Manageria
l
Economics
Dr. Mugdha Vaidya
IBS, Mumbai
Oligopoly
• It is a market in which only a few firms compete with one another,
and entry by new firms is obstructed
• The product that the firms produce might be differentiated, as with
automobiles, or it might be homogeneous, as with steel.
• Monopoly power and profitability in oligopolistic industries depend in
part on how the firms interact
• For example, if the interaction is more cooperative than competitive, firms
could charge prices well above marginal cost and earn large profits.
• When they compete aggressively, they may earn lower profits
Oligopoly
• Only a few firms account for most or all the production.
• In some oligopolistic markets, some or all firms earn substantial profits over the long
run because barriers to entry make it difficult or impossible for new firms to enter
• Some oligopoly industries make standardized products: steel, aluminum,
wire, and industrial tools. Others make differentiated products: cigarettes,
automobiles, computers, ready-to-eat breakfast cereal, and soft drinks.
• Barriers to entry may also be in the form of ‘strategic actions’ to deter entry
• For example, they might threaten to flood the market and drive prices down if entry
occurs, and to make the threat credible, they can construct excess production
capacity.
Oligopoly
• The firms that dominate an oligopoly recognize that they are
interdependent: What one firm does affects others.
• This interdependence stands in sharp contrast to the models of
perfect competition and monopolistic competition
Types of Oligopoly
• Based on Nature of product
• Pure Oligopoly
• Where product is homogeneous or identical
• Differentiated oligopoly
• When products produced and sold in the market are differentiated in some way
• Based on Entry Barriers
• Open oligopoly
• New entry is comparatively easy
• Closed oligopoly
• New entry is tougher /barriers to entry are high
Types of Oligopoly
• Based on Price leadership : Price leadership Pattern of pricing in which
one firm regularly announces price changes that other firms then
match.
• Partial Oligopoly:
• One firm is implicitly recognized as the “leader,” while the other firms, the
“price followers,” match its prices. This behavior solves the problem of
coordinating price: Everyone charges what the leader is charging
• Full Oligopoly:
• There is no leading firm to determine the prices in the market and firms
engage in price competition
Types of Oligopoly
• Based on Collusion
• Collusive oligopoly
• When different firms in the market have some informal or formal agreement about prices,
output, division of market share, profit sharing
• Non collusive Oligopoly
• When there is no agreement or collusion among the firms
• Based on degree of coordination
• Organized oligopoly
• When the firms avoid price competition by organizing themselves in a central association to fix
prices and output quotas etc.
• Syndicated oligopoly
• All the firms in the market create a syndicate or cartel to sell the output produced by all the firms
Non collusive oligopoly
• Kinked demand curve model
• Developed by Paul Sweezy – hence named after him
• Price rigidity is the basis of the kinked demand curve model of
oligopoly
• Price rigidity is the characteristic of oligopolistic markets by which firms are
reluctant to change prices even if costs or demands change.
• Oligopoly model in which each firm faces a demand curve kinked at
the currently prevailing price: at higher prices demand is very elastic,
whereas at lower prices it is inelastic.
Kinked demand curve model
• Each firm believes that if it raises its price above the current prevailing
price (P*), none of its competitors will follow suit as products are close
substitutes, so it will lose most of its sales. So small rise in price will
result in substantial loss of sale
• On the other hand, if it lowers price below the prevailing price (P*) ,
everyone will follow suit, and its sales will increase only to the extent
that market demand increases.
• As a result, the firm’s demand curve D is kinked at price P*, and its
marginal revenue curve MR is discontinuous at that point.
• If marginal cost changes (from MC to MC’), the firm will still produce the
same output level (Q*) and charge the same price (P*).
Kinked demand curve model
The firm doesn’t move away from the kink; hence price will remain at P*, profit maximizing output is Q* where,
MC=MR
Non collusive oligopoly
• Cournot model is an oligopoly model in which firms produce a
homogeneous good, each firm treats the output of its competitors as
fixed, and all firms decide simultaneously how much to produce
• Stackelberg model is an oligopoly model in which one firm sets its
output before other firms do. Production decisions are taken
sequentially
• Bertrand model is an oligopoly model in which firms produce a
homogeneous good, each firm treats the price of its competitors as
fixed, and all firms decide simultaneously what price to charge
The Collusive Oligopoly- Price
Leadership
• Collusive price leadership
• when companies with large market shares have an agreement to set the same price for their goods.
Smaller firms have to match the prices set by the price leaders in order to remain competitive in the
market.
• Dominant price leadership
• only one organization dominates the entire industry.
• Under dominant price leadership, other organizations in the industry cannot influence prices. The
dominant organization uses its power of monopoly to maximize its profits and other organizations must
adjust their output with the set price
• Barometric price leadership
• leadership in which one organization declares the change in prices at first and assumes that other
organizations would accept it.
• The organization does not dominate others, it is a barometer. It need not have large market share, it may
have special knowledge/expertise regarding changing market conditions, costs etc.
• This barometric organization only initiates a reaction to changing market situation, which other
organizations may follow it if they find the decision in their interest.
