group 2 oligopoly market structure
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FACULTY OF COMPUTER &MATHEMATICAL SCIENCES
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Group 2 Market Structure (Oligopoly)
Fajratul Aini Binti Mohd. Razali 2014459148
NurAiniBinti Azhar 2014654272
Caroline Hendry 2014261072
Norsyuhada Binti Johan 2014260284
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Market Structure
Market structure identifies how a market is made upin 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
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Market Structure
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PerfectCompetition
PureMonopoly
The further right on the scale, the greater the degreeof monopoly power exercised by the firm.
Monopolistic Competition Oligopoly Duopoly Monopoly
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Characteristicsof Oligopoly
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Oligopoly
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Oligopoly is a market structure characterized by a few sellers,
homogenous or differentiated products, and difficult marketentry. In this market structure, a few large firms dominate the
market. They aggressively compete with each other, forexample, by engaging in heavy advertising. Example of an
oligopoly market is where there are only two sellers.
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Characteristic
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There are few large firms in this industry. They are solarge that they can affect the market price. Industries
which best fir the description of oligopoly areautomobiles, aircraft, steel industries and oilindustries.
Few sellers but large in size
Sometimes the product is homogenous; for example oilfrom Saudi Arabia is the same as from Indonesia andMalaysia. Automobiles, tires and airlines services aredifferentiated products sold by oligopolists.
Homogenous or differentiated products
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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%
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The market shares of oligopolists change. In 1985, the marketleader in cell phones was Motorola with 45% market share andNokiasecond with 22%
In 2005, leadership reversed: Nokia held 35% of the market andMotorola 15%
However, technology in phones is changing, bringing wirelessweb, 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 profitmargins
Nokia must decide whether or not to invest heavily in the 3Gtechnology for the future.
Being a leader in a oligopoly does not mean that you remain the
leader for long.
Nokias Challenge
In Cell Phones
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There are barriers to entry, which include exclusive financialrequirements, control over an essential resource, patent rights andother legal barriers. But the most significant barrier to entry underoligopoly is economies of scale. For example, larger automakers likeHonda or Toyota achieve a lower cost than those incurred by smaller
ones like Proton. In the USA due to economies of scale, theautomobile industry has been reduced to three major operators frommore than 60 firms previously.
Difficult entry
Because of the fewness of the oligopoly firms, one firmspricing and
output policies can affect the market price and output as well as otherfirms price and output. This situation is called mutualinterdependence amongst firms in oligopoly. Mutual interdependenceis a condition in which an action by one firm may cause a reaction onthe part of other firms. For example, if one firm reduces its price,other firms will soon reduce their prices as well.
Mutual interdependence
Characteristic
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Elasticity
The theory of the kinkeddemand curve is based on twoassumption:
First assumption:If an oligopolist reduces itsprice, its rivals will follow andcut their prices to prevent losingthe customers.
Second assumption:If an oligopolist increases itsprice, its rivals do not increasethe price and keep their pricesthe same, thereby they gaincustomers from the firm thatincreases the price.
Kinked Demand Curve
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Elasticity
Demand is elastic above thekink where an increase in priceabove P0 will lead to a largedrop in quantity as morecustomers switch to the rivals
with lower prices. (Secondassumption : If a firm increasesthe price, others will not follow.)
Demand is inelastic below thekink, where decreasing the price
will only reflect with smallincrease in quantity since allother firms reduce the pricesbelow P0 and customers doswitch. (First assumption : If afirm decreases the price, otherswill follow.)
Kinked Demand Curve
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PriceDetermination
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Price Determination
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A single firm sets industry price and the remaining firmscharge 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 possiblereaction to the price, non-price and output changes ofanother firm.
Example:
If Maxis decrease the price of their internet plan, the otherfirms in the same industry such as Celcom and Digi also hadto decrease their price in order not to lost customers
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Price Determination Model Of Oligopoly :Price Leadership Model
Under price leadership, one firm assumes the role of a price leaderand fixes the price of the product for the entire industry.
The other firms in the industry simply follow the price leader andaccept 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 setindependently and there is usually some understanding among the
oligopolists operating in the industry. This agreement may beeither tacit or explicit.
There are various models concerning price-output determinationunder price leadership on the basis of certain assumptionsregarding the behaviour of the price leader and his followers.
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This is a system of price-output determination we sometimessee in oligopolistic market structures in which there is onefirm that is clearly dominant.
General Motors was once the price leader in the U.S. autoindustry.
Other dominant firms include Du Pont in chemicals, US
Steel (now USX), Phillip Morris, Fedex, Boeing, GeneralElectric, AT&T, and Hewlett Packard.
Dominant Firm
Price Leadership
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The Model
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1. The dominant firm sets the market price and remaining firmssell all they wish at this price
2. The demand curve for the price leader is found bysubtracting the market demand curve from the supply curveof the remaining sellers in the market
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FIGURE10.1: DOMINANTFIRMPRICELEADERSHIP
P'
P*
d Lneader ' set demand
I ndust r y demand
Supply cur vef or small f ir ms
D
S
d
M C M R
Q* Qs
Dollar s per Unit of O ut put
O ut put
D
P* is the price
established by
the dominant
firm
Q* + QS
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Example :
Let the market demand curve be given by:
QD= 2482P
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 = QDQS= 2482P(48 + 3P) = 2005P
The inverse (residual) demand curve facing the dominant firm
is given by:
P = 40 - .2Q
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Assume the dominant firm has a marginal cost function given
by:
MC = .1QThe 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 UnitsP = 40(.2)(80) = $24
At the price established by the dominant firm, the remaining 10
firms collectively supply 120 units (or 12 units each).
