Oligopoly

Chapter 12

Oligopoly

Lecture Plan

• Introduction• Features of Oligopoly• Duopoly• Cournot’s Model• Stackelberg’s Model• Kinked Demand Curve: Price Rigidity• Collusive Oligopoly • Price Leadership• Summary

Objectives

• To examine the nature of an oligopoly market.• To understand the indeterminate demand curve

for a firm under oligopoly• To look into the various models of price and

output decisions under oligopoly.• To comprehend the nuances of collusive

oligopoly, with detailed analysis of its various forms, including cartels.

• To identify with the practice of price leadership by an oligopolist.

Introduction

• Derived from Greek word: “oligo” (few) “polo” (to sell)

• A few dominant sellers sell differentiated or homogenous products under continuous consciousness of rivals’ actions.

• Oligopoly looks similar to other market forms; as there can be many sellers (like in monopolistic competition), but a few very large sellers dominate the market.

• Products sold may be homogenous (like in perfect competition), or differentiated (like in monopolistic competition).

• Entry is not restricted but difficult due to requirement of investments.

• One aspect which differentiates oligopoly from all other market forms, is the interdependence of various firms: no player can take a decision without considering the action (or reaction) of rivals.

Features of Oligopoly

• Few Sellers: small number of large firms compete

• Product: Some industries may consist of firms selling identical products, while in some other industries firms may be selling differentiated products.

• Entry Barriers: No legal barriers; only economic in nature – Huge investment requirements

– Strong consumer loyalty for existing brands

– Economies of scale


• Non Price Competition: Firms are continuously watching their rivals, each of them avoids the incidence of a price war.

• Two firms A & B sell a homogenous product.

• Prevailing price is P1, but firm A lowers the price.

• B fears loss of its customers and retorts by lowering the price below that of A.

• A further reduces the price and this process continues, till the firms reach P2.

• Both realize that this price war is not helping either of them and decide to end the war. Price stabilises at P2.

Market share of A

Market share of B

A B

O

P1

P2


• Indeterminate Demand Curve• Price and output determination is

very complex as each firm faces two demand curves.

• Demand is not only affected by its own price or advertisement or quality, but is also affected by the price of rival products, their quality, packaging, promotion and placement.

• When the firm increases the price it faces less elastic demand (DD); when it reduces the price it faces highly elastic demand (D1D1)

Quantity

D

O

D

D1

D1Price

Duopoly

• Duopoly is that type of oligopoly in which only two players operate (or dominate) in the market.

• Used by many economists like Cournot, Stackelberg, Sweezy, to explain the equilibrium of oligopoly firm, as it simplifies the analysis.

Price and Output Decisions

• No single model can explain the determination of equilibrium price and output– Difficult to determine the demand curve and hence the revenue

curve of the firm

– Tendency of the firm to influence market conditions by various activities like advertisement, and fear of price war resulting in price rigidity.

Cournot’s Model

• Augustin Cournot illustrated with an example of two firms engaged in the production and sale of mineral water.

• Each firm owns a spring of mineral water, which is available free from nature.

Assumptions • Each firm maximizes profit.• Cost of production is nil because the springs are available free

from nature, i.e. MC=0. • Market demand is linear; hence the demand curve is a downward

sloping straight line.• Each firm decides on its price assuming that the other firm’s

output is given (i.e. the other firm will continue to produce and sell the same amount of output in next period).

• Firms sell their entire profit maximizing output at the price determined by their demand curves.

Cournot’s Model

Period 1: Firm A: ½ (1) = ½ Firm B: ½ (1/2)= 1/4

Period 2: Firm A: ½ (1-1/4)= 3/8 Firm B: ½ (1-3/8) =5/16

Period 3: Firm A: ½ (1-5/16)=11/32 Firm B: ½ (1-11/32)= 21/64

Period 4: Firm A: ½ (1-21/64) = 43/128 Firm B: ½ (1-43/128)=85/256 ………

Period N: Firm A: ½ (1-1/3) =1/3 Firm B: ½ (1-1/3) = 1/3

Thus A’s output is declining progressively (with ratio=1/4), whereas B’s output is increasing at a declining rate.

