With the A2 Essay paper next week I thought something on the kinked demand curve might be useful. I alluded to in a previous post that one model of oligopoly revolves around how a firm perceives its demand curve. The model relates to an oligopoly in which firms try to anticipate the reactions of rivals to their actions. As the firm cannot readily observe its demand curve with any degree of certainty, it has got to estimate how consumers will react to price changes.
In the graph below the price is set at P1 and it is selling Q1. The firm has to decide whether to alter the price. It knows that the degree of its price change will depend upon whether or not the other firms in the market will follow its lead. The graph shows the the two extremes for the demand curve which the firm perceives that it faces. Suppose that an oligopolist, for whatever reason, produces at output Q1 and price P1, determined by point X on the graph. The firm perceives that demand will be relatively elastic in response to an increase in price, because they expects its rivals to react to the price rise by keeping their prices stable, thereby gaining customers at the firm’s expense. Conversely, the oligopolist expects rivals to react to a decrease in price by cutting their prices by an equivalent amount; the firm therefore expects demand to be relatively inelastic in response to a price fall, since it cannot hope to lure many customers away from their rivals. In other words, the oligopolist’s initial position is at the junction of the two demand curves of different relative elasticity, each reflecting a different assumption about how the rivals are expected to react to a change in price. If the firm’s expectations are correct, sales revenue will be lost whether the price is raised or cut. The best policy may be to leave the price unchanged.
With this price rigidity a discontinuity exists along a vertical line above output Q1 between the two marginal revenue curves associated with the relatively elastic and inelastic demand curves. Costs can rise or fall within a certain range without causing a profit-maximising oligopolist to change either the price or output. At output Q1 and price P1 MC=MR as long as the MC curve is between an upper limit of MC2 and a lower limit of MC1.
Criticisms of the kinked demand curve theory.
Although it is a plausible explanation of price rigidity it doesn’t explain how and why an oligopolist chooses to be a point X in the first place. Research casts doubt on whether oligopolists respond to price changes in the manner assumed. Oligopolistic markets often display evidence of price leadership, which provides an alternative explanation of orderly price behaviour. Firms come to the conclusion that price-cutting is self-defeating and decide that it may be advantageous to follow the firm which takes the first steps in raising the price. If all firms follow, the price rise will be sustained to the benefit of all firms.
If you want to gradually build the kinked demand curve model download the powerpoint by clicking below.
Following on from Geoff Riley’s blog post (see below) on the Tutor2u site here are the games that he was alluding to.
In this blog I am reprising an article produced by our good friend Mark Johnston from New Zealand in an early edition of the now discontinued Latte Magazine(2007). I am doing so because I know that many colleagues are interested in trying some experimental games with their students for example when teaching game theory, behavioural economics and the provision of public goods.
Click the link for the games in pdf format from the Latte Magazine
Here is another that I have used recently on Oligopolies.
Here is another presentation from the Khan Academy which covers the oligopoly market structure. An oligopoly is a market dominated by a few producers, each of which has control over the market. It is an industry where there is a high level of market concentration. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure.
The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. Normally an oligopoly exists when the top five firms in the market account for more than 60% of total market demand/sales.
Characteristics of an oligopoly
There is no single theory of how firms determine price and output under conditions of oligopoly. If a price war breaks out, oligopolists will produce and price much as a perfectly competitive industry would; at other times they act like a pure monopoly. But an oligopoly exhibits the following features:
1. Product branding: Each firm in the market is selling a branded (differentiated) product
2. Entry barriers: Significant entry barriers into the market prevent the dilution of competition in the long run which maintains supernormal profits for the dominant firms. It is perfectly possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on market prices and output
3. Interdependent decision-making: Interdependence means that firms must take into account likely reactions of their rivals to any change in price, output or forms of non-price competition. In perfect competition and monopoly, the producers did not have to consider a rival’s response when choosing output and price.
4. Non-price competition: Non-price competition s a consistent feature of the competitive strategies of oligopolistic firms. Examples of non-price competition includes:
a. Free deliveries and installation
b. Extended warranties for consumers and credit facilities
c. Longer opening hours (e.g. supermarkets and petrol stations)
d. Branding of products and heavy spending on advertising and marketing
e. Extensive after-sales service
f. Expanding into new markets + diversification of the product range
Below is a word document which contains various games that I have acquired over the years. You might find them useful when teaching market structures with your classes.
Behavioural Economics Games
Another great article from the Econz@Otago economics magazine. Having a look at the Casino industry in Las Vegas and Atlantic City we see a prevalent oligolistic market.
In 1969, the state of Nevada allowed financially well endowed companies to obtain gambling permits and subsequently within a couple of years huge resort-style casinos were built on the Las Vegas Strip. By 2008 24 of the largest casinos had captured approximately 84% of total Las Vegas casino revenues – NZ$8.03 billion which equates to 9% of NZ’s GDP in 2009.
