Oligopoly

Features
A Few sellers: It is a kind of market where a few dominant sellers sell homogenous or differentiated/heterogenous products under continuous consciousness of rivalry action by other firms. In the market where a small number of big firms compete may be termed as oligopoly. Automobile industry is the best example of oligopoly where one can count the number of players. When the oligopoly firms sell homogenous or identical products it is pure oligopoly. Example ;industries producing petroleum are pure oligopoly. When the firms sell differentiated products, called differentiated oligopoly, ex: cars. When there are only two sellers like Coke and Pepsi, the situation is known as duopoly.

 Interdependence of decision making: Since firms under oligopoly are small in number if a firm initiates a new business strategy in terms of pricing, advertisement and product modification, it anticipates action and counter actions by the rival firms. However price competition is not the major form of competition among oligopoly firms as it destroys profit. The more common form of competition is non price competition in the form of extensive advertisement, product differentiation and provision for survival. Barriers to entry: It arises on account of the market condition where huge investment requirement, economies of scale by the existing firms, preventing entry of new firms through price cutting. Indeterminate price and output: Few sellers and interdependence in decision under oligopoly causes difficulty in the derivation of demand curve. So the price and output under oligopoly is said to be indeterminate.

Oligopoly models: Price Rigidity: Kinked demand curve model It was developed by Paul Sweezy in 1939. He has shown through the kinked demand curve analysis that price and output once determined under oligopolistic conditions tend to remain stable. Sometimes the prices of some articles remain unchanged for a long period. This rigidity in prices led Sweezy to suggest that oligopolists behave as if facing a kinked demand curve.

MR1
Pk a MC MC MC

a b

b D

MR2

The kink in the demand curve is arrived when there is asymmetry in the response of other firms to one firms price change. Suppose that the price was initially at Pk the point of kink on the demand curve. 1. Suppose one firm raises the price and others might no follow the increase, the result is loss of sales by the firm which initiated increase in price. This is shown in relatively elastic curve above Pk 2. If the reverse happens that is when the firm reduces the price below Pk, and other firms will follow the suit, the original firm will also not gain much in its sales. This is shown in the relatively inelastic curve below Pk

The marginal revenue curve is always twice as great of the linear demand curve. The kinked demand curve consists of two linear curves joined at PK. The Mr curve above the kink is MR1 and that of below the kink is MR2. At the point of kink, the MR curve is a vertical line that connects the two segments. The MR curve is said to be dis continuous at point a and b. The vertical line ab represents this discontinuity. output occurs when MR=MC. At output Qk, and price Pk, the profit maximisation condition is fulfilled in the areas of kink. Because here MC intersects MR curve. If MC shifts upward to MCdue to increase in input prices, the profit maximising out put and price remain unchanged as the MR curve is vertical. If MC shifts downward to MC due to decline in input prices, there is no change in profit maximising output and prices, as the MC curve intersects the vertical portion of MR curve.

The price and output will be changed if MC curve and MR curve intersect either above a or below b. The implication of kinked demand curve is that even if there is substantial shift in the MC curve there is no variation in the prices. Sweezys observation is consistent with this as some oligopolists market exhibit stable prices. NB:Kinked demand curve model assumes that (i)rivals will match price reduction but not price increase; (ii) Kinked model predicts that price changes will be in frequent in oligopolistic market.

 It explains stability in the output and price, it does not say how the initial price is determined. Also many Oligopolistc firms show very little evidence of reluctance to price hike. In India, prices of most oligopoly firms (prices of cars)have been fluctuating.

Interdependence: The Cournot Model The feature of oligopolistic market of interdependence can be explained with the help of Cournot model, a French Mathematician in early 1800s. It is known as Cournots Duopoly (two sellers). Assumptions: Two fimrs; each firm makes its output decision assuming that other firms will produce the same amount as before. As the number of firm increases the Cournots result approaches the equilibrium result for perfect competition.

Although the two firms in all probability change its output from period to period, the two firms are assumed to be ignorant about this adjustment. Since there are 2 sellers under duopoly the total output be Qt which is q1 and q2 for individual 1 and 2. Let us take the product whose demand is is given by the following eqn:P=950-Qt , The MR and AR cost are assumed constant and equal to Rs50. This assumption is taken for simplifying the calculation. Let us think the firms behaves like a monopolist-a single seller maximising its profit when MC=MR MR=950-2Qt and the profit maximising output will be Qt=450 and the Price or P=500 Instead of monopoly , if the market is a perfect competition then the eqn is:950-Qt=50 and Qt = 900 and P=50 Hence the monopoly output is lower and price is higher than perfect competition. MR1=dTR/dq1=d[(950-q1-q2)*q1]/dq1=950-q2-2q1=50 MR2=950-q1-2q2=50 OR q1=450-0.5q2 (1) q2=450-0.5q1 (2) These two are the reaction functions as each firm reacts to the output choice of the other. If we solve these two equations we get q1 and q2 as 300 each. Thus the market is in equilibrium when each firm produces 300 units each. Two reaction curves intersect each other when it 300 units of output for each one.

