Oligopoly is a market structure with a small number of firms that interact strategically. Firms must consider competitors' actions when making decisions. Entry is difficult due to requirements for large investments. Firms may produce homogeneous or differentiated products. Pricing is complex and interdependent, as firms watch each other closely to avoid price wars. Collusion, either explicitly through cartels or tacitly, often emerges to increase profits through coordinated pricing and output decisions.

1. Chapter 12
Oligopoly

2. Oligopoly
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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
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Products sold:
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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
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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
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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
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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..
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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
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A special case of oligopoly, with only two players
No single model can explain the determination of equilibrium
price and output
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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:
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Each firm maximizes profit
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Cost of production is nil because the springs are available free from
nature, i.e. MC=0
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Market demand is linear; hence the demand curve is a downward
sloping straight line
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Each firm decides on its price assuming that the other firm’s output
is given
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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
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If a firm increases its price, others will not follow.
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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.
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Cartels
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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
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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.
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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
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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:
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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:
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allows other firms to exist by fixing a price at which small firms may
also sell
Two major reasons :
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lets others exist so that it does not have to face allegations of
monopoly creation;
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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:
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Success exists on the assumptions that others will follow the leaderW
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Another rival may take advantage of the benevolence of the leader and
charge a lower price.
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So, the dominant firm acts exploitative
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it fixes a price at which small inefficient players may not survive and thus it
gains large share of the market
Barometric Firm
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Has better industry intelligence and can preempt and interpret its external
environment in an effective manner
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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
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firm acts like a barometer for the market
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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