Ch 17 Oligopoly PDF

# 17 Oligopoly ## Concept of Oligopoly Oligopoly is a form of market in which there are a few big firms and a large number of buyers of a commodity. Each firm has a significant share of the market. Price and output decision of one firm significantly impacts the price and output decisions of the ri...

# 17 Oligopoly ## Concept of Oligopoly Oligopoly is a form of market in which there are a few big firms and a large number of buyers of a commodity. Each firm has a significant share of the market. Price and output decision of one firm significantly impacts the price and output decisions of the rival firms in the market. Accordingly, there is a high degree of interdependence among the competing firms, price and output policy of one firm depends on the price and output policy of other(s). This type of competition (involving a high degree of interdependence) is called 'cut-throat competition'. An oligopoly industry produces either a homogeneous product or a heterogeneous products. The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated oligopoly. Pure oligopoly is found primarily among producers of such industrial products as cement, copper, steel, aluminum, etc. Imperfect oligopoly is found among producers of such consumer goods as automobiles, cigarettes, soap and detergents, refrigerators, rubber, tyres and TVs. The special case of a market dominated by two firms is called a 'Duopoly'. ### Definition 1. According to P.G. Dooley, “An oligopoly is a market of only a few sellers offering either homogeneous or differentiated products. There are so few sellers that they recognise their mutual dependence." 2. In the words of Grinols, "An oligopoly is market situation in which each of a small number of interdependent competing producers influences but does not control the market." 3. In the words of Mansfield, “Oligopoly is a market structure characterised by a small number of firms and a great deal of interdependence." ## Features/Characteristics Of Oligopoly Following are some principal features of oligopoly : - **Small number of big firms** Oligopoly is a market in which there is a small number of big firms. Each firm commands a significant share of the market and hence can impact the market price of the product. A firm working under oligopoly form of market enjoys partial control over price through brand loyalty. Brand loyalty is achieved through heavy advertisement. However, full control (over price) is not possible as there are competitors in the market. - **Homogeneous or Differentiated Products** Firms in oligopolistic industry may produce either homogeneous or differentiated product. If the firms produce a homogeneous product like cement or steel the industry is called a pure or a perfect oligopoly. If the firms produce a product like automobiles, the industry is called differentiated or imperfect oligopoly. - **Interdependence** There is a recognised interdependence among the sellers in the oligopolistic market. Each oligopolist firm knows that changes in its price, advertising, product characteristics, etc. may lead to counter-moves by the rivals. This is because when the number of sellers is a few, any change in price, output policy by a firm will have direct effect on the fortune of the rivals, who will then retaliate in changing their own prices, output or advertising technique as the case may be. It is, therefore, clear that an oligopolistic firm must consider not only the market demand for the industry product, but also the reaction of other firms in the industry to any major decision it takes. - **Importance of advertising and selling costs** A direct effect of the interdependence of oligopolists is that the various firms have to employ various aggressive and defensive marketing weapons to gain a greater share in the market or to maintain their share. For this, various firms have to incur a good deal of costs on advertising and other measures of sales promotion. Therefore, there is a great importance of advertising and selling costs in an oligopoly market. It is to be noted that firms in such type of market avoid price cutting and try to compete on non-price basis, because if they start under cutting one another a type of ‘price-war’ will emerge which will drive a few of them out of the market as customers will try to buy from the seller selling at the cheapest price. - **Price rigidity and non-price competition** Oligopoly markets are characterised by rigid prices. Once a price comes to prevail, it continues for years as such in spite of changes in costs and demand. Firms tend to stick to the established price and limit their competitive effort to non-price competition–change in the design and advertising of the product. Maintaining quoted prices constant, firms try to improve their position in the market through various types of concessions to the consumers, free delivery through rail, guarantee and warranty for some time, repair facilities some kind of gifts with the product, etc. - **Entry barriers** There are some types of barriers to entry which tend to restraint new firms from entering the industry. They may be: - (i) economies of scale enjoyed by a few large firms; - (ii) Control over essential and