Chapter 12

Oligopoly
 Lecture Plan
• Introduction
• Features of Oligopoly
• Duopoly
• Cournot’s Model
• Stackelberg’s Model
• Kinked Demand Curve: Price Rigidity
• Collusive Oligopoly
• Price Leadership
• Summary
 Objectives
• To examine the nature of an oligopoly market.
• To understand the indeterminate demand curve
for a firm under oligopoly
• To look into the various models of price and
output decisions under oligopoly.
• To comprehend the nuances of collusive
oligopoly, with detailed analysis of its various
forms, including cartels.
• To identify with the practice of price leadership
by an oligopolist.
 Introduction
• Derived from Greek word: “oligo” (few) “polo” (to sell)
• A few dominant sellers sell differentiated or homogenous products
under continuous consciousness of rivals’ actions.
• Oligopoly looks similar to other market forms; as there can be many
sellers (like in monopolistic competition), but a few very large
sellers dominate the market.
• Products sold may be homogenous (like in perfect competition), or
differentiated (like in monopolistic competition).
• Entry is not restricted but difficult due to requirement of
investments.
• One aspect which differentiates oligopoly from all other market
forms, is the interdependence of various firms: no player can take a
decision without considering the action (or reaction) of rivals.
 Features of Oligopoly
• Few Sellers: small number of large firms compete
• Product: Some industries may consist of firms
selling identical products, while in some other
industries firms may be selling differentiated
products.
• Entry Barriers: No legal barriers; only economic in
nature
– Huge investment requirements
– Strong consumer loyalty for existing brands
– Economies of scale
 Features of Oligopoly

• Non Price Competition: Firms are continuously watching

their rivals, each of them avoids the incidence of a price war.

• Two firms A & B sell a homogenous

product.
• Prevailing price is P1, but firm A
lowers the price.
• B fears loss of its customers and
P retorts by lowering the price below
1
that of A.
• A further reduces the price and this
process continues, till the firms reach
A P B P2.
2 • Both realize that this price war is not
Market O Market helping either of them and decide to
share of A share of B end the war. Price stabilises at P2.
 Features of Oligopoly
• Indeterminate Demand Curve
• Price and output determination is
very complex as each firm faces
Pric D1 two demand curves.
e • Demand is not only affected by its
D own price or advertisement or
quality, but is also affected by the
price of rival products, their quality,
packaging, promotion and
placement.
D • When the firm increases the price it
D1
faces less elastic demand (DD);
O when it reduces the price it faces
Qua highly elastic demand (D1D1)
ntity
 Duopoly

• Duopoly is that type of oligopoly in which only two players

operate (or dominate) in the market.
• Used by many economists like Cournot, Stackelberg,
Sweezy, to explain the equilibrium of oligopoly firm, as it
simplifies the analysis.
Price and Output Decisions
• No single model can explain the determination of
equilibrium price and output
– Difficult to determine 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.
 Cournot’s Model

• Augustin Cournot illustrated with an example of two 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
• Each firm maximizes profit.
• Cost of production is nil because the springs are available free
from nature, i.e. MC=0.
• Market demand is linear; hence the demand curve is a downward
sloping straight line.
• Each firm decides on its price assuming that the other firm’s
output is given (i.e. 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.
 Cournot’s Model
Period 1: Firm A: ½ (1) = ½
Firm B: ½ (1/2)= 1/4
Period 2: Firm A: ½ (1-1/4)= 3/8
Firm B: ½ (1-3/8) =5/16
Period 3: Firm A: ½ (1-5/16)=11/32
Firm B: ½ (1-11/32)= 21/64
Period 4: Firm A: ½ (1-21/64) = 43/128
Firm B: ½ (1-43/128)=85/256 ………
Period N: Firm A: ½ (1-1/3) =1/3
Firm B: ½ (1-1/3) = 1/3
Thus A’s output is declining progressively (with ratio=1/4), whereas B’s
output is increasing at a declining rate.
•A’s equilibrium output=1/3
•B’s equilibrium output=1/3
 Cournot’s Model
• Firm A produces profit maximising
Price, output at MR=MC=0 and sells half
Reve D of the total market demand (equal
nue,
Cost to OD*).
• Point A is the mid point of DD*.
P A • Firm B assumes A will continue to
produce OQA ,so considers QAD*
A
P B as the market available to it and
AD* as its demand curve. Its MR
B curve will be MRB.
D
O Q Q • B maximizes profit and produce
M
Quan
*
M QB.
R tity
A B
RA B • A and B together supply to three
fourths of the total market, while
one fourth remains unattended.
 Stackelberg’s Model

• Developed by German Economist H. V. Stackelberg

• Popularly known as the Leader Follower Model.
• An extension of the model of Cournot.
• One of the players is sufficiently sophisticated to
recognize that the rival firm acts.
• The sophisticated firm is able to determine the reaction
curve of the rival and is also able to incorporate it in its
own profit function. Thus it acts as a monopolist.
• Naïve firm will act as follower.
 Stackelberg’s Model
Output of
Firm B RA • If firm A is the sophisticated
firm, it will try to produce that
output at which it can
X’B
b
maximize its profit, at point
RB
Firm A’s reaction function “a”.
• A will produce OXA and B will
Firm B’s reaction function be contended with OXB.
E
• B will act as a follower and
accept the leadership of A.
XB a • If firm B is the sophisticated
RA RB firm, will be at equilibrium at
O
X’A XA Output of Firm A
point “b”, producing OXB.
• A will act as the follower and
RARA: Reaction function of A accept B’s leadership will
RBRB: Reaction function of B produce only OXA.
Cournot’s equilibrium= E
 Kinked Demand Curve
• Paul Sweezy (1939) introduced concept of kinked demand curve to
explain ‘price stickiness’.
• Assumptions
– If a firm decreases price, others will also do the same. 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.
– If a firm increases its price, others will not follow. Firm will lose
large number of its customers to rivals due to substitution effect.
– Thus an oligopoly firm faces a highly elastic demand in case of
price fall and highly inelastic demand in case of price rise.
• A 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.
 Kinked Demand Curve
(price and output determination)
Price,
Revenue, D1
Cost • Discontinuity in AR (D1KD2)
MC1 creates discontinuity in the MR
P K
MC2 curve.
• At the kink (K), MR is constant
A

