Price Determination under Oligopoly

Price Determination under Oligopoly

Oligopoly is that market situation in which the number of firms is small but each firm
in the industry takes into consideration the reaction of the rival firms in the
formulation of price policy. The number of firms in the industry may be two or more
than two but not more than 20. Oligopoly differs from monopoly and monopolistic
competition in this that in monopoly, there is a single seller; in monopolistic
competition, there is quite a larger number of them; and in oligopoly, there are only a
small number of sellers.

CLASSIFICATION OF OLIGOPOLY:
The oligopolistic industries are classified in a number of ways:

(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly is
further classified as below:
(i) Perfect or Pure Duopoly: If the duopolists in an industry are
producing identical products it is called perfect or pure duopoly.
(ii) Imperfect or Impure Duopoly: If the duopolists in an industry are
producing differentiated products it is called imperfect or impure duopoly.

(b) Oligopoly: If there are more than two firms in an industry and each firm takes
consideration the reactions of the rival firms in formulating its own price policy it is
called oligopoly. Oligopoly is further classified as below:

(i) Perfect or Pure Oligopoly: If the oligopolists in an industry are

producing identical products it is called perfect or pure oligopoly.
(ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry
are producing differentiated products it is called imperfect or impure
oligopoly.

Types of Market Structures

Structure No. of Producers & Part of economy Firm’s degree Methods of
Degree of Product where prevalent of control over price Marketing
Differentiation

Many producers, Financial markets, & None Market exchange

Perfect competition Identical products Some agricultural products or auction
Imperfect
competition:
Monopolistic competition Many producers, Retail trade Some Advertising and
Many real or perceived (Gasoline, PCs, etc.) Quality rivalry,
differences in product Administered prices

Oligopoly Few producers, Steel, chemicals, etc.

No differences in product.

Few producers, Autos, aircraft, etc.

Some differentiation
of products

Single producer, Local telephone, Considerable but Advertising and

Monopoly Product without close electricity, and gas usually regulated Service promotion
substitutes

CAUSES OF OLIGOPOLY:
1. Economies of Scale: The firms in the industry, with heavy investment, using
improved technology and reaping economies of scale in production, sales, promotion,
etc, will compete and stay in the market.
2. Barrier to Entry: In many industries, the new firms cannot enter the industry as the
big firms have ownership of patents or control of essential raw material used in the
production of an output. The heavy expenditure on advertising by the oligopolistic
industries may also be a financial barrier for the new firms to enter the industry.
3. Merger: If the few firms in the industry smell the danger of entry of new firms, they
then immediately merge and formulate a joint policy in the pricing and production of
the products. The joint action of the few big firms discourages the entry of new firms
into the industry.
4. Mutual Interdependence: As the number of firms is small in an oligopolistic industry,
therefore, they keep a strict watch of the price charged by rival firms in the
industry. The firm generally avoid price ware and try to create conditions of mutual
interdependence.

CHARACTERISTICS OF OLIGOPOLY:
1. Every seller can exercise an important influence on the price-output
policies of his rivals. Every seller is so influential that his rivals cannot ignore
the likely adverse effect on them of a given change in the price-output policy of
any single manufacturer. The rival consciousness or the recognition on the
part of the seller is because of the fact of interdependence.
2. The demand curve under oligopoly is indeterminate because any step
taken by his rivals may change the demand curve. It is more elastic than
 under simple monopoly and not perfectly elastic as under perfect
competition.
3. It is often noticed that there is stability in price under oligopoly. This is
because the oligopolist avoids experimenting with price changes.He knows
that if raises the price, he will lose his customers and if he lowers it he will
invite his rivals to price war.

EFFECTS OF OLIGOPOLY:
1. Small output and high prices: As compared with perfect competition,
oligopolist sets the prices at higher level and output at low level.
2. Restriction on the entry: Like monopoly, there is a restriction on the
entry of new firms in an oligopolistic industry.
3. Prices exceed Average Cost: Under oligopoly, the firms fixed the prices
at the level higher than the AC. The consumers have to pay more than it is
necessary to retain the resources in the industry. In other words, the
economy’s productive capacity is not utilised in conformity with the consumers’
preferences.
4. Lower efficiency: Some economists argued that there is a low level of
production efficiency in oligopoly. There is no tendency for the oligopolists to
build optimum scales of plant and operate them at the optimum rates of
output. However, the Schumpeterian hypothesis states that there is high
tendency of innovation and technological advancement in oligopolistic
industries. As a result, the product cost decreases with production capacity
enhancement. It will offset the loss of consumer surplus from too high prices.
5. Selling Costs: In order to snatch markets from their rivals, the
oligopolistic firms may engage in aggressive and extensive sales promotion
effort by means of advertisement and by changing the design and improving
the quality of their products.
6. Wider range of products: As compared with pure monopoly or pure
competition, differentiated oligopoly places at the consumers’ disposal a wider
variety of commodities.
7. Welfare Effect: Under oligopoly, vide sums of money are poured into
sales promotion to create quality and design differentiations.Hence, from the
point of view of economic welfare, oligopoly fares fairly badly. The oligopolists
push non-price competition beyond socially desirable limits.

