Mic 12

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Mic 12

  1. 1. Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 1
  2. 2. CHAPTER12 Oligopoly Microeconomics All Rights Reserved © Oxford University Press Malaysia, 2008 12– 2
  3. 3. DEFINITION OF AN OLIGOPOLY Definition A market structure in which there are only a few firms selling either standardized or differentiated products and it restricts the entry into and exit from the marketMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 3
  4. 4. CHARACTERISTICS OF AN OLIGOPOLY Characteristics • Few numbers of firms: The number of firms is small but size of the firms is large. • Homogeneous or differentiated products: These products can be standardized products such as steel, zinc or copper which is price based. Other industries such as electronics automobiles offer different products where emphasis is on non-price competition, such as advertisirs.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 4
  5. 5. CHARACTERISTICS OF AN OLIGOPOLY (CON’T) • Mutual interdependence: Firms in an oligopoly market always considers the reaction of their rivals when choosing price, sales target, advertising budgets and other business policies.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 5
  6. 6. CHARACTERISTICS OF AN OLIGOPOLY (CON’T) • Barriers to entry: Restricts new entrants into the market through various types of barriers of entry such as the control of certain resources, ownership of patents and copyrights, exclusive financial requirements and legal barriers.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 6
  7. 7. PRICE AND OUTPUT DECISIONS FOR AN OLIGOPOLIST Non-Price Competition • Firms compete with each other using advertising and product differentiation techniques. • Firms try to capture the market from rivals through better advertising campaigns and produce high-quality products instead of reducing prices.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 7
  8. 8. PRICE AND OUTPUT DECISIONS FOR AN OLIGOPOLIST (CON’T) • Besides advertising, research and development activity is important for oligopoly firms to invent new products and improve the quality of the existing products.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 8
  9. 9. PRICE AND OUTPUT DECISIONS FOR AN OLIGOPOLISTPrice Rigidity and Kinked Demand Curve• Since there is mutual interdependence between oligopoly firms, the prices in the market are more stable. This is called price rigidity in oligopoly market.• The price rigidity explains the behaviour of an oligopoly firm that has no incentive to increase or decrease the price. The theory of the kinked demand curve is based on two assumptions.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 9
  10. 10. ASSUMPTIONS OF A KINKED DEMAND CURVE 1. First assumption: If an oligopolist reduces its price, its rivals will follow and cut their prices to prevent losing the customers. 2. Second assumption: If an oligopolist increases its price, its rivals would not increase their prices and keep their prices the same, thereby they gain customers from the firm that increases the price.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 10
  11. 11. KINKED DEMAND CURVEPrice (RM) An oligopoly firm faces two demand curves that is an individual demand curve (dd) and an industry demand curve (DD). According to the second assumption, when a firm increase the price (P*), no P* other firms will follow. Above P*, the firm will follow dd curve. If the firm decrease the price, other firms dd will follow. Below P*, the firm follow DD curve. DD Because of this assumption, an oligopolist faces kinked demand curve. Q* QuantityMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 11
  12. 12. KINKED DEMAND CURVE Price (RM) The kinked demand curve below point E creates a gap in the MR, which is indicated by the dotted line ab. MC1 MC2 E At this range of MR, any change in P* the MC does not reflect changes in the profit maximizing price and output. a b DD This shows price rigidity in the oligopoly market. Q* MR QuantityMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 12
  13. 13. PROFIT MAXIMIZATION USING THE EQUATION METHOD Athletic footwear faces the following demand curve: P1 = 600 − 0.5Q1 for price increase P2 = 700 − 0.75Q2 for price decrease The firm’s marginal cost is RM150. What is the price and output at the kink? At what range of value will the marginal cost shift without changing price and output.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 13
  14. 14. PROFIT MAXIMIZATION USING THE EQUATION METHOD (CON’T) Solution At the kink, P1 = P2 600 – 0.5Q = 700 – 0.75Q 0.25Q = 100 Q = 400 P = RM400 To find the range of MC, the upper limit and lower limit of MR needs to be found out. MR1 = 600 − Q1 = 600 – 400 = 200 MR2 = 700 − 1.5Q2 = 700 −600 = 100 The range for MC to shift is between 100 and 200Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 14
