Oligopoly

Introduction
It is a kind of market where a few dominant sellers sell
homogenous or differentiated/heterogenous products under
continuous consciousness of rivalry action by other firms. In the
market where a small number of big firms compete may be
termed as oligopoly. Automobile industry is the best example of
oligopoly where one can count the number of players. When the
oligopoly firms sell homogenous or identical products it is pure
oligopoly. Example; industries producing steel, copper, petroleum
etc. are pure oligopoly. When the firms sell differentiated
products, called differentiated oligopoly, ex: TV, cars.
When there are only two sellers like Coke and Pepsi, the situation
is known as duopoly.
Examples of oligopoly:
National markets for aluminum, cigarettes, electrical
equipment etc.
Local retail markets for gasoline, food, professional services,
etc.

FEATURES

Few Sellers: Sellers are few in number and produce the bulk of industry output
Interdependence of decision making: Since firms under oligopoly are small in
number, if a firm initiates a new business strategy in terms of pricing,
advertisement and product modification, it anticipates actions and counter
actions by the rival firms.
Homogenious or unique products: Oligopoly output can be identical (example;
aluminum)
Barriers to entry: The market condition is such that it requires Huge
investment and economies of scale in production by the existing firms. They
prevent the entry of other firms.
Imperfect dissemination of information: cost, price and product quality
information is withheld from un informed buyers.
Opportunity for economic profits in the longrun equilibrium for efficient firms
Non price competition: Due to small number of firms, they avoid incidence of
price war
Indeterminate demand curve of oligopoly which is very distinct from other
forms of competition. Price and output determination under oilgopoly is very
complex phenomenon as each firm faces two demand curves (one is highly
elastic and other one is less elastic). This is on account of different types of
reactions by rival firms in response to a move to change in its price by one firm.




Oligopoly models:
Interdependence: The Cournot Model
The feature of oligopolistic market of
interdependence can be explained with the help of
Cournot model (Augustin Cournot). He for the first
time developed the oligopoly model in 1838 in the
form of duopoly model. Let us explain Cournot
Model with two firms; known as Cournots Duopoly
facing a linear demand curve. It consists of two
sellers only and is explained using the example of
Spring (mineral) water.
Assumptions
Two firms;
Both the firms face a demand curve with constant
negative slope;
Each firm makes its output decision to maximise the
profit assuming that other firms output is given (not
change its production and sell of output);
The two firms are assumed to be ignorant about
probability of the change of output by each firm;
The firms have constant cost function (here zero cost)
D
O
MR
A
Q N M
P
P1
P2

P3
Two sellers, A & B. MC=0=MR. Let us take one seller, A.
For A selling OQ, the profit will be OPP2Q.
If B enters into the market, the market available for B is , which
is not supplied by A i.e QM. [This is half of the total market.
When MR=0, price elasticity is =1 i.e P2M/P2D=1=QM/OQ. This
means P2M=P2D and QM=OQ]. Bs output is QN (which is half
of QM)=1/2(1/2) =1/4 of the market. Bs profit is QRP3N. Now
firm A has to adjust the price which is low and the profit for A
becomes OP1RQ, less than OPP2Q. In the process of
adjustment the market share of A will decline and that of B will
increase. Finally the market will be settled when the share of
each will be equal.

MR
B
AR
R
Since there are 2 sellers under duopoly the total output
be Q
T
which is sum of q1 and q2 for individual 1 and 2.
Let us consider the product whose demand fn is given by
the following eqn: P=950- Q
T
,
The MC and AC are assumed to be constant and equal
to Rs 50. This assumption is taken for simplifying the
calculation and getting the insight more clearly.
A) Let the firm behaves like a monopolist- a single seller
maximising its profit when MC=MR
MR=950-2Q
T

The profit maximising eqn: 950-2Q
T
=50
solving the equation we get the profit maximising output
as Q
T
=450 and the Price or P=500
B) If the market is a perfectly competitive market Instead of
monopoly ;
P=950- Q
T
=50 and Q
T
= 900 and, P=50
Hence in the monopoly output is lower and price is higher than
perfect competition.
Now: TR1=[950-(q1+q2)] q1
= 950q1-q1
2
-q1.q2
MR1=dTR/dq1=950-q2-2q1=50
or q1=450-0.5q2 Firm-1
MR2=950-q1-2q2=50
or q2=450-0.5q1 Firm-2
These two are the reaction functions as each firm reacts to the
output choice of the other.
If we solve these two equations we get q1 and q2 as
300 each. Thus the market is in equilibrium when each firm
produces 300 units each. Two reaction curves intersect each
other at 300 units of output for each one.
Firm 2
Firm1
450
450
900
900
300
300
Reaction functions of Cournot Duopoly
Cournot Model with n Firms
The Cournot model can also be extended to n number
of firms under oligopoly. The industry with n firms , the
equilibrium output of Cournot Oligopoly is given by:
Q
n
=Q
c
(n/n+1)
If n becomes large the value of n/n+1 approaches
to unity.
This implies that as the number of firms in the
market increases, the combined output of those
firms approaches that of a perfectly competitive
market.

