Chapter Four

OLIGOPOLY MARKET STRUCTURE

4.1 Introduction
Learning objective
4.2 Non collusive oligopoly
4.2.1 The kinked demand curve model
4.2.2 Cournot model
4.2.2.1 Reaction curve approach
4.2.2.2 Mathematical version of cournot duopoly model
4.2.3 The Bertrand duopoly model
4.2.4 Stackelberg Model
4.3 Collusive oligopoly
4.3.1 Cartel
4.3.1.1 Cartel aiming at joint profit maximization
4.3.1.2 Market Sharing Cartel
4.3.2 Price leadership
4.3.2.1 Low cost price leadership
4.3.2.2 Dominant firm price leadership
4.3.2.3 Barometric price leader ship
Summary
Key concepts and terms
Exercise
Suggested readings

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 4.1 Introduction

In Privacy chapters, we have studied perfect competition and monopoly market

structure. Both of them in common assume that the decision taken by any particular firm has no
diffused effect on the environment in which other firms operate. Individual firm therefore safely
neglect the reaction or behavior of its competitor in making its decision. Especially, the issue of
strategic interaction between firms is irrelevant in perfect competition because the prevailing
market price convey all the external information that was relevant to the firm. Is the above
feature of firms can be applied to firms in oligopoly market structure? No, because when small
number of large firms dominating a particular industry producing homogenous or differentiated
product, any change in a firm’s price or output influence the sales and profit of its competitors.
As a result, each firm formulates its policies and strategies with an eye on its competitor
decision. A market model, which considers such interdependence of few firms when making
optimal decision, is called oligopoly market model/structure, which is the subject of this chapter.
The chapter begins with discussion about the characteristics and source of oligopoly market
model; then, examine various collusive and non-collusive duopoly model optimal price and
output determination under different behavioral assumption about the firms operating in different
oligopoly industry.

Learning objective
At the end of the chapter, you are expected to:
- Differentiate oligopoly from other forms of market
- Identify how interdependence between firms affect their optimal decision
- Explain the difference between different duopoly models
- Explain how equilibrium price and output determined in collusive and non-collusive
oligopoly market structure.
Oligopoly Market
As it is mentioned above, oligopoly is a market structure dominated by few sellers of
homogenous or differentiated product. As a result, the action of each firm affects the other
firm’s decision in the industry. A beer industry in Ethiopia is a good example of such type of
industry. Each of the major beer producers takes in to account the reaction of others when they
formulate their price and output policies. Bedel or Dashen in this case know that its own action
will have significant impact on the rest of the beer producers. Therefore, Bedel or any other
producer considers the possible reaction of its competitor in deciding prices, degree of product
differentiation to be introduced, the level of advertisement to be undertaken and the amount of
service to be provided and so on.

Automobile industry, which produces different cars and aerospace industry producing different
airplanes are also an example of oligopoly industry. Note also that, all oligopolists are not
necessary large firms as given in the above example. Two grocery stores that exist in isolated

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community can be oligopolists given that their decisions are interdependent and they are the sole
supplier of a specific product. This implies that the distinguishing feature of oligopoly is the
interdependence of decision making by rivalry firms in an industry. Such interdependence
between firms is the natural result of the existence of few numbers of firms in an industry.

Activity 4.1
1. List the key feature of oligopoly market structure
2. Identify industry you know that approximate oligopoly market other than the one given in
the example
3. What are the similarity and difference between oligopoly and monopolistically
competitive market structure?

In summary, oligopoly market structure is a market structure which contain firms

Characterized by the following features

 Few number of firms in a given industry

 Interdependence of firms in decision making
 Firms produce homogenous or differentiated product
 Firms have some power to set price

Well by now we have get familiar to the key features of the four different type’s market
structure (perfect competition, monopolistic competition, oligopoly and monopoly).To
recap the main points, their comparison in terms of market power, entry condition of new
firms and strategic behaviors of the firms are summarized in table 4.1

Table 4.1 properties of monopoly, oligopoly, monopolistic competition and perfect

competition

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Causes of Oligopoly
There are many cause of oligopoly market. Some of them are

1. Economies of scale: low costs cannot achieved in some industries unless a few firms are
producing output that account for substantial percentages of the total market demand .That
means the average cost of production reach minimum only when the output produced in large
amount by a few firms. As result, the number of firms in such type of industry should be reduced
in order to make use of the advantage of economies of scale in production. Economies of scale in
sales promotion and advertising may also promote oligopoly.

