MODULE VI- PRICE AND OUTPUT DETERMINATION UNDER DIFFERENT

MARKET STRUCTURE

Meaning of Market

The word market is used in many senses. The word is derived from the Latin word
“Mercatus” from the verb “Mercari” which means “to trade”. Market is a term which is
commonly used for a particular place or locality where goods are bought and sold. It is the act
or technique of buying and selling.

In economics, a market is more than a geographical area or a “Mandi” where goods are
bought and sold. Market is defined “as a complex set of activities by which potential buyers
and potential sellers are brought in close contact for the purchase and sale of a commodity”.

According to Prof. Samuelson, “A market is a mechanism by which buyers and sellers

interact to determine the price and quantity of a good or service”. A market can be regional,
national or international. The term marketing has numerous common meanings and different
phases like:

✓ To the housewife – it is shopping.

✓ To the farmer – it is the sale of his produce.
✓ To the wholesale – it is the scientific method of businessman advertising and sales
Proportion.
✓ To the industrialist – it is discovery of foreign outlets for goods manufactured.

But in Economics, it may be a place, perhaps may not be. In economics, m arket can
exist even without direct contact on buyer and seller. Thus, above statement indicates that face
to face contact of buyer and seller is not necessary for market. E.g. in stock or share market,
the buyer and seller can carry on their transactions through internet. So internet, here forms an
arrangement and such arrangement also is included in the market. The term market should
imply certain things i.e the following features:

1. Commodity: There must be a commodity which is being demanded and sold.

2. Buyers and Sellers: There must be buyers and sellers of the commodity.
3. Communication: There must be communication between buyers and sellers i.e contact.
4. Place or area: There must be a place or an area where buyers and sellers interact with each
other.
5. Price: There should be a price for the commodity bought and sold.

MARKET STRUCTURE / CLASSIFICATION OF MARKETS

Economists have given various criteria for the classification of markets. Markets are
classified 1) on the basis of Place or Size 2) on the basis of Time and 3) on the basis of
Competition. The Market Structure refers to the characteristics of the market either
organizational or competitive, that describes the nature of competition and the pricing policy
followed in the market. Thus, the market structure can be defined as, the number of firms
producing the identical goods and services in the market and whose structure is determined on
the basis of the competition prevailing in that market. The following figure illustrates the
classification of market followed by the explanation.

1) On the Basis of Place or Size

The market for products may be classified into local, national or international markets.
❖ Local Market – a product has a local market when buyers and sellers of a commodity carry
on business in a particular locality. Eg. Market for vegetable, Milk etc.
❖ National Market – this market is said to exist when a commodity is demanded and supplied
all over the country. Eg. Wheat, Cotton and Sugar etc.
❖ International Market – a commodity commands international or world market when the
buyers and sellers of a product come from all over the world. E.g. Petrol, Gold etc.

2) On the Basis of Time

According to Marshall, time plays an important role deciding the value of the
commodity and time does not have the same meaning as it has in everyday life. Marshall
introduced “Time” in value analysis and consequently classifies markets into short and long
period.

❖ Very Short Period – refers to that type of competitive markets in which the commodities
are perishable and supply of commodities cannot be changed at all. So, in a very short
period the market supply is almost fixed. Eg. Vegetables, fish, egg, fruits, milk etc.
❖ Short Period – this implies that the sellers have little influence on the price of the
commodity, since the commodity is durable. Supply cannot be increased after reaching full
capacity.
❖ Long Period – is period in which the commodity in consideration is durable and the supply
of the commodity is also variable by employing more capital. The supply can be increased
or decreased.
❖ Very Long / Secular Period – this implies change in the supply conditions. Here the
commodities and services are not taken into account, but a change in the supply of factors
of production is taken into account.

3) On the Basis of Situation (Relationship/Competition)

Different situations arise in marketing and determinations of price on the basis of

different relationships between the constituent elements in the market. These situations arise
on the basis of the influence of buyers and sellers and determination of the price.
❖ The Nature of the Product – whether it is identical, homogeneous or not determines the
amount of freedom which a firm will have in determining its price. The nature of the
product determines the price and output policies of the producer.
❖ The Number of Buyers – the number of buyers in the market determines the size of demand
and also possibilities of combination between them.
❖ The Number of Sellers – this also has similar significance combinations of sellers decide
the output and prices.
❖ The Interdependence of Buyers and Sellers – they come to a common agreement and the
price and output depend on aggregate demand and supply forces.

PRICE AND OUTPUT DETERMINATION

Let us now see the different types of Competition in detail

PERFECT COMPETITION MARKET

Perfect competition refers to a market situation in which there are large number of
buyers and sellers of homogeneous products. The price of the product is determined by industry
with the forces of demand and supply. There must be one price prevailing throughout the
market. Perfect competition is a market structure characterized by complete absence o f rivalry
among individual firms. A good example of perfect competition is the agriculture market.
Otherwise, it is an ideal situation which rarely exists in the real world.

According to Boulding, “Perfectly competitive market is a situation where large

number of buyers and sellers are engaged in the purchase and sale of identically similar
commodities, who are in close contact with one another and who buy and sell freely among
themselves”.

Features of Perfect Competition

▪ Large number of buyers and sellers: In perfect competition, the buyers and sellers are
large enough, that no individual can influence the price and the output of the industry. An
individual customer cannot influence the price of the product, as he is too small in relation
competition), the consumers are then not exploited. There is no wasting of resources either, as
the consumer's welfare increases with the product differentiation.

OLIGOPOLY MARKET

The word oligopoly is derived from the Greek word "oligo" meaning few and "polo"
meaning to sell; it means a market with a few sellers. Oligopoly consists of characteristics of
various other markets. Oligopoly occurs when a few firms dominate the market for a good or
service. This implies that when there are a small number of competing firms, their marketing
decisions exhibit strong mutual interdependence. By mutual interdependence we mean that a
firm's action say of setting the price has a noticeable effect on its rival firms and they are likely
to react in the same way. Each firm considers the possible reaction of rivals to its price and
product development decisions.

