Oligopoly

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.

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.

Cournots 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 firms 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. =

Period 1: Firm A: (1)

Firm B: (1/2)= 1/4 Period 2: Firm A: (1-1/4)= 3/8 Firm B: (1-3/8) =5/16 Period 3: Firm A: (1-5/16)=11/32 Firm B: (1-11/32)= 21/64 Period 4: Firm A: (1-21/64) = 43/128 Firm B: (1-43/128)=85/256 Period N: Firm A: (1-1/3) =1/3 Firm B: (1-1/3) = 1/3

Thus As output is declining progressively (with ratio=1/4), whereas Bs output is increasing at a declining rate. As equilibrium output=1/3 Bs equilibrium output=1/3

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:( from Foreign Book) A theory assuming that rival firms follow any decrease in price in order to maintain their respective market shares but refrain from following increases, allowing their market share to increase at the expense of the firm making the initial price increase. An often-noted characteristic of oligopoly markets is sticky prices. Once a general price level has been established, whether through cartel agreement or some less formal arrangement, it tends to remain fixed for an extended period. Such rigid prices are sometimes explained by what is referred to as the kinked demand curve theory of oligopoly prices. A kinked demand curve is a firm demand curve that has different slopes for price increases as compared with price decreases. The kinked demand curve describes a behavior pattern in which rival firms follow any decrease in price to maintain their respective market shares but refrain from following price increases, allowing their market shares to grow at the expense of the competitor increasing its price. The demand curve facing individual firms is kinked at the current price/ output combination, as illustrated in Figure . The firm is producing Q units of output and selling them at a price of P per unit. If the firm lowers its price, competitors retaliate by lowering their prices. The result of a price cut is a relatively small increase in sales. Price increases, on the other hand, result in significant reductions in the quantity demanded and in total revenue, because customers shift to competing firms that do not follow the price increase. Associated with the kink in the demand curve is a point of discontinuity in the marginal revenue curve. As a result, the firms marginal revenue curve has a gap at the current price/ output level, which results in price rigidity. To see why, recall that profit-maximizing firms operate at the point where marginal cost equals marginal revenue. Typically, any change in marginal cost leads to a

new point of equality between marginal costs and marginal revenues and to a new optimal price. However, with a gap in the marginal revenue curve, the price/output combination at the kink can remain optimal despite fluctuations in marginal costs. As illustrated in Figure , the firms marginal cost curve can vacillate between MC1 and MC2 without causing any change in the profit-maximizing price/output combination. Small changes in marginal costs have no effect; only large changes in marginal cost lead to price changes. In perfectly competitive grain markets, prices change every day. In the oligopolistic ready-to-eat cereals market, prices change less frequently.

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.

Cartel Arrangements All firms in an oligopoly market benefit if they get together and set prices to maximize industry profits. A group of competitors operating under such a formal overt agreement is called a cartel. If an informal covert agreement is reached, the firms are said to be operating in collusion. Both practices are illegal in the United States. However, cartels are legal in some parts of the world, and U.S. multinational corporations sometimes become involved with them in foreign markets. Several important domestic markets are also dominated by producer associations that operate like cartels and appear to flourish without interference from the government. Agricultural commodities such as milk are prime examples of products marketed under cartel-like arrangements. A cartel that has absolute control over all firms in an industry can operate as a monopoly. To illustrate, consider the situation shown in Figure. The marginal cost curves of each firm are summed horizontally to arrive at an industry marginal cost curve. Equating the cartels to tal marginal cost with the industry marginal revenue curve determines the profit-maximizing output and the price, P*, to be charged. Once this profit-maximizing price/output level has been determined, each individual firm finds its optimal output by equating its own marginal cost curve to the previously determined profit-maximizing marginal cost level for the industry. Profits are often divided among firms on the basis of their individual level of production, but other allocation techniques can be employed. Market share, production capacity, and a bargained solution based on economic power have all been used in the past. For a number of reasons, cartels are typically rather short-lived. In addition to the long-run problems of changing products and of entry into the market by new producers, cartels are subject to disagreements among members. Although firms usually agree that maximizing joint profits is mutually beneficial, they seldom agree on the equity of various profitallocation schemes. This problem can lead to attempts to subvert the cartel agreement. Cartel subversion can be extremely profitable. Consider a two-firm cartel in which each member serves 50 percent of the market. Cheating by either firm is very difficult, because any loss in profits or market share is readily detected. The offending party also can easily be identified and punished. Moreover, the potential profit and market share gain to successful cheating is exactly balanced by the potential profit and market share cost of detection and retribution. Conversely, a 20-member cartel promises substantial profits and market share gains to successful cheaters. At the same time, detecting the source of secret price concessions can be extremely difficult. History shows that cartels including more than a very few members have difficulty policing and maintaining member compliance. With respect to cartels, there is little honor among thieves.

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 A situation in which one firm establishes itself as the industry leader and all other firms in the industry accept its pricing policy. An informal but sometimes effective means for reducing oligopolistic uncertainty is through price leadership. Price leadership results when one firm establishes itself as the industry leader and other firms follow its pricing policy. This leadership may result from the size and strength of the leading firm, from cost efficiency, or as a result of the ability of the leader to establish prices that produce satisfactory profits throughout the industry.

A typical case is price leadership by a dominant firm, usually the largest firm in the industry. The leader faces a price/output problem similar to monopoly; other firms are price takers and face a competitive price/output problem. This is illustrated in Figure 11.5, where the total market demand curve is DT, the marginal cost curve of the leader is MCL, and the horizontal summation of the marginal cost curves for all of the price followers is labeled MCf. Because price followers take prices as given, they choose to operate at the output level at which their individual marginal costs equal price, just as they would in a perfectly competitive market. Accordingly, the MCf curve represents the supply curve for following firms. At price P3, followers would supply the entire market, leaving nothing for the dominant firm. At all

prices below P3, the horizontal distance between the summed MCf curve and the market demand curve represents the price leaders demand. At a price of P1, for example, price followers provide Q2 units of output, leaving demand of Q5 Q2 for the price leader. Plotting all of the residual demand quantities for prices below P3 produces the demand curve for the price leader, DL in Figure , and the related marginal revenue curve, MRL. More generally, the leader faces a demand curve of the following form: DL = DT Sf where DL is the leaders demand, DT is total demand, and Sf is the followers supply curve found by setting P = MCf and solving for Qf, the quantity that will be supplied by the price followers. Because DT and Sf are both functions of price, DL is likewise determined by price. Because the price leader faces the demand curve DL as a monopolist, it maximizes profit by operating at the point where marginal revenue equals marginal cost, MRL = MCL. At this optimal output level for the leader, Q1, market price is established at P2. Price followers supply a combined output of Q4 Q1 units. A stable short-run equilibrium is reached if no one challenges the price leader. A second type of price leadership is barometric price leadership. In this case, one firm announces a price change in response to what it perceives as a change in industry supply and demand conditions. This change could stem from cost increases that result from a new industry labor agreement, higher energy or material costs, higher taxes, or a substantial shift in industry demand. With barometric price leadership, the price leader is not necessarily the largest or the dominant firm in the industry. The price-leader role might even pass from one firm to another over time. To be effective, the price leader must only be accurate in reading the prevailing industry view of the need for price adjustment. If the price leader makes a mistake, other firms may not follow its price move, and the price leader may have to rescind or modify the announced price change to retain its leadership position. Some others types of price leadership: 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. At times results in monopoly type conditions

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 Cornets 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 Stackelbergs 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 nave firm will act as follower. In Sweezys 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.