LECTURE NOTES ON MANAGERIAL ECONOMICS FOR STUDENTS ACADEMIC USE BY DR.

NEHA
MATHUR MA'AM

Oligopoly: Definition, Characteristics and Concepts

Oligopoly Origin
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and
‘Polein’ meaning ‘to sell’.

Oligopoly Definition and Meaning

Oligopoly is defined as a market structure with a small number of firms, none of
which can keep the others from having significant influence.

Meaning of Oligopoly Market

An Oligopoly market situation is also called ‘competition among the few’. An
oligopoly is an industry which is dominated by a few firms. In this market, there are
a few firms which sell homogeneous or differentiated products. Also, as there are
few sellers in the market, every seller influences the behaviour of the other firms
and other firms influence it. Oligopoly is either perfect or imperfect/differentiated.
In India, some examples of an oligopolistic market are automobiles, cement,
steel, aluminium, etc.

Characteristics of Oligopoly
Now that the Oligopoly definition is clear, it’s time to look at the characteristics of
Oligopoly:

Few firms

Under Oligopoly, there are a few large firms although the exact number of firms is
undefined. Also, there is severe competition since each firm produces a significant
portion of the total output.
Barriers to Entry

Under Oligopoly, a firm can earn super-normal profits in the long run as there are
barriers to entry like patents, licenses, control over crucial raw materials, etc. These
barriers prevent the entry of new firms into the industry.

Non-Price Competition

Firms try to avoid price competition due to the fear of price wars in Oligopoly and
hence depend on non-price methods like advertising, after
sales services, warranties, etc. This ensures that firms can influence demand and
build brand recognition.

Interdependence

Under Oligopoly, since a few firms hold a significant share in the total output of the
industry, each firm is affected by the price and output decisions of rival firms.
Therefore, there is a lot of interdependence among firms in an oligopoly. Hence, a
firm takes into account the action and reaction of its competing firms while
determining its price and output levels.

Nature of the Product

Under oligopoly, the products of the firms are either homogeneous or differentiated.

Selling Costs

Since firms try to avoid price competition and there is a huge interdependence
among firms, selling costs are highly important for competing against rival firms for
a larger market share.

No unique pattern of pricing behaviour

Under Oligopoly, firms want to act independently and earn maximum profits on
one hand and cooperate with rivals to remove uncertainty on the other hand.

Depending on their motives, situations in real-life can vary making predicting the
pattern of pricing behaviour among firms impossible. The firms can compete or
collude with other firms which can lead to different pricing situations.

Indeterminateness of the Demand Curve

Unlike other market structures, under Oligopoly, it is not possible to determine the
demand curve of a firm. This is because on one hand, there is a huge
interdependence among rivals. And on the other hand there is uncertainty regarding
the reaction of the rivals. The rivals can react in different ways when a firm changes
its price and that makes the demand curve indeterminate.

Firms behaviour under Oligopoly

Based on the objectives of the firms, the magnitude of barriers to entry and the
nature of government regulation, there are different possible outcomes in relation to
a firm’s behaviour under Oligopoly. These are:

1. Stable prices

2. Price wars

3. Collusion for higher prices

Further, Oligopoly can either be collusive or non-collusive. Collusive oligopoly is a
market situation wherein the firms cooperate with each other in determining price
or output or both. A non-collusive oligopoly refers to a market situation where the
firms compete with each other rather than cooperating.

Non-Collusive Oligopoly-Sweezy’s Kinked Demand Curve Model (Price-Rigidity)

Usually, in Oligopolistic markets, there are many price rigidities. In 1939, Paul
Sweezy used an unconventional demand curve – the kinked demand curve to
explain these rigidities.

Reason for the kink in the demand curve

It is assumed that firms behave in a two-fold manner in reaction to a price change

by a rival firm. In simple words, firms follow price cuts by a rival company but not
price increases. So, if a seller increases the price of his product, his rivals do not
follow the price increase.

Therefore, the market share of the firm reduces significantly as a result of the price
rise. On the other hand, if a seller reduces the price of his product, then the rivals
also reduce their price to bring it at par with the price reduction of the firm.

This ensures that they prevent their market share from falling. Once the rivals react,
the firm lowering the price first cannot gain from the price cut.

Why the price rigidity?

As can be seen above, a firm cannot gain or lose by changing its price from the
prevailing price in the market. In both cases, there is no increase in demand for the
firm which changes its price. Hence, firms stick to the same price over time leading
to price rigidity under oligopoly.

Explanation of the Kinked-Demand Curve Model

In the figure above, KPD is the is the kinked-demand curve and OP0 is the
prevailing price in the oligopoly market for the OR product of one seller. Starting
from point P, corresponding to the point OP1, any increase in price above it will
considerably reduce his sales as his rivals will not follow his price increase.

This is because the KP portion of the curve is elastic and the corresponding portion
of the MR curve (KA) is positive. Therefore, any price increase will not just reduce
the total sales but also his total revenue and profit. On the other hand, if the seller
reduces the price of the product below OPQ (or P), his rivals will also reduce their
prices.

However, even if his sales increase, his profits would be less than before. This is
because the PD portion of the curve below P is less elastic and the corresponding
part of the marginal revenue curve below R is negative. Therefore, in both price-
raising and price-reducing situations, the seller is the loser. He will stick to the
prevailing market price OP0 which remains rigid.

Working of the kinked-demand curve

Let’s analyze the effect of changes in cost and demand conditions on price stability
in the oligopolistic market. Let’s suppose that the prevailing price in the market is
OP0.
Therefore, if one seller increases the price above OP0 and the rival sellers don’t and
keep the prices of their products at OP, then it will lead to the product becoming
costlier than the others.

Subsequently, the demand for the costlier product will fall significantly. This is
seen in the demand curve of a firm for any price above OP0 or the KP section of the
curve, is relatively elastic. The high elasticity reduces the demand significantly as a
result of the price increase.

On the other hand, if the seller reduces the price below OP0, the rivals also follow
the price cut to prevent their demand from falling. This is seen in the demand curve
of a firm for any price below OP0 or the PD segment of the curve is relatively
inelastic. The low elasticity does not increase the demand significantly as a result of
the price cut.

This asymmetrical behavioral pattern results in a kink in the demand curve and
hence there is price rigidity in oligopoly markets. The prices remain rigid at the
kink (point P). In other words, the price will remain sticky at OP0 and the output =
OR at this price.

Due to the difference in the elasticities, the MR curve becomes discontinuous

corresponding to the point of change in elasticity of the demand curve. The kink
represents this. At the output < OR, the demand curve is KP and the corresponding
MR curve is KA. For output > OR, the demand curve is PD and the corresponding
MR curve is BMR.

Collusive Oligopoly

Sometimes, firms may try to remove uncertainty related to acting independently and
enter into price agreements with each other. This is collusion. Collusion is either
formal or informal. It can take the form of cartel or price leadership.

A cartel is an association of independent firms within the same industry which

follow the common policies relating to price, output, sale, profit maximization,
and the distribution of products.

Price leadership is based on informed collusion. Under price leadership, one firm is
a large or dominant firm and acts as the price leader who fixes the price for the
products while the other firms allow it.