Managerial Economics in a

Global Economy, 5th Edition

by
Dominick Salvatore
Chapter 9
Oligopoly and Firm Architecture

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 1
 Oligopoly
• Few sellers of a product
• Nonprice competition
• Barriers to entry
• Duopoly - Two sellers
• Pure oligopoly - Homogeneous product
• Differentiated oligopoly - Differentiated
product

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 2
 Sources of Oligopoly
• Economies of scale
• Large capital investment required
• Patented production processes
• Brand loyalty
• Control of a raw material or resource
• Government franchise
• Limit pricing

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 3
 Measures of Oligopoly
• Concentration Ratios
– 4, 8, or 12 largest firms in an industry
• Herfindahl Index (H)
– H = Sum of the squared market shares of
all firms in an industry
• Theory of Contestable Markets
– If entry is absolutely free and exit is entirely
costless then firms will operate as if they
are perfectly competitive
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 4
 Cournot Model
• Proposed by Augustin Cournot
• Behavioral assumption
– Firms maximize profits under the
assumption that market rivals will not
change their rates of production.
• Bertrand Model
– Firms assume that their market rivals will
not change their prices.

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 5
 Cournot Model
• Example
– Two firms (duopoly)
– Identical products
– Marginal cost is zero
– Initially Firm A has a monopoly and then
Firm B enters the market

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 6
 Cournot Model
• Adjustment process
– Entry by Firm B reduces the demand for
Firm A’s product
– Firm A reacts by reducing output, which
increases demand for Firm B’s product
– Firm B reacts by increasing output, which
reduces demand for Firm A’s product
– Firm A then reduces output further
– This continues until equilibrium is attained
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 7
 Cournot Model

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 8
 Cournot Model
• Equilibrium
– Firms are maximizing profits
simultaneously
– The market is shared equally among the
firms
– Price is above the competitive equilibrium
and below the monopoly equilibrium

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 9
 Kinked Demand Curve Model
• Proposed by Paul Sweezy
• If an oligopolist raises price, other firms
will not follow, so demand will be elastic
• If an oligopolist lowers price, other firms
will follow, so demand will be inelastic
• Implication is that demand curve will be
kinked, MR will have a discontinuity,
and oligopolists will not change price
when marginal cost changes
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 10
 Kinked Demand Curve Model

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 11
 Cartels
• Collusion
– Cooperation among firms to restrict
competition in order to increase profits
• Market-Sharing Cartel
– Collusion to divide up markets
• Centralized Cartel
– Formal agreement among member firms to
set a monopoly price and restrict output
– Incentive to cheat
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 12
 Centralized Cartel

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 13
 Price Leadership
• Implicit Collusion
• Price Leader (Barometric Firm)
– Largest, dominant, or lowest cost firm in
the industry
– Demand curve is defined as the market
demand curve less supply by the followers
• Followers
– Take market price as given and behave as
perfect competitors
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 14
 Price Leadership

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 15
 Efficiency of Oligopoly
• Price is usually greater then long-run
average cost (LAC)
• Quantity produced usually does
correspond to minimum LAC
• Price is usually greater than long-run
marginal cost (LMC)
• When a differentiated product is
produced, too much may be spent on
advertising and model changes
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 16
 Sales Maximization Model
• Proposed by William Baumol
• Managers seek to maximize sales, after
ensuring that an adequate rate of return
has been earned, rather than to
maximize profits
• Sales (or total revenue, TR) will be at a
maximum when the firm produces a
quantity that sets marginal revenue
equal to zero (MR = 0)
Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 17
 Sales Maximization Model
MR = 0
where
Q = 50

MR = MC
where
Q = 40

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 18
 Global Oligopolists
• Impetus toward globalization
– Advances in telecommunications and
transportation
– Globalization of tastes
– Reduction of barriers to international trade

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 19
 Architecture of the Ideal Firm
• Core Competencies
• Outsourcing of Non-Core Tasks
• Learning Organization
• Efficient and Flexibile
• Integrates Physical and Virtual
• Real-Time Enterprise

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 20
 Extending the Firm
• Virtual Corporation
– Temporary network of independent
companies working together to exploit a
business opportunity
• Relationship Enterprise
– Strategic alliances
– Complementary capabilities and resources
– Stable longer-term relationships

Prepared by Robert F. Brooker, Ph.D. Copyright ©2004 by South-Western, a division of Thomson Learning. All rights reserved. Slide 21