12 – Oligopoly

Introduction

Oligopoly occurs when only a few firms (sellers) compete in the market for a specific commodity. Oligopoly is distinguished by the fact that neither the theory of monopolistic competition nor the theory of monopoly can explain the behaviour of an oligopolistic firm.

12.1 Characteristics of Oligopoly Market

1. Few sellers- There are few sellers in an oligopoly market.
There are no more than ten sellers. If there are more than ten sellers, a few are dominating and the others are inconsequential.

2. Products  are homogeneous or differentiated- commodities offered under oligopoly are either homogeneous or differentiated.
Differentiation can take the form of a brand name, a design, a colour, and so on.

3. Entry is feasible but difficult- In the case of an oligopoly, a new firm can enter the market, but it is difficult due to technological, financial, and other restrictions.

4. Interdependence- Because there are few firms in an oligopoly, a single firm cannot make independent decisions regarding price and output. Any decision made by one firm is met with reactions from rival or competitive firms. Different companies will make different decisions. As a result, the firms are interdependent. As a result, the firm needs to assess the potential reactions of other firms.

5. Uncertainty- Because enterprises are interdependent in determining price and output, an atmosphere of uncertainty exists. If one vendor boosts his output to acquire a huge portion of the market, others will follow suit. If one vendor raises the price of his product, others will not follow him out of fear of losing market share. On the other hand, if one seller lowers his or her price, others will follow suit. However, the extent to which they will reduce prices is unknown. This means that an oligopolist is unsure of how the other enterprises will react.

6. Indeterminacy of the demand curve- in the situation of perfect competition, prices are determined in the market by demand and supply factors, and the firm is a price taker, hence, the firm’s demand curve is perfectly elastic (parallel to the x-axis). In the case of a monopoly, a single seller determines the price of his commodity and sells it accordingly. As a result, the monopolist’s demand curve falls downward. And because substitute products are unavailable, the demand curve is steeper. When there are close substitute products available, the demand curve is downward sloping and more elastic, or flatter. This means that the demand curve has a distinct shape under perfect competition, monopoly, and monopolistic competition.

Due to the interconnectedness of enterprises and the uncertainty factor, the demand curve does not have a defined shape in the situation of oligopoly. It loses its steadfastness.

The demand curve under oligopoly is kinky, as illustrated in the diagram below.

12.2 Collusive and Non- Collusive Oligopoly

Because of the constant reactions of rival firms, the oligopoly market faces the difficulty of setting prices. Competition in the oligopoly market is fierce due to differentiated products. An oligopoly might be either collusive or non-collusive.

1. Non-Collusive Oligopoly

In a non-collusive oligopoly, firms operate independently despite their interdependence. The behaviour of each firm is influenced by how it anticipates its competitors will respond to its decisions. This results in intense competition, and a classic model illustrating this scenario is Sweezy’s kinked demand curve.

2. Collusive Oligopoly

In contrast, collusive oligopoly arises when firms within the market enter into agreements, either formal or tacit, to collectively determine prices and output. Such agreements aim to minimize uncertainty and curb cutthroat competition, often focusing on maximizing collective profits rather than individual gains.

Collusions are of two types:
a. Cartel and

b. price leadership

Collusive and non-collusive models are discussed below:

1. Oligopoly Pricing: The Kinked Demand Curve Model

In oligopoly markets, where a few firms dominate, pricing dynamics are intricate due to the constant reactions and interdependence among these market leaders. Let’s look at Sweezy’s kinked demand curve model to illustrate the non-collusive oligopoly scenario.

Non-Collusive Oligopoly: Sweezy’s Kinked Demand Curve Model

Consider a duopoly—an oligopoly scenario with two dominant firms. The model uses demand and marginal revenue curves to explain pricing behaviour.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

1. Increase in Price (Above Prevailing Price):

• Demand Curve DD: This represents the demand curve of Firm A, which is more elastic.
• Demand Curve D1D1: This represents the demand curve of Firm B, which is less elastic.
• Intersection Point K: The point where DD and D1D1 intersect, determining the prevailing price (OP) and quantity (OQ).

Explanation:

If Firm A increases the price, its customers might shift to Firm B due to the less elastic demand, leading to a substantial drop in demand.

This results in a more elastic demand curve above the prevailing price.

2. Decrease in Price (Below Prevailing Price):

• DKD1 Curve: The kinked demand curve resulting from the kink at point K in an oligopoly. The upper segment (DK) is more elastic, and the lower segment (KD1) is less elastic.

Explanation:

If Firm A lowers the price, competitors, including Firm B, quickly match the reduction to avoid losing customers.

This leads to a less elastic demand curve below the prevailing price.

Equilibrium of a Firm:

 

 

 

 

 

 

 

 

 

 

 

 

 

• MR Curve: The marginal revenue curve, lying halfway between AR curve and the Y-axis, has a discontinuous portion RS due to the kink in the demand curve.
• MC Curve: The marginal cost curve intersects the discontinuous portion RS of the MR curve.

