5 minute read
Working together by using cartels and collusion
Because the total quantity of output the monopolist sells, q, is produced in some combination from factories A and B, the quantities produced in each factory added together must equal the quantity sold by the monopolist.
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4. Substitute qA = –1,000 + 2qB from Step 1 for qA in Step 3’s equation.
5. Solve for qB.
6. Using the equation from Step 1, solve for qA.
7. Solve for q, the total quantity of output the monopolist sells.
8. Solve for P, the price the monopolist establishes.
P is determined by using the demand equation I give at the beginning of the example.
9. The monopolist’s total profit is determined by subtracting the total cost of producing the given output in each factory from total revenue.
So, the monopolist’s total profit is $96,500. Knowing how to minimize cost when producing in two or more facilities is even better than collecting $200 when you pass “Go” in the board game Monopoly.
Chapter 11 Oligopoly: I Need You
In This Chapter
▶ Competing with a few rivals ▶ Recognizing mutual interdependence ▶ Developing theories for anticipating rival behavior ▶ Prospering in the long run
INeed You is a popular song first performed by the Beatles. The lyrics describe how one person doesn’t realize how much he needs another with one lyric being “see just what you mean to me.” Well, in oligopoly, rival firms make decisions that impact or mean something to one another. Oligopolies need rivals.
Oligopolies have a small number of firms. As a result, you know that your rivals and their actions directly impact you and everybody else’s firm operating in that market. The result is mutual interdependence among firms. You need to understand how your rivals respond to your decisions, and responses can vary. Because anticipating reactions is difficult, no single theory describes oligopolistic markets. Several theories are needed to cover the range of possible behaviors.
In this chapter, I start by describing the characteristics of oligopoly. Understanding these characteristics helps you recognize when you must anticipate rival behavior. Next, I develop different models describing how various reactions affect your decisions and profits. For each of these models, I summarize the circumstances that make it the appropriate explanation for firm behavior helping you to choose when to use the model. I finish the chapter by examining how you maintain profit over an extended period of time.
So, as the song says, I need you. But I don’t want to need too many others, because keeping the number of rivals small enables me to enjoy profit for a long time.
Managing with a Few Rivals in Oligopoly
Oligopolistic markets are easily recognized by the small number of firms that dominate the market. Because there are very few rivals, everybody knows everything about everybody else. It’s sort of like living in a small town. Although this description may seem a little extreme, I’m not exaggerating by much. Examples of oligopolistic markets include the airline, steel, and automobile industries.
Identifying oligopolies
Oligopolies have two major characteristics.
✓ Small number of firms: Oligopolistic markets are dominated by a small number of firms. Each firm provides a fairly large percentage of the total quantity of the good available in the market. Therefore, individual firms have some degree of monopoly power and are able to set the good’s price. ✓ Barriers to entry: Barriers to entry ensure the continued dominance of a small number of firms. Barriers to entry also enable oligopolistic firms to maintain positive economic profit, or returns in excess of the normal rate of return, in the long run. Barriers to entry typically result from economies of scale. The presence of economies of scale leads to larger firms having lower production cost per unit. Smaller new firms with fewer customers and lower production levels find it difficult to match the lower per-unit production costs of the existing firms.
The type of commodity produced by oligopolies isn’t an important characteristic. Oligopolistic firms can produce either standardized — that is identical — or differentiated goods.
Living with mutual interdependence
Because of their small number, oligopolistic firms regard themselves as mutually interdependent. The actions of any one firm influence all other firms operating in the market. Oligopolistic firms must take into account how rivals respond to their actions.
Yikes! Mutual interdependence means you have to take into account how your rivals respond to your decisions, and there are only about a gazillion ways they might respond. This potential number of responses isn’t a big problem for economists. They don’t mind developing a gazillion theories. But for you it’s a problem — unless, of course, you don’t mind learning a gazillion theories.
Chapter 11: Oligopoly: I Need You
The key point is that oligopolistic markets can’t be described with a single theory like perfect competition and monopoly. (See Chapters 9 and 10 for details on perfect competition and monopoly, respectively.) Thus, I present several different theories that describe firm profit-maximizing behavior. With each of these theories, pay close attention to the way rivals respond to your decisions. Your understanding of rivals and how they respond determines which theory is appropriate.
Finally, mutual interdependence introduces the possibility of collusion among oligopolistic firms. Collusion occurs when firms act jointly in setting price and quantity. It typically isn’t legal to collude in the United States, although a few exceptions, such as Major League Baseball, exist.
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Engaging in advertising and non-price competition
Another method of discouraging entry to the market is to increase advertising. Advertising not only increases visibility and brand loyalty for an existing firm’s product, but it also makes it more difficult for new firms to attract potential customers. Advertising enables you to increase the demand for your product by attracting new customers and “stealing” current customers from rival firms.
Oligopolies also innovate to separate themselves from rivals. Innovations that improve product quality or result in a better product to satisfy the same consumer desires increase the firm’s demand and profits. Innovation can also increase profit by lowering the firm’s production costs.
Modeling Oligopoly Behavior
In this section, I present six theories for oligopoly behavior. I know six is a lot, so you may want to skip some. But also, remember, I’m trying to anticipate how rivals respond and guessing how others react is risky business.
Sticking with sticky prices
The theory of the kinked demand curve is used to explain price inflexibility in an oligopolistic market. This theory is used when prices change very rarely — or in other words, prices are sticky.