2. Barriers to entry: - there are varieties of barrier that did not allow the entry of some firms in to
the industry. This barrier may be technological, skill, cost, and size of the market in relation to
economies of scale, patent right and different activities of government such as licensing and
marketing quota.

3. Collusion (merger of small firms): Small firms collide to get market power and overcome
their competitor’s pressure. If they gain market power, firms set higher price and restricts output
supply that maximizes their profit. Such firms develop to oligopoly while other removed from
the market. From our pervious section discussion you have some idea about the general features
of oligopoly market structure and its cause. Now let us identify different types of oligopoly
model and see how equilibrium level of output and prices are determined in each model given
their underlying assumption. For simplicity, we consider only the case of two firms that is
termed as duopoly. In addition, we limit our self to the study of firms producing homogenous
product. This will allow us to avoid the problem related to analysis product differentiation and
focus on the study of strategic interaction between firms.

Based on the reaction pattern of firms in the industry, it is possible to classify oligopoly in to two
groups. These are collusive oligopoly and non-collusive oligopoly. Non-collusive oligopoly is
a condition in which firms operate independently to determine the optimal level of price and
output. That is firms in the industry will not go in to contractual agreement to cooperate in
making optimal decision. Under such cases, negotiation and enforcement of binding agreement is
not possible even though each firms make some expectation (assumption) about the reaction of
its rivalry in response to its action or observe the decision of its rivalry while setting profit
maximizing level of output and price. For example, if a firm in non-collusive oligopoly wants to
increase output or price to maximize its profit, it has to assume something about the possible
reaction of its rivalry and the effect of the reaction on profit maximization process. do you think
that the assumption firms make about their rival firm is the same in all different type of non-
collusive oligopoly model. The answer to this question will obtain after discussing6 the different
non-collusive oligopoly in subsequent subsections. Here are some of non-collusive oligopoly
model that we will consider right now after a moment.

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1. Kinked demand model

2. Cournot duopoly model

3. Bertrand duopoly model

4. Stackelberg duopoly model

In collusive oligopoly however, firms get together to make open and formal agreement in setting
prices and output so as to maximizes the total profit of the industry as in the case of cartel. It can
be also implicit cooperation of firms in the industry without actually making explicitly
agreement with one another as in the case of price leader.

4.2 Non collusive oligopoly

4.2.1 The kinked demand curve model

As you know from your pervious microeconomic course, Price in perfect competition, monopoly
and monopolistic competition markets adjusts rapidly to changing cost or demand conditions. Is
the adjustment of price possible to change in cost and demand conditions in the case of oligopoly
market like in other market? For instance, is the price of beer or soft drink changes frequently as
their demand and cost condition changes? You might answer these questions based up on the
assumption how oligopolist react to each other’s decisions according to kinked demand curve
model.

The kinked demand curve model, developed by Paul Sweezy in 1939, explains why prices are
rigid in some oligopoly market. The model assume that oligopolist often have strong desire to
keep stable price. Even under the condition when cost and demand changes, firms are reluctant
to change their prices. If costs fall or market demand declines, they fear that the lower prices
send the wrong message to their competitors and initiate price war among them. If costs and
demand rises, they do not increase price because they are afraid that their competitors may not
raise their price.

According to this model therefore, demand curve facing each firm in oligopoly market is kinked
at prevailing market price (Chamberlin’s intersection of individual and market demand)
reflecting the following behavioral pattern of oligopolists. Rivalry firms expected to follow
decrease in price but ignore price increase. That means if a firm increases its price, due to
increase cost of production or increase demand for its product, it would loss most of its customer
and cause total revenue to decrease. This is because other firms in the industry would not follow
the increase in price. As result, given that the product produced in the industry is homogenous,
consumer preference shifts from the other hand an oligopolist could not increase its market share
by lower intend to maintain prices constant even under the condition where their demand and

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cost changes as shown in figure 4.1. The demand curve is much more elastic above point E
(kinked point) than below the kink on the assumption that the competitors will not follow price
increase but quickly follow price decrease.