Explanation:

Equilibrium is reached when MR equals MC, determining output (OQ) and price (OP). The kink in the demand curve creates a price rigidity; firms are hesitant to change prices due to anticipated reactions from competitors.

Any change in MC leads to a movement along the discontinuous portion of the MR curve, maintaining constant price and output levels.

Example Illustration: Imagine two major smartphone manufacturers. If one raises the price of its flagship device, it anticipates customers might shift to the competitor offering a similar product. However, if one lowers the price, the competitor is likely to swiftly match the reduction, resulting in only a marginal increase in demand.

In summary, the kinked demand curve model in oligopoly reflects how firms strategically avoid altering prices to prevent customer losses or gain minimal benefits. Equilibrium is achieved when they balance profitability and costs, maintaining price rigidity amidst constant reactions from competitors.

2. Collusive oligopoly models

In an oligopoly, where a small number of firms dominate, there’s a tricky balance between interdependence and uncertainty. To avoid the unpredictability that comes with relying on each other, firms often make agreements to set consistent prices and outputs. These agreements can either be open (formal) or secret (tacit). However, openly agreeing on such matters is often illegal. When firms quietly agree on pricing and output to avoid competition, it’s called collusive oligopoly.

Example – OPEC: A prime example of collusive oligopoly is OPEC (Organization of Petroleum Exporting Countries). OPEC member countries collaborate to influence oil prices and market shares.

Types of Collusions:

-Cartel Agreement:

Definition: A cartel is an agreement among competing firms to maximize joint profits.

Forms: Two types – centralized cartel and market-sharing cartel.

Centralized Cartel:

Involves a common sales agency making decisions for all firms.

Decisions cover pricing, output distribution, and profit sharing.

Firms relinquish their autonomy for the sake of maximizing joint profits.

Also known as a perfect cartel.

Understanding a Cartel Agreement: Imagine two firms, A and B, and their industry. The goal of a cartel is to attain monopoly-like power.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

• Formation: The industry acts as a whole, with AR (average revenue) and MR (marginal revenue) being downward-sloping due to monopoly power.
• Output Determination: Total industry output (OM) aligns with the point where the sum of individual firm marginal costs equals industry marginal revenue (Summation MC = MR).
• Price Setting: The centralized authority sets the market price (OP), and each firm sells its quantity (OM1 and OM2) at the established price.
• Profit: Firms A and B each achieve profits based on their quantities and prices.
• Outcome: Firm A typically produces and sells more, leading to higher profits compared to firm B.

In summary, a cartel in a collusive oligopoly allows firms to coordinate on pricing and output decisions, achieving a balance between maximizing profits and avoiding competition.

In the world of business, particularly in markets with just a few key players (oligopoly), firms often face challenges in deciding prices due to their interdependence. To tackle this, some firms form cartels, which are agreements to coordinate pricing and outputs. One type is the loose cartel, where firms share markets in two ways:

1. Market Sharing by Non-Price Competition:

• Scenario: Firms agree on a fixed price but have flexibility in other aspects.
• Example: While selling at the same price, firms can tweak their product styles, advertising strategies, or offer additional perks like discounts.
• Consideration: If costs are similar, firms agree on a common price, but if costs differ, negotiations occur, and the low-cost firm might break away.

2. Market Sharing by Output Quota:

• Approach: Firms agree on specific output quotas and prices.
• Cost Impact: If costs are uniform, firms share the market equally. Due to past performance and negotiation prowess, different costs result in varying market shares.
• Alternative: Firms might divide markets by region, maintaining pricing and product flexibility.

Price Leadership: In an oligopoly, sometimes one firm takes the lead in setting prices to avoid unnecessary competition. Various types of price leadership include:

1. Price Leadership by a Low-Cost Firm:

• Scenario: A low-cost producer sets the price, and others follow.
• Consideration: The low-cost firm ensures that the set price is beneficial for both low and high-cost firms.

2. Price Leadership by a Dominant Firm:

• Dominance: One large firm, producing a significant share of the total output, dictates the price.
• Influence: Smaller businesses adhere to the dominant player’s set price.
• Consideration: Success depends on the dominant firm’s awareness of small firms’ reactions.

3. Barometric Price Leadership:

• Approach: An experienced and respected firm monitors market conditions and sets a price beneficial to all.
• Role: Others follow the leader’s pricing decisions.

4. Exploitative or Aggressive Price Leadership:

• Tactic: A large firm asserts leadership through an aggressive pricing strategy.
• Action: Threats may be used to keep other firms in check.
• Risk: Non-compliance may lead to exclusion from the market.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Considerations for Price Leadership:

• Non-Price Competition: Small firms may resort to non-price competition, like discounts, affecting market dynamics.
• Product Differentiation: In markets with varied products, firms may engage in competition, challenging the leader.
• Cost Differences: Setting a common price becomes tricky if costs vary, impacting the success of price leadership.

In essence, in the intricate world of oligopoly, firms employ various strategies to navigate pricing challenges and maintain market stability.