•A’s equilibrium output=1/3

•B’s equilibrium output=1/3

Cournot’s Model

Quantity

Price, Revenue, Cost

O

A

D

PAPB

B

QB

QA

M

RA

MRB

D*

• Firm A produces profit maximising output at MR=MC=0 and sells half of the total market demand (equal to OD*).

• Point A is the mid point of DD*. • Firm B assumes A will continue to

produce OQA ,so considers QAD* as the market available to it and AD* as its demand curve. Its MR curve will be MRB.

• B maximizes profit and produce QB.

• A and B together supply to three fourths of the total market, while one fourth remains unattended.

Stackelberg’s Model

• Developed by German Economist H. V. Stackelberg

• Popularly known as the Leader Follower Model.

• An extension of the model of Cournot.

• One of the players is sufficiently sophisticated to recognize that the rival firm acts.

• The sophisticated firm is able to determine the reaction curve of the rival and is also able to incorporate it in its own profit function. Thus it acts as a monopolist.

• Naïve firm will act as follower.

Stackelberg’s Model

RA

RA RB

RB

E

Output of Firm A

Output of Firm B

OXA

XB

Firm A’s reaction function

Firm B’s reaction function

a

X’B

X’A

b

• If firm A is the sophisticated firm, it will try to produce that output at which it can maximize its profit, at point “a”.

• A will produce OXA and B will be contended with OXB.

• B will act as a follower and accept the leadership of A.

• If firm B is the sophisticated firm, will be at equilibrium at point “b”, producing OXB.

• A will act as the follower and accept B’s leadership will produce only OXA.

RARA: Reaction function of A

RBRB: Reaction function of B

Cournot’s equilibrium= E

Kinked Demand Curve

• Paul Sweezy (1939) introduced concept of kinked demand curve to explain ‘price stickiness’.

• Assumptions

– If a firm decreases price, others will also do the same. So, the firm initially faces a highly elastic demand curve.

– A price reduction will give some gains to the firm initially, but due to similar reaction by rivals, this increase in demand will not be sustained.

– If a firm increases its price, others will not follow. Firm will lose large number of its customers to rivals due to substitution effect.

– Thus an oligopoly firm faces a highly elastic demand in case of price fall and highly inelastic demand in case of price rise.

• A firm has no option but to stick to its current price.

• At current price a kink is developed in the demand curve

• The demand curve is more elastic above the kink and less elastic below the kink.

Kinked Demand Curve(price and output determination)

• Discontinuity in AR (D1KD2) creates discontinuity in the MR curve.

• At the kink (K), MR is constant between point A and B.

• Producer will produce OQ, whether it is operating on MC1 or MC2, since the profit maximizing conditions are being fulfilled at points S as well as T.

• If MC fluctuates between A and B, the firm will neither change its output nor its price.

• It will change its output and price only if MC moves above A or below B.

• D1K = highly elastic portion of the demand curve when rival firms do not react to price rise

• KD2 = less elastic portion, when rival firms react with a price reduction.

• Kink is at point K.

D1

D2

K

A

B

MRQuantity

O

MC1

MC2

P

Q

ST

Price, Revenue, Cost

Collusive Oligopoly

• Rival firms enter into an agreement in mutual interest on various accounts such as price, market share, etc.

• Explicit collusion: When a number of producers (or sellers) enter into a formal agreement.

• Tacit collusion: A collusion which is not formally declared.• Cartel

• A formal (explicit) agreement among firms on price and output.• Occurs where there are a small number of sellers with

homogeneous product. • Normally involves agreement on price fixation, total industry

output, market share, allocation of customers, allocation of territories, establishment of common sales agencies, division of profits, or any combination of these.

• Immidiate impact is a hike in price and a reduction in supply. • Two types:

• centralized cartels • market sharing cartels.

Centralized Cartels

P

OQ

MR

AR=D

∑MCMCAMCB

QAQB

Price, Cost, Revenue

Quantity

• MCA = Firm A’s marginal cost

• MCB = Firm B’s marginal cost

• ∑MC = industry marginal cost

• OQ = profit maximizing output because (MR=∑MC).

