1. Unit 3 BCCA Economics Oligopoly and Duopoly
Prof Prasanna Shembekar

2. A1. What is an Oligopoly?
Oligopoly is a market structure in which a small number of firms have the large majority of market share.
An oligopoly is similar to a monopoly, except that rather than one firm, two or more firms dominate the market. 
There may be smaller firms in the market but their existence is negligible.
Examples of oligopoly are airlines industry, steel industry and telephone services (telecom) industry.

3. B3. What are the distinct characteristics of an oligopoly?
Few sellers. They are interdependent on each other.
Barriers to entry: There are very high barriers to entry. Those barriers can be artificial such as high investment costs, of natural barriers such as limited access to raw materials, etc.
Strategy: Firms have to take strategic decisions whether to compete with other firms or to collude with them (join hands with them).
Degree of competition: There is very stiff competition among few competitors.
Price rigidity: Firms stick to the prices and do not change prices often as the firms are interdependent.
Group Behaviour: It is an important characteristic as in oligopolies all major firms may act like rivals, followers of friends.
Less focus on product differentiation than price differentiation. Products are mostly homogeneous in nature

4. A8. What is a collusive oligopoly?
In oligopolistic markets firms may attempt to collude (unite together), rather than compete.
If colluding, participants act like a monopoly and can enjoy the benefits of higher profits over the long term.
Such association of major firms in oligopoly is called collusive oligopoly.

5. Types of collusive oligopolies
Overt: Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form trade associations like the Association of Petrol companies like HPCL, BPCL, etc.
Covert: Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid detection by regulators, such as when fixing prices.
Tacit: Tacit collusion arises when firms act together, called acting in concert, but where there is no formal or even informal agreement. For example, it may be accepted that a particular firm is the price leader in an industry, and other firms simply follow the lead of this firm. All firms may ‘understand’ this, but no agreement or record exists to prove it.
If firms do collude, and their behaviour can be proven to result in reduced competition, they are likely to be subject to regulation. In many cases, tacit collusion is difficult or impossible to prove, though regulators are becoming increasingly sophisticated in developing new methods of detection.

6. D9. Differentiate between collusive and non-collusive oligopoly.
It attempts to collude rather than competing with other firms
Firms are highly interdependent especially in price decisions.
It colludes in any of the three ways : Overt, Covert and Tacit collusions
It follows Price leadership model for price determination, where the leading firm takes price decisions and others follow either explicitly or implicitly.
Thus these firms try to come together and form a monopoly
Instead of Individual firm’s profit, they aim at collective profit from the market.
In collusive oligopoly, consumer receives less benefit as firms move towards a monopoly.

7. Non Collusive monopoly
In this type of monopoly firms compete with each other instead of colluding.
Firms are not dependent on each other directly.
It follows Kinked demand curve model stated by Paul Sweezy
Price remains more stable than the cost due to the price stickiness. If one firm increases price, others will not increase. This way the firm that increases price will face sales loss. But if one firm reduces price others will also reduce in order to minimize the benefit of price reduction to the first firm
Firms aim at individual profits rather than collective profits
Firms do not tend towards monopoly
Consumers are at benefit as they get the benefit of price war between the rival sellers.

8. C4. Explain the factors that cause oligopoly.
Huge capital investments: Due to the need of huge capital, not all companies can enter oligopolistic markets. Steel industry for example needs huge capital investment.
Economies of scale: Oligopolistic companies need to work on cost minimization for which they need to adopt economies of scale. Smaller firms can not bring down prices to the extent which large scale firms can do.
Patent rights and legal restrictions: Companies tend to patent their product differentiations so that no other firms can copy those differentiations. In some cases legal requirements are so rigid that many companies are discouraged from entering in to oligopoly.
Control over raw materials and natural resources: Only those firms can survive in oligopoly, that have control over natural resources and raw materials needed. Cafe coffee day owns its own coffee plantations and Tata tea has its own tea plantations.
Mergers and takeovers: Smaller firms are often acquired by larger firms in oligopoly, resulting in to less number of firms operating in the market.
Technological advancements: In some industries technical know how matters more. Only those companies who have evolved with greater technological advancements will survive in such oligopolies. Ex: Integrated circuits manufacturers

9. A11. What is a Cartel?
A cartel is a group of formally independent producers whose goal is to increase their collective profits by means of price fixing, limiting supply, or other restrictive practices.
Cartels typically control selling prices, but some are organized to control the prices of purchased inputs. Laws attempt to deter or forbid cartels.
Cartels usually occur in oligopolies, where there are a small number of sellers and usually involve homogeneous products.
 Bid rigging is a special type of cartel. Bid rigging is a form of fraud in which a commercial contract is promised to one party even though for the sake of appearance several other parties also present a bid.
This form of collusion is illegal in most countries. It is a form of price fixing and market allocation, often practiced where contracts are determined by a call for bids, for example in the case of government construction contracts.