To understand about the Oligopolistic market, we can take the laptops companies,
tractors, computer pen drive companies, cellular GSM network providing and car companies
(industry) or else satellite TV companies, as the best examples. Here we take DTH as the
example as this industry contains few sellers. Example companies in oligopolistic market 1)
Laptops companies: Dell, Sony vaio, Toshiba, Hewlett Packard, Acer.2) Cellular Phone service
providers: satellite TV Channel service providers Bike Companies. Etc. Many industries
including cement, steel, automobiles, mobile phones, cigrates, beverages etc.; are oligopolistic.

Oligopolies may be homogeneous or differentiated. If firms in an oligopolistic industry

produce standardized products like petroleum product, aluminum, rubber products, the industry
is said to be producing under oligopolistic conditions. On the other hand, if the firms are
producing goods, which are close substitutes for each other, then differentiate oligopoly is said
to prevail. Mutual interdependence is greater when products are identical and it is lesser when
goods are differentiated.

Definition

• According to Stigler Hads, "As that market situation in which a firm bases its market
policy in part on the expected behavior of a few close rival firms".
 • In the words of Jackson: "Oligopoly is an industry structure characterized by a few
firms producing all or most of the output of some good that may or may not be
differentiated".

Characteristics for Oligopolistic Market

The main characteristics of oligopoly are as follows:

❖ Few Sellers and Many Buyers: Refers to the primary feature of oligopoly. Under
oligopoly, few sellers dominate the entire industry. These sellers influence the prices of
each other. Moreover, in oligopoly, there are a large number of buyers.
❖ Homogeneous or Differentiated Products: Implies another important characteristic
of oligopoly. In oligopoly, organizations either produce homogenous products (similar
to perfect competition) or differentiated products (as in case of monopoly). If
organizations produce homogeneous products, such as cement, asphalt, concrete, and
bricks, the industry is said to be pure or perfect oligopoly. On the other hand, in case of
differentiated products, such as automobile, the industry is known as differentiated or
imperfect oligopoly.
❖ Barriers in Entry and Exit: Prevents the entry of new organizations. The barriers of
entry and exit distinguish the oligopoly market from monopolistic competition. In
oligopolistic market, new organizations cannot easily enter the market due to various
legal, social, and technological barriers. In such a case, existing organizations have a
complete control over the market.
❖ Mutual Interdependence: Refers to one of the important characteristics of the
oligopoly market structure. Mutual interdependence implies that organizations are
influenced by each other’s decisions. These decisions include pricing and output
decisions of organizations. In monopoly and perfect competition, organizations do not
take into consideration the decisions and reactions of other organizations, therefore, the
decision of organizations in such types of market structures are independent. However,
in oligopoly, an organization is not able to take an independent decision.
For example, in oligopoly, a few numbers of sellers compete with each other. In such a
case, the sale of one organization depends on its own price of products as well as the
price of competitor’s products. This mutual interdependence differentiates oligopoly
from rest of the market structures
 ❖ Lack of Uniformity: Refers to another important characteristic of oligopoly. In
oligopoly, organizations are not uniform in their sizes. Some organizations are very
large in size while some of them are very small. For example, in small car segment,
Maruti Udyog has the share of 86%, while Tata and Cielo have very low market share.
❖ Existence of Price Rigidity: Implies that organizations do not prefer to change the
prices of their products in oligopoly. This is because the change in price would not be
profitable for an organization in oligopoly. In case, an organization reduces its price,
its rivals also reduce prices, which adversely affect the profits of the organization. In
case, the organization increases prices, it would lose buyers.

Causes of Oligopoly

The main reasons which give rise to oligopoly are as follows:

I. Economies of scale: If the productive capacity of a few firms is large and are able
to capture a greater percentage of the total available demand for the product in the
market, there will then be a small number of firms in an Industry. The firms in the
industry with heavy investment, using improved technology and reaping economies
of scale in production, sales, promotion, etc., will compete and stay in the market.
The firms using outdated machinery and old techniques of production will not be
able to compete with the low unit costs producing firms and eventually wipe out
from the industry. Oligopoly is, thus, promoted due to the economies of scale.
II. Barriers to entry: In many oligopolies, the new firms cannot enter the industry as
the big firms have ownership of patents or control over the essential raw material
used in the production of an output. The heavy expenditure on advertising by the
oligopolistic industries may also be a financial barrier for the new firms to enter the
industry.
III. Merger: If the few firms in the industry smell the danger of entry of new firms,
they then immediately merge and formulate a joint policy in the pricing and
production of the products. The joint action of a few big firms discourage the entry
of new firms into the industry.
IV. Mutual interdependence: As the number of firms is small in an oligopolistic
industry, therefore, they keep a strict watch of the price charged by rival firms in
the industry. The firm generally avoid price war and try to create conditions of
mutual interdependence.
Types of Oligopoly
Oligopoly is of following types:

1. Perfect Oligopoly: The condition in which oligopoly firm sells homogeneous

goods is known as a perfect or an ideal oligopoly, i.e., all firms sell similar kind
of products such as cement companies, steel companies, they all sell the similar
product with different brand names.
2. Imperfect Oligopoly: The condition in which firms sell differentiated products
in the market is known as an imperfect oligopoly. For instance; Maruti and
Hyundai are selling their various variants of cars in the market.
3. Open Oligopoly: When there will be no entry barriers for any new firm to enter
into a market, such condition is known as an open oligopoly. i.e. any firm can
enter into the market without any restrictions.
4. Close Oligopoly: When there is the various number of restrictions or barriers for
the firms to enter the market, such as technical or legal barriers that condition is
known as a close oligopoly.
5. Partial Oligopoly: Partial oligopoly is a condition in which one firm is a price
leader, who dominates the whole market and all other firms have to follow the
prices and quantity set by this firm.
6. Full Oligopoly: If there is no price leadership and all firms are competing with
each other in the market that condition is known as a full oligopoly.
7. Collusive Oligopoly: When two or more firms merge to maximize their joint
profit that condition is termed as a collusive oligopoly, i.e., these firms don’t
 work for their benefit, but their motive is to maximize their collective profit.
Its one of the best examples is (OPEC) in which various nations work jointly as
oil-exporting company groups.
8. Non-collusive Oligopoly: When a various company competes in the market to
increase its market share, that condition is known as a non-collusive oligopoly.

