Oligopoly

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• Oligopoly is a market structure in which there are only few

sellers (firms) of a homogeneous or differentiated product. • Pure Oligopoly: Product is HOMOGENEOUS

• Differentiated Oligopoly: Product is DIFFERENTIATED

• Duopoly: An oligopoly with two sellers (competitors)• Duopoly is the limiting case of Oligopoly

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Issues for Discussion• Oligopoly

– Duopoly– How does Oligoply emerge?– Equilibrium in Oligopoly Market

• Cournot Solution– Other Oligopoly Models– Price Rigidity Without Collusion– Price Leadership

• Efficient firm• Dominant firm

– Perfect Collusion: Cartels

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Oligopoly• Oligopoly: Most prevalent form of Market organization

Exp: Soap, Detergent, Cigarettes, Automobiles, Electrical Equipment, Computer- Differentiated Product

Homogeneous Product: Close Resemble Petrochemicals, Telecom service (Reliance, Tata Indicom, BSNL, MTNL, AIRTEL, IDEA, HUTCH-BPL etc ! (excluding service))

• As FEW firms operate in the industry so ACTION of each firm affects the other firms in the industry and vice-versa.

• If one firm Reduces price then other firms can not Remain INDIFFERENT

• To avoid PRICE WAR Oligopolist prefer to compete on the basis of product differentiation, advertising and service

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CAN ADVERTISEMENT SOLVE the PROBLEM?

• Advertisement: Coca-cola vis-à-vis Pepsi(Aamir Khan vis-à-vis Shahrukh Khan)

KING FISHER vis-à-vis Jet and other domestic players

If one firm opts for major advertising campaign then others will follow suit.

Overall Inference: INTERDEPENDENCE OR RIVALRY AMONG THE FIRMS IN THE INDUSTRY. WHY?

As There are FEW firms in the industry

INFERENCE: EACH OLIGOPOLIST NEEDS TO TAKE INTO ACCOUNT EXPECTED COMPETITORS REACTION WITH RESPECT TO PRICING POLICY, DEGREE OF PRODUCT DIFFERENTIATION, LEVEL OF ADVERTISING TO BE UNDERTAKEN AND AMOUNT OF SERVICES TO BE PROVIDED.

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Why does Oligopoly emerge?

• Barriers to market entry: Conditions that make it difficult for new firms to enter the industry where existing firms have long-run

interests.

• Entry-limit pricing Set a price lower than the Profit Maximizing price to discourage potential

rivals to enter the market

• Excess Capacity and Economies of scale(Serve as a signal to potential entrants that exiting firm can reduce price and expand output if a new firm attempts to gain a share of market)

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Sources of Oligopoly continues…….

Economies of Scale: Operates over sufficiently large range of output so as to leave only few firms supplying the output. Average Cost of Production low

• Requirement of Huge Capital Investment and Specialized inputs to enter Oligopolistic Market

New Firms to raise tremendous amount of investment funds to install the plant & get equipments.

[Exp: Automoblie, Aluminium, Steel (SAIL, ISPAT, TATA STEEL etc)]

• Product differentiation or brand recognition(Existing firms Develop preference for their product by the

consumers. New firms can not attract the customers easily)

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Sources of Oligopoly……

© Brand Reflects the quality of product(Quality of Product and Services are two important factors that

determine profit)

Patent Rights: Few firms own patent right or exclusive right to produce

Control of supply of Required Raw Material by few Firms restricts new entrants entering the industry

• Sales and Distribution Networks

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Sources of Oligopoly PowerNeed to spend more money for Market

Recognition and Market Reputation

Access to Technology exclude potential competitors

Incumbent firms may adopt strategic actions to deter entry (Pindyck et al.)

Threaten to flood market and drive prices down if entry occurs.

To make threat credible, can construct excess production capacity.

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Equilibrium in Oligopoly Market• Management Challenges

– Strategic actions to Deter Entry• Threaten to decrease price against new Competitors by

keeping Excess Capacity– Rival behavior

• Because only a few firms, each must consider how its actions will affect its rivals and in turn how their rivals will react

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Equilibrium: Oligopoly• If one firm decides to cut price, then it must

consider what other firms in the industry will do– Could cut price.

• How much? The same amount, or more

– Could lead to PRICE WAR and drastic FALL in PROFITS for all

• Actions and reactions are dynamic, evolving over time

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Oligopoly: Equilibrium• Defining Equilibrium

– Market is in equilibrium if firms are doing the best they can and have no incentive to change their prices or output.