Figure 4.1 the kinked demand curve

As shown in the above figure 4.1, an oligopolist firm faces two demand curves for different
ranges of prices. Above P0 the relevant demand curve for the firm is dE. Because if the firm
increases its price, it would lose some of its customer to firm that maintained their previous
price. The firm will then face a demand curve given by dE, which is very elastic. On the other
hand, if the firm decreases its price below Po form the intention of increasing their market share,
they will not able to increase their market share, since other firms also decrease their price in
order to keep up their customers. Therefore, below Po the relevant demand curve of the firm is
ED. This implies the demand curve facing oligopolies is not straight line, rather kinked at a
certain price. Well , we have seen that oligopolist is reluctant to price change in response to
change in their cost and demand condition. Thus, their demand curve is kinked at the intersection
point of market and individual demand curve to reflect the rigidity of prices. Now let us see how

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their marginal revenue curve derived and how they undertake optimal decision. Normally,
marginal revenue curve derived from demand curve. So the marginal revenue curve associated to
kinked demand curve is discontinues at the level of output corresponds to the kinked point. It has
two segments as indicated in figure 4.1, dA and BMR. Segment dA corresponds to the upper part
of demand curve, while the segment BMR corresponds to the lower part of demand curve and
the kink point on demand curve corresponds to the discontinuous portion of marginal revenue
curve. The point of kink defines equilibrium of the firm since at any point to the left of the kink,
MC is below MR, while to the right of the kink; MC is larger than MR. Thus profit of the firm
maximized at the point of the kink. However, this equilibrium is not necessary defined by the
intersection of MC and MR curve. So long as MC passes through segment AB, the firm
maximizes its profit by producing Qo and charging po level of price. This level of price and
output is compatible with wide range of cost.

To sum up, the kinked demand curve model give us some insight about why price and output
will not change despite changes in cost and demand in oligopoly market structure. The only case
where a rise in cost results in increase in price is when the rise in cost equally affects all firms in
the industry. It is important to note here that a kinked demand curve model does not explain how
equilibrium price and output determined like other models rather, explain why price once set
remain fixed. Lastly some economists have been very critical of the model’s assumption .It
would certainly be a mistake to conclude that oligopolies in general are unresponsive to change
in cost as well as unresponsive to change in demand in the world of technological advancement
and change in taste of consumer preference. Perhaps we observe the opposite in many oligopoly
industries.

Activity 4.2

1. Why price in oligopoly industry becomes unresponsive to change in demand and cost
conditions

2. Describe the nature of demand curve facing an oligopolist according to kinked demand curve
model.

3. Kinked demand curve model;

a) Explain how an equilibrium price is established.

b) Explain how firms change their price when cost of production and demand changes

c) Explain how equilibrium price determined

d) It explains prices are rigid in oligopoly market.

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4.2.2 Cournot model
A French mathematician, Augustine cournot in 1938 using two firm producing homogenous
products, illustrated cournot model for the first time. He illustrates the model assuming two firms
having identical cost facing linear market demand. Given these assumptions, each firms known
that the market price will depend on the total output of both firms. Thus to maximize their profit
each of the cournot duopolist simultaneously decides, how much to produce by taking its rivals’
output constant at existing level regardless of what output it decides to produce . Thus, each firm
takes the other firms output level as given and chooses its own output level to maximize profit.
The level of output that it chooses will, of course depend on how much it thinks its rival will
produce. In other words, each firm recognizes that its own decision about output yi will affect its
revenue through affecting market price but any one firm has output decisions do not affect those

now let us see cournot simplified illustration of the model. He started his illustration by assuming
that there are two firms (firm-A and firm-B), each producing mineral water at zero cost and face
linear demand curve DD as shown in figure 4.2. . Each firm also acts on the naïve assumption
that its competitor will not change its output when deciding its profit maximizing level of output.

Assume that firm A is the first to start producing and selling mineral water assuming that firm B
produce nothing. Firm-A therefore thinks that its effective demand curve is the market demand
because the firm thinks that it will be the sole producer of mineral water. So to find the profit
maximizing level of output and price, we use the marginal principle (MR=MC). Since it is
assumed that cost of production equals to zero MC is also zero. Therefore profit maximization
condition of the firm reduced to MR= 0. This point corresponds to Q1 level of output that is half
of the total market demand.

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 Figure 4.2 :Cournot equilibrium

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is the costless production (identical cost and demand) assumption of cournot in the above
analysis is realistic? No, because there are different type of cost involved in production in real
world and definitely, the cost of production in most cases different from one firm to the other.
Hence, let us reconsider the model after relaxing identical cost and demand assumptions. In other
words how much should each firm produce to maximizes their profit if they under take
production of their output at different cost and demand condition. This can be determined using
another approach called a reaction curve approach that we consider next.

4.2.2.1 Reaction curve approach

Under this approach, we try to see how cournot duopolist choice output level that maximizes
their profit after relaxing the identical cost and demand assumption. Here we use the reaction
curves of the two firms to determine the optimal level of output of the duopolist under the basic
cournot behavioral assumption. So before using the reaction curves as a tool for determination of
the optimal choose of the firms, it is helpful first if we understand what a reaction curve is and
how one can derive a reaction curve.

