Oligopoly and the Kinked Demand Curve Model

Overview

• Focus: Detailed look at oligopoly using the Kinked Demand Curve Model.
• Structure:
  • Characteristics of oligopoly.
  • Kinked Demand Curve diagram.
  • Conclusions from the model.
• Next topic: Using Game Theory to analyze oligopoly behavior.

Characteristics of Oligopoly

• Few Firms: Dominated by a few firms, high concentration ratio (e.g., no more than 7 firms with 70%+ market share).
• Differentiated Goods: Firms are price makers with unique goods.
• High Barriers to Entry/Exit:
  • Start-up costs, economies of scale, sunk costs, brand loyalty.
• Interdependence:
  • Firms do not make independent decisions; they consider rivals' actions and reactions.
  • Results in price rigidity.
• Non-Price Competition: Branding, advertising, product/service quality.
• Objective Ambiguity: Profit maximization is not always the sole objective.

Real-World Examples

• Global Examples:
  • Soft drinks (Coca-Cola, Pepsi).
  • Car industry.
  • OPEC (legal oligopoly).
• UK Examples:
  • Supermarkets, energy industry, fuel providers.
  • Bus and airline markets.

The Kinked Demand Curve Model

Basic Concepts

• Price Rigidity: Firms are disincentivized to change prices.
  • Elasticity Differences: Above the current price (P1), demand is price elastic; below, it is price inelastic.
• Raising Price (P1 to P2):
  • Quantity demanded decreases more than price increase.
  • Rivals do not follow (undercut), resulting in loss of market share and revenue.
• Lowering Price (P1 to P3):
  • Demand increases less than price decrease.
  • Rivals follow, leading to a price war and no long-term market share change.

Marginal Revenue Curve

• Vertical Gap: Exists in the MR curve, signifying that within this gap, price remains at P1 despite cost changes.
• Profit Maximization: Firms produce where MC = MR, ensuring price remains P1 if costs change within the MR gap.

Conclusions from the Model

1. Price Competition:
   • Despite irrationality, firms may engage in price wars (e.g., UK supermarkets, short-haul airlines).
2. Non-Price Competition:
   • Logical outcome if prices remain sticky (e.g., branding and advertising).
3. Interdependence Issues:
   • Frustration due to constant consideration of rivals’ actions.
   • Temptation to collude, act like a monopoly, fix prices, and gain high profits.

Future Topics

• Next lecture: Game Theory and its application in understanding oligopoly behavior.

Note: Stay tuned for more insights into oligopolistic market dynamics.