MICROECONOMICS II

BCOM 4TH SEMESTER( HONS & GEN)

KOYEL CHAKRABORTY
OLIGOPOLY MARKET

Characteristics of Oligopoly Market

1. Interdependence:

The foremost characteristic of oligopoly is interdependence of the

various firms in the decision making.

This fact is recognized by all the firms in an oligopolistic industry. If a

small number of sizeable firms constitute an industry and one of these
firms starts advertising campaign on a big scale or designs a new model
of the product which immediately captures the market, it will surely
provoke countermoves on the part of rival firms in the industry.

Thus different firms are closely inter-dependent on each other.

2. Advertising:

Under oligopoly a major policy change on the part of a firm is likely to

have immediate effects on other firms in the industry. Therefore, the
rival firms remain all the time vigilant about the moves of the firm
which takes initiative and makes policy changes. Thus, advertising is a
powerful instrument in the hands of an oligopolist. A firm under
oligopoly can start an aggressive advertising campaign with the
intention of capturing a large part of the market. Other firms in the
industry will obviously resist its defensive advertising.

Under perfect competition advertising is unnecessary while a

monopolist may find some advertising to be profitable when his product
is new or when there exist a large number of potential consumers who
have never tried his product earlier. But according to Prof. Baumol,
“under oligopoly, advertising can become a life-and-death matter where
a firm which fails to keep up with the advertising budget of its
competitors may find its customers drifting off to rival products.”

3. Group Behaviour:

In oligopoly, the most relevant aspect is the behaviour of the group.

There can be two firms in the group, or three or five or even fifteen, but
not a few hundred. Whatever the number, it is quite small so that each
firm knows that its actions will have some effect on other firms in the
group. In contrast, under perfect competition there are a large number of
firms each attempting to maximise its profits.

Similar is the situation under monopolistic competition. Under

monopoly, there is just one profit maximising firm. Whether one
considers monopoly or a competitive market, the behaviour of a firm is
generally predictable.

In oligopoly, however, this is not possible due to various reasons:

(i) The firms constituting the group may not have a common goal

(ii) The group may or may not have a formal or informal organization
with accepted rules of conduct

(iii) The group may be dominated by a leader but other firms in the
group may not follow him in a uniform manner.

4. Competition:

This leads to another feature of the oligopolistic market, the presence of

competition. Since under oligopoly, there are a few sellers, a move by
one seller immediately affects the rivals. So each seller is always on the
alert and keeps a close watch over the moves of its rivals in order to
have a counter-move. This is true competition, “True competition
consists of the life of constant struggle, rival against rival, whom one can
only find under oligopoly.”

5. Barriers to Entry of Firms:

As there is keen competition in an oligopolistic industry, there are no
barriers to entry into or exit from it. However, in the long-run, there are
some types of barriers to entry which tend to restrain new firms from
entering the industry.

These may be:

(a) Economics of scale enjoyed by a few large firms;

(b) Control over essential and specialized inputs;

(c) High capital requirements due to plant costs, advertising costs, etc.

(d) Exclusive patents; and licenses; and

(e) The existence of unused capacity which makes the industry

unattractive.

When entry is restricted or blocked by such natural and artificial barriers

the oligopolistic industry can earn long-run supernormal profits.

6. Lack of Uniformity:

Another feature of oligopoly market is the lack of uniformity in the size

of firms. Firms differ considerably in size. Some may be small, others
very large. Such a situation is asymmetrical. This is very common in the
American economy. A symmetrical situation with firms of a uniform
size is rare.

7. Existence of Price Rigidity:

In oligopoly situation, each firm has to stick to its price. If any firm tries
to reduce its price, the rival firms will retaliate by a higher reduction in
their prices. This will lead to a situation of price war which benefits
none. On the other hand, if any firm increases its price with a view to
increase its profits; the other rival firms will not follow the same. Hence,
no firm would like to reduce the price or to increase the price. The price
rigidity will take place.

8. No Unique Pattern of Pricing Behaviour:

The rivalry arising from interdependence among the oligopolists leads
to two conflicting motives. Each wants to remain independent and to get
the maxmium possible profit. Towards this end, they act and react on
the price-output movements of one another which are a continuous
element of uncertainty.

On the other hand, again motivated by profit maximisation each seller

wishes to cooperate with his rivals to reduce or eliminate the element of
uncertainty. All rivals enter into tacit or formal agreement with regard to
price-output changes.