PRICE DETERMINATION UNDER OLIGOPOLY:

The price and output behaviour of the firms operating in oligopolistic or duopolistic
market condition can be studied under two main heads:

1. Price and Output Determination under Duopoly:

(a) If an industry is composed of two giant firms each selling identical or
homogenous products and having half of the total market, the price and
output policy of each is likely to affect the other appreciably, therefore there is
every likelihood of collusion between the two firms. The firms may agree on a
 price, or divide the total market, or assign quota, or merge themselves into
one unit and form a monopoly or try to differentiate their products or accept
the price fixed by the leader firm, etc.
(b) In case of perfect substitutes the two firms may be engaged in price
competition. The firm having lower costs, better goodwill and clientele will
drive the rival firm out of the market and then establish a monopoly.
(c) If the products of the duopolists are differentiated, each firm will have a
close watch on the actions of its rival firms. The firm good quality product with
lesser cost will earn abnormal profits. Each firm will fix the price of the
commodity and expand output in accordance with the demand of the
commodity in the market.

2. Price and Output Determination under Oligopoly:

(a) If an industry is composed of few firms each selling identical or
homogenous products and having powerful influence on the total market,
the price and output policy of each is likely to affect the other appreciably,
therefore they will try to promote collusion.
(b) In case there is product differentiation, an oligopolist can raise or lower
his price without any fear of losing customers or of immediate reactions from
his rivals. However, keen rivalry among them may create condition
of monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behaviour
regarding price and output in the market. There are set of theories like Cournot
Duopoly Model, Bertrand Duopoly Model, the Chamberlin Model, the Kinked Demand
Curve Model, the Centralised Cartel Model, Price Leadership Model, etc., which have
been developed on particular set of assumptions about the reaction of other firms to
the action of the firm under study.

COLLUSIVE OLIGOPOLY:
The degree of imperfect competition in a market is influenced not just by the number
and size of firms but by how they behave. When only a few firms operate in a market,
they see what their rivals are doing and react. ‘Strategic interaction’ is a term that
describes how each firm’s business strategy depends upon its rivals’ business
behaviour.

When there are only a small number of firms in a market, they have a choice
between ‘cooperative’ and ‘non-cooperative’ behaviour:

• Firms act non-cooperatively when they act on their own without any explicit or
implicit agreement with other firms. That’s what produces ‘price wars’.
• Firms operate in a cooperative mode when they try to minimise competition between
them. When firms in an oligopoly actively cooperate with each other, they engage in
‘collusion’. Collusion is an oligopolistic situation in which two or more firms jointly set
 their prices or outputs, divide the market among them, or make other business
decisions jointly.

A ‘cartel’ is an organisation of independent firms, producing similar products, which

work together to raise prices and restrict output. It is strictly illegal in Pakistan and
most countries of the world for companies to collude by jointly setting prices or
dividing markets. Nonetheless, firms are often tempted to engage in ‘tacit collusion’,
which occurs when they refrain from competition without explicit agreements. When
firms tacitly collude, they often quote identical (high) prices, pushing up profits and
decreasing the risk of doing business. The rewards of collusion, when it is
successful, can be great. It is more illustrated in the following diagram:

The above diagram illustrates the situation of oligopolist A and his demand curve DaDa
assuming that the other firms all follow firm A’s lead in raising and lowering prices. Thus the
firm’s demand curve has the same elasticity as the industry’s DD curve. The optimum price
for the collusive oligopolist is shown at point G on DaDa just above point E. This price is
identical to the monopoly price, it is well above marginal cost and earns the colluding
oligopolists a handsome monopoly profit.

