Oligopoly Market 

What is Oligopoly Market?

Oligopoly is a market structure characterized by a small number of large firms that dominate the market for a particular product or service. In an oligopoly market, each of the large firms has significant market power, and their actions can significantly affect the overall market.

Oligopoly is competition among few. That means there are few firms in the market selling homogenous or heterogonous types of goods or we can say in other words that there are few firms selling similar goods or non-similar goods in the market. So the first one is called homogenous (Perfect) oligopoly and the later one is called heterogeneous (Imperfect) oligopoly.


Characteristics of Oligopoly Market

Few Sellers

There are few sellers in the market. Few means action of each other affects the every participant in the market.

Restrictions of new entry

New entry is sometime restricted legally by government for public interest and sometimes by the tactics of the already existing firms. There are many ways new entry can be restricted but if there is huge firm coming in it will follow the predatory prices and will easily make a way for it.

Non Price competition

Most of the time competition among the few firms remain only non-price competitions, because price competition hurt the profits of firms and benefits to consumers. So the firms usually change the rapper, advertisement, some extra benefits but they do not much change the price.

Interdependency

Every firm is interdependent because action of single firms affects the other firm so to nullify the initial firm’s action other firm’s also take actions, and this continuous till the time firms think that this is it. Cournot’s duopoly model is the best model to understand this concept.

Collusion or non-collusion

Firms can make group against the firms coming in or against consumers to remain highly profitable in the market or to take higher price and profits from the consumers, for this they can make cartels. Making cartel is illegal in most of the countries.


Types of Oligopoly, (Collusive Oligopoly)

A cartel or Collusion is an association of independent firms within the same industry. The cartel follows common policies relating to prices, outputs, sales and profit maximization and distribution of products. Cartels may be voluntary or compulsory and open or secret depending upon the policy of the government with regard to their formation. They are of many forms and use many devices in order to follow varied common policies depending upon the type of the cartel.

We will discuss two most common types of cartels

  • Joint profit maximization or perfect cartel; and

  • Market-sharing cartel.

Joint Profit Maximisation Cartel under Perfect Collusion

The uncertainty is found in an oligopoly market which provides an incentive to rival firms to form a perfect cartel. Perfect cartel is an extreme form of perfect collusion. Under it, firms producing a homogeneous product form a centralized cartel board in the industry.

The individual firms surrender their price-output decisions to this central board. The board determines for its members the output, quotes the price to be charged and the distribution of industry profits. The central board acts like a single monopoly whose main aim is to maximize the joint profits of the oligopolistic industry.

Assumptions

The analysis of joint profit maximisation cartel is based on the following assumptions:

  • Only two firms A and B are assumed in the oligopolistic industry that form the cartel.

  • Each firm produces and sells a homogeneous product that is a perfect substitute for each other.

  • The market demand curve for the product is given and is known to the cartel.

  • The number of buyers is large.

  • The price of the product determines the policy of the cartel.

  • The cost curves of the firms are different but are known to the cartel.

  • The cartel aims at joint profit maximization.

Joint Profit Maximization Solution

Given these assumptions, and given the market demand curve and its corresponding MR curve, joint profits will be maximized when the industry MR equals the industry’s MC. Figure 3.1 shows the situation where D is the market (or cartel) demand curve and MR is its corresponding marginal revenue curve. The aggregate marginal cost curve of the industry EMC is drawn by the lateral summation of the MC curves of firms A and B, so the EMC = MCa + MCb. The cartel solution-that maximizes joint profit is determined at point ? where the ?

MC curve intersects the industry MR curve. Consequently, the total output is OQ which will be sold at OP = (QF) price. As under monopoly, the cartel board will allocate the industry output by equating the industry MR to the marginal cost of each firm. The share of each firm in the industry output is obtained by drawing a straight line from E0 to the vertical axis which passes through the curves MCb, and MCa of firms B and A at points Eb, and Ea respectively.

Figure 3.1

Thus the share of firm A is OQa and that of firm B is OQb which equal the total output OQ (= OQb + OQA ). The price OP and the output OQ distributed between A and B firms in the ratio of OQa : OQb , is the monopoly solution. Firm A with the lower costs sells a larger output OQb than the firm B with higher costs so that OQa > OQb ,.

