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Theoretical Background

An oligopoly is defined as a market structure wherein industries are


dominated or handled by “few” firms. In this context, Nordaus (2001) refers “few” in
having as little as two firms or as many as 10-15 firms. This market structure
dominates the market structures available, accounting half of the total outputs in the
U.S. Industries which adapt to these vary from manufacturers of automobiles to
breakfast cereal or even television broadcasting to airlines. A feature of an oligopoly
is that each firm’s decisions and actions are strategically linked. Their strategic
behaviour deciphers what other firms are likely to do in a particular situation and
counter with tactics which could either increase their gains or decrease their losses.

Oligopolies may produce homogenous or differentiated products. Firms which


opt to sell homogeneous products like oil industries would compete solely by
lowering prices or depend on brand loyalty of their consumers. On the other hand,
firms which sell differentiated products could appeal to more customers through
advertising, improvement in quality and price. In this case, these firms would be
price-makers rather than price-takers.

Barriers in an oligopoly are high, unlike in a monopolistic competition. The


most significant barriers are the natural resources, wherein these sources are
limited, and the economic scale of a firm, wherein resources required in reaching an
appropriate scale of production would need a capital investment only a few firms
may provide. Government authorization is also an entry barrier which generates
oligopoly, especially if entry is limited to only a few firms.

Concentration ratios are also used in measuring market structures. A low


concentration of 40% are considered for oligopolies; 50%-80% having medium
concentration and 80%-100% (ranges from oligopoly to monopoly) having high
concentration.

Firms in an oligopoly are mutually independent. Since barriers are high and
entry is limited to few, each firm is aware and recognizes the actions of their rivals. In
some situations, collusion among firms is made. An example of this is OPEC which
has weighty influence on the prices of oil. Non-collusive oligopolies on the other
hand, would operate reactively to offset and counter any strategy used by a rival.

Price warfare strategies are also prevalent in oligopolies. As stated, the firms
are highly aware of their competitors’ actions, because of this they would try to keep
their prices constant, and would rather compete in other methods than price cutting.
Competitors are expected to counter in price cutting of other firms while they do not
take action in price increasing.

There is no single model in oligopolistic market. This is because of the


complexity of having various firms in competing on the basis of price, marketing,
innovation and the like.

The simplest of all oligopoly models is the Cournot-Nash model. According to Kreps
(1990), it assumes that there are two “equally positioned firms”; the firms would
contend quantity rather than price and each firm makes an “output decision
assuming that the other firm’s behavior is fixed”. The market demand curve is
assumed to be linear and marginal costs are constant. The Cournot-Nash
equilibrium determines how an individual firm would react or counter the other firm.
The pattern of action-reaction continues until neither firm desires “to change what it
is doing, given how it believes the other firm will react to any change, as stated by
Kreps.
For example (as derived from Samuelson & Marks. 2003), assume that the Firm A’s
demand function is “P = (50 - Q2) - Q1” where Q2 is the outputs of Firm B and Q1 is
the outputs by firm A. Assume that marginal cost is 10. Firm A would want to know
its maximizing quantity and price. It then follows the profit maximization rule:
marginal revenue equals marginal costs. Firm A’s total revenue function is PQ =
Q1(50 - Q2 - Q1) = 50Q1- Q1Q2 - Q12. The marginal revenue function is MR = 50 - Q2 -
2Q.

MR = MC
50 - Q2 - 2Q = 10
2Q = Q2 - 40
Q1 = 20 - 0.5Q2 [1.1]
Q2 = 20 - 0.5Q1 [1.2]

Equation 1.1 is the reaction function for Firm A. Equation 1.2 is the reaction function
for Firm B.
Another non-collusive model of oligopoly is the Kinked – Demand Model,
developed by Hall and Hitch (UK), and Sweezy (USA). The model is based on the
assumption that firms react only in times when its competitors decrease their prices.
A kinked-demand curve has two distinct segments with different elasticities which
forms a kink. This model is used to explain price rigidity in oligopolies. The two
segments are: (1) a relatively more elastic segment for price increases and (2) a
relatively less elastic segment for price decreases. The relative elasticities of these
two segments are directly based on the interdependent decision-making of
oligopolistic firms, as stated by Amos (2002).

The model has two assumptions:

Competing firms would not try to match or counter the price increase of an
oligopolistic firm since price increase would cause a decrease in quantity
demand.

Firms, however would try to match or counter price decrease since it would lead
to an increase in quantity demand.
Assume that the current price charged by Firm A is P1. Then, Firm A changes
its price to increase customers. In this situation, two demand curves would be
produced depending on the response of Firm A’s competitors. The curve D
represents the situation if Firm A’s competitors were to retain their selling price. The
quantity sold at this stage would be Q1. Curve d, however, represents the price
change to match Firm A.

If Firm A made the decision to put price down to P2, they would hope to be on
the demand curve D, and have a quantity sold of Q3. Because this curve is fairly
price elastic, they would be able to gain a competitive advantage and increase total
profits. However, in reality this is not the case as competitors would react by also
reducing their prices meaning that quantity sold would only increase to Q2.

P1

P2
D
d

Q1 Q2 Q3
NON-COLLUSIVE OLIGOPOLY
DRAFT

ECONONE K38

Group 2

Aniag
Chan
Edrozo
Eleazar
Gabriel
Gacutan
Gan
Jose
Sanico
Uy

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