PRICE DETERMINATION MODELS OF OLIGOPOLY:

1. Kinky Demand Curve: The kinky demand curve model tries to explain that in non-
collusive oligopolistic industries there are not frequent changes in the market prices
of the products. The demand curve is drawn on the assumption that the kink in the
curve is always at the ruling price. The reason is that a firm in the market supplies a
significant share of the product and has a powerful influence in the prevailing price of
the commodity. Under oligopoly, a firm has two choices:

(a) The first choice is that the firm increases the price of the product. Each
firm in the industry is fully aware of the fact that if it increases the price of the
product, it will lose most of its customers to its rival. In such a case, the upper
part of demand curve is more elastic than the part of the curve lying below the
kink.
(b) The second option for the firm is to decrease the price. In case the firm
lowers the price, its total sales will increase, but it cannot push up its sales
 very much because the rival firms also follow suit with a price cut. If the rival
firms make larger price cut than the one which initiated it, the firm which first
started the price cut will suffer a lot and may finish up with decreased
sales. The oligopolists, therefore avoid cutting price, and try to sell their
products at the prevailing market price. These firms, however, compete with
one another on the basis of quality, product design, after-sales services,
advertising, discounts, gifts, warrantees, special offers, etc.

In the above diagram, we shall notice that there is a discontinuity in the marginal
revenue curve just below the point corresponding to the kink.During this discontinuity
the marginal cost curve is drawn. This is because of the fact that the firm is in
equilibrium at output ON where the MC curve is intersecting the MR curve from
below.

The kinky demand curve is further explained in the following diagram:

In the above diagram, the demand curve is made up of two segments DB and
BD’. The demand curve is kinked at point B. When the price is Rs. 10 per unit, a firm
sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it loses a large
part of the market and its sales come down to 40 units with a loss of 80 units. In
case, the producer lowers the price to Rs. 4 per unit, its competitors in the industry
will match the price cut. Its sales with a big price cut of Rs. 6 increases the sale by
only 40 units. The firm does not gain as its total revenue decreases with the price cut.

2. Price Leadership Model: Under price leadership, one firm assumes the role of a
price leader and fixes the price of the product for the entire industry. The other firms
in the industry simply follow the price leader and accept the price fixed by him and
adjust their output to this price. The price leader is generally a very large or dominant
firm or a firm with the lowest cost of production. It often happens that price leadership
is established as a result of price war in which one firm emerges as the winner.

In oligopolistic market situation, it is very rare that prices are set independently and
there is usually some understanding among the oligopolists operating in the
industry. This agreement may be either tacit or explicit.

Types of Price Leadership: There are several types of price leadership. The
following are the principal types:

(a) Price leadership of a dominant firm, i.e., the firm which produces the
bulk of the product of the industry. It sets the price and rest of the firms simply
accepts this price.
(b) Barometric price leadership, i.e., the price leadership of an old,
experienced and the largest firm assumes the role of a leader, but undertakes
also to protect the interest of all firms instead of promoting its own interests as
in the case of price leadership of a dominant firm.
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its
supremacy in the market by following aggressive price leadership. It compels
other firms to follow it and accept the price fixed by it. In case the other firms
show any independence, this firm threatens them and coerces them to follow
its leadership.

Price Determination under Price Leadership: There are various models

concerning price-output determination under price leadership on the basis of certain
assumptions regarding the behaviour of the price leader and his followers. In the
following case, there are few assumptions for determining price-output level under
price leadership:

(a) There are only two firms A and B and firm A has a lower cost of
production than the firm B.
(b) The product is homogenous or identical so that the customers are
indifferent as between the firms.
(c) Both A and B have equal share in the market, i.e., they are facing the
same demand curve which will be the half of the total demand curve.
In the above diagram, MCa is the marginal cost curve of firm A and MCb is the
marginal cost curve of firm B. Since we have assumed that the firm A has a lower
cost of production than the firm B, therefore, the MCa is drawn below MCb.

Now let us take the firm A first, firm A will be maximising its profit by selling OM level
of output at price MP, because at output OM the firm A will be in equilibrium as its
marginal cost is equal to marginal revenue at point E. Whereas the firm B will be in
equilibrium at point F, selling ON level of output at price NK, which is higher than the
price MP. Two firms have to charge the same price in order to survive in the
industry. Therefore, the firm B has to accept and follow the price set by firm A. This
shows that firm A is the price leader and firm B is the follower.

Since the demand curve faced by both firms is the same, therefore, the firm B will
produce OM level of output instead of ON. Since the marginal cost of firm B is
greater than the marginal cost of firm A, therefore, the profit earned by firm B will be
lesser than the profit earned by firm A.