The most important flaw in this
model is in respect of its
assumptions ;
(i)rivals output remains
unchanged. In reality the rivals
change their out put.
(ii) Zero cost of production which
is unrealistic.
There are 2 firms in the industry, A &
B and the demand function is
P=200 Q, Q
A
and Q
B
are the
output of A and B.
MC
A
=MC
B
=80.
Find the reaction curves of the two
firms and their profit maximising
output.
Stackelbergs Model
German economist H.V. Stackelberg developed
his model known as the leader followed
model. One of the sophisticated firm is able to
determine the reaction curve of the rivals and
incorporates in its own profit function. Thus it
acts like a monopolist. The nave firm will
follow the decision of the first mover.
Under this model,Price signaling can reduce
uncertainty in oligopoly markets.
Price leadership occurs when firms follow the
industry leaders pricing policy.

Price Rigidity/sticky: Kinked demand curve model
It was developed by Paul Sweezy in 1939. He has shown
through the kinked demand curve analysis that price
and output once determined under oligopolistic
conditions tend to remain stable. Sometimes the prices
of some articles remain unchanged for a long period.
This rigidity in prices led Sweezy to suggest that
oligopolists behave as if facing a kinked demand curve.
The kinked demand curve model of oligopoly is based on
the assumption that rivals will match price reduction but
not price increase.
This model predicts that price change will be infrequent
in oligopolistic markets.
Sweezy model predicts sticky prices.

Price increases are sometimes ignored.
Price decreases are sometimes followed
Uncertainty creates sticky prices


Kinked Demand Curve

If competitors expect price increases to be ignored but
price decreases to be followed, a kink in the demand
curve results.

Sweezy model explains why prices in oligopoly markets
sometimes fail to respond to marginal cost changes.
MC
MC
MC
D
D
MR
2
MR
1
P
k
a
b
a
b
Q
k
The kink in the demand curve is
arrived when there is asymmetry
in the response of other firms to
one firms price change.
Suppose that the price was
initially at P
k
the point of kink on
the demand curve.
1. If one firm raises the price
and others might not follow
the increase, the result is loss
of sales by the firm which
initiated increase in price. This
is shown in relatively elastic
curve above P
k
(Dp)

2. If the reverse happens that is
when the firm reduces the
price below P
k
, and other
firms will follow it, the
original firm will also not gain
much in its sales. This is
shown in the relatively
inelastic curve below P
k
(pD)


O
p
e
e
e
Kinked demand curve Model
(SWEEZY MODEL)
c
n
Quantity
Price
The marginal revenue curve is always will be below the linear
demand curve. The kinked demand curve consists of two linear
demand curves joined at p for price P
K
. The MR curve above the kink
is MR
1
and that of below the kink is MR
2
. At the point of kink, the MR
curve is a vertical line that connects the two segments. The MR curve
is said to be dis continuous at point a and b. The vertical line ab
represents this discontinuity. Profit maximisation output occurs when
MR=MC. At output Q
k
, and price P
k
, the profit maximisation condition
is fulfilled in the areas of kink where MC intersects MR curve.
If MC shifts upward to MC due to increase in input prices, the profit
maximising out put and price remain unchanged as the MR curve is
vertical.
If MC shifts downward to MC due to decline in input prices, there is
no change in profit maximising output and prices, as the MC curve
intersects the vertical portion of MR curve.


The price and output will be changed if MC
curve and MR curve intersect either above a or
below b. As long as MC curves are placed at the
vertical portion of the MR curve there is no change
in the optimal output and prices.

The implication of kinked demand curve is
that even if there is substantial shift in the MC
curve there is no variation in the prices. Sweezys
observation is consistent with this as some
Oligopolists market exhibit very stable prices for a
long time..
Criticism
Though it explains stability in the output
and price, it does not say how the initial
price was determined. In this sense the
model is considered as incomplete to a
great extent.
Sufficient Empirical research has not yet
verified the prediction of the model in
respect of price change.

Problem:
Given the following functions
P
1
=7-1/4Q
1
; TR1=P1*Q1=7Q
1
-1/4Q1
2

MR1=7-1/2Q
1
P
2
=10-Q
2
; MR2=10-2Q
2

TC=1/4Q
2
+Q+50 MC=1/2Q+1
At kink: output Q1=Q2=Q and P=P1=P2
Hence:7-1/4Q=10-Q, Hence Q=4, P=6
MR1=5, MR2=2, MC=3
And MC falls between the gap of MR1 and MR2.
Derive MR
1
,MR
2
and MC . Determine price and output at the kink. What
are the lower and upper limits of MR curve? Prove that MC falls in the MR
gap