It leads to a sort of monopoly within oligopoly. They may even

recognize one seller as a leader at whose initiative all the other sellers
raise or lower the price. In this case, the individual seller’s demand
curve is a part of the industry demand curve, having the elasticity of the
latter. Given these conflicting attitudes, it is not possible to predict any
unique pattern of pricing behaviour in oligopoly markets.

9. Indeterminateness of Demand Curve:

In market structures other than oligopolistic, demand curve faced by a

firm is determinate. The interdependence of the oligopolists, however,
makes it impossible to draw a demand curve for such sellers except for
the situations where the form of interdependence is well defined. In real
business operations, the demand curve remains indeterminate. Under
oligopoly a firm can expect at least three different reactions of the other
sellers when it lowers its prices.

This happened due to the reason:

(i) It is possible that other maintain the prices they had before. In this
case, an oligopolist can hope that its demand would increase
substantially as the prices are lowered,

(ii) When an oligopolist reduces his price, the other sellers also lower
their prices by an equivalent amount. In this situation although demand
of the oligopolist making the first move will increase as he lowers his
price, the increase itself would be much smaller than in the first case.
(iii) When a firm reduces its price, the other sellers reduce their prices far
more. Under the circumstances the demand for the product of the
oligopolistic firm which makes the first move may decrease. Thus
uncertainty under oligopoly is inevitable, and as a result, the demand
curve faced by each firm belonging to the group is necessarily
indeterminate.

Non-Collusive Oligopoly: Sweezy’s Kinked Demand Curve

Model:
One of the important features of oligopoly market is price rigidity. And
to explain the price rigidity in this market, conventional demand curve
is not used. The idea of using a non-conventional demand curve to
represent non-collusive oligopoly (i.e., where sellers compete with their
rivals) was best explained by Paul Sweezy in 1939. Sweezy uses kinked
demand curve to describe price rigidity in oligopoly market structure.

The kink in the demand curve stems from the asymmetric behavioural
pattern of sellers. If a seller increases the price of his product, the rival
sellers will not follow him so that the first seller loses a considerable
amount of sales. In other words, every price increase will go unnoticed
by rivals.

On the other hand, if one firm reduces the price of its product other
firms will follow the first firm so that they must not lose customers. In
other words, every price will be matched by an equivalent price cut. As
a result, the benefit of price cut by the first firm will be inconsiderable.
As a result of this behavioural pattern, the demand curve will be kinked
at the ruling market price.
Suppose, the prevailing price of an oligopoly product in the market is
QE or OP of Fig. 5.19. If one seller increases the price above OP, rival
sellers will keep the prices of their products at OP. As a result of high
price charged by the firm, buyers will shift to products of other sellers
who have kept their prices at the old level. Consequently, sales of the
first seller will drop considerably.

Kinked Demand Curve and Oligopoly Equilibrium

That is why demand curve in this zone (dE) is relatively elastic. On the
other hand, if a seller reduces the price of his product below QE, others
will follow him so that demand for their products does not decline.
Thus, demand curve in this region (i.e., ED) is relatively inelastic. This
behavioural pattern thus explains why prices are inflexible in the
oligopoly market — even if demand and costs change.

The kink in the demand curve at point E results in a discontinuous MR

curve.

The MR curve has two segments :

At output less than OQ the MR curve (i.e., dA) will correspond to DE

portion of AR curve, and, for output larger than OQ, the MR curve (i.e.,
BMR) will correspond to the demand curve ED. Thus, discontinuity in
MR curve occurs between points A and B. In other words, between these
two points, MR curve is vertical.

Equilibrium is achieved when MC curve passes through the

discontinuous portion of the MR curve. Thus the equilibrium output is
OQ, to be sold at a price OP.

Suppose, costs rise. As a result, MC curve will shift up from MC1 to

MC2. The resulting price and output remain unchanged at OP and OQ,
respectively. This fact explains stickiness of prices. In other words, in
oligopolistic industries price is more stable than costs.

At first sight, the model seems to be attractive since it explains the

behaviour of firms realistically. But the model has certain limitations.
Firstly, it does not explain how the ruling price is determined. It explains
that the demand curve has a kink at the ruling price.

In this sense, it is not a theory of pricing. Secondly, price rigidity

conclusion is not always tenable. Empirical evidence suggests that
higher costs force a further price rise above the kink. Despite these
limitations, the model is popular among textbook authors.

Collusive Oligopoly or Cartel Model

In a model of collusive oligopoly, we discuss the economics of

agreement between the firms in an undifferentiated oligopolistic
industry. When these firms get together and agree to set prices and
outputs so as to maximise total industry profits, they are known as
a cartel.
Assumptions of the Cartel Model:

For the sake of simplicity, we shall make here the following

assumptions:

(i) There are only two firms in the oligopolistic industry,

i.e., here we have a case of duopoly.