A reaction curve is a graphic representation of reaction function. A reaction function is a

function that shows the functional relationship between the optimal output level of one firm and
its beliefs about other firm optimal choice. For instance, reaction function of firm-A shows, how
firm-A will react in making its output decision to its perception of how much it thinks firm-B
will produce and sell. That is for firm-A to decide to produce let say Y1 level of output, it has to
forecast first the amount of output firm-B produce such as Y2. A function which shows the
amount of Y1 as a function of Y2 gives the reaction of firm-A. Similarly, reaction function of
firm-B defined in the same fashion.

A reaction curve is a graphic representation of reaction function. A reaction function is a

function that shows the functional relationship between the optimal output level of one firm and
its beliefs about other firm optimal choice. For instance, reaction function of firm-A shows, how

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firm-A will react in making its output decision to its perception of how much it thinks firm-B
will produce and sell. That is for firm-A to decide to produce let say Y1 level of output, it has to
forecast first the amount of output firm-B produce such as Y2. A function which shows the
amount of Y1 as a function of Y2 gives the reaction of firm-A. Similarly, reaction function of
firm-B defined in the same fashion.

4.2.2.2 Mathematical version of cournot duopoly model

Following the usually optimization procedure, take the first order condition of the profit function
of each firm with respect to choice variable (their output level). The result of first order condition
gives the reaction function of each firm. Then solve the two-reaction curves to gather
simultaneously to get the equilibrium output level of the two firms.

Activity 4.4

1. Given the following demand and cost function of cournot duopolist

Y= 40-0.2p where Y=Y1+Y2

C1 =50+2y1 C2 =100 +10y2

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A. Find the profit function of each firm and their reaction function

B. Find cournot equilibrium level of output and price

C. Calculate the profit of each firm

2. Suppose that we have two firms that face a linear demand curve P Y a bY ( ) = − and have
constant marginal costs, c, for each firm. Find the equilibrium level of output for the two firms in
terms of a and b assuming that are act according to cournot model.D. Show graphically the
equilibrium level of output of the two firms.

4.2.3 The Bertrand duopoly model

In cournot model, we have seen that firms are choosing quantities of output produced and letting
the market to determine price. However, in case of Bertrand model, firms set their price and
letting the market to determine the amount of output sold. This implies the strategic variable up
on which firms are competing to maximize their profit is price rather than output for Bertrand
duopolist. Similar to cournot model however, each firm makes decision about the level of price
that maximizes their profit simultaneously by assuming their competitor’s price fixed at existing
level. The model also assumes that firms operating in the industry produce homogenous product
with identical cost. This implies that each firm faces the same demand curve and consumer will
prefer to purchase from lower price seller or firm. Thus if the two firm charge different price,
lower price firm will supply the entire market while the firm which charges higher price sell
nothing. If both firms charge the same price, the consumers are indifferent between the two
firms’ product. This leads to a return to firm-1 of the form:

Equation (1) to (3) represent the profit earned by firm-1, when it set price less than, equal to and
greater than firm-2 respectively. Therefore, Bertrand model is an oligopoly model in which firms
producing homogenous product set price simultaneously that maximize their profit by assuming
their competitors price fixed at a certain level.

Activity 4.5

 Given the above underline features of the Bertrand model, what level of prices should
each firm charge to maximize their profit?