Difficulties of Price Leadership: The following are the challenges faced by a price
leader:

(a) It is difficult for a price leader to correctly assess the reactions of his
followers.
(b) The rival firms may secretly charge lower prices when they find that the
leader charged unduly high prices. Such price cutting devices are rebates,
favourable credit terms, money back guarantees, after delivery free services,
easy instalment sales, etc.
(c) The rivals may indulge in non-price competition. Such non-price
competition devices are heavy advertisement and sales promotion.
(d) The high price set by the price leader may also attract new entrants into
the industry and these new entrants may not accept his leadership.
ECONOMIC COSTS OF IMPERFECT COMPETITION AND OLIGOPOLY:
(a) The cost of inflated prices and insufficient output: The monopolist, by
keeping the output a little scarce, raises its price above marginal cost. Hence,
the society does not get as much of the monopolist’s output as it wants in
terms of product’s marginal cost and marginal value. The same is true for
oligopoly and monopolistic competition.
(b) Measuring the waste from imperfect competition: Monopolists cause
economic waste by restricting output. If the industry could be competitive, then
the equilibrium would be reached at the point where MC = P at point E. Under
perfect competition, this industry’s quantity would be 6 with a price of 100. The
monopolist would set its MC equal to MR (not to P), displacing the equilibrium
to Q = 3 and P = 150. The GBAF is the monopolist’s profit, which compares
with a zero-profit competitive equilibrium. Economists measure the economic
harm from insufficiency in terms of the deadweight loss; this term signifies the
loss in real income that arises because of monopoly, tariffs and quotas, taxes,
or other distortions. The efficiency loss is the vertical distance between the
demand curve and the MC curve. The total deadweight loss from the
monopolist’s output restriction is the sum of all such losses represented by the
grey triangle ABE:

In the above diagram, DD curve represents the consumers’ marginal utility at each
level of output, while the MC curve represents the opportunity cost of the devoting
production to this good rather than to other industries. For example, at Q = 3, the
vertical difference between B and A represents the utility that would be gained from a
small increase to the output of Q. Adding up all the lost social utility from Q = 3 to Q =
6 gives the shaded region ABE.

EMPIRICAL STUDIES OF COSTS OF MONOPOLY:

1. Economists have studied impact of the overall costs of imperfect
competition to an economy. These studies estimate the deadweight loss of
 consumer surplus in ABE for all industries. Early studies set the total
deadweight loss from monopoly at less than 0.1% of US GDP. Now, in
modern days, it would total only about $7 billion.
2. The next important reservation about this approach is that it ignores the
impact of market structure upon technological advance or ‘dynamic
efficiency’. But according to Schumpeterian hypothesis, imperfect competition
actually promotes the invention and technological advances which offset the
efficiency loss from too high prices.
3. Some skeptical economists retort that monopolists mainly promote the
quiet life, poor quality and uncivil service. Indeed, a common complaint about
companies with a dominant market position is that they pay little attention to
quality of product.
4. Most people object to imperfect competition on the grounds that
monopolists may be earning supernormal profits and enriching themselves at
the expense of hapless consumers.

INTERVENTION STRATEGIES:
According to a Nobel Prize winner Milton Friedman, basically there are three choices
– private unregulated monopoly, private monopoly regulated by the government, or
the government operation. In most market economies of the world, the monopolists
are regulated by the State.There are several methods and tools for controlling the
power misuse by monopolistic and oligopolistic firms:

1. Anti-trust Policy: Anti-trust policies are laws that prohibit certain kinds of behaviour
(such as firm’s joining together to fix prices) or curb certain market structures (such
as pure monopolies and highly concentrated oligopolies).
2. Encouraging Competition: Most generally, anticompetitive abuses can be avoided
by encouraging competition whenever possible.There are many government policies
that can promote vigorous rivalry even among large firms. In particular, it is crucial to
keep the barriers to entry low.
3. Economic Regulations: Economic regulation allows specialised regulatory agencies
to oversee the prices, outputs, entry, and exit of firms in regulated industries such as
public utilities and transportation. Unlike antitrust policies, which tell businesses what
not to do, regulation tells businesses what to do and how to do.
4. Government Ownership of Monopolies: Government ownership of monopolies has
been an approach widely used. In recent years, many governments have privatised
industries that were in former times public enterprises, and encouraged other firms to
enter for competition.
5. Price Control: Price control on most goods and services has been used in wartime,
partly as a way of containing inflation, partly as a way of keeping down prices in
concentrated industries.
6. Taxes: Taxes have sometimes been used to alleviate the income-distribution
effects. By taxing monopolies, a government can reduce monopoly profits, thereby
softening some of the socially unacceptable effects of monopoly.