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Economics 1021A/B
Michael Parkin

Nicole Wallenburg Economics Parkin Nov 28, 2011 Economics – Textbook Notes What is Oligopoly? Oligopoly lies between perfect competition and monopoly. The firms in oligopoly might produce an identical product and compete only on price, or they might produce a differentiated product and compete on price, product quality, and marketing. Oligopoly is a market structure in which:  Natural or legal barriers prevent then entry of new firms  A small number of firms compete Barriers to Entry Natural or legal barriers to entry can create oligopoly.  Economics of scale and demand can create a natural oligopoly Duopoly is an oligopoly market with two firms  There is no room in this market for three firms  But id there were only one firm, it would make an economic profit and a second firm would enter to take some of the business and economic profit A legal oligopoly arises when a legal barrier to entry protects the small number of firms in a market Small Number of Firms Because barriers to entry exist, oligopoly consists of a small number of firms, each of which has a large share of the market. Such firms are interdependent, and they face a temptation to cooperate to increase their joint economic profit.  Interdependence o With a small number of firms in a market, each firm’s actions influence the profits of all the other firms  Temptation to Cooperate o When a small number of firms share a market, they can increase their profits by forming a cartel and acting like a monopoly  A cartel is a group of firms acting together – colluding – to limit output, raise price, and increase economic profit  Cartels are illegal Examples of Oligopoly The dividing line between oligopoly and monopolistic competition is hard to pin down. The Herfindahl-Hirschman Index is used to figure out the difference Two Traditional Oligopoly Models The Kinked Demand Curve The kinked demand curve model of oligopoly is based on the assumption that each firm believes that if it raises its price, others will not follow, but if it cuts its price, other firms will cut theirs. Nicole Wallenburg Economics Parkin Nov 28, 2011  At prices above the kink, a small price rise brings a big decrease in the quantity sold. If one firm raises its price, other firms will hold their current price constant  At prices below the kink, even a large price cut brings only a small increase in the quantity sold. In this case, if one firms cuts its price, other firms will match the price cut  To maximize profit, the firm produces the quantity at which marginal cost equals marginal revenue o The quantity is where the marginal cost curve passes through the gap at the kinked quantity o If the marginal cost fluctuates between the gap, the firm does not change its price of its quantity. Only if it fluctuates outside the gap does it change its price and output  The kinked demand curve model predicts that price and quantity are insensitive to small cost changes  Problem: if marginal cost increases by enough to cause the firm to increase its price and if all firms experience the same increase in marginal cost, they all increase their prices together o A firm that bases its actions on beliefs that are wrong does not maximize profit and might even end up incurring an economic loss Dominant Firm Oligopoly A dominant firm oligopoly, which arises when one firm – the dominant firm – has a big cost advantage over the other firms and produces a large part of the industry output  The dominant firm sets the market price and the other firms are price takers o Example: large gasoline retailer or a big box store Oligopoly Games Game theory is a tool for studying strategic behaviour –
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