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It is known that price cannot be set less than marginal cost since each firm has the incentive to
decrease their price to increases its profit by reducing production level. So let us see how
Bertrand duopolist set price under the case where price is greater than marginal cost for the two
competing firms. Suppose that both firms sell their product at some price greater than marginal
cost. If firm-1 lower its price by small amount while the other firm keeps its price fixed, the
entire consumer will prefer to purchase from firm-1 and the other firm sell nothing as stated
above. However, the other firm also acts in the same way (have the incentive to reduce its
product) if its price is greater than marginal cost. Therefore, price greater than marginal cost
cannot be stable equilibrium because each firm has an incentive to cut price as long as
production remain profitable. The only equilibrium point where firms have no incentive to
change their decision is where price equal to marginal cost. This is the same as competitive
market equilibrium condition. Both firms set price equals to marginal cost in the short run and
both will set price equal to average cost in the long run because of constant cost assumption,
which leads to earning of zero profit. The equilibrium price level of Bertrand model can be also
determined through reaction curve approach. As we have seen under cournot model, reaction
curves are derived from Isoprofit maps. However, Bertrand Isoprofit curve represent different
thing from cournot’s isoprofit curve. Bertrand model isoprofit curves contain locus of point that
represents a combination of prices of a firm and its competitor that yields the same level of profit
to the firm. Unlike cournot isoprofit curve, the shape of Bertrand duopolist isoprofit curve is
convex to the price axis of the firms. what does the shape of Bertrand duopolist isoprofit imply?
The shape of Isoprofit of Bertrand duopolist show how a firm reacts to price cut by its
competitor. For example if the competitor of a firm cut price, the firm also adjust its price to
maintain its profit at the same level. Such process continues up to the minimum point of the
isoprofit curve, which represents lower level of profit. If the competitor cut price beyond the
minimum point, the firm cannot adjust its price to keep the same level of profit. The profit of the
firm decreases due to fall in price and increase in output level. This can be indicated by moving
to the lower level of Isoprofit curve. For example, firm-A in figure 2.6 moves from Isoprofit
curve π2 A to I so profit curveπA1 when firm-B cut its price below P2B. This implies Isoprofit
curve found nearer to the price axis of the duopolist represent lower level of profit. If we join the
minimum point of successive isoprofit curves of firm-A, it result in reaction curve of A. They are
locus of point firm-A can attain by charging a certain price, given the price of its rival. The
reaction curve for firm-B also derived in the similar way by joining the lowest point of isoprofit
curves given the price level of firm-A.

Given the two reaction curves, Bertrand equilibrium defined by the intersection of the reaction
curves of the firms as indicated by figure 4.7.

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Also like cournot model, Bertrand equilibrium does not lead to maximization of industry (joint)
profit, due to the fact that firms behave naively (firms set their price by assuming its rival keep
its price fixed and they never learn from past experience) to decide the price that maximizes their
profit. The industry profit could be increased if firms recognized their past mistakes and
abandoned the Bertrand pattern of behavior.

Although the Bertrand model used to understand the strategic interaction of oligopolist on price
setting, it has plenty of shortcomings for various reasons. For one thing, firms, which produce
exactly the same product, seem to compete more by focusing on non-price competition than on
price competition. Moreover, if they focus on price competition, they set the same price in
accordance with the model; there is no real assurance that they split the market equally. Also like
cournot model, Bertrand model is criticized for its naïve assumption of firms.

Activity 4.6

a) What are the difference and similarity between Bertrand and cournot model.

b) On which variable do firms in Bertrand model make strategic interaction (output, price)

c) What do the concave shape of the isoprofit curve of Bertrand duopoly implies?

d) In what aspect that the Bertrand model similar with perfect competition market model

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4.2.4 Stackelberg Model
In the previous duopoly model we have seen that duopolists make simultaneous optimal decision
about level of output produced and price charged. However, according to Stackelberg model
firms make decision about output that maximizes their profit sequentially. That is, there is

a firm known as a dominant (stackelberg leader) which knows the other firm behaves naively in
cournot fashion (i.e. known the reaction function of naïve firm). The firm, which behaves in
cournot, fashion (take competitor’s output as given) and make decision after observing
leader’sdecision is called the follower. The leader has extra information and potential than the
follower firm to make decision before the follower firm. In choosing its own output, therefore,
the leader could account the effect of its output on follower behavior while the follower naively
took leader’s output as given.

For instance, IBM is often considered as a dominant firm in the computer industry. Small firms
in the industry wait for the decision made by IBM in order to make decision how much to
produce and the type of product they supply to the market. In general, the leader firm (the first
mover) decides to produces certain amount of output, which maximizes its profit; it will take into
consideration the impact of follower firm. The follower firm, after identifying the level of output
produced by the leader firm, responds by producing certain amount of output to maximize its
profit. Each firm act in the stated way while making its output decision because each of them
know that the total output produced determined the market price and then profit they earn.

Given the structure of the model, what output should the leader choose to maximize its profits?
Leader firm recognizes its influence on the action of followers firm and total level of output
when making decision on the level of output to maximize profit. This relationship between
follower and leader optimal choice can be summarized with the help of reaction function of
follower firm. So the leaders first determine the reaction function of its follower and then
incorporate it to its own profit function. Then it maximizes the newly formed profit function like
monopoly firm by setting marginal revenue equals to marginal cost. On the other hand follower
firm react to the optimal choice of the leader according to its reaction function to come up with
its profit maximizing level of output.

The stackleberg solution can also be illustrated graphically using isoprofit curves and reaction
curves. Both firms have the same shaped isoprofit curve as in the case of cournot. The highest
profit level is represented by the isoprofit curve found near to the quantity axis of each firm and
the lowest level of profit is represented by isoprofit curve, which found away from the quantity
axis. Given such properties of isoprofit curves of the firms, they are acting in the following ways
to determine their optimal output level.