(ii) Each firm produces and sells a product that is a perfect

substitute for that of the other.

(iii) The product is perishable.

(iv) There are many knowledgeable buyers of the product.

(v) Each firm knows the market demand for the product.

(vi) The two firms have different cost curves.

(vii) Both the firms have the same expectations about the prices and
productivities of the inputs which they use.

(viii) The price of the product is the sole parameter of action of each
firm.

(ix) The two firms are contemplating whether or not to form a cartel
and agree upon a price that will promise the maximum
maximorum of profits per period to both of them jointly

Collusive Oligopoly Model: Price Leadership Model:

Non-collusive oligopoly model (Sweezy’s model) presented in the

earlier section is based on the assumption that oligopoly firms act
independently even though firms are interdependent in the market. A
vigorous price competition may result in uncertainty.
The question that arises now is: how do oligopoly firms remove
uncertainty? In fact, firms enter into pricing agreements with each other
instead of adopting competition or price war with each other. Such
agreement—both explicitly (or formal) and implicit (or informal)—may
be called collusion.

Always, every firm has the inclination to achieve more strength and
power over the rival firms. As a result, in the oligopolist industry, one
finds the emergence of a few powerful competitors who cannot be
eliminated easily by other powerful firms.

Under the circumstance, some of these firms act together or collude with
each other to reap maximum advantage. In fact, in oligopolist industry,
there is a natural tendency for collusion. The most important forms of
collusion are: price leadership cartel and merger and acquisition.

When a formal collusive agreement becomes difficult to launch,

oligopolists sometimes operate on informal tacit collusive agreements.
One of the most common form of informal collusion is price leadership.
Price leadership arises when one firm—may be a large as well as
dominant firm—initiates price changes while other firms follow.

An example of dominant firm price leadership is shown in Fig. 5.20

where DT is the industry demand curve. Since small firms follow the
leader—the dominant firm—they behave as “price-takers”. MCs is the
horizontal summation of the MC curves of all small firms.
Price Leadership Model

Suppose, the dominant firm sets the price at OP1 (where DT and MCs
intersect each other at point C). The small firms meet the entire demand
P1C at the price OP1. Thus, the dominant firm has nothing to sell in the
market. At a price of OP3, the small firm will supply nothing. It is
obvious that price will be set in between OP1 and OP3 by the leader.

The demand curve faced by the leader firm of the oligopoly industry is
determined for any price—it is the horizontal distance between industry
demand curve, DT, and the marginal cost curves of all small firms, MCS.
In Fig. 5.20, DL is the leader’s demand curve and the corresponding MR
curve is MRL.

Being a leader in the industry, the dominant firm’s supply curve is

represented by the MCL curve. Since it enjoys a cost advantage, its MC
curve lies below the MCS curve.
A dominant firm maximizes profit at point E where its MCL and MRL
intersect each other. The corresponding output of the price leader is
OQL. Price thus determined is OP2. Small firms accept this price OP2
and sell QLQT (=AB) amount – industry demand the OQT output.

In actual practice, the analysis of price leadership is complicated,

particularly when new firms enter the industry and try to become the
leader or dominant.

Collusive Oligopoly—Merger and Acquisition:

Another method to remove price war among oligopoly firms is merger.

Merger may be defined as the consolidation of two or more independent
firms under single ownership. When a firm purchases assets of another
firm, acquisition takes place. Merger and acquisition take place because
the management comes to a conclusion that a consolidated firm is
powerful than the sum of individual firms.

Since basically the difference between cartel and merger is a legal one,
we won’t consider mergers and acquisitions. The marginalistic principle
applied in the case of profit maximizing cartel is also applicable in the
case of merger.

Conclusion:

Can we make some definite conclusions from the oligopolistic market

structure? Though one can make unambiguous predictions about perfect
competition as well as monopoly, no such predictive element of an
oligopolistic competition exists. It is, thus, a perplexing market structure.
One important characteristic of an oligopoly market is interdependence
among sellers.

Each seller’s price-output decision is influenced by the perceptions of

countermoves of rival sellers.
Given the large number of possible reactions, we come up with different
models based on different assumptions about the behaviour of the rival
sellers, the extent and form of exit and entry, the likelihood of collusion
between firms. ‘Unfortunately, economic theory does not suggest which
assumptions to use. In any event, each of these theories must ultimately
stand or fall on its predictive powers’.