PRICE AND OUTPUT DETERMINATION UNDER

OLIGOPOLY

INTRODUCTION:
The market in economics is the place where sellers of goods and services meet
the buyers of these goods and services where there is a likely possibility for a
transaction to take place.
Economists assume that there are a number of different buyers and sellers in the
marketplace; this means that we have competition in the market, which allows
price to change in response to changes in supply and demand. Furthermore, for
almost every product there are substitutes, so if one product becomes too
expensive, a buyer can choose a cheaper substitute instead.
The basic principle in markets is easily stated: a commodity should be produced
if the costs can be covered by the sum of revenues and a properly defined measure
of consumer’s surplus. The optimum can be realized in a market if perfectly
discriminatory pricing is possible.

DEFINITION OF MARKET:
An arrangement whereby buyers and sellers come in close contact with each other
directly or indirectly, to sell and buy goods is described as market.
CLASSIFICATION OF MARKET STRUCTURES:
 CLASSIFICATION OF MARKETS

AREAWISE TIME ELEMENT COMPETITION

LOCAL VERY SHORT PERIOD PERFECT

MARKETS MARKET COMPETITION

REGIONAL SHORT PERIOD MONOPOLY

MARKETS MARKET

NATIONAL LONG PERIOD OLIGOPOLY

MARKETS MARKET

WORLD MONOPOLISTIC
MARKETS VERY LONG PERIOD COMPETITION
MARKET

IMPERFECT COMPETITION:
Theoretically, perfect competition is the simplest market situation assumed by the
economists. Modern economists like Mrs. Joan Robinson and Prof. Chamberlin
have, however, challenged the very concept of perfect competition. They regard
and it as a totally unrealistic model, something imaginary, without any relation
whatsoever to economic reality. All conditions of perfect competition do not exist
simultaneously. So, in reality there is imperfect rather than perfect competition.
In reality, competition is never perfect. So, there is imperfect competition when
perfect form of competition among the sellers and the buyers does not exist. This
happens as the number of firms may be small or products may be differentiated
by different sellers in actual practice. Similarly, there is no pure monopoly in
reality. Imperfect competition covers all other forms of market structures ranging
from highly competitive to less competitive in nature. Traditionally, oligopoly
and monopolistic competition are categorised as the most realistic forms of
market structures under imperfect competition.
OLIGOPOLY:
Oligopoly is a market structure characterized by a small number of large firms
that dominate the market, selling either identical or differentiated products, with
significant barriers to entry into the industry. This is one of four basic market
structures. The other three are perfect competition, monopoly, and monopolistic
competition. Oligopoly dominates the modern economic landscape, accounting
for about half of all output produced in the economy. Oligopolistic industries are
as diverse as they are widespread, ranging from breakfast cereal to cars, from
computers to aircraft, from television broadcasting to pharmaceuticals, from
petroleum to detergent.
Oligopoly is a market structure characterized by a small number of relatively
large firms that dominate an industry. The market can be dominated by as few as
two firms or as many as twenty, and still be considered oligopoly. With fewer
than two firms, the industry is monopoly. As the number of firms increase (but
with no exact number) oligopoly becomes monopolistic competition.

Because an oligopolistic firm is relatively large compared to the overall market,

it has a substantial degree of market control. It does not have the total control over
the supply side as exhibited by monopoly, but its capital is significantly greater
than that of a monopolistically competitive firm.

Relative size and extent of market control means that interdependence among
firms in an industry is a key feature of oligopoly. The actions of one firm depend
on and influence the actions of another. Such interdependence creates a number
of interesting economic issues. One is the tendency for competing oligopolistic
firms to turn into cooperating oligopolistic firms. When they do, inefficiency
worsens, and they tend to come under the scrutiny of government. Alternatively,
oligopolistic firms tend to be a prime source of innovations, innovations that
promote technological advances and economic growth.

Like much of the imperfection that makes up the real world, there is both good
and bad with oligopoly. The challenge in economics is, of course, to promote the
good and limit the bad.