specialised inputs; - (iii) high capital requirements due to plant costs, advertising costs, etc. - (iv) exclusive patents and licenses; and - (v) The existence of unused capacity which makes the industry unattractive. When an entry is restricted or blocked by such natural and artificial barriers, the oligopolistic industry can earn long-run super-normal profits. ## Difficult to trace firms’s demand curve It is not possible to trace the demand curve for the product of an oligopolist. Since under oligopoly the exact behaviour pattern of a producer cannot be ascertained with certainty, his demand curve cannot be drawn accurately, and with definiteness. How does an individual seller’s demand curb look like in oligopoly is most uncertain because a seller’s price or output moves lead to unpredictable reactions on price-output policies of his rivals, which may have further repercussions on his price and output. The chain of action reaction as a result of an initial change in price or output is all a guess-work. Thus, a complex system of crossed conjectures emerges as a result of the interdependence among the rival oligopolists which is the main cause of the indeterminateness of the demand curve. ## Formation of cartels With a view to avoiding competition, oligopoly firms often form cartels. It is a formal agreement among the firms to avoid competition. It is sort of collision of the competing firms but against the competition. Therefore, it is often called collusive oligopoly. Under it, output and price are fixed by different firms as a group. Sometimes, a leading firm in the market is accepted by the cartel as a ‘price-leader’. All firms in the cartel accept the price as set by the price leader. Collusive oligopoly is like a monopoly form of market. A cartel takes full control of the market. It makes monopoly profits. ## No unique pattern of pricing behaviour The rivalry arising from interdependence among the oligopolists leads to two conflicting motives. Each wants to remain independent and to get the maximum level of profit. Towards this end, they act and react on the price-output movements of one another in a continuous element of uncertainty. On the other hand, again motivated by profit maximisation each wishes to co-operate with his rivals to reduce or eliminate the element of uncertainty. All rivals enter into a tacit or formal agreement with regard to price-output changes. It leads to a sort of monopoly within an oligopoly. They may even recognise one seller as a leader at whose initiative all the other sellers rise or lower the price. In this case, the individual seller’s demand curve is a part of the industry demand curve, having the elasticity of the latter. Given these conflicting attitudes, it is not possible to predict any unique pattern of pricing behaviour in an oligopoly market. ## Forms/Classification of Oligopoly - **Pure and differentiated oligopoly** Oligopoly situations can be classified as pure (or perfect) and differentiated (or imperfect) on the basis of the presence or absence of differentiation. If the products of the various firms are homogeneous, the term pure oligopoly is applied. Pure oligopoly is found in some of the capital-goods industries, such as cement production. Mutual interdependence will be greater when products are identical than when they are differentiated. Since any price change by one firm is certain to produce substantial effects upon the sale of competitors and cause them to change their prices. On the other hand, in differentiated oligopoly, the products are not homogeneous, price changes will have a less direct effect on competitors, because of practical isolation of the market for each firm. The stronger the differentiation, the weaker will be the feeling of mutual interdependence. Differentiated oligopoly is characteristic of a very large portion of the economy, including most consumer goods manufacturing industries, and retail trade in most areas. The degree of differentiation and strength of feeling of mutual interdependence vary widely among the industries. This fact greatly complicates the development of a model for price-output analysis. - **Collusive and non-collusive oligopoly** Collusive oligopoly is a form of the market in which there are few firms in the market and all decide to avoid competition through a formal agreement. They collude to form a cartel. Price and output of the member firms are fixed as a collective/co-operative decision. Sometimes a leading firm in the market is accepted by the cartel as price leader members of the cartel accept the price policy as specified by the price leader. Non-collusive oligopoly is a form of the market in which there are few firms in the market, and each firm pursues its own price and output policy independent of the rival firms. Each firm tries to increase its market share through competition. Competition is preferred to collusion as a means of profit maximisation, because there are only a few big firms in the market, there is a rut-throat competition. Bond loyalty is developed through aggressive advertisement. - **Open or closed oligopoly** Open oligopoly is that market situation in which there is no barrier on the entry of new firms in the