10. 1. Joint Profit Maximization Cartel:
The uncertainty to be found in an oligopolistic market provides an incentive to rival firms to form a perfect cartel Perfect cartel is an extreme form of perfect collusion.
In this, 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 output quotas for its members, the price to be charged and the distribution of industry profits.
Since the central board manipulates prices, outputs, sales and distribution of profits, it acts like a single monopoly whose main aim is to maximize the joint profits of the oligopolistic industry.

11. 2. 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.
The firms enter into a market-sharing agreement to form a cartel “but keep a considerable degree of freedom concerning the style of their output, their selling activities and other decisions.”
There are two main methods of market-sharing:
(a) Quota system and,
(b) Non-price competition

12. A. Market Sharing by Quota Agreement
The first 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.

13. C17. What is 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 colour, 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-price basis while selling the product at the agreed common price.
This type of cartel is inherently unstable because if one low-cost firm cheats the other firms by charging a lower price than the common price, it will attract the customers of other member firms and earn larger profits.
When other firms come to know of this, they will leave the cartel. A price war will start and ultimately the lowest-cost firm will remain in the industry.
In case the cost curves of the firms forming a cartel differ, the low-cost firms may not stick to the common price. They may try to increase their share of the market by means of secret price concessions. They may also resort to better sales promotion methods.

14. Figure 1: Price and output determination in Cartel collusion
Price for every firm and the industry is same. RSEGE is profit of firm A and ABEG is profit of firm 2. Total profit of Industry is the addition of all profits which is equal to PFEG in figure 3. Quantity of industry is addition of quantities of all industries.

15. C18. Explain an overview of Oligopoly Models.
Various models are used to describe Oligopoly and duopoly ( special case of oligopoly where there are two sellers):
Chamberlin’s oligopoly model
Cournet’s model of duopoly
Sweezy’s Kinked demand curve model
Price leadership models : price leadership of low cost firm, dominant firm and barometric firm
Baumol’s sales revenue maximization model
The game theory model of oligopoly ( prisoner’s dilemma model)

16. A7. What is a kinked demand curve. B5
A7. What is a kinked demand curve? B5. What is Sweezy‘s Kinked-Demand Curve? D4. Explain Sweezy’s kinked demand curve model for oligopoly.

17. Assumptions of Kinked demand curve model:
There are only a few firms in an oligopolistic market.
The firms are producing close-substitute products.
The quality of the products remains constant and the firms do not spend on advertising.
A set of prices of the product has already been determined and these prices prevail in the market at present.
Each firm believes that if it reduces the price of its product, the rival firms would follow suit, but if it increases the price, then the rivals would not follow it, they would simply keep their prices unchanged.

18. If the firm prices above P1, the demand will be highly elastic as other firms will not follow the price rise and there will be direct impact on demand for the firm
Below P1 , demand becomes inelastic as further reduction in price below P1, other firms will follow the price reduction and there will not be any significant benefit in demand to the firm as everybody has reduced the price.
Hence there is a kink in demand curve at point X. So actually there are two demand curves in non collusive oligopoly
Figure 2
Marginal revenue curve is discontinuous at X and falles steeply after X showing that revenues fall steeply after X
During discontinuity of MR , marginal cost can be changed between MC1 and MC2 . Above MC1 , it will change the price point X

19. D8. How the Price and Output Determined In Collusive Oligopoly ?

20. In order to avoid uncertainty arising out of interdependence and to avoid price wars and cut throat competition, firms working under oligopolistic conditions often enter into agreement regarding a uniform price-output policy to be pursued by them.
In a cartel type of collusive oligopoly, firms jointly fix a price and output policy through agreements.
But under price leadership one firm sets the price and others follow it.
The one which sets the price is a price leader and the others who follow it are its followers.
Price leadership are also of three types : Dominant leadership, barometric leadership and aggressive price leadership

21. Simple Price leadership model
Suppose there are two organizations, A and B producing identical products where organization A has a lower cost of the production than organization B. Therefore, consumers are indifferent between these two organizations due to identical products. This implies that both the organizations would face same demand curve, which further represents equal market share.
In Figure-4, DD is the demand curve of both the organizations and MR is their marginal revenue. MCa and MCb are the marginal cost curves of organization A and B respectively. As stated earlier, the cost of production of organization A is less than B, thus, MCa is drawn below MCb.
Figure 3 : Price Leadership Model

22. Let us first start the discussion of price leadership with the case of organization A. The profits of organization A would be maximized at a point where MR intersects MCa.
At this point, the output of organization A would be OQ with the price level OP. On the other hand, the profits of organization B would be maximized at a point where MR intersects MCb with output OQ1 and price OP1.
In such a case, the price of organization B is more as compared to organization A. However, both the organizations have to charge the same price as products are homogeneous. In this case, organization A is the price leader and organization B is the follower.