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Price Rigidity &Kinked Demand
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Price Rigidity
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Since there is mutual interdependence between oligopolyfirms, the prices in the market are more stable which is calledprice rigidity in oligopolistic market.
This can be explained by kinked demand curve.
The price rigidity explains the behavior of an oligopoly firmthat 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 gaincustomers from the firm that increases the price
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Kinked Demand Curve Model
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1. A combination of two demand curves
2. Show a situation where the best situation for players is tomaintain current prices and that prices remain stable in spiteof firms with different cost structures
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Elasticity
Demand is elastic above thekink where an increase inprice above P0 will lead to alarge drop in quantity as more
customersswitch to the rivalswith lower prices.
Demand is inelastic below thekink, where decreasing the
price will only reflect withsmall increase in quantitysince all other firms reduce theprices below P0and customersdo not switch.
Kinked Demand Curve
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"Kinked" demand curves and traditional demand curves are similar inthat they are both downward-sloping. They are distinguished by ahypothesized 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 producerwith some market power (either due to oligopoly or monopolisticcompetition) will set marginal costs equal to marginal revenue. Thisidea can be envisioned graphically by the intersection of an upward-
sloping marginal cost curve and a downward-sloping marginal revenuecurve (because the more one sells, the lower the price must be, so theless a producer earns per unit).
In classical theory, any change in the marginal cost structure (howmuch it costs to make each additional unit) or the marginal revenue
structure (how much people will pay for each additional unit) will beimmediately reflected in a new price and/or quantity sold of the item.
This result does not occur if a "kink" exists. Because of this jumpdiscontinuity in the marginal revenue curve, marginal costs couldchange without necessarily changing the price or quantity.
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Our primary technology for analyzingoligopoly behaviour will be gametheory. As we will see, these aremethods designed to focus onstrategic considerations. Before wedo that though, let's look at a simplemodel which combines the profitmaximization model we know wellwith some simple strategicconsiderations.
Consider the two demand curvesshown to the right. An oligopolistmight not know which of thesedemand curves it faces. Suppose afirm knows that any time it raises or
lowers its prices all other firms in theindustry will do the same. In this caseit faces DI, the inelastic curve. If allfirms change prices together, theeffect of a price change won't have alarge effect on the sales of any one of
the firms.
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If no other firms follow its changes inprices the firm will instead find itselfon DE, a much more elastic demandcurve. If the firm is the only one to raise
prices it will experience a large drop insales. Likewise, if it is the only one tolower prices it will find sales increaserapidly. So DE is the relevant demandcurve if others don't follow the firmsprice changes.
Before it can set profit maximizing priceand quantity the firm must determinewhich is the appropriate demand curve.The kinked demand curve model isbased on the idea that, if the firm raises
prices other firms won't follow becausethey don't worry about losing marketshare to a firm which is raising price.However, if the firm lowers its pricesother firms will respond by lowering theirprices also since they don't want to lose
market share.
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If price increases are ignored by otherfirms but price decreases lead tolowering of prices by competitors thefirm will face a kinked demandcurve as shown to the right, with thekink at the current market price of P*.
Keep in mind that the firm's belief thatit faces a kinked demand curvecomesfrom basic strategic considerations. Itbelieves that competitors won'trespond to price increases but thatthey will respond to price decreases.This in turn, means that the elasticity
of the demand curve it faces dependson the direction of a price change.From here we use the simple logic ofprofit maximization to analyzebehaviour.
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If the demand curve is kinked asshown to the right the marginalrevenue curve will have an unusualshape.
As always the marginal revenuecurve lies below the relevantdemand curve and is steeper, so it
makes sense that the MR curveshown here has two segments withvery different slopes. What isunusual is the gap in the MR curve,shown by the dashed line. Simplyput, if the firm lowers price
below P* a strong reaction fromcompetitors occurs in the form ofindustry wide price drops. Thiscauses MR to drop dramatically,causing a gap in the curve.
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If marginal costs fall anywherebetween MC1and MC2 the firm willchoose to leave price and outputunchanged. Because of its belief
about how other firms will respondto a price change the firm is betteroff not altering price even in theface of rather significant changesin production costs.
As we will see, strategicconsiderations can causebehaviour that varies considerablyfrom the simple mechanisticresponses predicted by profitmaximization. Not that there is
anything wrong with the profitmaximizing model in otherindustrial structures, but it doesn'tcapture the rich strategiccomplexity that we must allow forin our study of oligopoly.
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An analysis using the kinked-demand curve to explain rigid pricesoften found with oligopoly.
The kinked-demand curve contains two distinct segments whichare one for higher prices that is more elastic and one for lowerprices that is less elastic.
Key to this analysis is that the corresponding marginal revenue
curve contains three segments :a) associated with the more elastic segmentb) associated with the less elastic segmentc) 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 themarginal revenue curve. This suggests that marginal cost mustchange significantly before an oligopolistic firm is inclined tochange price.
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The kinked-demand curve analysis of oligopoly builds on the
notion of interdependent decision-making to explain why pricestend to be relative stable or rigid.
The key to this analysis is that competing firms do not respond inthe 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 loseform raising prices. As such, the firm is inclined to keep pricesstable.
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Profit Maximization
Example :Athletic footwear faces the following demand curve:
P1 = 600 - 0.5Q1 for price increaseP2 = 7000.75Q2 for price decrease
The firms marginal cost is RM150
a) What is the price and output at the kink?
At the kink,
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b) At what range of value will the marginal cost shift withoutchanging price and output?
To find the range of MC, the upper limit and lower limit of MRneeds 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
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c) What is the profit maximizing price and quantity if the marginalcost 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