Oligopoly

• Introduction
• Features of Oligopoly
• Duopoly
• Cournot’s Model
• Stackelberg’s Model
Lecture Plan • Kinked Demand Curve: Price Rigidity
• Collusive Oligopoly
• Price Leadership
• Summary
Objectives

• To examine the nature of an oligopoly market.

• To understand the indeterminate demand curve for a firm
under oligopoly
• To look into the various models of price and output
decisions under oligopoly.
• To comprehend the nuances of collusive oligopoly, with
detailed analysis of its various forms, including cartels.
• To identify with the practice of price leadership by an
oligopolist.
Introduction

• Derived from Greek word: “oligo” (few) “polo” (to sell)

• A few dominant sellers sell differentiated or homogenous products under
continuous consciousness of rivals’ actions.
• Oligopoly looks similar to other market forms; as there can be many sellers
(like in monopolistic competition), but a few very large sellers dominate the
market.
• Products sold may be homogenous (like in perfect competition), or
differentiated (like in monopolistic competition).
• Entry is not restricted but difficult due to requirement of investments.
• One aspect which differentiates oligopoly from all other market forms, is the
interdependence of various firms: no player can take a decision without
considering the action (or reaction) of rivals.
 • Few Sellers: small number of large firms
compete
• Product: Some industries may consist of
firms selling identical products, while in
some other industries firms may be selling
Features of differentiated products.
Oligopoly • Entry Barriers: No legal barriers; only
economic in nature
• Huge investment requirements
• Strong consumer loyalty for existing brands
• Economies of scale
Features of Oligopoly

• Non Price Competition: Firms are continuously watching their

rivals, each of them avoids the incidence of a price war.

• Two firms A & B sell a homogenous

product.
• Prevailing price is P1, but firm A
lowers the price.
• B fears loss of its customers and
P retorts by lowering the price below
that of A.
1
• A further reduces the price and this
process continues, till the firms reach
A P B P2.
2 • Both realize that this price war is not
Market share O Market share helping either of them and decide to
end the war. Price stabilises at P2.
of A of B
 Features of Oligopoly

• Indeterminate Demand Curve

• Price and output determination is very
complex as each firm faces two
Pric D1 demand curves.
e • Demand is not only affected by its own
D price or advertisement or quality, but is
also affected by the price of rival
products, their quality, packaging,
promotion and placement.
• When the firm increases the price it
D faces less elastic demand (DD); when it
D1 reduces the price it faces highly elastic
O
demand (D1D1)
Quan
tity
 Duopoly
• Duopoly is that type of oligopoly in which only two players operate (or dominate) in
the market.
• Used by many economists like Cournot, Stackelberg, Sweezy, to explain the
equilibrium of oligopoly firm, as it simplifies the analysis.
Price and Output Decisions
• No single model can explain the determination of equilibrium price and output
• Difficult to determine the demand curve and hence the revenue curve of the firm
• Tendency of the firm to influence market conditions by various activities like advertisement,
and fear of price war resulting in price rigidity.
Cournot’s Model

• Augustin Cournot illustrated with an example of two firms

engaged in the production and sale of mineral water.
• Each firm owns a spring of mineral water, which is available
free from nature.
Assumptions
• Each firm maximizes profit.
• Cost of production is nil because the springs are available free from
nature, i.e. MC=0.
• Market demand is linear; hence the demand curve is a downward
sloping straight line.
• Each firm decides on its price assuming that the other firm’s output is
given (i.e. the other firm will continue to produce and sell the same
amount of output in next period).
• Firms sell their entire profit maximizing output at the price determined
by their demand curves.
Cournot’s Model
• Firm A produces profit maximising
Price, output at MR=MC=0 and sells half
Reven D of the total market demand (equal
ue, to OD*).
Cost
• Point A is the mid point of DD*.
P A • Firm B assumes A will continue to
produce OQA ,so considers QAD*
A B as the market available to it and
P AD* as its demand curve. Its MR
B curve will be MRB.
O D • B maximizes profit and produce
Q Q Quant
M M * Q B.
R ity
A B
R • A and B together supply to three
A B
fourths of the total market, while
one fourth remains unattended.
Stackelberg’s Model