23. Thus, organization A will dictate the price to organization B
Thus, organization A will dictate the price to organization B. Both the organizations will follow the same output, OQ and price OP.
However, the profits earned by organization B are less than A, as it has to produce at price OP which is less than its profit maximizing price, OP1.
In addition, the organization B also has high costs of production that leads to lower profits at price OP1.
Price and output determination in Cartels is already explained in Figure 1

24. Baumol’s Theory of sales maximization
Profit Maximization not the only goal of a firm.
According to Baumol – Firm’s objective is “Sales
Maximisation” not “Profit Maximization”
Why do firms prefer Sales Maximization?
Ownership and Management are separate.
Managers and Owners have different goals.
Managers’ goals are based on Sales Maximization

25. 1. Salaries and perks to managers depend on sales, not profits.
2. Banks give loans to firms with more sales,
3. Better payment to staff, when sales, but falls when sales decrease,
4. Sales increases prestige of managers, but large profits go to shareholders/ owners.
5. Managers prefer steady level of profits, not maximum profits which are difficult to maintain.
6. Increasing sales increases firm’s market power,
7. Managers wish to avoid risky ventures that may temporarily increase profits.

26. Baumol’s Static Model : Assumptions: 1. Single time period, 2
Baumol’s Static Model : Assumptions: 1. Single time period, 2. Oligopoly firm, 3. Sales Maximisation objective, 4. Minimum profit to satisfy shareholders’ expectations, keep up share prices, and meet bank requirements, 5. U – Shaped cost curves (AC and MC), Perfect Competition in factor markets, 6. Downward sloping D-curve,

27. Figure 4

28. • In Figure 1, taking TC and TR, the usual profit
maximisation Q is Qm, where TR – TC is maximum.
• But here TR is still rising, it has not reached its
maximum, dR/dQ> 0.
• According to Baumol, managers prefer to have
maximum sales, up to Qs.
• Here dR/dQ = 0, and TR is maximum.
• Some minimum profits = Rs Qs = 0a, can still be
earned.
• Line aa is the minimum acceptable profits, to satisfy
shareholders, owners, etc. (Profit constraint).

29. Figure 5

30. Criticism
• Cost and demand functions of individual firms
are not known.
• Oligopoly interdependence has not been taken
into account. Other firms may also lower Price
leading to Price wars.
• Uncertainties in oligopoly, not discussed.
• Relationship between firm and industry
equilibrium not shown.
• Owners may demand higher profits not sales.

31. D5. Explain application of game theory to oligopolistic strategy.
D11. Explain the strategy in Game Theory in Detail?
D12. What are the different uses of Game theory?

32. Game Theory
Game theory is about the games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others' intentions
Game theory analysis relates with the conduct and behaviour of firms in oligopolistic markets – for example the decisions that firms must take over pricing and levels of production, and also how much money to invest in research and development spending, and risky decisions.
A company might lose the competitive edge in the market and suffer a long term decline in market share and profitability, if they take wrong decisions.
The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and the other firm does, then their profits fall and they lose market share.
However, only few companies invest in R&D because may ultimately yield a lower total rate of return than if only one firm opts to proceed.

33. Prisoner’s Dilemma : Example of Game theory
The classic example of game theory is the Prisoner's Dilemma, a situation where two prisoners are being questioned over their guilt or innocence of a crime.
They have a simple choice, either to confess to the crime (so that their punishment will be reduced) and accept the consequences, or to deny all involvement and hope that their partner does likewise.
Confess or keep quiet? The Prisoner's Dilemma is a classic example of basic game theory in action!
The "pay-off" in this game is measured in terms of years in prison arising from their choices and this is summarized in the table given.
No communication is permitted between the two suspects – in other words, each must make an independent decision, but clearly they will take into account the likely behaviour of the other when under-interrogation.
This highlights the importance of uncertainty in an oligopoly.

34. Game theory: Nash Equilibrium
Nash Equilibrium is an important idea in game theory – it describes any situation where all of the participants in a game are pursuing their best possible strategy given the strategies of all of the other participants.
In a Nash Equilibrium, the outcome of a game that occurs is when player A takes the best possible action given the action of player B, and player B takes the best possible action given the action of player A

35. If prisoner A confesses and Prisoner B also confesses, both get 5 yrs Jail. But if A confesses and B does not, then A is set free and B goes for 20 yrs in Jail. If both remain silent, then both will get minimum punishment i.e. 1 year Jail.

