Sweezy+oligopoly


 * Sweezy Oligopoly**

Paul M Sweezy suggested that the ordinary concept of a demand curve is inapplicable to oligopoly. The assumption that everything else would remain unchanged if an oligopoly changed their price was unrealistic. Oligopoly is therefore more complicated than other models of monopoly or perfect competition and there are several methods used to model oligopoly.

This wiki will focus on the Sweezy Model which was developed by Paul Sweeny is 1939.

__**DEFINITION**__

An industry is characterized as a Sweezy Oligopoly if the following are true.
 * There are few firms in the market serving many customers
 * The firms produce differentiated products
 * Each from believes that rivals will cut their prices in response to a price reduction but will not raise their prices in response to a price increase
 * Barriers to entry exist

Unlike monopolistic competition and pure competition, oligopolistic competition is hardly anonymous. Because there are few sellers each knows the others identity. Every marketing and production decision needs to take into account the different possible reactions of competitors. And even if there are no deliberate decisions under consideration, the oligopoly firm’s management needs to monitor the activities of the competition and be prepared to react accordingly.

Sweezy reasoned that competitors are likely to react asymmetrically with respect to price increases and price decreases initiated by one of the firms in the market. Given these conditions, competitors are far less likely to follow a price increase than a price decrease. Sweezy then reasoned that demand would be relatively more elastic above the current price, but relatively more inelastic below the current price. This implied that the oligopolistic competitor’s demand curve is bent or kinked.



In the figure above, A represents the price in an oligopoly market. Above this price, an individual firm is afraid of increasing prices. The perception is that the competition will not follow a firm’s price increase. If they do not follow they will get the firm’s customers and sales. Therefore a price increase would create an elastic demand curve above price P. If demand is elastic and prices rise, then total revenue falls.

A price decrease has a similar effect. The reasoning is that if the competitor does not follow the price cut, firms will entice customers away from the competitor. Therefore the competition must follow price cuts or lose customers and sales. As a result a price decrease would create an inelastic demand curve below price P. If demand is inelastic and prices decrease, then total revenue also falls.

The firm is in a lose-lose situation. There is no point above or below P at which a firm can increase revenue. Hence, price remains rigidly at P which creates a kink in the demand curve.

The following figure shows the kinked demand and marginal revenue curve. The profit maximizing level of output occurs when marginal revenue = marginal costs, and the profit maximizing price is the maximum price consumers will pay for that level of output. The kinked shaped marginal revenue curve implies that there exists a range over which changes in marginal costs will not impact the profit-maximizing level of output. This is not true for competitive, monopolistically competitive, and monopolistic firms; all of these firms increase output when marginal costs decline. Therefore, firms may have no incentive to change price provided that marginal costs remains in a given range. Because of the effect a firms price changes have on the behavior of competitors, firms in a Sweezy oligopoly do not want to change their prices.




 * __REAL WORLD EXAMPLE__**

The competition within the pharmaceutical industry can be best described as Sweezy Oligopoly. There are relatively few companies that serve many customers and each produces differentiated products. Furthermore, each firm can be certain that a rival will respond with a price reduction not a price increase and there are barriers for entry. Newly patented pharmaceutical products that are the first in class are monopolies; this is short lived however. First in class pharmaceutical products have the highest cost of attrition. Since there are high profits this attracts other firms to develop and market generic drugs and as the number of entries into market increases the firms experience decreasing profits.

The Sweezy model has a high analytical value. It is useful for explaining price stability in competitive, non-collusive oligopolies. It is a simple graphic way of illustrating why changing conditions of demand and costs in non-collusive oligopolies are often observed to have no effect on output and price. The model also has high teaching value. It demonstrates the key relationship between demand elasticity and marginal revenue in a managerial decision making context. Specifically, it reveals that price lethargy over time in a non-collusive oligopoly may have a sound rational foundation.


 * __ISSUES WITH THE MODEL__**

There are a few problems with the kinked demand curve model; one is that it fails to explain oligopolies behavior consistently. The second is that is provides no explanation of how any actual price, like P, is established in the first place. Nevertheless, the Sweezy model shows how a firm’s belief of their rival firm’s reactions can play a big part in the strategic pricing decisions.

__**MULTIPLE CHOICE QUESTIONS:**__

1. Demand above the kink is: a. Inelastic b. Elastic c. Higher d. Lower

2. What rule do Sweezy Oligopoly firms use to maximize profits? a. MR=P b. MC=P c. MR=MC d. AVC=MR

3. If demand is inelastic and a firm decreases price, what does this do to Total Revenue? a. Stays constant b. Increases c. Decreases d. None of the above

4. Which of these are indicators of a Sweezy oligopoly a. Large number of firms b. Differentiated products c. No barriers to entry d. Homogeneous products

5. In a Sweezy Oligopoly, if a firm decreases its prices, a competitor will? a. Increase prices b. Decrease prices c. Keep their prices constant d. Either B or C

Question 1 answer: B - Elastic - Competitors are less likely to follow a price increase Question 2 answer: C - MR=MC - The profit maximizing level of output occurs when marginal revenue = marginal costs Question 3 answer: C - Decreases - A price decrease would create an inelastic demand curve below price P. If demand is inelastic and prices decrease, then total revenue also falls. Question 4 answer: B - Differentiated products - These indicators fro Sweezy Oligopoly are: There are few firms in the market serving many customers, the firms produce differentiated products, each from believes that rivals will cut their prices in response to a price reduction but will not raise their prices in response to a price increase, and barriers to entry exist Question 5 answer: B - Decrease prices - If the competitor does not follow the price cut, firms will entice customers away from the competitor. Therefore the competition must follow price cuts or lose customers and sales.
 * __ANSWERS:__**

References: Baye, M. R. (2006). //Managerial Economics and Business Strategy// (Fifth ed.): McGraw-Hill. Casey Jr, W. L., & Kaushik, S. K. (1984). THE IMPROPER DERIVATION OF MARGINAL REVENUE IN KINKY OLIGOPOLY MODELS: A REPLY. //American Economist, 28//(2). Cyert, R. M., & March, J. G. (1955). ORGANIZATIONAL STRUCTURE AND PRICING BEHAVIOR IN AN OLIGOPOLISTIC MARKET. //American Economic Review, 45//(1), 129. Kaushik, S. K., & Casey Jr, W. L. (1982). THE KINKED-DEMAND MODEL OF OLIGOPOLY: TEXTBOOK DEPARTURES FROM THE ORIGINAL SWEEZY MODEL. //American Economist, 26//(2), 25-32. Sawyer, M. C. (1988). THEORIES OF MONOPOLY CAPITALISM. //Journal of Economic Surveys, 2//(1), 47. http://en.wikipedia.org/wiki/Kinked_demand