• Developed by German Economist H. V. Stackelberg

• Popularly known as the Leader Follower Model.
• An extension of the model of Cournot.
• One of the players is sufficiently sophisticated to recognize
that the rival firm acts.
• The sophisticated firm is able to determine the reaction curve
of the rival and is also able to incorporate it in its own profit
function. Thus it acts as a monopolist.
• Naïve firm will act as follower.
 Stackelberg’s Model
Output of
Firm B RA • If firm A is the sophisticated
firm, it will try to produce that
output at which it can
b
X’B maximize its profit, at point
RB
Firm A’s reaction function “a”.
• A will produce OXA and B will
Firm B’s reaction function be contended with OXB.
E
• B will act as a follower and
accept the leadership of A.
a
• If firm B is the sophisticated
XB
firm, will be at equilibrium at
RA RB
O point “b”, producing OXB.
X’A XA Output of Firm A
• A will act as the follower and
RARA: Reaction function of A accept B’s leadership will
produce only OXA.
RBRB: Reaction function of B
Cournot’s equilibrium= E
 Kinked Demand Curve

• Paul Sweezy (1939) introduced concept of kinked demand curve to explain

‘price stickiness’.
• Assumptions
• If a firm decreases price, others will also do the same. So, the firm
initially faces a highly elastic demand curve.
• A price reduction will give some gains to the firm initially, but due to
similar reaction by rivals, this increase in demand will not be sustained.
• If a firm increases its price, others will not follow. Firm will lose large
number of its customers to rivals due to substitution effect.
• Thus an oligopoly firm faces a highly elastic demand in case of price fall
and highly inelastic demand in case of price rise.
• A firm has no option but to stick to its current price.
• At current price a kink is developed in the demand curve
• The demand curve is more elastic above the kink and less elastic below the
kink.
Kinked Demand Curve
(price and output determination)
Price, D
Revenue, 1 • Discontinuity in AR (D1KD2)
Cost
MC1 creates discontinuity in the MR
P K
MC2 curve.
• At the kink (K), MR is constant
A between point A and B.
S
T
D2
• Producer will produce OQ,
B whether it is operating on MC1 or
O
Q
MC2, since the profit maximizing
Quantity
MR
conditions are being fulfilled at
points S as well as T.
• D1K = highly elastic portion of • If MC fluctuates between A and
the demand curve when rival B, the firm will neither change its
firms do not react to price rise output nor its price.
• KD2 = less elastic portion, • It will change its output and price
when rival firms react with a only if MC moves above A or
price reduction. below B.
• Kink is at point K.
Collusive Oligopoly
• Rival firms enter into an agreement in mutual interest on various
accounts such as price, market share, etc.
• Explicit collusion: When a number of producers (or sellers) enter
into a formal agreement.
• Tacit collusion: A collusion which is not formally declared.
• Cartel
• A formal (explicit) agreement among firms on price and output.
• Occurs where there are a small number of sellers with homogeneous
product.
• Normally involves agreement on price fixation, total industry output,
market share, allocation of customers, allocation of territories,
establishment of common sales agencies, division of profits, or any
combination of these.
• Immidiate impact is a hike in price and a reduction in supply.
• Two types:
• centralized cartels
• market sharing cartels.
Centralized Cartels
Price, MCA ∑MC
MCB • MCA = Firm A’s marginal cost
Cost,
Revenue • MCB = Firm B’s marginal cost
• ∑MC = industry marginal cost
• OQ = profit maximizing output
P because (MR=∑MC).
• OQA = A’ output, OQB = B’s
output
AR=D • OQ=OQA + OQB; OQA >
MR OQB.
• OP = price at which both firms
O
QB QA Q Quantity
can sell their output. Price will
be determined by summation
of all firms’ costs and demand.
• An individual firm is thus just a
price taker.
Market Sharing Cartels
Price, • Firms decide to divide the
Cost, market share among them and
Revenue fix the price independently.
MC AC
• All firms have the same cost
PA functions because they are
producing a homogenous
PB
product.
• Due to different demand
ARA functions, at equilibrium total
MRA output (OQ)=OQA+ OQB, where
ARB OQA> OQB.
MRB • The quantity of output produced
O QB Q
A Output and sold would depend upon
the terms of agreement among
the firms.
Factors Influencing Cartels

