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Economics explained


Market structures

Oligopoly - diagram

Oligopoly - diagram

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The difficulty in studying oligopoly is that the behaviour of firms can follow two different routes –

in some industries, there may be cut-throat competition between aggressive fi rms

while in others, there may well be cooperation or tacit evidence of collusion.

Consequently, just how one firm actually reacts will depend on how it expects competitors to react. A theory that attempts to explain how oligopolists behave is the theory of the kinked demand curve

It is assumed that a firm is producing at price P and output Q.

If the firm increases its price above P, other firms in the market will not follow.

This is because these firms will be able to sell more themselves, attracting customers from the firm that increased its price. So, the fi rm’s demand curve is A-D and its marginal revenue curve is MR. This demand curve is relatively elastic to an increase in price.

If the firm lowers its price, it assumes that other firms in the market will follow this lead so as not to lose market share.

This starts a price war, the result of which is likely to be that all firms lose out. The demand curve below A is inelastic and indicated by A-D. The marginal revenue curve is EF. So, overall the oligopolist’s demand curve appears to be P1AD. Price will be rigid at P since there is no incentive for a firm to increase or decrease the price it charges. If it did, either way, it would lose out. The kinked demand curve is in some respects a useful way to explain the behaviour of oligopolists.

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