Reaction functions of Cournot Duopoly

900

Firm1 450

300

Firm 2

300

450

900

 Cournot Model with n Firms The cournot model can also be extended to n number of firms. The industry with n firms , the equilibrium output of Cournot can Oligopoly is given by: Qn=Qc(n/n+1) Where n 1 and Qc is the output resulting from a perfectly competitive market. In case of monopoly, n=1 and the output will be 450. In case of duopoly, n=2 and the output will be 600. If n becomes large the value of n/n+1 approaches to unity. This implies that as the number of firms in the market increases, the combined output of those firms approaches that of a perfectly competitive market. Cournot model suggests that increased competition as measured by the number of firms in the market drives prices down towards cost. The most important flaw in this model is in respect of its assumption that the rivals output remains unchanged.

Cartels and Collusion

In oligopoly industries the mangers try to avoid price competition. The best alternative for them is to collude and set prices at or near monopoly price. A cartel is an association of business firms formulated by an explicit agreement between the firms. Under this the firms collude to make price output decisions with a view to eliminate uncertainty and restraining competition and thereby ensuring monopolistic gains to the cartel group. The cartel works through a board of control to determine the market share for each of the members. The profit to each firm will be maximum.

Firm 1

Firm2

Industry AC2 MC P

MC1

AC1

MC2 C2

C1

C AR
MR

Q1

Q2

Collusion and cheaters

D d

P1
P2

e d MC=AC

Q1

Q2

The agreed price=P1 and MC and AC are constant and equal for all the firms. The economic profit earned by each member in the cartel is P1mrs. For every firm in the industry the demand curve is DD which is relatively inelastic. Let us now suppose one firm cheats on the collusive agreement and reduces the price from P1 to P2. It increases the demand from Q1 to Q2 for the firm and the demand curve is dd (relatively elastic). It will lose the profits which was at P1 (area of loss=P1P2nm).The gain is rnef , much higher than the loss. As long as other firms adhere to the price fixing agreement, the cheater will earn additional profit. When they are aware, they will also start lowering their price and price competition became active, if there no mechanism in the industry to control it.

Price Leadership
Price leadership is a substitute for illegal collusion. The dominant firm in the industry will charge its profit maximising price and smaller firms will charge the same price. This helps in infrequent change in prices and price discipline is maintained in the industry. There are mainly two forms of price leadership: Dominant Firm price leadership and Barometric price leadership.

Dominant firm price leadership : When the industry constitutes one large firm and several smaller firms, the large firm sets profit maximising price and the smaller ones will follow the price set by the large firms.

DT DT: total demand

DT

MCF

MCL P0 PL

DL MRL QL QT

DT

Price and output with Dominant Firm Price leadership

MCF is the sum of MC for all the small firms. If the price is set at P0, the small firms will meet total demand and the dominant firm will have no sales because there is no residual demand. So price will be set below P0. The leaders demand curve is DL and Marginal revenue curve is MRL, MCL is the leaders marginal cost curve. The dominant firm is like monopolist and profit maximising output is QL and price is PL. The output of small firms is QT-QL units. Recentl years this type of leader ship is not very common due to growth of markets, technological change and foreign competitors.

Barometric Price leadership Under this type of leadership it is not necessary that only the dominant firm will set the price. One firm may come forward to set the price according to the behaviour of the market and other will follow this. The leadership can also be changed and shifted to some other firms. Hence barometric price leadership is a method of signaling a need for the price change through change in cost or demand.

Game theory and Strategic behaviour under oligopoly

Game theory is a technique used to analyse situations where individuals or organisations have conflicting objectives. Two important concepts are often used in game theory. (i) Strategy and (ii) Payoffs. A strategy is a course of action while the payoff is the outcome of the strategy. This theory was first developed by Von Neuman and Oskar Margenstem. It explains the strategic interaction among the Oligopoly firms. The nature of Problems faced by the Oligopoly firms is best explained by the Prisoners Dilemma game. Let two persons are involved with some illegal activities were arrested and kept separately so that they cannot communicate each other. Four possible options were kept before them: (i) If both confess, each one will get 5 years imprisonment; (ii) If Both deny, no one will be put in jail due to lack of evidence; (iii) If A confesses and B denies, A will get 5 year imprisonment and B will get 15 years imprisonment ; (iv) If B confesses and A denies, B will get 5 year imprisonment and A will get 15 years imprisonment .

Prisoners Dilemma: The Pay-off matrix Bs Options As max 15

Deny
As Options Confess Deny A 0 A 5 B 0 B 15 15

Confess
A 15 A 5 B 5 B 5 5

Bs Max

With much of uncertainty, no one knows the action of each other, there is dilemma in taking a decision. The best option for both is to deny the involvement of crime. Since no one knows what the other person will do, it is likely that both may confess and 5 years of jail to each. This the second best strategy. This is an example of non cooperative game.

 In oligopoly, the business firm choses its strategies to achieve equilibrium. There are actions, reactions and interaction to increase their prices to achieve the optimum profit. To analyse this type of situation, an American mathematician (John Nash)developed a technique which is known as Nash equilibrium, It is defined as a situation where none of the players can improve their pay off, given the strategy of the other players. A game may have more than one Nash equilibrium.

Prisoners Dilemma: The Pay-off matrix Bs Options No Increase Increase A 10 A -20 B 10 B 30 A 100 A 140 B -30 B 15

As Options

Increase

No Increase