  15. 15. GAME THEORY (CON’T) A game theory is a model of analyzing strategic behaviour of rivals. Strategic behaviour refers to the actions taken by firms to consider the expected movement of rivals and the mutual recognition of interdependence between these firms.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 15
  16. 16. GAME THEORY (CON’T) Strategies are the important actions for each player. The score obtained by each player in this game is called payoff.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 16
  17. 17. GAME THEORY (CON’T) The payoff refers to the profits and losses of players, which is determined by strategies and constraints faced by the players. Constraints faced by the players come from the consumers who determine the demand curve for the product in this industry.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 17
  18. 18. PRISONERS’ DILEMMA In order to understand how the game theory works, we can start with a simple non-economic example called the prisoner’s dilemma.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 18
  19. 19. PRISONERS’ DILEMMA (CON’T) • The strategy is to separate the partners in different rooms to make sure they cannot communicate with each other. Four combinations of strategies that might be possible in this game are given below.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 19
  20. 20. PRISONERS’ DILEMMA (CON’T) 1. Both Gavin and Tan confess 2. Neither Gavin nor Tan confesses 3. Gavin confesses and Tan does not 4. Tan confesses and Gavin does not Based on the four possible outcomes, we can tabulate of these outcomes. This is called the payoff matrix.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 20
  21. 21. PAYOFF MATRIX If both of them confess for TAN If Gavin confess for murder murder offence; they will get offence and Tan does not; 3- 15-year sentence. year sentence for Gavin and Confess Do not confess 25-year sentence for Tan. Tan: Tan: Confess 15 years 25 years GAVIN Gavin : Gavin : 15 years 3 years Tan: Tan: 3 years 5 years Do not confess Gavin : Gavin : 25 years 5 years If Tan confess for murder A payoff matrix is a table that shows a listing If both of them does not offence and Gavin does of payoffs that each player will get for each confess for murder offence; not; 3-year sentence for possible combination of strategies that the they will get 5-year sentence Tan and 25-year sentence two partners might choose. for bank robbery. for Gavin.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 21
  22. 22. PRICE LEADERSHIP Price leadership means the pricing strategy in which the firms in an oligopolistic industry follow the price set by the leading firm. Price leadership is one form of collusion under oligopoly. There is no formal or tacit agreement. There are two types of price leadership.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 22
  23. 23. TYPES OF PRICE LEADERSHIP 1. Dominant price leadership - The dominant price leadership firm may be the largest firm that dominates the overall industry. - The dominant price leadership firm can act as a monopoly where it sets its price to maximize profits; other firms will set their prices at the same level. 2. Barometric price leadership - One firm will be the first to announce price change. This firm does not dominate the industry. - Its price will be followed by others.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 23
  24. 24. CARTEL A cartel is a group of firms whose objective is to limit the scope of competitiveness in the market. Cartel arises because firms want to eliminate uncertainty and improve profits by stabilizing market shares and prices, reducing competitiveness and eliminating promotional cost.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 24
  25. 25. CARTEL (CON’T) • The most famous cartel is Organization of Petroleum Exporting Countries (OPEC). • Cartel agreement is an arrangement among the oligopoly firms to cooperate with one another to act together as a monopoly. • An ideal cartel will be powerful to establish monopoly price and earns supernormal profits.Microeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 25
  26. 26. CARTEL (CON’T) • Profits are divided among firms based on their individual level of production. • Each firm sells different quantities and obtains different profits depending on the level of AC at the point of productionMicroeconomics All Rights Reserved© Oxford University Press Malaysia, 2008 12– 26

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