– All firms assume competitors are taking rival

decisions into account• Nash Equilibrium

– Each firm is doing the best it can given what its competitors are doing

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Equilibrium in Duopoly Market: The Cournot Model

• Duopoly: Market in which Two Firms Compete with each other• Introduced by French Mathematical Economist: Augustin Cournot (1838)

• Two Profit Maximizing Duopolists selling Spring Water under Zero long run Marginal Cost of Production– EACH FIRM TREATS OUTPUT of its COMPETITORS as FIXED. – BASED on it EACH FIRM DECIDES how much to PRODUCE to

Maximize Profit

Each Firm assumes that other Firm will hold its OUTPUT Constant– Each Firm will adjust its output based on what it thinks the other

firm will produce

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Assumptions of Cournot Model

• – Homogenous Product Produced by Two firms– Each Duopolist assume OUTPUT of other

Duopoly as Fixed– Each Duopolist fully know the Linear Market

Demand Curve

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MC1

50

MR1(75)

D1(75)

12.5

If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is

shifted to the left by this amount.

Firm 1’s Output Decision

Q1

P1D1(0)

MR1(0)

Firm 1 and market demand curve, D1(0), if Firm 2 produces nothing.

D1(50)MR1(50)

25

If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is

shifted to the left by this amount.

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Oligopoly

• The Reaction Curve– The relationship between a firm’s PROFIT

MAXIMIZING OUTPUT and the amount it thinks its COMPETITOR will produce

(Ex. If Firm 1 thinks firm 2 will produce nothing then it (firm 1) produces 50 units. If Firm 2 Produces 50, firm 1 produce 25 (=1/2 of the market not supplied by firm 2). Firm 2 produce 75, firm 1 produce 12.5 (1/2 of 25), firm 2 produce 100, firm 1 produce nothing)

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Firm 2’s ReactionCurve Q*2(Q1)

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Q2

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

Firm 1’s reaction curve shows how much itwill produce as a function of how much it thinks Firm 2 will produce. The x’s

correspond to the previous model.

The Reaction Curve & Cournot Equilibrium

Q1

100755025

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The Reaction Curve & Cournot Equilibrium

Firm 2’s ReactionCurve Q*2(Q1)

Q225 50 75 100

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximizes its own profits.

CournotEquilibrium

Q1

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Cournot Equilibrium

Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly

• Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium)

The action reaction continues as the firms don’t learn from past pattern of reaction of their rival.

Equilibrium Point: INTERACTION of TWO REACTION CURVES

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Equilibrium……

Each firm maximizes profit in each period but industry profits are not maximised.

Recognition of Interdependence (open Collusion) leads to HIGHER PROFIT- A case of Monopoly power

Collusion: Feasible to Produce ONE-HALF of total output.

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The Linear Demand Curve

• Compare Cournot Equilibrium with Competitive Equilibrium and the Equilibrium resulting from Collusion

– Two firms face linear market demand curve– We can say Market demand is P = 30 - Q – Q is total production of both firms:

Q = Q1 + Q2

– Both firms have MC1 = MC2 = 0

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An Example

• Firm 1’s Reaction Curve MR = MC

111 )30( QQPQR :Revenue Total

122

11

1211

30

)(30

QQQQ

QQQQ

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An Example of Cournot Equilibrium

12

21

11

21111

2115

2115

0230

QQ

QQ

MCMRQQQRMR

Curve Reaction s2' Firm

Curve Reaction s1' Firm

103020

10)2115(2115:other)each with intersect curvesreaction (Two

mEquilibriuCournot

21

1

21

QPQQQ

QQQ

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Cournot Equilibrium

Q1

Q2

Firm 2’sReaction Curve

30

15

Firm 1’sReaction Curve

15

30

10

10

Cournot Equilibrium

The demand curve is P = 30 - Q andboth firms have 0 marginal cost.

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Profit Maximization with Collusion

15Q when Maximized isProfit Total15 Q implies 0

0.:230

30)30(

.........&..................2

MRButMCMCMRmEquilibriu

QQRMRQQQQPQR

equallyprofitsplittodecidedcolludetodecidedfirmstwoLet

Curve Q1 + Q2 = 15-Collusion Curve Shows all pairs of output Q1 and Q2 that maximize total profits If they share profit equally, then both can produce half of the totalQ1 = Q2 = 7.5Inference: In collusion, less output (7.5 each) and higher profits as compared to Cournot equilibrium (more output: 10 each)

Cournot outcome (firm) is better than Perfect Competition, but not as good as the Collusion

In Collusion each firm sells lower output

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Duopoly Example

Firm 1’sReaction Curve

Firm 2’sReaction Curve

Q1

Q2

30

30

10

10

Cournot Equilibrium

CollusionCurve

7.5

7.5

Collusive Equilibrium

For the firm, collusion is the bestoutcome followed by the Cournot

Equilibrium and then the competitive equilibrium

15

15

Competitive Equilibrium (P = MC; Profit = 0)

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Thanks a lot