industry. Closed oligopoly, on the other hand, is characterised by so many barriers, particularly those related to ‘patent rights’. - **Partial or full oligopoly** Partial oligopoly is that situation in which there is a dominant firm, overshadowing all other firms in the industry. This dominant firm often enjoys the status of price leader. It fixes the market price and others simply accept it. Full oligopoly, on the other hand, is a situation in which there is no dominant firm or price leader in the market ## Pricing Under Pure Oligopoly We now analyse how prices are determined in the case of pure oligopoly, that is oligopolists selling a homogeneous commodity. - **(1) Independent Pricing** For the sake of simplicity let us assume that all oligopoly firms have identical costs and equal share of the market. In Fig. 1 AR is the demand curve of an oligopoly firm, MR is its marginal revenue curve and MC the marginal cost curve. MR and MC curves intersect at E. So the firm is in equilibrium with output OQ and price OP. it maximises profit in this situation of equilibrium. It can be generalised that when demand and cost conditions of oligopoly firms are almost identical, independent action of each firm determines the equal price of the commodity. This generalisation, however, is not all because the price so determined is the monopoly price. The reason for the determination of monopoly price is that the number of firms is very small and not that the oligopolists try to maximise profit. The assumption of maximum profit will not be something extra-ordinary for the oligopolists. When the number of sellers is very large, each firm can think that the impact of its price policy will be so negligible for others that its rivals will take no notice of it. So in order to sell more, each firm lowers its price . When the number of firms in the industry is small and one firm does not notice the price cut by others, competitive price will be determined. But the reality is that in the case of only a few firms in the industry, the action of one firm will be noted by others and proper reaction will follow. Hence it becomes doubtful that independent pricing is possible under oligopoly. Every oligopoly firm suffers from a feeling of uncertainty and insecurity. Each firm is likely to be a prey of such selfish feeling that it should seize a large part of the market. In addition, the firm grows in size with time. On the other hand, each firm does not have the same cost function. Firms of different sizes and costs follow different price policies. But there is the possibility that because of uncertainty and insecurity firms may resort to price leadership and collusion. - **(2) Price Wars** Often oligopolists are fired by the ambitions of increased sales and an influential place in the industry. Pure oligopolists are likely to take the help of advertisements to attain their ambitions. Policy of price cutting may also be adopted for this purpose. But price cutting policy is adopted by oligopolists with great hesitation because it may spoil the market, or may lead to retaliation and it may be against business ethics. Yet, price cutting may be adopted if oligopolist is ambitions or he expects that other firms will resort to it after a long time gap. This policy often leads to price wars. In other words, if one firm cuts price, other retaliate by doing the same. Ordinary cut in prices is not price war. All price wars are price cuts, though all cuts in prices are not price wars. The earmark of a price war is to force the rival to the wall or at least to injure him. Price is cut so much that it becomes less than the average total cost or the average variable cost of the rivals. The following may be the objectives of price wars: - (i) to seize the major part of the total sale, - (ii) to expand the monopoly power after victory, or - (iii) to threaten the rivals so that they accept its leadership. But price war is not an easy thing. A number of important things must be noted before adopting it, such as cost, demand for the commodity, the amount of profit to be earned after the defeat of the rival. - **( 3)Price Leadership** Independent pricing is seldom possible in oligopoly. Greater possibility is that oligopoly firms will come to some sort of collusion. Agreement may be of two types, namely, (a) tacit agreement and (b) formal agreement or cartel. Tacit agreement comes into existence without mutual talk and without correspondence. Such agreement can be seen in the uniform price policy in the behaviour of the firms. Formal agreement comes into being through mutual consultation. Tacit agreement often takes the form of price leadership which can take the following forms: - (i) **Leadership of the dominant firm:** One of the oligopoly firms, by controlling the major share of total output, can dominate the market as a monopolist. The other small firms do not challenge this leadership due to motives ranging from fear to convenience to laziness. The dominant firm has the knowledge of total demand and costs of production of small firms. Like a monopolist, the largest firm determines its price by equating marginal revenue with marginal cost. The small firms treat the leader’s price as if it