Three Important Models of Oligopoly

Three Important Economic Models of Oligopoly are as:
1. Price and output determination under collusive oligopoly.
2. Price and output determination under non-collusive oligopoly.
3. Price leadership model.

(1) Price and Output Determination Under Collusive Oligopoly:

The term 'collusion' implies to 'play together'. When firms under oligopoly agree
formally not to compete with each other about price or output, it is called collusive oligopoly.
The firms may agree on setting output quota, or fix prices or limit product promotion or agree
not to 'poach' in each other's market. The completing firms thus from a 'cartel'. The members
of firms behave as if they are a single firm.
Assumptions of Price and Output Determination Under Collusive Oligopoly:
For price output determination in a collusive oligopoly, we assume that
a) there are only three firms in the industry and they form a cartel,
b) the products of all the three firms are homogenous
c) the cost curves of these firms are identical.
Under the assumptions stated above, the equilibrium of the industry under collusive
oligopoly is explained with the help of a diagram.

Diagram:
 In this figure 17.4, the industry demand curve DD consisting of three firms is identical.
So is the case with the MR curve and MC curve which are identical. The cartel's MR curve
intersects the MC curve at point L. Profits are maximized at output OQ 1, where MC = MR. The
cartel will set a price OP1, at which OQ1, output will be demanded.
Having agreed on the cartel price, the members may then complete each other using
non price competition to gain as big share of resulting sales OQ 1 as they can. There is another
alternative also. The cartel members may agree to divide the market between them. Each
member would given a quota. The sum of all the quotas must add up to Q 1. In case the quotas
exceeded OQ1 either the output will remain unsold at OP price or the price would fall.

(2) Price and Output Determination Under Non-Collusive Oligopoly:

It will be explain with the help of kinked Demand Curve Model.
(i) The Kinked Demand Curve Model:
The Kinked demand curve model was developed by Paul Sweezy (1939). According
to him, the firms under oligopoly try to avoid any activity which could lead to price wars among
them. The firms mostly make efforts to operate in non-price competition for increasing their
respective shares of the market and their profit. An analytical device which is used to explain
the oligopolistic price rigidity is the Kinked Demand Curve.
This model operates on fulfilling certain conditions which, in brief, are as under:
a) All the firms in the industry are quite developed with or without product differentiation.
b) All the firms are selling the goods on fairly satisfactory price in the market.
c) If any one firm lowers the price of its product to capture a larger share of the market, the
other firms follow and reduce the price of their goods in order to retain their share of the
market.
d) If one firm raises the price of its goods, the other firms will not follow the price increase.
Some of the customers of the price raising firm will shift to the relatively low-priced firms.

Mr. Paul Sweezy used two demand curve concepts to explain the model. These are reproduced
below:
Diagram:

In the figure 17.5. DD / is a kinked demand curve. It is made up or two segments DB

and BD/. The demand curve is kinked or has a bend at point B. The kink is formed at the
prevailing market price level BM ($10 per unit). The segment of the demand curve above the
prevailing price level ($10) is highly elastic and the segment of the demand curve below the
prevailing price level is fairly inelastic. This is explained now in brief.
Explanation:
❖ Price increase. If an oligopolistic raises the price of his products from $10 per unit to
$12 per unit, he loses a large part of the market and his sale comes down to 40 units
from 120 units. There is a loss of 80 units in sale as most of his customers are now
purchasing goods from his competitor firms who are selling the goods at $10 per units.
So an increase in price above the prevailing level-shows that the demand curve to the
left of and above point B is fairly elastic.
❖ Price reduction. If an oligopolistic reduces the prices of its goods below the prevailing
price level BM ($10 per unit) for increasing his sales, his competitors will also match
price changes so that their customers do not go away from them. Let us assume that
 Oligopolist has lowered the price to $4.0 per unit. Its competitors in the industry match
the price cut. The sale of the oligopolist with a big price cut of $.6.0 per unit has
increased by only 40 units (160 - 120 = 40). The firm does not gain as the total revenue
decreases with the price cut. The BD / portion of the demand curve which lies on the
right side and below point B is fairly inelastic.
❖ Rigid Prices. The firms in the oligopolist market 'have no incentive to raise or lower
the prices of the goods. They prefer to sell the goods at the prevailing price level due to
reaction function. The price BM ($10 per unit) will, therefore, tend to remain stable or
rigid, as every member of the oligopoly does not see any gain by lowering or raising
the price of his goods.

(3) Price Leadership Model:

The firms in the oligopolistic market are not happy with price competition among
themselves. They try various methods to maximize joint profits. Price leadership is one of the
means which provides relief to the firms from the strains of price competition.
The firms in the oligopolistic industry (without any formal agreement) accept the price
set by the leading firm in the industry and move their prices in line with the prices of the leader
firm. The acceptance of price set by the price leader firm maximizes the total profits of each
firm in the oligopolistic industry.
Assumptions:
The main assumptions of price leadership model under oligopoly are as under:
a) There are two firms A and B in the market.
b) The output produced by the two firms is homogeneous.
c) The firm 'A being the low-cost firm or a dominant firm acts as a leader firm.
d) Both of the firms face the same demand curve.
e) Each of the two firms has an equal share in the market. The price and output determination
under-price leadership is now explained with the help of the diagram below.