But this does not mean that A will be getting more profit than B. The joint maximum profit is the sum of RSTP and ABCP earned by A and B respectively. It will be pooled into a fund and distributed by the cartel board according to the agreement arrived at by the two firms at the time of the formation of the cartel.

Advantages

Perfect collusion by oligopolistic firms in the form of a cartel has many advantages. It avoids price wars among rivals. The firms forming a cartel gain at the expense of customers who are charged a high price for the product. The cartel operates like a monopoly organization which maximizes the joint profit of firms. Generally, joint profits are high than the total profits earned by them if they were to work independently.

Problems of a Cartel

The problems of cartels are stated below

  • It is difficult to make an accurate estimate of the market demand curve.

  • The estimation of the market MC curve may be inaccurate because of the supply of wrong data about their MC by individual firms to the cartel.

  • The formation of a cartel is a slow process which takes a long time for the agreement to arrive at by firms especially if their number is very large.

  • The larger the number of firms in a cartel, the less is its chances of survival for long because of the distrust. The cartel will, therefore, break down. In theory, the cartel-members agree on joint profit maximisation. But in practice, the seldom agree on profit distribution.

  • The price of the product fixed by the cartel cannot be changed even ifthe market conditions require it to be changed. This is because it takes a long time for the members to arrive at an agreed price.

  • Prices tackiness gives rise to ‘chislers’ who scarcely cut the price or violate the quota agreement.

  • Unless all member firms in the cartel are strongly committed to cooperation, outside disturbances, such as a sharp fall in demand, may lead to the breakdown of the cartel.

  • Some high-cost uneconomic firms may refuse to shut down or leave the cartel despite the cartel board’s request.

Market-Sharing Cartel

Another type of perfect collusion in an oligopolistic market is found in practice which relates to market-sharing by the member firms of a cartel. There are two main methods of market-sharing:

(a) Non-price competition; and


(b) Quota system.

They are discussed as under:

Non-Price Competition Cartel

The non-price competition agreement among oligopolistic firms is a loose form of cartel. Under this type of cartel, the low-cost firms press for a low price and the high-cost firms for a high price. But ultimately, they agree upon a common price below which they will not sell. Such a price must allow them some profits.

The firms can compete with one another on a non-price basis by varying the color, design, shape packing etc. of their product and having their own different advertising and other selling activities. Thus each firm shares the market on a non-prices basis while selling the product at the agreed common price.

Market Sharing on Quota Agreement

The second method of market sharing is the quota agreement among firms. (All firms in an oligopolistic industry enter into collusion for charging an agreed uniform price. But the main agreement relates to the sharing of the market equally among member firms so that each firm gets profits on its sales.)

Assumptions

This analysis is based on the understated assumptions

  1. Only two firms can enter into market-sharing agreement on the basis of the quota system.

  2. Each firm produces and sells a homogeneous product.

  3. The number of buyers is large.

  4. The market demand curve for the product is given and known to the cartel.

  5. Each firm has its own demand curve having the same elasticity as that of the market demand curve.

  6. Both firms share the market equally.

  7. Cost curves of the two firms are identical.

  8. There is no threat of entry by new firms.

  9. Each sells the product at the agreed uniform price.

Market-Sharing Solution

Figure 3.2

With these assumptions, the equal market sharing between the two firms is explained in Figure 3.2 where D is the market demand curve and rf/MR is its corresponding MR curve. ZMC is the aggregate MC curve of the industry. The ZMC curve intersects the rf/MR curve at point E which determines QA (= OP) price and total output OQ for the industry. This is the monopoly solution in the market-sharing cartel.

How will the industry output be shared equally between the two firms? Let us assume that the d/MR is the demand curve of each firm and mr is its corresponding MR curve. AC and MC are their identical cost curves. The MC curve intersects the mr curve at point e so that the profit maximization output of each firm is Oq. Since the total output of the industry is OQ which is equal to 2 x O q = (OQ = 20q), it is equally shared by the two firms as per the quota agreement.