were their marginal revenue. Then they adjust their outputs so that their marginal cost equals the leader’s price and maximise their profits. The remaining output is sold by the leader. Small firms cannot charge a higher price because, at the higher price, it cannot sell anything. (We are analysing the case of pure oligopoly when the product of all firms is homogeneous.) They will not lower the price either because at the price fixed by the leader they can sell all they produce. At the leader’s price, the demand curves of small firms become horizontal. - **(ii) Barometric price leadership:** The largest or oldest, most experienced or respected firm evaluates demand, cost, reactions from related commodities and trade cycle changes. The firm chosen as the leader is considered as a barometer. On the basis of evaluation the new price is fixed which is acceptable to other firms. Whether or not the price initiative is followed depends upon how closely the change reflects market conditions common to all. A firm belonging to another industry (say, steel) may be accepted as a barometric leader of another industry (say, motor-car). - **(iii) Exploitative or aggressive price leadership:** In this type of price leadership, the strongest firm may try to oust some of its rivals or may compel other firms to accept its leadership. One type of such leadership may be a price war. Analysis of price leadership cannot be of any one type because assumptions can take different forms requiring separate examination. Complex mathematics may be needed for such examination. ## (4) Formal Agreement: Cartel Cartel is an important state of oligopoly. Any formal agreement is called a cartel. It is an open agreement among firms. Through a formal agreement, i.e., cartel, oligopoly firms cooperate with regard to agreed procedures on such variables as price and output. With the establishment of cartel, oligopoly, in fact, becomes a monopolist. Yet, the analysis of cartel is done under oligopoly because cartel may not continue in the long run. The objective behind the formation of the cartel is maximum joint profit, but the division of this profit leads to the dispute which results in the break-up of the cartel. Cartel may be perfect or imperfect. A perfect cartel is one to which individual oligopoly firms surrender their freedom totally. Non-surrender of total freedom results in an imperfect cartel which does not last long. Analysis of a perfect cartel in presented in Fig. 3. The objective of a complete cartel is the maximisation of joint profit, i.e., industry profit. In the figure AD is the demand curve of the cartel, while AF is its marginal revenue curve. MC, is the marginal cost of the cartel. At point E, cartel’s marginal revenue equals its marginal cost. So OQ is the equilibrium output. If the marginal cost of any oligopoly firm be MC, its output is OB, given by the intersection of its marginal cost and cartel’s marginal revenue. Perfect cartel is a polar case. It maximises joint profit. But it also entails the complete surrender of the decision-making power of the firm. But cartel, in fact, is such an agreement between firms which keep to themselves their freedom and separate existence. Firm’s reluctance to surrender their freedom completely is the cause of the short life of a cartel. Thus cartels are always imperfect. It means that though they are capable of raising both output and prices, yet they cannot reach the state of a monopoly. There are two models of imperfect cartels: - (A) Cartels aiming at joint (industry) profit maximisation; and - (B) Market-sharing cartels. - **( A) Joint-profit maximising cartels** Cartels reduce the uncertainty which arises from the mutual interdependence of competing oligopolists. Here the aim is maximisation of industry (joint) profit. In the case of pure oligopoly, that is, all oligopolists producing a homogeneous product and perfect cartel, the allocation of production among the members of the cartel and the distribution of maximum joint profit among the participating members will take place in the manner shown in Fig. 4 which is an expanded form of Fig. 3. The above monopoly solution is theoretically easy for the cartel to derive, but, in practice, it rarely gets maximum joint profit for the following reasons¹: - (i) Mistakes in the anticipation of market demand; - (ii) Mistakes in the estimation of marginal cost; - (iii) Slow process of cartel negotiations; by the time agreement is reached, conditions might change; - (iv) Stickiness of the negotiated price; - (v) The bluffing attitude of some members during the bargaining process; - (vi) Fear of government interference; - (vii) Fear of entry; and - (viii) Keeping freedom regarding design and advertising. "It is clear that there are two many exceptions to the theory of joint profit maximisation for it to be a satisfactory theory of oligopolistic behaviour." - **( B) Market-sharing cartels** This form of the cartel is more popular because it is more common in practice. It is an imperfect cartel because the firms come to an agreement over market sharing only and keep freedom regarding the style of their output, their selling activities and other decisions. There are two basic methods