Diagram:
 In this figure 1 7.6, DD / is the demand curve which is faced by each of the two firms.
MR is the marginal revenue curve of each firm. MCa is the marginal cost of firm A and MCb is
the marginal cost of firm B. We have assumed that the firm A is a low-cost firm than firm B.
As such the MCa lies below MCb.
The leader firm using the marginalist rule of MC = MR is in equilibrium at point E. The
firm A maximizes profits by selling output OM and setting price MP. The firm B is in
equilibrium at point F where MC b = MR. The firm B maximizes profits by producing ON
output and selling it at NK price. The firm B has to compete firm A in the market, if the firm
B fixes the price NK per unit, it will not be able to compete with firm A which is selling goods
at MP price per unit.
Hence, the firm B will be compelled to follow the leader firm A. The firm B will also
charge MP price per unit as set by the firm A. The firm B will also produce QM output like the
firm A. Thus, both the firms will charge the same price MP and sell each of them OM output.
The total output will thus be twice of OM.
The firm A being the low-cost firm will maximize profits by selling OM output at MP price.
The profits of the firm B is lower than of firm A because its costs of production is higher than
of firm A.
Conclusion
After studying the pricing and output decisions under various forms of oligopoly, the
main conclusion drawn is that allocate and productive efficiency are unlikely to be achieved
under them. However, Schumpeter's view Is that oligopolists have both the Incentive and
financial and technical resources to be more technological progressive than competitive firms.
 DUOPOLY MARKET

Duopoly is a market structure in which only two sellers (producers). This is the basic form
of duopoly competition. The two players serve multiple buyers and sell competing goods and
services. In this market, players have a high strategic dependence, especially in making business
decisions such as pricing and production. If an industry is composed of only two massive firms,
each selling identical products and having half of the total market, there is every likelihood of
collusion between the two firms. The firms may agree on a price, or divide the market, or assign
quota, or merge themselves into one unit and form a monopoly or try to differentiate their
products or accept the price fixed by the leader firm, etc., etc. In case the duopolists producing
perfect substitute engage in price competition, the firm having lower costs, better goodwill and
trade will drive the rival firm out of the market and then establish a monopoly.
If the products of the duopolists are differentiate, each firm will have a close watch on
the actions of its rival firms. The firms manufacturing good quality products with lesser cost
will earn abnormal profits. Each firm will fix the price of the commodity and expand output in
accordance with the demand of the commodity in the market.
➢ Duopoly relation to Monopoly: A duopoly is close to a monopoly (one firm
dominating market). One definition of a monopoly is a firm with more than 25%
market share. If an industry has two firms (duopoly), then they will both have
significant monopoly power.
➢ Duopoly relation to Oligopoly: A duopoly is a concentrated form
of oligopoly (where several firms dominate the market). If two firms have a
market share of over 70%, then the industry will definitely meet the criteria of
an oligopoly (five firm concentration ratio of greater than 50%)

Examples of Duopoly
▪ Visa and Mastercard – two companies which process credit card payments take
around 80-90% of market share, gaining highly profitable commission on the
processing of payments. According to Reuters, Visa has 60% market share, Mastercard
30% and American Express (8.5%) (Reuters) The market share of Visa and Mastercard
have led to the EU commission investigating for monopoly power. The EU forced the
two companies to cut fees for tourists paying in different country.
 ▪ Mobile Phone Operating Systems. Apple and Android operating systems account for
97.3% of mobile operating systems, with other rivals accounting for only 2.7%
(Macworld)
▪ Aeroplane Manufacturers. Boeing and Airbus are a classic duopoly with the two
companies dominating the market for airline production with the two companies
owning 99% of the market for commercial production. Boeing used to enjoy a
monopoly until 1970 when Airbus was founded. By the 1990s, Airbus had become a
major rival. The industry for airline manufacturer has very high fixed costs and
substantial economies of scale, which means that it would be impractical for the
industry to have several competitors.
▪ Some particular Airline Routes. On routes from London to Edinburgh, there are two
aeroplane companies offering direct flights on this route – EasyJet and British Airways.
This is a pure duopoly in the particular market for direct air flights.
▪ Coca-cola and Pepsi. For the cola market, the two brand names of Coca-cola and Pepsi
dominate. In 2018, Coca-cola had 43%, Pepsi had 29%, giving a two-firm concentration
ratio of 68%. (Statista)

• Intel and Advanced Micro Devices (AMD) in the global semiconductor chip
market. Intel controls a market share of around 66.7%, and AMD controls around 33.2%
between the first quarter of 2015 and 2020.

• Android and iOS in the mobile phone operating system. Android controls a market share
of around 86.1% and iOS 13.9% for global smartphone shipments in 2019.

Duopoly Characteristics

1. Market consists of two producers. Both producers serve a large number of buyers, so
their bargaining power is high.
2. Producers have a high strategic dependence. Strategic actions and decisions by one
company have a significant impact on the competitor.
3. Chances of collusive behaviour are high. Since both of them are highly interdependent,
they are likely to collude to secure high market profits.
4. The level of competition may be fierce. This happens when the two do not collude.
Regulators usually keep a close eye on this market to avoid anti-competitive practices.
Therefore, the strict supervision of regulators means that the two cannot collude.
 5. Monopoly power is significant. Apart from controlling the market supply, the two
companies may also adopt a differentiation strategy. As long as each adopts a
differentiation strategy, each product will have several loyal customers, presenting
significant monopoly power.
6. Entry barriers are high. It can stem from structural barriers inherent in natural
characteristics of markets such as economies of scale. Or, both companies have
deliberately built entry barriers such as low-price strategies and brand loyalty.
7. Economies of scale are high. Each of the companies enjoyed high sales because the
market was split between only two companies.

Duopoly Models
There are four main duopoly models which explain the price and quantity
determinations in duopoly. These models are:

• Cournot duopoly

• Bertrand duopoly

COURNOT DUOPOLY MODEL

The earliest duopoly model was developed in 1838 by the French economist Augustin
Cournot. The model may be presented in many ways. The original version is quite limited in
that it makes the assumption that the duopolists have identical products and identical costs.
Actually, Cournot illustrated his model with the example of two firms each owning a spring of
mineral water, which is produced at zero costs. We will present briefly this version, and then
we will generalize its presentation by using the reaction curves approach.