DEFINITION:
“A market dominated by a small number of participants who are able to
collectively exert control over supply and market prices”.
FEATURES OF OLIGOPOLY:
FEW SELLERS - Oligopoly form of market consists of few sellers. As against
perfect and imperfect market, the numbers in oligopoly is limited, usually it is
not more than ten. In case there are more sellers, a few will be dominant firms,
others being insignificant.
DIFFERENTIATED PRODUCT - Oligopolists usually sell differentiated
products. Differentiation is in the form of trade mark, design or service.
Developing brand equity has become important for oligopoly firms.
ENTRY IS POSSIBLE BUT DIFFICULT - A new firm can enter the
oligopoly market. In reality, however, it is highly difficult to enter due to
financial, technological and other barriers to the entry. Whenever the profits are
high, the new firms do enter the market.
UNCERTANITY - Interdependence on other firms for one’s own decision
creates an atmosphere of uncertainty about the output and price. If an oligopolist
increases his output to capture the larger portion of the market, others too will
react in a similar way. In case he increases the price, others are unlikely to do so.
The rivals will not increase the price in order to sell more at a lower
price. On the contrary when an oligopolist decreases the price others will also
reduce the price in order to prevent any reduction in sales due to non-competitive
price. An oligopolist therefore is highly uncertain about the reaction of his rivals
to his own decision.
BEHAVIOUR OF OLIGOPOLY:
Although oligopolistic industries tend to be diverse, they also tend to exhibit
several behavioral tendencies: (1) interdependence, (2) rigid prices, (3) nonprice
competition, (4) mergers, and (5) collusion.
 Interdependence: Each oligopolistic firm keeps a close eye on the activities
of other firms in the industry. Decisions made by one firm invariably affect
others and are invariably affected by others. Competition among
interdependent oligopoly firms is comparable to a game or an athletic
contest. One team's success depends not only on its own actions but on the
actions of its competitor. Oligopolistic firms engage in competition among
the few.
 Rigid Prices: Many oligopolistic industries (not all, but many) tend to keep
prices relatively constant, preferring to compete in ways that do not involve
changing the price. The prime reason for rigid prices is that competitors
are likely to match price decreases, but not price increases. As such, a firm
has little to gain from changing prices.
 Nonprice Competition: Because oligopolistic firms have little to gain
through price competition, they generally rely on nonprice methods of
competition. Three of the more common methods of nonprice competition
are: (a) advertising, (b) product differentiation, and (c) barriers to entry.
 The goal for most oligopolistic firms is to attract buyers and increase
market share, while holding the line on price.
 Mergers: Oligopolistic firms perpetually balance competition against
cooperation. One way to pursue cooperation is through merger--legally
combining two separate firms into a single firm. Because oligopolistic
industries have a small number of firms, the incentive to merge is quite
high. Doing so then gives the resulting firm greater market control.
 Collusion: Another common method of cooperation is through collusion--
two or more firms that secretly agree to control prices, production, or other
aspects of the market. When done right, collusion means that the firms
behave as if they are one firm, a monopoly. As such they can set a
monopoly price, produce a monopoly quantity, and allocate resources as
inefficiently as a monopoly. A formal method of collusion, usually found
among international produces is a cartel.
PRICE LEADERSHIP:
A method used by a group of firms in the same market (typically oligopoly
firms) in which one firm takes the lead in setting or changing prices, with
other firms then following behind. The lead firm is often the largest firm
in the industry, but it could be a smaller firm that has just historically
assumed the role of price leader perhaps because it is more aware of
changing market conditions. While price leadership is totally legal, it could
be a sign of collusion, particular implicit collusion, in which the firms have
effectively monopolized the market.
CARTEL:
One of the most noted examples of explicit collusion is a cartel. While the
term cartel can be used to mean any type of explicit collusion, it is often
reserved for international agreements, such as the Organization of
Petroleum Exporting Countries (better known as OPEC).
OPEC is perhaps the most famous international cartel, which exerts control
over the world petroleum market. International cartels, more often than not,
officially are political treaties among countries. However, when the
countries also control the production of a good like petroleum, and when
the treaty is primarily designed as a means of influencing the global market
for this good, then the treaty also becomes a formal economic arrangement
and an example of explicit collusion.
PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY:
There is no single model describing the operation of an oligopolistic market. The
variety and complexity of the models is due to the fact that you can have two to
102 firms competing on the basis of price, quantity, technological innovations,
marketing, advertising and reputation. Some of the better-known models are the
dominant firm model, the Cournot-Nash model, the Bertrand model and the
kinked demand model.
Dominant firm model - In some markets there is a single firm that controls a
dominant share of the market and a group of smaller firms. The dominant firm
sets prices which are simply taken by the smaller firms in determining their profit
maximizing levels of production. This type of market is practically a monopoly
and an attached perfectly competitive market in which price is set by the dominant
firm rather than the market.
Cournot-Nash model - The Cournot-Nash model is the simplest oligopoly
model. The models assume that there are two “equally positioned firms”; the
firms compete on the basis of quantity rather than price and each firm makes an
“output decision assuming that the other firm’s behavior is fixed.” The market
demand curve is assumed to be linear and marginal costs are constant. To find the
Cournot-Nash equilibrium one determines how each firm reacts to a change in
the output of the other firm. The path to equilibrium is a series of actions and
reactions. The pattern continues until a point is reached where neither firm desires
“to change what it is doing, given how it believes the other firm will react to any
change.”
Bertrand model - The Bertrand model is essentially the Cournot-Nash
model except the strategic variable is price rather than quantity.
The model assumptions are:
• There are two firms in the market.
• They produce a homogeneous product.
They produce at a constant marginal cost.
• Firms choose prices PA and PB simultaneously.
• Firms output are perfect substitutes.
• Sales are split evenly if PA = PB.
• The only Nash equilibrium is PA = PB = MC.
PRICE DETERMINATION MODEL OF OLIGOPOLY:
The kinked demand curve theory is an economic theory regarding oligopoly and
monopolistic competition. When it was created, the idea fundamentally
challenged classical economic tenets such as efficient markets and rapidly-
changing prices, ideas that underlie basic supply and demand models. Kinked
demand was an initial attempt to explain sticky prices.
An oligopolist faces a downward sloping demand curve but the elasticity may
depend on the reaction of rivals to changes in price and output. Assuming that
firms are attempting to maintain a high level of profits and their market share it
may be the case that:
(a) rivals will not follow a price increase by one firm - therefore demand will be
relatively elastic and a rise in price would lead to a fall in the total revenue of the
firm
(b) rivals are more likely to match a price fall by one firm to avoid a loss of market
share. If this happens demand will be more inelastic and a fall in price will also
lead to a fall in total revenue.