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Figure 4.8: Stackelberg equilibrium

Firm 2 as a follower will choose an output along its reaction curve, while firm-1 (the leader)
choose the output level on the reaction curve of firm-2 that gives him the highest maximum
profit. As a result, the equilibrium point of the stackelberg duopolists is not defined by the
intersection of their reaction curve. This is because the leader firms no more take the follower’s
output as given. It knows the follower output would depend on its own output level in
accordance with its reaction function. This implies the equilibrium point of the Stackelberg
model defined by the tangency of the isoprofit of the leader with the reaction curve of the
follower as indicated by figure 4.8 below.

Since the leader, firm-1 makes choose on the reaction curve of follower, firm 2, point e
represents stable stackleberg’s equilibrium. At point-e, the leader get higher profit and the
follower firm get lower profit compared to cournot equilibrium. In short if one firm is
sophisticated, it will emerge as a leader and stable equilibrium will established since the naïve
firm act as a follower. However if both firms are sophisticated, both wants to be a leader to get
higher profit. In this case, market situation becomes unstable. Such situation is known as
Stackleberg disequilibrium. The effect of such situation will be either a price war until one of
them surrender and agree to act as follower or collusion of both firms abandoning their reaction
function and move to a point close to edge worth contract curve where both of them get higher
profit

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 4.3 Collusive oligopoly
All oligopoly models described up until now are an example of non-collusive oligopoly. In such
type of industry each firm make independent decision to maximize its profit even though each of
them take other’s likely behavior in to account during the process of decision making. Now we
consider other possibility in which firms found in a given industry make collusive agreement
implicitly or explicitly to some degree in setting price and output. Firm enter in to such collusive
agreement in order to cultivate the advantage of increasing profit, decreasing uncertainties and to
create better opportunity to prevent other’s entry to the industry. To see how firms operating in
such arrangement make decision we will consider cartel and price leader ship in this sub section.

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4.3.1 Cartel
A cartel is a formal organization of firms producing the same product. It is formed to coordinate
the policies of member firm so as to increase their joint profit by limiting the scope of
competition among them. It also reduces uncertainty arising from their mutual interdependence.
Here we will study two typical forms of cartels.
a) Cartels aiming at joint profit maximization
b) Market sharing cartel

4.3.1.1 Cartel aiming at joint profit maximization.

Cartel aiming at joint profit maximization is formed as its name indicates with the objective of
maximizing the total industry’s profit. In order to achieve this objective member firm appoint a
central agency to which they delegate the authority to decide not only the total quantity and price
at which the industry’s profit maximized but also allocation of output and profit among the
member of cartel.

o make such decisions, it is assumed that central agency have access to information about the
cost of individual firms and know market demand. Given the information about cost and
demand, central agency determine price and output that maximizes industry’s profit defined by
the intersection of marginal revenue and marginal cost curve. Marginal revenue curve can be
derived from market demand and the marginal cost used for decision can be obtained by
summing up individual marginal cost. In this case, the cartel act as multiplant monopoly and

Since total revenue depends on the sum of all cartel members’ output levels, marginal revenue is
the same no matter whose output level is sold. At the profit maximization point therefore, this
common marginal revenue will be equated with each firm’s marginal production cost. For
simplicity let us assumes there are only two firms in the cartel with marginal cost MC1and MC2
as indicated in figure 4.9. So the industry’s marginal cost (MC) obtained by summing up
marginal costs of the two firms. From the market demand DD, we can derive industry’s marginal
revenue. The intersection point of MC and MR gives profit-maximizing level of output and price

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Figure: 4.9 Joint profit maximization of cartel

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4.3.1.2 Market Sharing Cartel
In market sharing cartel the member firms agree on how to share the market but they keep a
Considerable degree of freedom concerning the style of their output, their selling activities and
other decisions. Each firm therefore operates in one area or region agreed upon without
encroaching on others’ territories. This form of cartel is more common in real world and more
popular than cartel aiming at maximization of joint industry profit. There are two basic methods
for sharing market by the member firm of cartel: non-price competition and quota.

1. Non- price competition

In such form of cartel the member firm agree on a common price at which they sell their output.
The price up on which they agreed set by the process of bargaining. In the bargaining process,
low cost firm pressing for lower price and high cost firm press for higher price. At the end
common price which allow all members certain amount of profit, is set. At such price firms
compete to maximizing their profit by increasing their sell volume through different way of
nonprice competition like quality, style, selling activities and advertising. Such form of cartel is
unstable most of the time compared to cartel aiming at joint profit maximization. Because,
whenever there is cost and liquidity difference, low cost firms have the incentive to cheat
bylowering their price and initiates price war among member firms, which result in instability.