Cournot assumed that there are two firms each owning a mineral well, and operating
with zero costs. They sell their output in a market with a straight-line demand curve. Each firm
acts on the assumption that its competitor will not change its output, and decides its own output
so as to maximize profit.

Assume that firm A is the first to start producing and selling mineral water. It will
produce quantity A, at price P where profits are at a maximum (figure 9.1), because at this
point MC =MR = 0. The elasticity of market demand at this level of output is equal to unity
and the total revenue of the firm is a maximum. With zero costs, maximum R implies maximum
profits, Π. Now firm B assumes that A will keep its output fixed (at 0/1), and hence considers
that its own demand curve is CD’. Clearly firm B will produce half the quantity AD’, because
(under the Cournot assumption of fixed output of the rival) at this level (AB) of output (and at
price F) its revenue and profit is at a maximum. B produces half of the market which has not
been supplied by A, that is, B’s output is ¼ (= ½. ½) of the total market.

Firm A, faced with this situation, assumes that B will retain his quantity constant in the
next period. So, he will produce one-half of the market which is not supplied by B. Since B
covers one-quarter of the market, A will, in the next period, produce ½ (1 – ¼) = ½. ¾ = ⅜ of
the total market

Firm B reacts on the Cournot assumption, and will produce one-half of the unsupplied
section of the market, i.e. ½ (1 – ⅜) = 5/16. In the third period firm A will continue to assume
that B will not change its quantity, and thus will produce one-half of the remainder of the
market, i.e. ½ (1 – 5/16). This action-reaction pattern continues, since firms have the naive
behaviour of never learning from past patterns of reaction of their rival. However, eventually
an equilibrium will be reached in which each firm produces one-third of the total market.
Together they cover two-thirds of the total market. Each firm maximises its profit in each
period, but the industry profits are not maximised.

That is, the firms would have higher joint profits if they recognized their
interdependence, after their failure in forecasting the correct reaction of their rival. Recognition
of their interdependence (or open collusion) would lead them to act as ‘a monopolist,’
producing one-half of the total market output, selling it at the profit-maximizing price P, and
sharing the market equally, that is, each producing one-quarter of the total market (instead of
one-third).
 The equilibrium of the Cournot firms may be obtained as follows:

Thus, the Cournot solution is stable. Each firm supplies 4 of the market, at a common
price which is lower than the monopoly price, but above the pure competitive price (which is
zero in the Cournot example of costless production). It can be shown that if there are three
firms in the industry, each will produce one-quarter of the market and all of them together will
supply ¾ (= ¼ . 3) of the entire market OD’. And, in general, if there are n firms in the industry
each will provide n /(n + 1) of the market, and the industry output will be n/(n + 1) = 1 /(n + 1)
. n. Clearly as more firms are assumed to exist in the industry, the higher the total quantity
supplied and hence the lower the price. The larger the number of firms the closer is output and
price to the competitive level.
Cournot’s model leads to a stable equilibrium. However, his model may be criticized on
several Accounts

• The behavioural pattern of firms is naive. Firms do not learn from past miscalculations
of competitors’ reactions.
• Although the quantity produced by the competitors is at each stage assumed constant,
a quantity competition emerges which drives P down, towards the competitive level.
• The model can be extended to any number of firms. However, it is a ‘closed’ model, in
that entry is not allowed: the number of firms that are assumed in the first period
remains the same throughout the adjustment process.
• The model does not say how long the adjustment period will be.
• The assumption of costless production is unrealistic. However, it can be relaxed without
impairing the validity of the model. This is done in the subsequent presentation of the
model, based on the reaction-curves approach.
• The reaction-curves approach is a more powerful method of analysis of oligopolistic
markets, because it allows the relaxation of the assumption of identical costs and
identical demands.
• This approach is based on Stackelberg’s indifference-curve analysis, which introduces
the concept of iso-profit curves of competitors. We will first establish the shape of the
iso-profit curves for substitute commodities, and from these curves we will
subsequently derive the reaction curves of the Cournot duopolists.

BERTRAND DUOPOLY MODEL

Bertrand developed his duopoly model in 1883. His model differs from Cournot’s in
that he assumes that each firm expects that the rival will keep its price constant, irrespective of
its own decision about pricing. Thus, each firm is faced by the same market demand, and aims
at the maximization of its own profit on the assumption that the price of the competitor will
remain constant. The model may be presented with the analytical tools of the reaction functions
of the duopolists.
 PRICE LEADERSHIP UNDER OLIGOPOLY

There are a number of oligopolistic organizations in the market, but one

of them is dominant organization, which is called price leader. Price
leadership takes place when there is only one dominant organization in the
industry, which sets the price and others follow it.

Sometimes, an agreement may be developed among organizations to

assign a leadership role to one of them. The dominant organization is treated
as price leader because of various reasons, such as large size of the
organization, large economies of scale, and advanced technology. According
to the agreement, there is no formal restriction that other organizations
should follow the price set by the leading organization. However, sometimes
agreement is formal in nature. Price leadership is assumed to stabilize the
price and maintain price discipline.

Definition

Price Leadership refers to a situation where the dominant firm sets up

the price of goods or services in the market. It generally happens when the
goods are homogeneous, i.e., there is no difference in the goods or services
provided by different firms. Therefore, customers don’t have a preference and
choose the lowest price. Such a model is usually seen in the Oligopolistic
market, where competition is less.

Price Leadership Example

• Indian Telecom Company (Reliance JIO) gave a free Internet and calling
facility more than six months after its launch. The existing telecom
providers were charging for both Internet and calling.
• Previously customers used to limit internet usage to 2GB per month.
After the launch of JIO, they started using unlimited data daily. It was
a revolution. The calling was made entirely free.
 • It led to a huge change in the telecom industry of INDIA. Several small
providers started Merging to survive or exit from the market.
• Slowly, when JIO started charging cheap rates from customers every
month, other providers had to follow the pricing mechanism of JIO to
survive. It is an example of price leadership.

