Oligopoly and the Economy

This is a brief discussion of the effect of oligopolies on an economy. It is an example of the macroeconomic effects of microeconomic processes.   The derivation is based on the idea of the kinked demand curve, developed by Paul Sweezy in the 1950’s. 

Those not interested in the derivation may jump ahead to the discussion at the conclusion. 

Those interested may find the various derivations of kinked demand curve theory on You Tube helpful, and perhaps easier to follow than what I have presented here.  Here’s one:

http://www.youtube.com/watch?v=5BQPx8SL9F4.
You might also find  discussions on monopoly, a simpler case of extra-normal profit, helpful.  Here’s one:
http://www.youtube.com/watch?v=3NMbcfS68IQ&feature=related

And for contrast, perfect competition:

http://www.youtube.com/watch?v=7lhX78vlHSY

We discuss competitive oligopolies, where collusion is not necessary for fixed prices.

For your convenience a little background.  Oligopolies are a common market structure.  Indeed, many markets seem to evolve, or  have evolved, into oligopolies, (or its cousin, oligopsonies,)  They are ubiquitous.

An oligopoly has some of the characteristics of a monopoly, in that its members can charge higher than normal prices and make higher than normal profits.  The particular characteristics of an oligopoly are,  1 It consists of a relatively few, relatively large, sellers  2.  Each firm is big enough to affect the others. 3:  The products are similar or identical.  4:  There are barriers to entry, such as initial capital costs. 

The traditional analysis of oligopolies is that, rather than a normal straight demand curve, they face a kinked demand curve D, which for a particular firm is also their average revenue curve AR.  Diagram 1 shows this demand curve for a particular oligopolist.  The oligopolist wants to sell at the kink, which is at some price p_a, which is really determined by the market, and some quantity q_a, which is determined by other factors, which we will discuss in the conclusion.In any event, the kink is at a price higher than the equilibrium price in perfect competition, and a quantity lower than the equilibrium quantity. Fewer goods are produced, and consumers are forced to pay a higher price for them.

If we were to discuss all the members of this oligopoly, they would each have a separate, though similar, diagram.  The prices at the kink would all be the same, but the quantities at the kink might be different. 

  

Our oligopolist’s total revenue, that is, how much money he takes in, is price times quantity sold, or p_a x q_a.

Why does he want to sell at price p_a?  If he raises his prices above p_a, to p_b hoping to make an extra profit, none of his competitors will follow.  So his prices will be above theirs, and because their products are similar to or identical to his, he will lose some, perhaps many of his customers to them.  If his price goes up a little, the quantity of products he sells will go way down, to q_b so he will take in less money. The area  

p_b x q_b, the money he takes in now, is less than the area p_a x q_a, the money he took in before.  This is the characteristic of an elastic demand curve. As you move up the curve, the quantity sold goes down faster than the price goes up.   

Suppose instead he lowers his prices, below p_a, to p_c,  hoping to gain market share.  Then his competitors will quickly follow suit, since they don’t want to lose their market share to him.  So he won’t gain market share, he’ll just be selling at a lower price, and making less money.  He may sell a few more products, at q_c just because his, and everybody’s, price is lower, but not enough to compensate for the decrease in price.    The area  p_c x q_c , the money he takes in now, is less than the area p_a x q_a, the money he took in before.  This is the characteristic of an inelastic demand curve.  As you go down the demand curve, the price goes down faster than the quantity sold goes up.

Now for a firm to maximize profits, its marginal costs, MC, must equal its marginal revenue MR.  This is always the case, but what does this mean?  Marginal cost is the increase in total cost accrued by the firm for the next unit it produces.  If the firm produces 4 units for $60 and 5 units for $90, then the marginal cost of the fifth unit is $30.

Marginal revenue is the increase in revenue that results from selling one more unit.    For imperfect competition, as we have in the case of oligopolies, MR is always less than the average revenue, AR.  This is because when you sell more units, you have to sell them at a lower price, but you have to sell all your units at that lower price.  So if you sell 4 units at $100 total revenue and 5 units at $120 total revenue the average revenue AR, the price you are selling them at, for 5 units is $24, but the marginal revenue MR for the 5^th unit is only $20.

Profit is maximized when MR = MC because when MC is greater than MR, it costs more to produce the next unit than you get paid for it.  With the figures we used, you would produce 4 units for $60, sell them for $100, and make $40 profit.  If you were maximizing profit, you wouldn’t make 5 units for $90, having to sell them at $120, and only make $30 profit. 

See Diagram 2.  The marginal cost MC curve is the lopsided “u.” When you produce something, costs first go down, savings of scale, then they go up, dissavings of scale.  (Imagine a restaurant.  The first meal is very costly, because of all your fixed costs. As you produce more, each next meal is cheaper to produce, as you use your assets more efficiently, until you reach some minimum.  Then the costs per each additional meal start going back up, because you run out of stove space, people start getting in each others way, etc.) 