Thus each sells Oq output at the same price qB (= OP) and earns RP per unit profit. The total profit earned by each firm is RP x Oq and by both is RP x 20q or RP x OQ. Practically , there are more than two firms in an oligopolistic industry which do not share the market equally. Moreover, their cost curves are also not identical. In case their cost curves differ, their market shares will also differ. Each firm will charge an independent price in accordance with its own MC and MR curves.

They may not sell the same quantity at the agreed common price. They may be charging a price slightly above or below the profit maximization price depending upon its cost conditions. But each will try to be nearest the profit maximization price. This will lead to the breaking up of the market sharing agreement.

Price leadership. (Low cost price leadership, barometric price leadership and dominant price leadership)

Another form of collusion is price leadership. In this form of coordinated behaviour of oligopolists one firm sets the price and the others follow it because it is advantageous to them or because they prefer to avoid uncertainty about their competitors’ reactions even if this implies departure of the followers from their profit-maximizing position. Price leadership is much more practiced in the business world. It may be practiced either by explicit agreement or informally. In nearly all cases price leadership is tacit since open collusive agreements are illegal in most countries.

Price leadership is more widespread than cartels, because it allows the members complete freedom regarding their product and selling activities and thus is more acceptable to the followers than a complete cartel, which requires the surrendering of all freedom of action to the central agency. If the product is homogeneous and the firms are highly concentrated in a location the price will be identical. However, if the product is differentiated prices will differ, but the direction of their change will be the same, while the same price differentials will broadly be kept.

There are various forms of price leadership

The most common types of leadership are

(a) Price leadership by a low-cost firm.


(b) Price leadership by a large (dominant) firm.

Figure 3.3

Barometric price leadership

The characteristic of the traditional price leader is that he sets his price on marginality rules, that is, at the level defined by the intersection of his MC and MR curves. For the leader the behavioral rule is MC = MR. The other firms are price-takers who will not normally maximize their profit by adopting the price of the leader. If they do, it will be by accident rather than by their own independent decision.

The Model of the Low-cost Price Leader

We will illustrate this model with an example of duopoly. It is assumed that there are two firms which produce a homogeneous product at different costs, which clearly must be sold at the same price. The firms may have equal markets (or they may come to an agreement to share the market equally) as in figure 9, or they may have unequal markets (or agree to share the market with unequal shares), as in figure 3.4. The important condition for this model is that the firms have unequal costs.

Figure 3.4

The firm with the lowest cost will charge a lower price (PA ) and this price will be followed by the high-cost firm, although at this price firm B (the follower) does not maximize its profits. The follower would obtain a higher profit by producing a lower output (XBe) and selling it at a higher price (PB ). However, it prefers to follow the leader, sacrificing some of its profits in order to avoid a price war, which would eliminate it if price fell sufficiently low as not to cover its LAC. It should be stressed that for the leader to maximize his profit price must be retained at the level PA and he should sell XA .

This implies that the follower must supply a quantity (0XB in figure 10, or OX1 = OX2 in figure 3.3) sufficient to maintain the price set by the leader. Although the price- leadership model stresses the fact that the leader sets the price and the follower adopts it, it is clear that the firms must also enter a share-of-the-market agreement, formally or informally, otherwise the follower could adopt the price of the leader but produce a lower quantity than the level required to maintain the price (set by the leader) in the market, and thus push (indirectly, by not producing enough output) the leader to a non-profit-maximizing position.

In this respect the price follower is not completely passive he may be coerced to adopt the leader’s price, but, unless tied by a quota-share agreement (formal or informal) he can push the leader to a non-maximizing position.

The Dominant-firm Price Leader

Figure 3.5

In this model it is assumed that there is a large dominant firm which has a considerable share of the total market, and some smaller firms, each of them having a small market share. The market demand (DD in figure 3.5) is assumed known to the dominant firm. It is also assumed that the dominant leader knows the MC curves of the smaller firms, which he can add horizontally and find the total supply by the small firms at each price; or at best that he has a fair estimate, from past experience, of the likely total output from this source at various prices.