Collusion
One of the important feature of oligopoly is collusion
in which rival firms enter into an agreement with
mutual interest in respect of prices, market share etc.
In oligopoly industries the mangers try to avoid price
competition (known as price war). The best
alternative for them is to collude and set prices at or
near monopoly price. The collusion may be explicit
or tacit. Explicit collusion takes place when the
number of producers or sellers enter into an
agreement formally. The collusion which is not
Overt is called tacit collusion. The main aim of the
collusion is to reduce price competition and increase
profits of individual firms.
Cartel: When there is an explicit agreement among the
firms on price and out put decision it is called a cartel.
Under this the firms collude to make price output
decisions with a view to eliminate uncertainty and
restraining competition to ensure monopolistic gains to
the cartel group. The cartel works through a board of
control to determine the market share for each of the
members so that the profit to each firm will be
maximum. Cartel agreement normally covers the fixation
of price, output, market share, allocation of territories,
establishment of common sales agency, division of profits
or any combination of these. There are Two types of
cartel operating. (i) centralised cartel and (ii) market
sharing cartel
AR=D
MR
MC
A
+MC
B
MC
A
MC
B
O Q Q
A
Q
B
P
Centralised Cartel
It faces one
demand curve
and one MR
curve and MC
is the industry
MC. OP price
fixed by the
industry will be
followed by both
by A and B. The
price being fixed
by the industry,
the individual
firms are price
takers. In case
the number of
firms are large
and the market
is small, there
is every
possibility of
cheating in a
cartel

The objective is to maximise joint profits wherein
the product is homogeneous. Two firms join the
cartel and act like one firm in price and output
determination. Here OQ is the joint output for A
and B sold at price OP determined by the
association and the product is homogeneous.
Firm A is more efficient than B. Oligopoly is
combination of perfect competition and
monopoly. When the market is small with
homogeneous product, there is every possibility
that some firms may deviate from the cartel price
and cheat other members.
Market sharing cartel: Under this type of cartel,
members decide to divide the market among
them and fix the price independently. The
basic assumption is that all the firms have the
same cost function because they are
producing a homogeneous product. They
agree to sell the product in the allotted
market segment and not to enter into others
segments. Thus each firm operates like a
monopoly in its respective market segment.
AR
A
AR
B
MR
A
MR
B
AC
MC
Q
A
Q
B
P
A
P
B
Market sharing cartel
Assuming that Two firms
are facing the same cost
curve. OQ being the
total output it is shared
between A and B. Each
of them may agree to
share the market
demand 50:50. But the
graph shows A is selling
more with more profit
than B. This is because
they face different
demand curves.
But the sustainability of
these type of cartel is
unstable due to the
same cost function for
both the markets.
Due to uncertainty of these two cartels, there
is always a possibility that members of a cartel
have the incentive to deviate from their
agreement. When this happens it is called
cheating in cartel.The cartel can not sustain in
the long run. Empirical studies shows that the
life of a cartel varies from 5 to 8 years.
MC=AC
D
D
d
d
P1
P2
Q1
Q2
m
n
r
s
e
f
O
Collusion and cheaters
The agreed price is P1 and MC
and AC are constant and equal
for all the firms. The economic
profit earned by each member in
the cartel is P1mrs. For every
firm in the industry the demand
curve is DD which is relatively
inelastic.
Let us now suppose that one
firm cheats on the collusive
agreement and reduces the price
from P1 to P2. It increases the
demand from Q1 to Q2 for the
firm and the demand curve is dd
(relatively elastic). It will lose the
profits which was at P1 (area of
loss=P1P2nm).The gain is rnef ,
much higher than the loss.
As long as other firms adhere to
the price fixing agreement, the
cheater will earn additional
profit. When others are aware,
they will also start lowering their
price. If there no mechanism in
the industry to control it, price
war/competition became
active. .
Price Leadership
Price leadership is a substitute for illegal collusion. The
dominant firm in the industry will charge its profit
maximising price and smaller firms will charge the same
price. This helps in infrequent change in prices and price
discipline is maintained in the industry. There are mainly
two forms of price leadership: Dominant Firm price
leadership and Barometric price leadership.

Dominant firm price leadership : When the industry
constitutes one large firm and several smaller firms, the
large firm sets profit maximising price and the smaller
ones will follow the price set by the large firms.
D
T
D
T
D
L
MR
L
MC
F
MC
L
Q
T
Q
L
P
L
P
0
Price and output with Dominant Firm Price leadership
DT DT: total demand
MC
F
is the sum of MC for all
the small firms. If the price is
set at P
0
, the small firms will
meet total demand and the
dominant firm will have no
sales because there is no
residual demand. So price will
be set below P
0
. The leaders
demand curve is D
L
and
Marginal revenue curve is
MR
L
, MC
L
(the leaders
marginal cost curve). The
dominant firm is like a
monopolist and profit
maximising output is Q
L
and
price is P
L
. The output of small
firms is Q
T
-Q
L
units. In Recent
years this type of leader ship is
not very common due to
growth of markets,
technological change and
foreign competitors.
Barometric Price leadership
Under this type of leadership it is not
necessary that only the dominant firm will set
the price. One firm may come forward to set
the price according to the behaviour of the
market and others will follow this. The
leadership can also be changed and shifted to
some other firms. Hence barometric price
leadership is a method of signaling a need for
the price change through change in cost or
demand.