• OQA = A’ output, OQB = B’s output

• OQ=OQA + OQB; OQA > OQB.

• OP = price at which both firms can sell their output. Price will be determined by summation of all firms’ costs and demand.

• An individual firm is thus just a price taker.

Market Sharing Cartels

Output

Price, Cost, Revenue

O QA

PA

ARA

MRA

ACMC

ARB

PB

MRB

QB

• Firms decide to divide the market share among them and fix the price independently.

• All firms have the same cost functions because they are producing a homogenous product.

• Due to different demand functions, at equilibrium total output (OQ)=OQA+ OQB, where OQA> OQB.

• The quantity of output produced and sold would depend upon the terms of agreement among the firms.

Factors Influencing Cartels

• Number of firms in the industry: Lower the number of firms in the industry, the easier to monitor the behaviour of other members.

• Nature of product: Formed in markets with homogenous goods rather than differentiated goods, to arrive at common price. But if goods are homogeneous, an individual firm may gain larger market share by cheating, i.e. by lowering the price.

• Cost structure: Similar cost structures make it easier to coordinate.

• Characteristics of sales: Low frequency of sales coupled with huge amounts of output in each of these sales make cartels less sustainable, because in such cases firms would like to undercut the price in order to gain greater market share.

– with large number of firms and small size of the market some firms may deviate from the cartel price and thus cheat other members.

Informal and Tacit Collusion

• Formed when firms do not declare a cartel, but informally agree to charge the same price and compete on non price aspects.

• Sometimes this agreement invloves division of the market among the players in such a way that they may charge a price that would maximize their profit without fear of retaliation.

• Also seen in case of highly skilled human resource. • It is as damaging to consumers as formal cartels,

because it makes an oligopoly act like a monopoly (in a limited sense) and deprives consumers of the benefits of competition.

Price Leadership• Dominant Firm: a leader in terms of market share, or presence in all

segments, or just the pioneer in the particular product category.– May be either a benevolent firm or an exploitative firm.

• Benevolent leader– Allows other firms to exist by fixing a price at which small firms

may also sell.• so that it does not have to face allegations of monopoly

creation;• Earns sufficient margin at this price and still retains market

leadership• Exploitative leader: fixes a price at which small inefficient players

may not survive and thus it gains large share of the market.• Barometric Firm: has better industry intelligence and can preempt

and interpret its external environment in an effective manner.– No single player is so large to emerge as a leader, but there may

be a firm which has a better understanding of the markets.– Acts like a barometer for the market.

Summary

• Oligopoly is a market with a few sellers, differentiated or homogenous product, interdependent decision making by firms, non price competition and indeterminate demand curve.

• Duopoly is a special case of oligopoly, in which only two players operate (or dominate) in the market. All the characteristics of duopoly are same as those of oligopoly.

• Difficulty in determining the demand curve, tendency to influence market conditions and fear of price war resulting in price rigidity are some of the reasons which pose a major constraint in developing a model to explain oligopoly.

• In Cournot’s model firms ignore interdependence and take decisions as if they are operating independently in the market. At equilibrium in a two firm industry, each firm will be maximizing profit by selling equal amounts of output at the same price.

• In Stackelberg’s model the sophisticated firm is able to determine the reaction curve of the rival and is also able to incorporate it in its own profit function. Thus it acts as a monopolist. The naïve firm will act as follower.

Summary

• In Sweezy’s kinked demand curve model firms avoid a situation like price war; therefore they stick to the current price. Thus the oligopoly price remains rigid.

• The kink in demand curve signifies that the demand curve has two different degrees of price elasticity.

• Under collusion rival firms enter into an agreement in mutual interest on various accounts such price, market share, etc. Collusion may be open or tacit. The most commonly found form of explicit collusion is known as cartels.

• A centralized cartel is an arrangement by all the members, with the objective of determining a price which maximizes joint profits. In market sharing cartel members decide to divide the market share among them and fix the price independently.

• A dominant firm is a leader in terms of market share, or presence in all segments, or just being the pioneer in the particular product category. A leader can be benevolent or exploitative.

• A barometric firm has better industry intelligence and can preempt and interpret its external environment in an effective manner.

Education

Oligopoly