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2. Sharing of the market by agreement on quotas

In this case, member firms agree to supply a certain quantity of output at agreed price. The quota
allocation made based on the cost structure of the firms. If they have identical costs, the
monopoly solution will emerge by sharing the market equally. However if costs are different, the
quota of market share differs between the firms. Under such cases quota sharing depend on the
bargaining power of the firms. During bargaining process past levels sales and or the basis for
productive capacity of the firms are considered for decision

The other form of sharing market is made through defining geographical boundaries to which
each member firm supply their product. Like non-pricing competition, market sharing cartels or
regional sharing cartels agreement are also unstable. The agreements are violated intentionally o
by mistake by low cost firm who have the incentive to expand their output by cutting price. Most
of the above forms of cartels are unstable. The firms will not act according to output and price
level upon which they agreed due to a number of reasons. Some of the reasons includes: the
member firms have different costs, different assessments of the market demand and even have
different objective. So most of the time they wants to set price at different level. Furthermore,
each member of the cartel tempted to cheat by lowering price slightly to capture larger share of
market than allocated for the firm. This implies there should be some sort of enforcement
mechanism for a cartel to be successful. Threat in the long run for the member who breaks the
agreement should be there. Also gaining certain monopoly power to set price by cartel is other
factor for the success of cartel i.e., if the potential gain form cooperation are large ,cartel member
have more incentive to solve their organizational problem and hence profit for cartelization is
large enough to give incentive for the members to act according to the contractual agreement.

4.3.2 Price leadership

Unlike firms in cartel, which agree explicitly to cooperate in setting price and output, firms in
price leadership collusive oligopoly, agree to cooperate implicitly in making decisions about
price and output without any formal discussion. They enter in to such agreement voluntarily to
avoid any uncertainty about the competitor reaction. In such type of model, one firm implicitly
recognized as the leader and set price. The other remaining firm, the follower take price as given
and adopt the price set by the leader firm even though its profit did not maximized. This follow
from the assumption that the two firm selling identical products. If one charged a different price
form the other, all of the consumers would prefer the producers with the lower price. In addition,
if two firms do not agree implicitly on common price, there is possibility to enter in to a price
war. Price war through reduction of prices cause low profit level and even causes destruction of

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the firm. These conditions may force oligopoly firms to cooperate without actually making
explicitly agreements with one other.

There are various form of price leadership, the most common ones are:

1. Price leadership by low cost firm

2. Price leadership by large (dominant) firm

3. Barometric price leadership

4.3.2.1 Low cost price leadership

This model assumes that there are two firms in the industry producing homogenous product at
different cost. One firm produce at low cost compared to its competitor. Moreover, firms may
have equal or unequal market share. Given firms with the stated features, low cost firm becomes
the leader and set price, which maximizes its profit. Follower firm by scarifying some of its
profit take the price set by the leader. This is to avoid a price war, which would eliminate the
firm from the industry if price set lower than its LAC.

However, the price set by the leader firm using marginal principle (MC=MR) would remain at
the stated position through maintaining output constant. Deviation of output from the point
where MR=MC due to over or under supply of output by follower firm will change the price
and then the profit of the leader will not maximized. This implies that the follower must supply
a quantity sufficient to maintain the price set by the leader. So at the optimal price level, the
firms must also enter agreement on the share of the market formally or informally. Other wise
even though the follower adopt leaders price, producing higher or lower level of output
required to maintain the price (set by the leader) in the market push the leader to non-profit
maximizing position. In this respect, the follower is not completely passive; it can affect the
market price and then the profit of the leader unless they enter in to formal or informal
agreement to supply certain proportion of the total output.

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4.3.2.2 Dominant firm price leadership
In such oligopoly industry there is one large firm having large share of the total market with a
group of smaller firms supply the rest. The larger firm, which is also known as, the dominant
firm become the leader and set price that maximize its profit. The other smaller firms, which

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could have little influence over price, would be a price taker like firms in perfect competitive
firm. That is each of the small firms produces an amount determined by setting marginal cost
equals to price announced by the leader and the leader supply the residual.