The Collusive Oligopoly- Cartels
• Uncertainty about the interaction of rival firms makes specification of
a single model of oligopoly impossible
• Firms in any industry could achieve the maximum profit attainable if
they all agreed to select the monopoly price and output and to share
the profits.
• One approach to the analysis of oligopoly is to assume that firms in the
industry collude, selecting the monopoly solution
• Here the firms sell identical /non differentiated products
• When these firms get together and agree to set prices and outputs to
maximize total industry profits, they are known as a cartel.
Cartels
• Producers in a cartel explicitly agree to cooperate in setting prices and
output levels.
• A cartel is defined as a group of firms that gets together to make output and
price decisions.
• Not all the producers in an industry need to join the cartel, and most
cartels involve only a subset of producers. But if enough producers
adhere to the cartel’s agreements, and if market demand is
sufficiently inelastic, the cartel may drive prices well above
competitive levels
• Cartel is the oligopoly behaviour in which firms coordinate and
collectively act as a monopoly to gain monopoly profits
Cartels
• Cartels are illegal in some countries like US are illegal
• The organization of petroleum‐exporting countries (OPEC) is perhaps
the best‐known example of an international cartel; OPEC members
meet regularly to decide how much oil each member of the cartel will
be allowed to produce.
• Oligopolistic firms join a cartel to increase their market power, and
members work together to determine jointly the level of output that
each member will produce and/or the price that each member will
charge.
Assumptions of the Cartel Model
• There are only two firms in the oligopolistic industry assuming a case of duopoly.
• Each firm produces and sells a product that is a perfect substitute for that of the
other.
• There are many knowledgeable buyers of the product.
• Each firm knows the market demand for the product
• The two firms have different cost curves.
• Both the firms have the same expectations about the prices and productivities of
the inputs which they use.
• The price of the product is the sole parameter of action of each firm.
• The two firms are contemplating whether to form a cartel and agree upon a price
that will promise the maximum of profits per period to them jointly
Cartels-Joint profit Maximisation
• Two (or more) oligopoly firms(A and B) under collusion would distribute the
production of output between their plants in such a way that their marginal
costs (MC) become equal .(= )
• if we have > (in the two-firm case), then the firms A+B (X1 + X2) would reduce the
quantity of production in the higher cost firm A (X1) and increase the quantity in the
lower cost firm B(X2), total output remaining the same, till rises and falls to become
equal
• if < , the firms A+B (X1 + X2) will reduce output in firm B (X2) and increase it in firm A
(X1), till rises and falls to become equal.
• Thus, the firm with the lower costs produces a larger amount of output.
However, this does not mean that it will also take the larger share of the at
tained joint profit. The distribution of profits is decided by the central agency
of the cartel.
Cartels-Joint profit Maximisation
• The total output for which the firms A+B(X1+ X2) would be jointly earning
the maximum profits is obtained at the point of intersection, e, of the MR and
MC (+ )curves
• The total industry profit is the sum of the profits from the output of the two
firms, denoted by the shaded areas of the graph.
Cartels-Joint profit Maximisation
• Although theoretically the monopoly solution is easy to derive, in
practice cartels rarely achieve maximum joint profits.
• joint profit maximization will be easier to attain and will be generally stable if
firms have identical costs and identical demands, conditions that are rarely
met in practice
• Mistakes in the estimation of market demand, estimation of MC, rigidity of
the negotiated price to changes in market conditions, existence of high-cost
firms etc. may lead to problems in maximizing joint profits
• In theory, the cartel-members agree on joint profit maximization. But in
practice, the seldom agree on profit distribution
Market-sharing cartels
Two main methods of market-sharing-
• Non-price competition
• The low-cost firms press for a low price and the high-cost firms for a high
price. But ultimately, they agree upon a common price below which they will
not sell
• Such a price must allow them some profits. The firms can compete with one
another on a non-price basis by varying the colour, design, shape packing etc.
of their product and having their own different advertising and other selling
activities.
• Thus, each firm shares the market on a non-price basis while selling the
product at the agreed common price.
Market-sharing cartels
• Quota Agreement system
• Assumption is that two firms can enter into market-sharing agreement based
on the quota system. Agreement is on the quantity that each member may
sell at the agreed price (or prices)
• Each firm produces and sells a homogeneous product.
• Both firms share the market equally.
• If all firms have identical costs, the monopoly solution will emerge,
with the market being shared equally among member firms. For
example, if there are only two firms with identical costs, each firm will
sell at the monopoly price one-half of the total quantity demanded in
the market at that price.
Market-sharing cartels
• Allocation of quota-shares based on costs is unstable.
• Shares in the case of cost differentials are decided by bargaining. The
final quota of each firm depends on the level of its costs as well as on
its bargaining skill.
• During the bargaining process two main statistical criteria are most
often adopted as quotas are decided based on past levels of sales,
and/or based on ‘productive capacity’.
• The ‘past-period sales’ and/or the definition of ‘capacity’ of the firm
depends largely on their bargaining power and skill
Market-sharing cartels
Monopoly price is PM and the quotas which will be agreed in case of two
firms are X1 = X2 = ½ XM