• Number of firms in the industry: Lower the number of firms in the industry,
the easier to monitor the behaviour of other members.
• Nature of product: Formed in markets with homogenous goods rather than
differentiated goods, to arrive at common price. But if goods are
homogeneous, an individual firm may gain larger market share by cheating,
i.e. by lowering the price.
• Cost structure: Similar cost structures make it easier to coordinate.
• Characteristics of sales: Low frequency of sales coupled with huge amounts of
output in each of these sales make cartels less sustainable, because in such
cases firms would like to undercut the price in order to gain greater market
share.
• with large number of firms and small size of the market some firms may
deviate from the cartel price and thus cheat other members.
Informal and Tacit Collusion

• Formed when firms do not declare a cartel, but informally

agree to charge the same price and compete on non price
aspects.
• Sometimes this agreement invloves division of the market
among the players in such a way that they may charge a price
that would maximize their profit without fear of retaliation.
• Also seen in case of highly skilled human resource.
• It is as damaging to consumers as formal cartels, because it
makes an oligopoly act like a monopoly (in a limited sense) and
deprives consumers of the benefits of competition.
Price Leadership
• Dominant Firm: a leader in terms of market share, or presence in all
segments, or just the pioneer in the particular product category.
• May be either a benevolent firm or an exploitative firm.
• Benevolent leader
• Allows other firms to exist by fixing a price at which small firms may
also sell.
• so that it does not have to face allegations of monopoly creation;
• Earns sufficient margin at this price and still retains market
leadership
• Exploitative leader: fixes a price at which small inefficient players may not
survive and thus it gains large share of the market.
• Barometric Firm: has better industry intelligence and can preempt and
interpret its external environment in an effective manner.
• No single player is so large to emerge as a leader, but there may be a
firm which has a better understanding of the markets.
• Acts like a barometer for the market.
Summary

• Oligopoly is a market with a few sellers, differentiated or homogenous

product, interdependent decision making by firms, non price competition
and indeterminate demand curve.
• Duopoly is a special case of oligopoly, in which only two players operate
(or dominate) in the market. All the characteristics of duopoly are same as
those of oligopoly.
• Difficulty in determining the demand curve, tendency to influence market
conditions and fear of price war resulting in price rigidity are some of the
reasons which pose a major constraint in developing a model to explain
oligopoly.
• In Cournot’s model firms ignore interdependence and take decisions as if
they are operating independently in the market. At equilibrium in a two
firm industry, each firm will be maximizing profit by selling equal amounts
of output at the same price.
• In Stackelberg’s model the sophisticated firm is able to determine the
reaction curve of the rival and is also able to incorporate it in its own profit
function. Thus it acts as a monopolist. The naïve firm will act as follower.
Summary

• In Sweezy’s kinked demand curve model firms avoid a situation like price
war; therefore they stick to the current price. Thus the oligopoly price
remains rigid.
• The kink in demand curve signifies that the demand curve has two different
degrees of price elasticity.
• Under collusion rival firms enter into an agreement in mutual interest on
various accounts such price, market share, etc. Collusion may be open or
tacit. The most commonly found form of explicit collusion is known as
cartels.
• A centralized cartel is an arrangement by all the members, with the objective
of determining a price which maximizes joint profits. In market sharing cartel
members decide to divide the market share among them and fix the price
independently.
• A dominant firm is a leader in terms of market share, or presence in all
segments, or just being the pioneer in the particular product category. A
leader can be benevolent or exploitative.
• A barometric firm has better industry intelligence and can preempt and
interpret its external environment in an effective manner.
Suppose the market demand curve for a commodity is P=70-Q.
There are 2 firms with constant MC= 10 RUPES.
ASSUMING THEY BEHAVE AS COURNOTS DUOPOLIES WHAT WILL BE
THE PRICE AND TOTAL INDUSTRY OUTPUT.
COMPARE THE OUTCOME UNDER PURE MONOPOLY AND PERFECT
COMPETITION.
• IN A CONSTANT COST INDUSTRY HAVING 0 COST THE INVERSE
DEMAND FUNCTION IS GIVEN BY P=12-Q ESTIMATE THE
EQUILLIBRIUM VALUE OF THE PRICE AND OUTPUT MONOPOLY ,
COURNOT DUOPOLY AND PERFECT COMPETITION