make each additional unit) or the marginal revenue
structure (how much people will pay for each additional unit) will be
immediately reflected in a new price and/or quantity sold of the item.

This result does not occur if a "kink" exists. Because of this jump
discontinuity in the marginal revenue curve, marginal costs could
change without necessarily changing the price or quantity.

Our primary technology for analyzing

oligopoly behaviour will be game
theory. As we will see, these are
methods designed to focus on
strategic considerations. Before we
do that though, let's look at a simple
model which combines the profit
maximization model we know well
with
some
simple
strategic
considerations.

Consider the two demand curves

shown to the right. An oligopolist
might not know which of these
demand curves it faces. Suppose a
firm knows that any time it raises or
lowers its prices all other firms in the
industry will do the same. In this case
it faces DI, the inelastic curve. If all
firms change prices together, the
effect of a price change won't have a
large effect on the sales of any one of
the firms.

If no other firms follow its changes in

prices the firm will instead find itself
on DE, a much more elastic demand
curve. If the firm is the only one to raise
prices it will experience a large drop in
sales. Likewise, if it is the only one to
lower prices it will find sales increase
rapidly. So DE is the relevant demand
curve if others don't follow the firms
price changes.

Before it can set profit maximizing price

and quantity the firm must determine
which is the appropriate demand curve.
The kinked demand curve model is
based on the idea that, if the firm raises
prices other firms won't follow because
they don't worry about losing market
share to a firm which is raising price.
However, if the firm lowers its prices
other firms will respond by lowering their
prices also since they don't want to lose
market share.

If price increases are ignored by other

firms but price decreases lead to
lowering of prices by competitors the
firm will face a kinked demand
curve as shown to the right, with the
kink at the current market price of P*.

Keep in mind that the firm's belief that

it faces a kinked demand curve comes
from basic strategic considerations. It
believes
that
competitors
won't
respond to price increases but that
they will respond to price decreases.
This in turn, means that the elasticity
of the demand curve it faces depends
on the direction of a price change.
From here we use the simple logic of
profit
maximization
to
analyze
behaviour.

If the demand curve is kinked as

shown to the right the marginal
revenue curve will have an unusual
shape.

As always the marginal revenue

curve lies below the relevant
demand curve and is steeper, so it
makes sense that the MR curve
shown here has two segments with
very different slopes. What is
unusual is the gap in the MR curve,
shown by the dashed line. Simply
put, if the firm lowers price
below P* a strong reaction from
competitors occurs in the form of
industry wide price drops. This
causes MR to drop dramatically,
causing a gap in the curve.

If marginal costs fall in the gap of

the MR curve P* will remain the profit
maximizing price and Q* will be the
profit maximizing output.

One of the points of the kinked

demand curve model was that it
provided an explanation for a
behaviour that economists were well
aware of within oligopoly. It had been
observed that firms in oligopolistic
industries didn't change price and
output often, even when production
costs were known to have changed.

It turns out that this simple bit of

strategic thinking on the part of firms
in an oligopoly was able to explain
this otherwise strange phenomenon,
strange because all our models have
shown that profit maximizing firms
will change price and output when
variable costs change.

If marginal costs fall anywhere

between MC1 and MC2 the firm will
choose to leave price and output
unchanged. Because of its belief
about how other firms will respond
to a price change the firm is better
off not altering price even in the
face of rather significant changes
in production costs.

As
we
will
see,
strategic
considerations
can
cause
behaviour that varies considerably
from the simple mechanistic
responses predicted by profit
maximization. Not that there is
anything wrong with the profit
maximizing
model
in
other
industrial structures, but it doesn't
capture
the
rich
strategic
complexity that we must allow for
in our study of oligopoly.

 An analysis using the kinked-demand curve to explain rigid prices

often found with oligopoly.
The kinked-demand curve contains two distinct segments which
are one for higher prices that is more elastic and one for lower
prices that is less elastic.
Key to this analysis is that the corresponding marginal revenue
curve contains three segments :
a) associated with the more elastic segment
b) associated with the less elastic segment
c) associated with the kink.
A profit-maximizing firm can then equate marginal cost to a wide
range of marginal revenue values along the vertical segment of the
marginal revenue curve. This suggests that marginal cost must
change significantly before an oligopolistic firm is inclined to
change price.
31

 The kinked-demand curve analysis of oligopoly builds on the

notion of interdependent decision-making to explain why prices
tend to be relative stable or rigid.
The key to this analysis is that competing firms do not respond in
the same way when one firm increases or decreases its price.
Competing firms match price decreases, but not price increases.
This means a firm is likely to lose market share for price increases,
but does not gain market share for price decreases.
A firm has little to gain from reducing prices and much to lose
form raising prices. As such, the firm is inclined to keep prices
stable.
32

Profit Maximization
Example :
Athletic footwear faces the following demand curve:
P1 = 600 - 0.5Q1
for price increase
P2 = 700 0.75Q2
for price decrease
The firms marginal cost is RM150
a) What is the price and output at the kink?
At the kink,

33

b) At what range of value will the marginal cost shift without

changing price and output?
To find the range of MC, the upper limit and lower limit of MR
needs to be found out.
Firstly, derive the demand curve.
Price increase (upper limit) :

Price increase (lower limit) :

The range for MC to shift is between 100 and 200

34

c) What is the profit maximizing price and quantity if the marginal

cost is RM250?
For profit maximization to take place, we use MR=MC rule.

We equate

to MC because MC is more than the upper limit

35