36. Applying the Prisoner's Dilemma to Business Decisions in Oligoppoly
Game theory examples revolve around the pay-offs that come from making different decisions.
In the prisoner's dilemma the reward to defecting is greater than mutual cooperation which itself brings a higher reward than mutual defection which itself is better than the sucker's pay-off.
Critically, the reward for two players cooperating with each other is higher than the average reward from defection and the sucker's pay-off.

38. Different Uses of the game theory
The key point is that game theory provides an insight into the interdependent decision-making that lies at the heart of the interaction between businesses in a competitive market.
It explains pricing strategy decisions of two interdependent competing firms
It explains decisions for investments in R &D, new plant development, entry in markets and decisions regarding whether to advertise or not.
It helps collusions to arrive at a win-win situation called as Nash equilibrium.
The Prisoners' Dilemma can help to explain the breakdown of price-fixing agreements between producers which can lead to the out-break of price wars among suppliers
It can explain the break-down of joint ventures between producers
It can explain collapse of free-trade agreements between countries when one or more countries decides that protectionist strategies are in their own best interest. ( example Exit of Great Britain from European Union)

39. A2. Define Duopoly. C10. What are different characteristics of Duopoly?

40. Duopoly
A duopoly is a situation in which two companies own all or nearly all of the market for a given product or service.
A duopoly is the most basic form of oligopoly, a market dominated by a small number of companies.
A duopoly can have the same impact on the market as a monopoly if the two players collude on prices or output. 
Collusion results in consumers paying higher prices than they would in a truly competitive market and is illegal in many countries
Example : Boeing and Airbus have been called a duopoly for their command of the large passenger airplane market. 

41. Characteristics of Duopoly
It is a special case of Oligopoly
Two firms in the industry · Strong control over price
Uses Non price competition to compete
Firms will either compete or collude
Very strong Barriers to entry
A duopoly is a special type of oligopoly in which the market has only two major firms
There are two general categories of duopoly: Cournot and Bertrand.

42. B7. Write a short note on A Classical Model of Duopoly.
C19. Explain the assumptions of Cournet’s Duopoly Model.
D16. Explain the Cournet’s Duopoly Model.

43. Cournot’s model of duopoly
Augastine Cournot, a French economist, developed duopoly model in 1838
Cournot concludes that each seller ultimately supplies to one third of the market and both the firms charge the same price. And one third remaining market remains unsupplied.
Cournot assumed that there are two firms each owning a mineral well, and operating with zero costs.
They sell their output in a market with a straight-line demand curve.
Each firm acts on the assumption that its competitor will not change its output, and decides its own output so as to maximize profit.

44. Assuptions of Cournot’s model
There are two firms each has similar product to sell to the market
Both the firms operate their firms at zero marginal cost MC=0
Both of them face a demand curve with constant negative slope
Each seller acts on the assumption that his competitor will not react to his decision to change his output and price

45. Demand curve is downward sloping and Demand = AR
MC= 0 as per Cornet so profit is maximized at MC = MR = 0 at price OP for seller A and OP’ for seller B.
If total market is OD’ , then market captured by firm A is OA while remaining market AD’ is left for firm B. out of this market .
Demand curve used by firm A is DC then relevant part of demand curve that remains for firm B is CD’. Now B sells at a lesser price OP’ thus A also has to reduce his price to OP’.
So as initially a sells ½ of the market, B selles to the half of the remaining market i.e ¾ of the market. A then sells half of it i.e. 3/8 which is lesser than its initial share which was ½. At this moment market that remains for B is half of what remains i.e half of 1-3/8 i.e 5/16. Once B captures market share of 5/16, market that remains for A is 11/16. Now A captures half of its share i.e 11/32… this continues till both A and B get equal market shares i.e 1/3 each and 1/ is left untapped.
Criticism :
MC = 0 is not practically possible
It is not necessary that firms use same strategy every time. They may change their outputs.

46. D15. Explain different advantages and disadvantages of Duopoly.
The advantages of a duopoly are: 
Close competition
Competition in prices as a direct reaction to the other producer will benefit the consumer at the end
Interaction of competitors with each others creates market control
Simplicity of market operations
Better than monopoly
The disadvantages are: In some cases, duopolies will reach a Nash Equilibrium, and prices will not drop.
Two huge corporations in one market will make it very difficult for smaller firms to gain recognition or a market share. This means many new firms will die out before they are able to generate any new competition.
The lack of new firms can mean a lack of new products, and a market can go stale in absence of new products and strategies.
If the two firms collude, they will tend operate like a monopoly.