of market sharing, namely, (i) non-price competition agreements and (ii) agreement on quotas. - **(i) Non-price competition agreements:** It is a form of imperfect or loose cartel. Members of the cartel agree on a common price at which they can sell any quantity demanded. They agree not to sell at a price below this agreed price. But there is no restriction on them over variation in the style of their product and their selling activities. It means that the cartel members can compete on a non-price basis, i.e., regarding the quality and appearance of the product as also advertising and other selling costs. - **(ii) Agreement on quotas:** It means agreement on the quantity that each firm may sell at the common (agreed) price. In the case of identical costs of all firms, the monopoly price will result and each firm will have equal the share of the market. When costs are different, quotas and market shares will be different and will be determined by: - the level of costs of the firm; - bargaining skill of the firm; - past levels of sales; and - capacity of the firm. “Cartel models of collusive oligopoly are ‘closed’ models. If the entry is free, the inherent instability of cartels is intensified : the behaviour of the entrant is not 'predictable' with certainty."² ## Pricing Under Differentiated Oligopoly Differentiated oligopoly is a mixture of pure oligopoly and monopolistic competition. Like pure oligopoly, there are only a small number of sellers and like monopolistic competition, there is product differentiation. Monopoly element is imparted to pure oligopoly by the smallness of a number of the firms. In differentiated oligopoly, both smallness of number and product differentiation impart monopoly element to firms. - **Independent and Collusive Pricing** The basic elements of price determination in a differentiated oligopoly are the same as in pure oligopoly. There are only a few firms, each producing products of different qualities. Each firm tries to maximise profits and while determining price, each has to consider the reaction of the rival firms. Independent pricing will lead to monopoly price. The maximum price that each will charge will differ because each produces a different product. Collusive pricing is also possible under differentiated oligopoly. Price fixed by the cartel for each firm will hover around monopoly price. Another possibility is that the cartel-determined price serves as a reference price and each firm has the freedom to fix the price separately according to the characteristics of its product, demand and cost on the basis of this reference price. - **Price Leadership** Like pure oligopoly price leadership may emerge in differentiated oligopoly too. One firm fixes the price which is followed by other firms. Price charged by other firms may be equal to leader’s price or a little different from it. Sometimes one firm will be the leader, sometimes another firm. - **Differences in Prices** Whatever way price is determined in differentiated oligopoly—independently or under price leadership or through collusion—there are two differences from price under pure oligopoly. They are: - ( i) differences in the prices of different firms and - ( ii) non-price competition. In the case of a homogeneous product, different firms may charge the same price. If one firm lowers the price, buyers may turn to other firms (sellers). So if one firm reduces the price, the rivals are likely to do so. But when different firms do not produce and a sell homogeneous product, price need not be same. If design, quality and brand widely differ, wide differences in prices are likely. But if these differences are very small, differences in different firms’ prices will also be very small. The result of differences in prices would mean that the demand curve of each seller becomes more indeterminate compared to pure oligopoly. Accordingly, uncertainty increases about the increase in demand due to the price cut. Differences in prices lead to a second result. It will be even more difficult to form a cartel even in pure oligopoly. Difficulty increases many folds in differentiated oligopoly. - **Non-Price Competition** Price-cutting policy is very unpopular among oligopolists. Product differentiation and advertisements are more popular. It is for the reason that there is an immediate response to price cutting by the rivals, change in quality cannot be copied easily. - **Selling Costs** Inclusion of selling costs makes the analysis of price determination even more complex. Now three problems arise before the oligopolist, namely, - ( a) At what price the commodity to be sold; - ( b) How to change the quality of the product; and - ( c) What amount to be spent on advertisement to earn maximum profit. It is a situation very similar to one that arises in monopolistic competition. But oligopolists face greater difficulties on account of their larger interdependence. - **Price Rigidity and Kinky Demand Curve** Oligopolists do not want to change the prices of their products very often. Once established, oligopoly price may remain constant for months, sometimes even for a few years because agreement over prices comes after hard bargaining and no one would like to reopen