Types of Price Leadership:

Price leadership helps in stabilizing prices and maintaining price
discipline. There are three major types of price leadership, which are present
in industries over a passage of time.

These Three Types of Price Leadership are explained as follows:

i. Dominant Price Leadership:

Refers to a type of leadership in which only one organization dominates
the entire industry. Under dominant price leadership, other organizations in
the industry cannot influence prices. The dominant organization uses its
power of monopoly to maximize its profits and other organizations have to
adjust their output with the set price. The interests of other organizations are
ignored by the dominant organization. Therefore, dominant price leadership
is sometimes termed-as partial monopoly. Price leadership by the leading
organization is most commonly seen in the industry.

ii. Barometric Price Leadership:

Refers to a leadership in which one organization declares the change in
prices at first and assumes that other organizations would accept it. The
organization does not dominate others and need not to be the leader in the
industry. Such type of organization is known as barometer. This barometric
organization only initiates a reaction to changing market situation, which
other organizations may follow it if they find the decision in their interest. On
the contrary, the leading organization has to be accurate while forecasting
demand and cost conditions, so that the suggested price is accepted by other
organizations.
 Barometric price leadership takes place due to the following
reasons:
a. Lack of capacity and desire of organizations to estimate appropriate
supply and demand conditions. This influences organizations to follow
price changes made by the barometric organization, which has a proven
ability to make correct forecasts.

b. Rivalry among the organizations may make a leader, which can be

unacceptable by other organizations. Thus, most of the organizations
prefer barometric price leadership.

iii. Aggressive Price Leadership:

Implies a leadership in which one organization establishes its
supremacy by threatening the organizations to follow its leadership. In other
words, a dominant organization establishes leadership by following aggressive
price policies and forces other/organizations to follow the prices set by it.

This also helps in attaining effective price leadership, which works under
the following conditions:

i. When the number of organizations is small

ii. Entry to the industry is restricted

iii. Products are homogeneous

iv. Demand is inelastic or less elastic

v. Organizations have similar cost curves

Price-Output Determination under Price Leadership:

Price leadership takes place when there is only one dominant
organization in the industry, which sets the price and others follow it.
Different economists have developed different models for determining price
and output in price leadership.

Here, we would discuss a simple model for determining price and

output in price leadership, which is shown in Figure-4:
 Suppose there are two organizations, A and B producing identical
products where organization A has a lower cost of the production than
organization B. Therefore, consumers are indifferent between these two
organizations due to identical products. This implies that both the
organizations would face same demand curve, which further represents equal
market share.

In Figure-4, DD is the demand curve of both the organizations and MR

is their marginal revenue. MCa and MCb are the marginal cost curves of
organization A and B respectively. As stated earlier, the cost of production of
organization A is less than B, thus, MCa is drawn below MCb.
Let us first start the discussion of price leadership with the case of
organization A. The profits of organization A would be maximized at a point
where MR intersects MCa. At this point, the output of organization A would
be OQ with the price level OP. On the other hand, the profits of organization
B would be maximized at a point where MR intersects MCb with output
OQ1 and price OP1.
In such a case, the price of organization B is more as compared to
organization A. However, both the organizations have to charge the same price
as products are homogeneous. In this case, organization A is the price leader
and organization B is the follower. Thus, organization A will dictate the price
to organization B. Both the organizations will follow the same output, OQ and
price OP. However, the profits earned by organization B are less than A, as it
has to produce at price OP which is less than its profit maximizing price, OP1.
In addition, the organization B also has high costs of production that leads to
lower profits at price OP1.
Advantages

• It reduces price wars. In price leadership, small firms follow the price
of the dominant firms, so they are not engaged in a price war to gain
market share, which reduces the profitability for all firms.
• If a market leader increases the price and another small firm follows it,
it will increase the probability for all the small firms and the big firm.
So small firms are enjoying the price set by the leaders.
• When the dominant firm decreases the price and other firms follow,
buyers gain from the low prices. It helps to increase savings as money
is saved.

Drawbacks of Price Leadership:

The price leadership suffers from various drawbacks.

i. Makes it difficult for the price leader to assess the reactions of

followers.

ii. Leads to malpractices, such as charging lower prices by rival

organizations in the form of rebates, money back guarantees, after
delivery free services, and easy instalment facility. The prices charged
by rival organizations are comparatively less than the prices set by the
price leader.

iii. Leads to non-price competition by rival organizations in the form of

aggressive promotion strategies.

iv. Influences new organizations to enter into the industry because of

price rise. These new organizations may not follow the leader of the
industry.

v. Poses problems if there are differences in cost of price leaders and

price followers. In case, if cost of production of price leader is less, then
 he/she would fix lower prices. This will lead to a loss for a price follower
if his/her cost of production is more than the price leader.

Conclusion

Price Leadership is often followed when a strong firm tries to show its
presence in the market. Following price leadership and not engaging in a price
war is beneficial for small firms. There should be regulations to control price
leadership if the motive behind the price leadership is a monopoly or to charge
higher prices from buyers.
Problems of Price Determination under Oligopoly:

In an oligopoly market the determination of price and output by a firm

creates problems. The main problem arises in the construction of a stable and
a certain demand curve for the product of an oligopolist. This point may be
explained further.

NON-COLLUSIVE OLIGOPOLY:

SWEEZY’S KINKED DEMAND CURVE MODEL:

The kinked demand curve of oligopoly was developed by Paul M. Sweezy
in 1939. Instead of laying emphasis on price-output determination, the model
explains the behavior of oligopolistic organizations. The model advocates that
the behavior of oligopolistic organizations remain stable when the price and
output are determined.

This implies that an oligopolistic market is characterized by a certain

degree of price rigidity or stability, especially when there is a change in prices
in downward direction. For example, if an organization under oligopoly
reduces price of products, the competitor organizations would also follow it
and neutralize the expected gain from the price reduction.

