Oligopoly

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.

Features of Oligopoly 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 differentiated products. 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 P 1, but firm A lowers the price. B fears loss of its customers and retorts by lowering the price below that of A. A further reduces the price and this process continues, till the firms reach P 2. Both realize that this price war is not helping either of them and decide to end the war. Price stabilises at P 2. Market share of A Market share of B AB O P1P1 P2P2

Features of Oligopoly Indeterminate Demand Curve Price and output determination is very complex as each firm faces two demand curves. Demand is not only affected by its own 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 faces less elastic demand (DD); when it reduces the price it faces highly elastic demand (D 1 D 1 ) Quan tity D O D D1D1 D1D1 Pric e

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.

Collusion and Competition Oligopoly firms may collude (act as a monopoly) and earn positive profits. OR Oligopolists may compete with each other and drive prices down to where profits are zero.

While it pays for firms to collude, in order to earn positive profits, it also pays to cheat on the collusive agreement. If one firm cuts its price to slightly below the others, it could gain a lot of business. If everyone cheats on the agreement, however, the agreement falls apart.

Collusive agreements less likely to succeed when secret price cuts are difficult and costly to detect. (Quality changes are difficult to monitor.) market conditions are unstable. (Differences in expectations make it difficult to reach an agreement.) vigorous antitrust action increases the cost of collusion.

Some oligopolistic markets operate in a situation of price leadership. A single firm sets industry price and the remaining firms charge the same price as the leader.

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) Discontinuity in AR (D 1 KD 2 ) creates discontinuity in the MR curve. At the kink (K), MR is constant between point A and B. Producer will produce OQ, whether it is operating on MC 1 or MC 2, since the profit maximizing conditions are being fulfilled at points S as well as T. If MC fluctuates between A and B, the firm will neither change its output nor its price. It will change its output and price only if MC moves above A or below B. D 1 K = highly elastic portion of the demand curve when rival firms do not react to price rise KD 2 = less elastic portion, when rival firms react with a price reduction. Kink is at point K. D1D1 D2D2 K A B MR Quantity O MC 1 MC 2 P Q S T Price, Revenue, Cost

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 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.