With the kinked demand or AR curve, the MR curve is very strange.  The upper AR_U and the upper MR_U curve, the curves above the kink,  both start at the same point on the axis, (in the direction where the arrows come together,) but the MR_U curve descends more steeply, twice as steep, it turns out. When they reach the kink, however, the MR_L and AR_L curves, the curves below the kink, also extend from a point on the axis, (much higher on the axis) in the direction of the dotted arrows, so the MR_L curve, being twice as steep as the AR_L curve, is much lower than the MR_U curve at the kink.  In this diagram, in fact, it is so much lower it is negative, which means MR_L curve is irrelevant.  What is not irrelevant is the fact that, because MR_L is negative, the MR curve which connects the MR_U and MR_L curves,  (green line) crosses the Q axis at the kink.  This means that the quantity of production of maximum revenue (which is where the MR curve crosses the Q axis) and profit maximization (where MR = MC)are at the same quantity, q_a.

What is important is the green line, the MR curve at the kink.  Now since, when we maximize profit,  MR = MC, when ever MC crosses the green line, the profit maximizing quantity and price are going to stay the same.  See Diagram 3.  The firm, whether its marginal cost curve is MC₁, or MC₂ or MC₃  is going to want to produce the same amount, and charge the same price.  Here this will maximize both profit and revenue.

Conclusion:
 Even in competition, oligopolists can make extra-normal profits.   Firms in oligopolistic competition tend to be locked in to price, so they must find other ways to compete, and maintain or gain market share.  (We make the casual observation that one need look no further than oligopoly pricing (and as we shall see, oligopsony pricing) to deduce a cause for Keynesian ‘price stickiness.’  In an economy rife with oligopoly we would expect many points of price, and quantity, fixedness, making deflation a uneven and problematic process.)  The owner of a service station, for instance, locked in competition with 3 other service stations at an intersection, might, to attract more customers, initiate full service, or add a convenience store or coffee shop.  He might do this, raising his costs, until the marginal cost curve was something like MC₃ in Diagram 3.  The oligopolist would not want to raise costs any more, because then his profit maximization would occur at a price higher than p_a, and he would lose market share.

However, the opposite can also happen.  Since price is, with in a range, independent of costs, the oligopolist may decide to shave costs, cut corners, and so increase his profit that way.  Were an industry to do this, we would have a situation like the American auto industry in the 60’s and 70’s, before imports began to significantly impact on their market.

Oligopolies do not consist of identical or identically sized firms, with identical shares of the market. The quantity a particular oligopolist sells at is determined by historical factors, and his ability, or inclination, to compete in ways which do not affect the price.  Historical factors, for instance, most notably their activities during the period their industry was more competitive and open, determined the relative sizes of GM, Ford, Chrysler, and American Motors, back when they constituted an oligopoly.  Foreign Competition and decisions since have changed their relative sizes and profitability.   

Another point is that, unlike perfect competition, firms of various efficiencies can co-exist in an oligopoly, operating at differing capacities and different economies of scale, each firm collecting its particular degree of profit.  And unlike perfect competition, much of this profit is extra-normal, more than the profits we would expect to see from perfect competition, which tends to drive profit to a minimum.

What other things might we expect?  Well, we would expect the transfer of some consumer surplus to the producer, in the form of his extra-normal profits.  Consider that oligopolies are becoming economically pervasive.  Each of these oligopolies extracts its rent, transferring resources from consumers, to the oligopolists.  Indeed, to simplify considerations, let us just model the entire economy as two tiers, consisting of an oligopoly and its market.  Consider first perfect competition, where the economy was efficient and in balance, Diagram 4.

Supply equals demand and the equilibrium point is at e, and surplus is divided between consumer and producer. (Consumer’s Surplus is  exaggerated a bit, to keep the lines the same.  Sorry.)  With oligopoly, Diagram 5, there is a net transfer of surplus from the consumer to the oligopolists. (the greenish-yellow box) 

 In the real economy, this would be manifest as higher corporate profits, and, since most corporate stock is held by the wealthy, an increase in income of the wealthy.  Corresponding to this, we would expect a decrease in the welfare of the rest of the economy, as the increase in income of the wealthy has to come from somewhere.

Efficiency has also declined because an oligopoly produces less than the competitive equilibrium production, at a higher price creating deadweight loss:  The blue triangle.  That is, the economy is producing less than it would otherwise, less than consumers would be willing to buy at the lower, equilibrium, price.  Indeed, the economy may perhaps be producing less than it needs to.  For instance, since the public sector is also supplied by the private sector, as the private sector becomes increasingly organized as oligopoly, we would expect public sector costs to increase disproportionately.  We would also expect, due to dead weight loss, an increasing shortage, and/or a decline of the quality, of public goods.  This includes much of the infrastructure the private sector, the oligopolist, relies on.