With this knowledge the leader can obtain his own demand curve as follows. At each price the larger firm will be able to supply the section of the total market not supplied by the smaller firms. That is, at each price the demand for the product of the leader will be the difference between total D (at that price) and the total S1 . For example, at price P1 the demand for the product of the leader will be zero, because the total quantity demanded (D1 ) is supplied by the smaller firms.

Figure 3.6

As price falls below P1 the demand for the leader’s product increases. At P2 the total demand is D2 ; the part P2 A is supplied by the small firms and the remaining AD2 is supplied by the leader. At P3 total demand is D3 and the total quantity is supplied by the leader since at that price the small firms do not supply any quantity. Below P3 the market demand coincides with the leader’s demand curve. Now we have derived his demand curve (dL in figure 3.6) and given his MC curve, the dominant firm will set the price “P” at which his MR = MC and his output is 0x.

At price P the total market demand is PC, and the part PB is supplied by the small firms followers while quantity BC = 0x is supplied by the leader. The dominant firm leader maximizes his profit by equating his MC to his MR, while the smaller firms are price-takers, and may or may not maximize their profit, depending on their cost structure. It is assumed that the small firms cannot sell more (at each price) than the quantity denoted by S1 , But if the leader is to maximize his profit, he must make sure that the small firms will not only follow his price, but that they will also produce the right quantity (PB, at price P).

Thus, if there is no tight sharing-the- market agreement, the small firms may produce less output than PB and thus force the leader to a non-maximizing position.As price falls below P1 the demand for the leader’s product increases. At P2 the total demand is D2 ; the part P2 A is supplied by the small firms and the remaining AD2 is supplied by the leader. At P3 total demand is D3 and the total quantity is supplied by the leader since at that price the small firms do not supply any quantity. Below P3 the market demand coincides with the leader’s demand curve.

Now we have derived his demand curve (dL in figure 3.6) and given his MC curve, the dominant firm will set the price “P” at which his MR = MC and his output is 0x. At price P the total market demand is PC, and the part PB is supplied by the small firms followers while quantity BC = 0x is supplied by the leader. The dominant firm leader maximizes his profit by equating his MC to his MR, while the smaller firms are price-takers, and may or may not maximize their profit, depending on their cost structure.

It is assumed that the small firms cannot sell more (at each price) than the quantity denoted by S1 , But if the leader is to maximize his profit, he must make sure that the small firms will not only follow his price, but that they will also produce the right quantity (PB, at price P). Thus, if there is no tight sharing-the- market agreement, the small firms may produce less output than PB and thus force the leader to a non-maximizing position.

Barometric Price Leadership

In this model it is formally or informally agreed that all firms will follow (exactly or approximately) the changes of the price of a firm which is considered to have a good knowledge of the prevailing conditions in the market and can forecast better than the others the future developments in the market. In short, the firm chosen as the leader is considered as a barometer, reflecting the changes in economic environment. The barometric firm may be neither a low-cost nor a large firm.

Usually it is a firm which from past behavior has established the reputation of a good forecaster of economic changes. A firm belonging to another industry may also be chosen as the barometric leader. For example, a firm in the steel industry may be agreed as the (barometric) leader for price changes in the motor-car industry. Barometric price leadership may be established for various reasons. Firstly, rivalry between several large firms in an industry may make it impossible to accept one among them as the leader.

Secondly, followers avoid the continuous recalculation of costs, as economic conditions change. Thirdly, the barometric firm usually has proved itself as a ‘reasonably’ good forecaster of changes in cost and demand conditions in the particular industry and the economy as a whole, and by following it the other firms can be ‘reasonably’ sure that they choose the correct price policy.

Sweezy’s Kinked Demand Curve Model

The kinked demand curve of oligopoly was developed by Paul M. Sweezy in 1939. Instead of laying emphasis on price-output determination, the model explains the behaviour of oligopolistic organizations. The model advocates that the behaviour of oligopolistic organizations remain stable when the price and output are determined. This implies that an oligopolistic market is characterized by a certain degree of price rigidity or stability, especially when there is a change in prices in downward direction.