On the other hand, if the organization increases the price, the

competitor organizations would also cut down their prices. In such a case, the
organization that has raised its prices would lose some part of its market
share.

The kinked demand curve model seeks to explain the reason of price
rigidity under oligopolistic market situations. Therefore, to understand the
kinked demand curve model, it is important to note the reactions of rival
organizations on the price changes made by respective oligopolistic
organizations.

There can be two possible reactions of rival organizations when there

are changes in the price of a particular oligopolistic organization. The rival
organizations would either follow price cuts, but not price hikes or they may
not follow changes in prices at all.

A kinked demand curve represents the behavior pattern of oligopolistic

organizations in which rival organizations lower down the prices to secure
their market share, but restrict an increase in the prices.

Following are the assumption of a kinked demand curve:

i. Assumes that if one oligopolistic organization reduces the prices,
then other organizations would also cut their prices

ii. Assumes that if one oligopolistic organization increases the prices,

then other organizations would not follow increase in prices

iii. Assumes that there is always a prevailing price

A kinked demand curve model is explained with the help of Figure-2:

The slope of a kinked demand curve differs in different conditions, such

as price increase and price decrease. In this model, every organization faces
two demand curves. In case of high prices, an oligopolistic organization faces
highly elastic demand curve, which is dd’ in Figure-2.
 On the other hand, in case of low prices, the oligopolistic organization
faces inelastic demand curve, which is DD’ (Figure-2). Suppose the prevailing
price of a product is PQ, as shown in Figure-2. If one of the oligopolistic
organizations makes changes in its prices, then there can be three reactions
of rival organizations.

▪ Firstly, when the oligopolistic organization would increase its prices, its
demand curve would shift to dd’ from DD’. In such a case, consumers
would switch to rivals, which would lead to fall in the sales of the
oligopolistic organization. In addition, the dP portion of dd’ would be
more elastic, which lies above the prevailing price.

On the other hand, if price falls, the rivals would also reduce their
prices, thus, the sales of the oligopolistic organization would be less. In
such a case, the demand curve faced by the oligopolistic organization
is PD’, which lies below the prevailing price.

▪ Secondly, rival organizations will not react with respect to changes in

the price of the oligopolistic organization. In such a case, the
oligopolistic organization would face DD’ demand curve.

▪ Thirdly, the rival organizations may follow price cut, but not price hike.
If the oligopolistic organization increases the price and rivals do not
follow it, then consumers may switch to rivals. Thus, the rivals would
gain control over the market. Thus, the oligopolistic organization would
be forced from dP demand curve to DP demand curve, so that it can
prevent losing its customers.

This would result in producing the kinked demand curve. On the other
hand, if the oligopolistic organization reduces the price, the rival organizations
would also reduce prices for securing their customers. Here, the relevant
demand curve is Pd’. The two parts of the demand curve are DP and Pd’, which
is DPd’ with a kink at point P.
 Let us draw the MR curve of the oligopolistic organization. The MR curve
would take the discontinuous shape, which is DXYC, where DX and YC
correspond directly to DP and Pd’ segments of the kinked demand curve. The
equilibrium point is attained when MR = MC. In Figure-2, the MC curve
intersects MR at point Y where at output OQ.

At point Y, the organization would achieve maximum profit. Now, if cost

increases, the MC curve would move upwards to MC. In such a case, the
oligopolistic organization cannot increase the prices. This is because if the
organization would increase the prices, the rival organizations would decrease
their prices and gain the market share. Moreover, the profits would remain
same between point X and Y. Thus, there is no motivation for increasing or
decreasing prices. Therefore, price and output would remain stable.

The MR curve has two segments:

At output less than OQ the MR curve (i.e., dA) will correspond to DE
portion of AR curve, and, for output larger than OQ, the MR curve (i.e., BMR)
will correspond to the demand curve ED. Thus, discontinuity in MR curve
occurs between points A and B. In other words, between these two points, MR
curve is vertical.

Equilibrium is achieved when MC curve passes through the

discontinuous portion of the MR curve. Thus the equilibrium output is OQ,
to be sold at a price OP.

Suppose, costs rise. As a result, MC curve will shift up from MC1 to

MC2. The resulting price and output remain unchanged at OP and OQ,
respectively. This fact explains stickiness of prices. In other words, in
oligopolistic industries price is more stable than costs.
At first sight, the model seems to be attractive since it explains the
behaviour of firms realistically. But the model has certain limitations. Firstly,
it does not explain how the ruling price is determined. It explains that the
demand curve has a kink at the ruling price.
 In this sense, it is not a theory of pricing. Secondly, price rigidity
conclusion is not always tenable. Empirical evidence suggests that higher
costs force a further price rise above the kink. Despite these limitations, the
model is popular among textbook authors.

However, kinked demand curve model is criticized by various

economists.

Some of the major points of criticism are as follows:

i. Lays emphasis on price rigidity, but does not explain price itself.

ii. Assumes that rival organizations only follow price decrease, which
does not hold true empirically.

iii. Ignores non-price competition among organizations. Non-price

competition can be in terms of product differentiation, advertising,
and other tools used by organizations to promote their sales.

iv. Ignores the application of price leadership and cartels, which

account for larger share of the oligopolistic market.

COLLUSION MODEL-THE CARTEL:

In oligopolistic market situations, organizations are indulged in high
competition with each other, which may lead to price wars. For avoiding such
type of problems, organizations enter into an agreement regarding uniform
price-output policy. This agreement is known as collusion, which is opposite
to competition. Under collusion, organizations are involved in collaboration
with each other to take combined actions for keeping their bargaining power
stronger against consumers.

Some of the popular definitions of collusion are as follows:

 According to Samuelson, “Collusion denotes a situation in which two or
more firms jointly set that prices or output, divide the market among
them, or make other business decisions.”

In the words of Thomas J. Webster, “Collusion represents a formal

agreement among firms in an oligopolistic industry to restrict
competition to increase industry profits.”

Collusion helps oligopolistic organizations in many ways.