Given the structure of the model, what price would the dominant firm set to maximize its profit?
Is the leader firm considering the impact of other small firms while setting price? By assumption,
the dominant firm knows the market demand and the marginal cost of small firms. This
assumption enables the dominant (the leader) firm to derive its own demand function form the
market demand and marginal costs of smaller firms. That is since small firms in the industry
behave like prefect competitive firm, the dominant firm equate price with the sum of their

marginal costs to get their supply function then the leader firm’s demand
Function, which is also known as, the residual demand curve, can be obtained by subtracting the
supply function of the smaller firms from the market demand.

Once the leader identify its demand function, it act like a monopoly to set price and output level
which maximizes its profit by equating marginal revenue with its marginal cost . Here the
marginal revenue used for decision is derived from residual demand that actually measures how
much output it will be able to sell at each given price.

As indicated in figure 4.10. For example at P1 the demand for the product of the leader will be
zero, because the total quantity D1 is supplied by smaller firm. As price fall below p1 the
demand for the leader’s product increases. At p the total demand is D2 out of which PA is
supplied by small firms and the remaining AD2 is supplied by the leader. Having derived the
demand curve of the leader as in figure 2.10(b) and given its MC, the dominant firm will set
price at which his MR=MC. However smaller firms may or may not maximizes it profit
depending up on its cost structure at the set level of price.

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4.3.2.3 Barometric price leader ship

In this type of price leadership oligopoly, there is a firm which have good knowledge of the
prevailing condition in the market and can forecast better than other about the future
development in the market. Such type of firm used as the barometer for other firms to reflect the
changes in economic environment. Such type of firm acts as a leader and when its price changes,
other firm follow change in price. Usually a barometric firm may or may not be a firm with low
cost or larger firm. However, it is a firm which establishes good reputation in the past in
forecasting economic changes. Even a firm belonging to other industry having good reputation
may also used as a barometric leader to affect the decision of other firms. For example, a firm in
steel industry might be taken as barometric price leader for motor car industry

Summary

 Oligopoly is a market structure with only few firms dominate the whole industry.
Economic decision in such type of market involves strategic considerations; each firm
must consider how its action affects its rivals and how they likely react.
 There are two different forms of oligopoly. These are non-collusive models and collusive
models. The classification is based up on whether there exist some forms of cooperation
between firms or not. It is also possible to classify non collusive oligopoly in to four
types depending upon the way they make decision and the strategic variable upon which
they interact: kinked demand, cournot duopoly, Bertrand duopoly, and Stackelberg
duopoly models.
 The kinked demand curve model explains why prices often remain stable in oligopoly
markets, even when costs rise. The other three models try to predict the behaviours of
oligopoly firms based on different kinds of assumption about the rival firm.
 In Cournot duopoly model of oligopoly, firms make their output decisions at the same
time by assuming others firm keep its output fixed at existing level. At equilibrium
therefore each firm maximizes their profit given the output of its competitor.
 In Bertrand firm make strategic decision on price as the same time by assuming the price
of their competitor remain fixed. In this model the equilibrium outcome is the same as
perfectively competitive market even though the number of firm in the industry is two.
 In Stackelberg’s duopoly model it is assumed that one duopolist with better information
becomes sophisticated to recognize his competitor act on the cournot assumption. Thus
the sophisticated firm will determine the reaction curve of his rival and incorporates it in
his own profit function, to determine price that maximizes its profit and taken as given by
the follower firm.

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  The other form of oligopoly is collusive oligopoly in which firms make cooperative
agreement implicitly or explicitly to set optimal level of output produced and price
charged. Cartel is a collusive form of oligopoly in which firm producing the same product
enter in to explicit contractual agreements to set price and the level of output produced.
This will avoid the uncertainty created between for decision making. There are two
different forms of cartel. These are Cartel aiming at joint profit maximizing of the
industry and market sharing cartel Joint profit maximizing cartel has the objective to
maximizing the profit of the industry.
 Decision for such type of cartel is made by the central agency assigned by the member
firm. The central agency set price which maximizes the industry’s profit and allocate the
profit among the member firms. In practice the industry profit cannot maximized due to
various reason like cheating by low cost firm, mistake in estimation of costs and market
demand by central agency while setting price and output levels.
 In Market sharing cartel, the firm agree to share the market, but keep a considerable
degree of freedom concerning the style of their output, their selling activities and other
decisions. This can occur when firms agreed not to compete on price. Because of the
difficult of forming effective cartel, oligopolists may attempt to cooperate implicitly
without making explicit agreements with one other. Such type of oligopoly is called price
leader oligopoly. There are three forms of price leadership; price leadership by a low cost
firm, price leadership by a large (dominant) firm and Barometric price leadership. In all
the three forms the leader firm set price and the follower firm take price set by the leader
as given.

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