the issue. A fall in demand may not lead to a price cut but to a aggressive advertising to increase sales. Prices in oligopolistic industries which remain unchanged are said to be “rigid". They are in contrast to competitive prices which are "flexible". Rigidity of prices should be distinguished from the constancy of prices. The former means the lack of movement in spite of changes in demand or in costs or in both. In the early part of the twentieth century, prices in American Steel Industry was remarkably stable. The industry had few firms and it was fit to be called an oligopoly. The unusually stable prices were sought to be explained in terms of the kinked demand curve. Let us start with an initial equilibrium. The demand curve of the oligopolist has a kink at the point of equilibrium. As shown in Fig. 5, the oligopolist charges an initial price of OP. If the firm, in order to sell more, cuts price, other firms respond by meeting the price cut, so the original price-cutter can sell only a little more at the lower price. In other words, in the region below the initial equilibrium price OP, the firm’s demand curve is relatively inelastic. If the firm raises the price above OP, the competing oligopolists would not meet the price increase, so that the firm loses a lot of sales. In other words, in the region above OP, the firm’s demand curve is highly elastic. In Figure 8 the kink in the demand curve dKD has been shown at the point K. At this point firm’s equilibrium price is OP and sells OQ quantity. At prices higher than OP, the dK portion of the dKD demand curve is highly elastic, while at prices lower than OP, the KD portion of the demand curve dKD is had very low elasticity. Marginal revenue curve corresponding to the demand curve dK is MR. Marginal revenue curve corresponding to the demand curve KD is MR’ which becomes negative after a point. The chief feature of this figure is that there is a gap a break-in the marginal revenue curve due to kink in the demand curve. The gap is equal to AB. The marginal revenue curve MC intersects the gap which can be regarded as if it were a vertical portion of the marginal revenue curve. If the marginal cost curve rises from MC to MC', but not above point A, and if it falls to MC", but not below point B, output and price do not change. It is so because MC still crosses the vertical part of MR curve. It is thus explained why prices are rigid in oligopolistic industries . Hall and Hitch in 1939 used the kinked demand curve to explain why the price, once determined, remains rigid. Paul M. Sweezy, in the same year, i.e., in 1939, introduced the kinked demand curve as an operational tool. But the kinked demand curve hypothesis is not a complete theory. It does not say how the original price OP was determined. It only says that if the oligopoly firm faces a kinked demand curve, demand and cost conditions can vary to some extent without changing the price the firm charges. 1. A. Koutsoyiannis, _Modern Micro-economics_, ELBS, 1985, pp. 240-41. 2. A. Koutsoyiannis, _Modern Micro-economics_, ELBS, 1985, p. 244. ## Questions **Long Answer Type Questions** 1. Explain the concept of oligopoly market and discuss its characteristics. 2. Distinguish oligopoly from the monopolistic competition. 3. What is collusion? Distinguish formal collusion from the tacit agreement. 4. Explain independent pricing in oligopoly. What factors hinder this type of pricing in oligopoly? 5. What is price leadership? What are its different types? Explain fully. 6. What is a Cartel? Explain different types of cartels. 7. What are rigid prices? Why does a “kinked” demand curve tend to lead to rigid prices? **Short Answer Type Questions** 1. What do yoy mean by oligopoly? 2. Mention the characterising of oligopoly. 3. What do you mean by kinked demand curve. 4. Differentiated between collusive and non-collusive oligopoly. 5. What do you mean by pur monopoly? **Multiple Choice Questions** 1. According to Cournot, duopoly output is : - (A) Less than competitive output - (B) More than competitive output - (C) Equal to competitive output - (D) None of these 2. According to Bertrand, duopoly output and price are the same as in : - (A) Imperfect competition - (B) Perfect competition - (C) Both (A) and (B) - (D) None of these 3. The German economist Heinrich Von Stackelberg presented an extension of the : - (A) Edgeworth Model - (B) Bertrand’s Model - (C) Cournot Model - (D) None of these 4. To explain why the price once determined, remains rigid, Hill and Hitch used : - (A) Marginal Demand Curve - (B) Kinked Demand Curve - (C) Both (A) and (B) - (D) None of these 5. Homogeneous products are sold under : - (A) Collusive oligopoly - (B) Non-collusive oligopoly - (C) Perfect oligopoly - (D) Imperfect oligopoly 6. In the context of oligopoly, which one of the following is incorrect? - (A) Small number of big firms - (B) Perfect knowledge among the buyers - (C) Indeterminate firm’s demand curve - (D) Non-price competition 7. When there are seller of a product selling differentiated product, then it is a case of : - (A) Pure-oligopoly - (B) Duopoly - (C) Differentiated oligopoly - (D) Monopoly [Ans. 1. (A), 2. (B), 3. (C), 4. (B), 5. (C), 6. (B), 7. (C)]