In 1976, eager to gain the revenue from casinos, the state of New Jersey made gambling legal. Like Las Vegas the state required that only investors with large amounts of financial backing could operate and own gaming establishments. In the late 1990’s Atlantic City was on a par with Las Vegas regading revenue and similarly the industry was dominated by as few as 11 firms earning NZ$6.37 billion.
In both Las Vegas and Atlantic City the largest firms came to dominate the industry. The following were common features:
1. Economies of scale – a casino twice the size can accommodate more than twice the customers.
2. Economies of scope – larger casinos can supply a larger variety of facilities – hotels, night-clubs, shows etc.
With these characteristics firms can dominate and therefore operate in a oligopolistic market. The difference between the oligopoly that has emerged in Las Vegas and the one that has emerged in Atlantic City is the sea of smaller gambling establishments (called a competitive fringe) which continues to engulf the Las Vegas Strip. In Nevada, the gaming commission sets few restrictions on new casinos entering the industry whereas the size restrictions in New Jersey allows for only large establishments and bars small entrants.
Last week, with my A2 class, I had a few discussions about oligopolies, game theory, and the existence of cartels. In the Weekend New Zealand Herald there was a very relevant article on the case of a cartel between 13 international airlines who had colluded to raise the price of freighting cargo by imposing fuel surcharges on cargo shipments into and out of New Zealand. The New Zealand Commerce Commission started proceedings against the 13 airlines in December 2008 and the price fixing period was between 2000 and 2006.
Of the 13 airlines there are some major carriers including: British Airways, Air NZ, Cathy Pacific, Emirates, Japan Airlines, Korean Airlines, Malaysian Airlines, Singapore.
Qantas admitted liability and agreed to a settlement of NZ$6.5m which is approximately a 50% discount for co-operating with the Commerce Commission. Other airlines that have settled are British Airways, Cargulox International Airlines. The price-fixing case starts in May and the main issue is what was the definition of a ‘market in New Zealand’ and if air cargo services inbound to New Zealand were part of such a market.
The EU competition watchdog fined one South Korean and four Taiwanese electronics companies more than $850m for colluding to fix prices on LCD screens for televisions and computers between 2001 and 2006. The companies involved include:
– LG Display (South Korea)
– AU Optronics
– Chimei InnoLux Corporation,
– Chunghwa Picture Tubes
– HannStar Display Corporation
“Foreign companies, like European ones, need to understand that if they want to do business in Europe they must play fair,” European competition commissioner Joaquin Almunia said in a statement. The EU found that the companies held monthly meetings, usually in hotels in Taiwan, to agree on price ranges and minimum prices. From the BBC – Dubbed “the Crystal meetings”, these traded information on future production planning, capacity utilisation, pricing and other commercial conditions. Competition regulators started investigating the cartel in 2006, in the United States and Asia as well as in Europe. LG and Chunghwa, along with Japanese firm Sharp, pleaded guilty in the United States and were fined there in November 2008.
With the A2 essay paper on Friday here is an example of a cartel that got caught. Remeber the theory behind cartels. A cartel operates in the Oligopoly market. It is a mistake to believe that ALL oligopolists face a KINKED DEMAND CURVE. Oligopolists may either:
a) COMPETE VIGOROUSLY or
b) COLLUDE (e.g. in cartels) or
c) PLAY SAFE (as in Kinked Demand Curve Theory)
Collusion in oligopoly
Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development. A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.
Collusion between firms whether formal or informal is more likely when:
• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.
• they have similar costs of production and methods of production making any agreement on price easier to reach.
• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.
• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.
• the laws against collusion in a country are weak or ineffective.
PRACTICE – CARGO CARTEL
Yesterday the European Commission fined 11 airlines almost 800m euros for fixing the price of air cargo between 1999 and 2006. The airlines colluded on some surcharges between December 1999 and February 2006.
* Initially, the airlines contacted each other so as to ensure that worldwide airfreight carriers imposed a flat rate surcharge per kilo for all shipments.
*The cartel members extended their co-operation by introducing a security surcharge and refusing to pay a commission on surcharges to their clients.
The Commission imposed the biggest fine – 340m euros – on Air France-KLM, which was formed from a merger in 2004 and which now owns Martinair, which was also fined (see table). Lufthansa escaped a fine because it alerted the regulatory authorities to the cartel. Obviously companies that used the freight service were affected by this therefore a group of firms, led by the Swedish telecoms group Ericsson and Dutch electronics giant Philips, are suing Air France-KLM and its Martinair subsidiary for 400m euros. (NZ$ = €0.56)