For example, if an organization under oligopoly reduces price of products, the competitor organizations would also follow it and neutralize the expected gain from the price reduction. On the other hand, if the organization increases the price, the competitor organizations would also cut down their prices.

In such a case, the organization that has raised its prices would lose some part of its market share. The kinked demand curve model seeks to explain the reason of price rigidity under oligopolistic market situations.

Therefore, to understand the kinked demand curve model, it is important to note the reactions of rival organizations on the price changes made by respective oligopolistic organizations. There can be two possible reactions of rival organizations when there are changes in the price of a particular oligopolistic organization.

The rival organizations would either follow price cuts, but not price hikes or they may not follow changes in prices at all. A kinked demand curve represents the behavior pattern of oligopolistic organizations in which rival organizations lower down the prices to secure their market share, but restrict an increase in the prices.

Following are the assumption of a kinked demand curve

  • Assumes that if one oligopolistic organization reduces the prices, then other organizations would also cut their prices
  • Assumes that if one oligopolistic organization increases the prices, then other organizations would not follow increase in prices
  • Assumes that there is always a prevailing price

A kinked demand curve model is explained with the help of Figure-13

A kink in the demand curve at point P.

Figure 3.7

The slope of a kinked demand curve differs in different conditions, such as price increase and price decrease. In this model, every organization faces two demand curves. In case of high prices, an oligopolistic organization faces highly elastic demand curve, which is dd’ in Figure-3.7. On the other hand, in case of low prices, the oligopolistic organization faces inelastic demand curve, which is DD’ (Figure-3.7). Suppose the prevailing price of a product is PQ, as shown in Figure-13.

If one of the oligopolistic organizations makes changes in its prices, then there can be three reactions of rival organizations. Firstly, when the oligopolistic organization would increase its prices, its demand curve would shift to dd’ from DD’. In such a case, consumers would switch to rivals, which would lead to fall in the sales of the oligopolistic organization. In addition, the dP portion of dd’ would be more elastic, which lies above the prevailing price.

On the other hand, if price falls, the rivals would also reduce their prices, thus, the sales of the oligopolistic organization would be less. In such a case, the demand curve faced by the oligopolistic organization is PD’, which lies below the prevailing price. Secondly, rival organizations will not react with respect to changes in the price of the oligopolistic organization. In such a case, the oligopolistic organization would face DD’ demand curve.

Thirdly, the competing organizations may follow price cut, but not price hike. If the oligopolistic organization increases the price and competitors do not follow it, then consumers may switch to competitors. Thus, the competitors would gain control over the market. Thus, the oligopolistic organization would be forced from dP(small) demand curve to DP demand curve, so that it can prevent losing its customers. This would result in producing the kinked demand curve. On the other hand, if the oligopolistic organization reduces the price, the rival organizations would also reduce prices for securing their customers.

Here, the relevant demand curve is Pd’. The two parts of the demand curve are DP and Pd’, which is DPd’ with a kink at point P. Let us draw the MR curve of the oligopolistic organization. The MR curve would take the discontinuous shape, which is DXYC, where DX and YC correspond directly to DP and Pd’ segments of the kinked demand curve. The equilibrium point is attained when MR = MC. In Figure-3.7, the MC curve intersects MR at point Y where at output OQ.

At point Y, the organization would achieve maximum profit. Now, if cost increases, the MC curve would move upwards to MC. In such a case, the oligopolistic organization cannot increase the prices. This is because if the organization would increase the prices, the rival organizations would decrease their prices and gain the market share. Moreover, the profits would remain same between point X and Y. Thus, there is no motivation for increasing or decreasing prices. Therefore, price and output would remain stable. However, kinked demand curve model is criticized by various economists.

Some of the major points of criticism are as follows

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

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

  • Ignores non-price competition among organizations. Non-price competition can be in terms of product differentiation, advertising, and other tools used by organizations to promote their sales.

FAQ

What is Oligopoly Market?

Oligopoly is a market structure characterized by a small number of large firms that dominate the market for a particular product or service. In an oligopoly market, each of the large firms has significant market power, and their actions can significantly affect the overall market.

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