Oligopoly
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  • 1. Chapter 12 Oligopoly
  • 2. Oligopoly    Derived from Greek word: “oligo” (few) “polo” (to sell) A few dominant sellers sell differentiated or homogenous products under continuous consciousness of rivals’ actions. Features  Small number of producers  Term ‘few’ is ambiguous and does not specify any particular number of players. So, any market in which a small number of large firms compete is oligopoly.  Can be many sellers (as in monopolistic competition), with a few very large sellers dominating the market  Products sold:     homogenous (like in perfect competition: petrol, cement, steel and aluminium), or differentiated (like in monopolistic competition: cars, motorbikes, televisions, washing machines, and soft drinks) Entry is not restricted but difficult due to requirement of investments Interdependence of various firms  no player can take a decision without considering the action of rivals
  • 3. More on Features  Entry Barriers  no legal barriers to entry but there are various economic barriers which restrict the number of firms in the market     Huge investment requirements Strong consumer loyalty for existing brands Economies of scale Interdependent Decision Making  one firm cannot take any decision independent of other firms  each is selling a product which is either a perfect substitute (homogenous) or a very close substitute (differentiated)
  • 4. More..  Non Price Competition: Firms are continuously watching their rivals, each of them avoids the incidence of a price war. P1 A P2 Market share of A   O B Market share of B •Two firms A & B sell homogenous product. •Prevailing price is P1, but firm A lowers the price. • By this act of A, 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 P2. • At this point both realize that this price war is not helping either of them and decide to end the war. With this, the price stabilises at P2. Since the prevailing price is fixed after a series of such price wars and firms know that price war benefits only consumers and not the firms, hence they keep the price untouched. In case of cartels, all the firms openly or tacitly agree to sell their products at the same price.
  • 5. More..  Indeterminate Demand Curve Price and output determination is a very complex as each firm faces two demand curves.  Demand is not only affected by its own price or advertisement or quality, but also by the price of rival products, their quality, packaging, promotion and placement. One of these two demand curves is highly Pric D elastic and the other one is less elastic. e This is due to the different types of D reactions by rival firms in response to a move to change its price by one firm.  1 D1 O D Quantity
  • 6. Duopoly   A special case of oligopoly, with only two players No single model can explain the determination of equilibrium price and output     Difficulty in determining 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 First attempt was in 1938 by French economist Cournot, followed thereafter by various other models.
  • 7. Cournot’s Model 2 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    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
  • 8. Cournot’s Model Price, Revenue, Cost D A PA B PB O QA QB MRA MRB •Firm A produces profit maximising output at MR=MC=0. •Firm A sells half of the total market demand (equal to OD*). •Point A is the mid point of DD*. •Firm B assumes A will continue to produce OQA ,so considers QAD* as the market available to it and AD* as its demand curve. D* Its MR curve will be MRB. Quantity •B maximizes profit and produce QB. A and B together supply to three fourths of the total market, while one fourth remains unattended.
  • 9. Kinked Demand Curve Paul Sweezy (1939)  Explains ‘price stickiness’ Two Basic assumptions:  If a firm decreases price, others will also do the same    If a firm increases its price, others will not follow.     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. Firm will lose large number of its customers to rivals due to substitution effect. Thus the 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.
  • 10. Price, Revenue, D1 Cost MC1 K P MC2 A S T D2 B O Q MR Quantity •Kink is at point K. •D1K = highly elastic portion of the demand curve •KD2 = less elastic portion, when rival firms react with a price reduction. •Discontinuity in AR creates discontinuity in the MR curve. •At the kink, MR is constant between point A and B. •Producer will produce OQ, whether it is operating on MC1 or MC2, 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.
  • 11. Collusive Oligopoly Rival firms enter into an agreement in mutual interest on various accounts like 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: is a formal (explicit) agreement among firms on price and output.    Cartels   occur 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 . can be of two types: centralized cartels and market sharing cartels
  • 12. Centralized Cartel Price, Cost, Revenue MCB MCA ∑MC P AR=D MR O QB QA Q Quantity MCA = A’s marginal cost MCB = B’s marginal cost In cartel,∑MC = industry marginal cost; OQ is the profit maximizing output because at this output level MR=∑MC. OP = price at which both firms can sell their output. At MC=MR; OQA = output of A, OQB = output of firm B. OQ=OQA + OQB; OQA > OQB. Price will be determined by summation of all firms’ costs and demand. An individual firm is thus just a price taker. But with large number of firms and small size of the market some firms may deviate from the cartel price and thus cheat other members.
  • 13. Informal and Tacit Collusion   Firms do not declare a cartel, but informally agree to charge the same price and compete on non price aspects. Oligopolists desist from price variation due to the fear of price war.    This results in a kinked demand curve. 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. As damaging to consumers as formal cartels   makes an oligopoly act like a monopoly (in a limited sense) and deprives consumers of the benefits of competition
  • 14. Price Leadership The agreed upon price under collusion is fixed on going rate or is the price charged by largest or most sophisticated player.  Dominant Firm:     a leader in terms of market share, or presence in all segments, or just being 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 Two major reasons :  lets others exist 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
  • 15. Price Leadership Limitation:  Success exists on the assumptions that others will follow the leaderW  Another rival may take advantage of the benevolence of the leader and charge a lower price.  So, the dominant firm acts exploitative  it 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  firm acts like a barometer for the market  firm would be able to see the link of this phenomenon with its impact on cost of production, on the demand for the product or on the general price index