S
T
D2
B
O MC2, since the profit maximizing
Q Quantity
MR
• D1K = highly elastic portion of
the demand curve when rival
firms do not react to price rise
• KD2 = less elastic portion,
when rival firms react with a
price reduction.
• Kink is at point K.
between point A and B.
• Producer will produce OQ,
whether it is operating on MC1 or
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.
 Collusive Oligopoly
• Rival firms enter into an agreement in mutual interest on
various accounts such as 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
• A formal (explicit) agreement among firms on price and output.
• Occurs 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.
• Two types:
• centralized cartels
• market sharing cartels.
 Centralized Cartels
∑MC
Price, MCB MCA • MCA = Firm A’s marginal cost
Cost,
Revenue • MCB = Firm B’s marginal cost
• ∑MC = industry marginal cost
P • OQ = profit maximizing output
because (MR=∑MC).
• OQA = A’ output, OQB = B’s
output
AR=D
• OQ=OQA + OQB; OQA >
MR
OQB.
O • OP = price at which both firms
QB QA Q Quantity can sell their output. Price will
be determined by summation
of all firms’ costs and demand.
• An individual firm is thus just a
price taker.
 Market Sharing Cartels
Price, • Firms decide to divide the
Cost, market share among them and
Revenue fix the price independently.
MC AC
• All firms have the same cost
PA functions because they are
PB
producing a homogenous
product.
• Due to different demand
ARA functions, at equilibrium total
MRA output (OQ)=OQA+ OQB, where
ARB OQA> OQB.
MRB
O Q B QA • The quantity of output
Output
produced and sold would
depend upon the terms of
agreement among the firms.
 Factors Influencing Cartels

• Number of firms in the industry: Lower the number of firms in the

industry, the easier to monitor the behaviour of other members.
• Nature of product: Formed in markets with homogenous goods
rather than differentiated goods, to arrive at common price. But if
goods are homogeneous, an individual firm may gain larger market
share by cheating, i.e. by lowering the price.
• Cost structure: Similar cost structures make it easier to coordinate.
• Characteristics of sales: Low frequency of sales coupled with huge
amounts of output in each of these sales make cartels less
sustainable, because in such cases firms would like to undercut the
price in order to gain greater market share.
– with large number of firms and small size of the market some firms
may deviate from the cartel price and thus cheat other members.
 Informal and Tacit Collusion

• Formed when firms do not declare a cartel, but informally

agree to charge the same price and compete on non
price aspects.
• 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.
• Also seen in case of highly skilled human resource.
• It is as damaging to consumers as formal cartels,
because it makes an oligopoly act like a monopoly (in a
limited sense) and deprives consumers of the benefits of
competition.
 Price Leadership
• Dominant Firm: a leader in terms of market share, or presence in all
segments, or just the pioneer in the particular product category.
– May be either a benevolent firm or an exploitative firm.
• Benevolent leader
– Allows other firms to exist by fixing a price at which small firms
may also sell.
• so that it does not have to face allegations of monopoly
creation;
• 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.
• Barometric Firm: has better industry intelligence and can preempt
and interpret its external environment in an effective manner.
– 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.
– Acts like a barometer for the market.
 Summary

• Oligopoly is a market with a few sellers, differentiated or

homogenous product, interdependent decision making by firms,
non price competition and indeterminate demand curve.
• Duopoly is a special case of oligopoly, in which only two players
operate (or dominate) in the market. All the characteristics of
duopoly are same as those of oligopoly.
• Difficulty in determining the demand curve, tendency to influence
market conditions and fear of price war resulting in price rigidity are
some of the reasons which pose a major constraint in developing a
model to explain oligopoly.
• In Cournot’s model firms ignore interdependence and take
decisions as if they are operating independently in the market. At
equilibrium in a two firm industry, each firm will be maximizing profit
by selling equal amounts of output at the same price.
• In Stackelberg’s model the sophisticated firm is able to determine
the reaction curve of the rival and is also able to incorporate it in its
own profit function. Thus it acts as a monopolist. The naïve firm will
act as follower.
 Summary
• In Sweezy’s kinked demand curve model firms avoid a situation like
price war; therefore they stick to the current price. Thus the oligopoly
price remains rigid.
• The kink in demand curve signifies that the demand curve has two
different degrees of price elasticity.
• Under collusion rival firms enter into an agreement in mutual interest
on various accounts such price, market share, etc. Collusion may be
open or tacit. The most commonly found form of explicit collusion is
known as cartels.
• A centralized cartel is an arrangement by all the members, with the
objective of determining a price which maximizes joint profits. In
market sharing cartel members decide to divide the market share
among them and fix the price independently.
• A dominant firm is a leader in terms of market share, or presence in
all segments, or just being the pioneer in the particular product
category. A leader can be benevolent or exploitative.
• A barometric firm has better industry intelligence and can preempt
and interpret its external environment in an effective manner.