The oligopoly market structure is of particular interest since many major industries in the US and in the world operate in oligopoly markets.

1. A few large firms dominate the market, i.e. they have a substantial market share.

2. The product may be homogenous or differentiated.

3. The dominant firms have significant market power -- they can set their own price.

4. There are significant barriers to entry; entry or exit is difficult.

5. Access to information is limited.

6. There is mutual interdependence among the dominant firms; this means that competition is personal and each firm recognizes that its actions affect the rival firms and theirs affect it.

A firm under oligopoly faces a kinked demand curve (see fig. 1). The point of the kink is the point of the established market price. The kink of the demand curve suggests that a competitor would react asymmetrically to price increases and price decreases by the firm. Consider the soft drink market, where Pepsi and Coke combined have over 90% of the market share. Suppose the price is established at $1.99 for a six-pack of either Pepsi or Coke. Let's consider the demand curve for Pepsi. If Pepsi increases its price to $2.49 per six-pack, it will lose some of its market to Coke along the AB component of the demand curve in Fig. 1. Pepsi will be able to sell 500 six-packs a day instead of the original sales level of 1000. Coke is likely to stay at $1.99 and enjoy the additional sale, as some people who were originally buying Pepsi will be switching to Coke.

D

If Pepsi lowers its price to $1.49 to gain an advantage over Coke and increase it sales to 1500 six-packs, it may not succeed. The increase in sales by Pepsi to 1500 can only happen if Coke did not react to Pepsi's price cut. However, Coke is likely to match the price reduction by Pepsi to protect itself against loss of market share. As the result of price cuts by both Pepsi and Coke, there will be an increase in sales by both -- at least partially at the expense of smaller competitors. In our example, the sales of Pepsi increases to 1300 six-packs per day from the original 1000. This is along the BC segment of the demand curve. Therefore, there are two demand curves facing Pepsi--AB for price increases and no reaction by Coke, and BC for price decreases and price matching reaction by Coke. This explains the kinked demand curve for Pepsi and similarly for Coke. Notice that the kink in the demand curve is at the established market price. It is also important to realize that the established price tends to be maintained. Neither Pepsi nor Coke will be inclined to raise their price since it would cause loss of sales and market share to the rival. Also neither of them is particularly interested in lowering the price and starting a price war since the outcome is loss of profit for both in favor of consumers.

Now that we have established ABC as the demand for each of the firms in an oligopoly, we can derive the MR curve for this demand curve. We can apply the rule of thumb (see chapter 9) to each segment of the kinked demand curve to derive the relevant MR for each segment. The MR that corresponds to the AB segment of the demand curve is relevant only up to the point of the kink, i.e. up to the quantity of 1000 (illustration A of Fig. 2). The MR that corresponds to the BC segment of the kinked demand curve is only relevant for quantities larger than 1000 (illustration B of Fig. 2). Therefore, the marginal revenue curve the kinked demand curve is the discontinuous curve shown by the dotted line in illustration C of Fig. 2)

D

 Profit Maximization under Oligopoly 

If we now add to the demand-MR model the cost curves for a firm under oligopoly, we would be able to determine the profit maximization level of output. The profit maximizing level of output is 1000 six-packs of Pepsi, where MC = MR. Pepsi can sell this quantity at $1.99 according to the demand curve. The average total cost of production at 1000 level of output is $0.99 per six-pack. Therefore the company is making $1000 a day of economic (or excess) profit as illustrated in Fig. 3. An interesting observation is that the profit maximization of oligopolies, generally, occurs at the kink of the demand curve, which in-turn represents the established market price and market shares of the oligopolies. Another observation is that moderate changes in the cost conditions of oligopolies do not cause a change in their profit maximization quantity and price as long as they are in the vertical range of the MR curve. This implies that technological improvements that lower the cost of production or change in the price of inputs encountered by an oligopoly would not lead to a quantity or price change. We therefore suggest that under an oligopoly market prices are rigid. Firms especially avoid lowering their price from fear of igniting a price war. Instead oligopolies resort to non-price competition such as advertising. Price wars can and occasionally do occur when one of the dominant firms in the oligopoly market experiences a significant decrease in its production cost and attempts to increase its market share.

D

As we discussed earlier, the kink in the demand curve for an oligopoly is an already established price. The question is how the market price, in our example $1.99 per six-pack, is established. The following list suggests a few of the ways that help establish the oligopoly market price.

1. Explicit Collusion-- Where explicit collusion among firms is legal, the firms in an oligopoly market may collectively negotiate and determine the quantity and the price that maximizes their collective profits. This arrangement is called a cartel. Maintaining a cartel requires for the firms to stick to the agreed-upon price and market shares. OPEC is an example of an international cartel.

2. Price leadership-- In this case a firm becomes a price leader either because of its larger market share or cost advantage. Once a firm is considered by the competitors to be a price leader, the competitors avoid changing their price unless the price leader initiates such a change.

3. Test Pricing-- In this arrangement any of the major players may declare a price and observe the reaction of other firms to see if the new price will be agreeable to major players. This appears to be a practice among airliners.

4. Game Theory-- In this approach the commonly agreed upon price is arrived at through a rather sophisticated assessment of the probability of different reactions of competitors by each firm. The basis of this approach is each firm determining the best price, taking into account the range of alternatives available to the competitors.

A review of the table of concentration ratios in your textbook is helpful in becoming familiar with examples of oligopolies. Concentration ratio is generally defined as the market share of the top four firms in the industry.

Power in U.S. Product Markets

The domestic production of many familiar products is concentrated among a few firms. These firms have substantial control over quantity supplied to the market, and thus over market price. The concentration ratio measures the share of total output produced by the largest producers in a given market. The following table provides the share of the top four firms in each industry.

Sources: Data from Federal Trade Commission, The Wall Street Journal, Advertising Age, Financial World, Standard & Poor's, Fortune, and industry sources.

Note: Individual corporations with a market share of at least 40 percent are designated in boldface. Market shares based on selected years, 2000-2004.