Figure 1
The kink in the demand curve at price P and output Q means that there is a
discontinuity in the firm's marginal revenue curve. If we assume that the marginal
cost curve in is cutting the MR curve then the firm is maximizing profits at this
point.

Figure 2
In the bottom diagram, we see that a rise in marginal costs will not necessarily
lead to higher prices providing that the new MC curve (MC2) cuts the MR curve
at the same output. The kinked demand curve theory suggests that there will be
price stickiness in these markets and that firms will rely more on non-price
competition to boost sales, revenue and profits.

Figure 3

THE BAD OF OLIGOPOLY:

Like much of life, oligopoly has both bad and good. The bad are that oligopoly:
(1) tends to be inefficient in the allocation of resources and (2) promotes the
concentration, and thus inequality, of income and wealth.
• Inefficiency: First and foremost, oligopoly does NOT efficiently allocate
resources. Like any firm with market control, an oligopoly charges a higher price
and produces less output than the efficiency benchmark of perfect competition.
In fact, oligopoly tends to be the worst efficiency offender in the real world,
because perfect competition does not exist, monopolistic competition
inefficiency is minor, and monopoly inefficiency has the potential for being so
bad that it is inevitably subject to corrective government regulation.
• Concentration: Another bad is that oligopoly tends to increase the
concentration of wealth and income. This is not necessarily bad, but it can be self-
reinforcing and inhibit pursuit of the microeconomic goal of equity. While the
concentration of wealth is not bad unto itself, such wealth can then be used (or
abused) to exert influence over the economy, the political system, and society,
which might not be beneficial for society as a whole.
THE GOOD OF OLIGOPOLY:
With the bad comes a little good. The two most noted goods from oligopoly are
(1) by developing product innovations and (2) taking advantage of economies of
scale.
• Innovations: Of the four market structures, oligopoly is the one most likely to
develop the innovations that advance the level of technology, expand production
capabilities, promote economic growth, and lead to higher living standards.
Oligopoly has both the motive and the opportunity to pursue innovation. Motive
comes from interdependent competition and opportunity arises from access to
abundant resources.
• Economies of Scale: Oligopoly firms are also able to take advantage of
economies of scale that reduce production costs and prices. As large firms, they
can "mass produce" at low average cost. Many modern goods--including cars,
computers, aircraft, and assorted household products--would be significantly
more expensive if produced by a large number of small firms rather than a small
number of large firms.