Some of the benefits of collusion are as follows:

i. Helps organizations to increase their performance

ii. Helps organizations in preventing uncertainties

iii. Provides opportunities to prevent the entry of new organizations

The agreement of collusion formed may be tacit or formal in nature. A

formal agreement formed among competing organizations is known as cartel.
In other words, cartel can be defined as a group of organizations that together
make pricing and output decisions.

Some of the management experts have defined cartel in the following

ways:
According to Leftwitch, “the firms jointly establish a cartel organization
to make price and output decisions, to establish production quotas for
each firm, and to supervise market activities of the firms in the
industry.”

According to Khemani and Shapiro, “Cartels are productive structures

involving multiple producers acting in unison that allow producers to
exercise monopoly power.”

In the words of Boyce and Melvin, “A cartel is an organization of

independent firms, whose purpose is to control and limit production
and maintain or increase prices and profits.”
 According to Webster, “A cartel is a formal agreement among firms in
an oligopolistic industry to allocate market share and/or industry
profit.”

Under cartels, the price and output determination is done by the

common administrative authority, which aims at equal profit distribution
among all member organizations under cartel. The total profits are distributed
in proportion as decided among member organizations. The most famous
example of cartel is Organization of the Petroleum Exporting Countries
(OPEC), which has shared control of petroleum markets.

Let us understand price and output decisions under cartels with the
help of an example. Assume that there are two organizations that have formed
a cartel.

The price and output decisions of these two organizations are shown in
Figure-3:

In Figure-3 (c), AR is the aggregate demand curve of both the

organizations and MC curves are the addition of MC1 and MC2 curves of
organizations A and B, respectively. The total output of industry is determined
according to MR and MC of the industry. In Figure-3 (c), OQ and OP are the
equilibrium price and output of the industry.
Now, this output will be allocated among the organizations. This can be
done by drawing a horizontal line from equilibrium point E of industry,
towards MC curves of organizations A and B. The points of intersection E1 and
E2 are the equilibrium levels of the organizations, A and B, respectively.
OQ1 is the equilibrium output of organization A and OQ2 is the equilibrium
output of organization B. Thus, OQ1 + OQ2 = OQ. These levels of outputs
ensure the maximum joint profits of member organizations.

COLLUSIVE OLIGOPOLY MODEL: PRICE LEADERSHIP MODEL:

Non-collusive oligopoly model (Sweezy’s model) presented in the earlier
section is based on the assumption that oligopoly firms act independently
even though firms are interdependent in the market. A vigorous price
competition may result in uncertainty.

The question that arises now is: how do oligopoly firms remove
uncertainty? In fact, firms enter into pricing agreements with each other
instead of adopting competition or price war with each other. Such
agreement—both explicitly (or formal) and implicit (or informal)—may be
called collusion.

Always, every firm has the inclination to achieve more strength and
power over the rival firms. As a result, in the oligopolist industry, one finds
the emergence of a few powerful competitors who cannot be eliminated easily
by other powerful firms.

Under the circumstance, some of these firms act together or collude

with each other to reap maximum advantage. In fact, in oligopolist industry,
there is a natural tendency for collusion. The most important forms of
collusion are: price leadership cartel and merger and acquisition.

When a formal collusive agreement becomes difficult to launch,

oligopolists sometimes operate on informal tacit collusive agreements. One of
the most common form of informal collusion is price leadership. Price
leadership arises when one firm—may be a large as well as dominant firm—
initiates price changes while other firms follow.

An example of dominant firm price leadership is shown in Fig. 5.20

where DT is the industry demand curve. Since small firms follow the leader—
the dominant firm—they behave as “price-takers”. MCs is the horizontal
summation of the MC curves of all small firms.
 Suppose, the dominant firm sets the price at OP1 (where DT and MCs
intersect each other at point C). The small firms meet the entire demand P1C
at the price OP1. Thus, the dominant firm has nothing to sell in the market.
At a price of OP3, the small firm will supply nothing. It is obvious that price
will be set in between OP1 and OP3 by the leader.
The demand curve faced by the leader firm of the oligopoly industry is
determined for any price—it is the horizontal distance between industry
demand curve, DT, and the marginal cost curves of all small firms, MCS. In
Fig. 5.20, DL is the leader’s demand curve and the corresponding MR curve is
MRL.
Being a leader in the industry, the dominant firm’s supply curve is
represented by the MCL curve. Since it enjoys a cost advantage, its MC curve
lies below the MCS curve.
A dominant firm maximizes profit at point E where its MCL and
MRL intersect each other. The corresponding output of the price leader is OQL.
Price thus determined is OP2. Small firms accept this price OP2 and sell
QLQT (=AB) amount – industry demand the OQT output.
In actual practice, the analysis of price leadership is complicated, particularly
when new firms enter the industry and try to become the leader or dominant.

Collusive Oligopoly—Merger and Acquisition:

Another method to remove price war among oligopoly firms is merger.
Merger may be defined as the consolidation of two or more independent firms
under single ownership. When a firm purchases asset of another firm,
acquisition takes place. Merger and acquisition take place because the
management comes to a conclusion that a consolidated firm is powerful than
the sum of individual firms.

Since basically the difference between cartel and merger is a legal one,
we won’t consider mergers and acquisitions. The marginalist principle applied
in the case of profit maximizing cartel is also applicable in the case of merger.

Conclusion:
Can we make some definite conclusions from the oligopolistic market
structure? Though one can make unambiguous predictions about perfect
competition as well as monopoly, no such predictive element of an oligopolistic
competition exists. It is, thus, a perplexing market structure. One important
characteristic of an oligopoly market is interdependence among sellers. Each
seller’s price-output decision is influenced by the perceptions of countermoves
of rival sellers. Given the large number of possible reactions, we come up with
different models based on different assumptions about the behaviour of the
rival sellers, the extent and form of exit and entry, the likelihood of collusion
between firms. ‘Unfortunately, economic theory does not suggest which
assumptions to use. In any event, each of these theories must ultimately
stand or fall on its predictive powers’.