PRICE AND OUTPUT DETERMINATION UNDER OLIGOPOLY

GROUP MEMBERS

ROLL NO 18 24 32 47

SANGITHA NADAR (GL) NISHA PAWAR KHALID SHAIKH SALMA SHAIKH

INDEX

 INTRODUCTION FEATURES OF OLIGOPOLY

INTRODUCTION

The term Oligopoly has been derived from two Greek words Oligi which means few and polein which means sellers. Oligopoly is a market form in which there are few sellers of homogeneous or differentiated products. If the commodity is homogenous, it is called pure oligopoly. It is a differentiated oligopoly market, if the product is differentiated. Theoretically, entry in to the oligopoly market is allowed but in reality it is very difficult. In India we have the oligopoly market in automobiles where each group cars, scooters, trucks, is an oligopoly market. Domestic airlines, refrigerators, T.V. sets, air conditioners are some examples of oligopoly markets in India. Oligopoly theory makes heavy use of game theory to model the behavior of oligopolies:

Stackelberg's duopoly - In this model the firms move sequentially. Cournot's duopoly - In this model the firms simultaneously choose quantities. Bertrand's oligopoly - In this model the firms simultaneously choose prices.

Definition
A market dominated by a small number of participants who are able to collectively exert control over supply and market prices.

FEATURES OF OLIGOPOLY

Few sellers Oligopoly form of market consists of few sellers.

As against perfect and imperfect market, the numbers in oligopoly is limited, usually it is not more than ten. In case there are more sellers, a few will be dominant firms, others being insignificant.

Differentiated product Oligopolists usually sell

differentiated products. Differentiation is in the form of trade mark, design or service. Developing brand equity has become important for oligopoly firms.

Entry is possible but difficult

A new firm can enter the oligopoly market. In reality, however, it is highly difficult to enter due to financial, technological and other barriers to the entry. Whenever the profits are high, the new firms do enter the market.

Interdependence Due to few firms in the market, an

individual firm is neither free nor independent to take its own decision about the output and price. Any decision resulting in a change in the price or output attracts reaction from the rival firms. There may be different reactions from different firms. The situation makes a firm dependent on others for its own decision. It is essential for a firm to keep in mind the possible reaction of its competitors while taking a decision.

Uncertainty Interdependence on other firms for ones own

decision creates an atmosphere of uncertainty about the output and price. If an oligopolist increases his output to capture the larger portion of the market, others too will react in a similar way. In case he increases the price others are unlikely to do so. The rivals will not increase the price in order to sell more at a lower

price. On the contrary when an oligopolist decreases the price others will also reduce the price in order to prevent any reduction in sales due to non-competitive price. An oligopolist therefore is highly uncertain about the reaction of his rivals to his own decision.

Indeterminateness The demand curve faced by an oligopolist

is indeterminate. Under perfect competition a firm being one of the large number of firms, has a perfectly elastic (horizontal) demand curve. Here the firm is a price taker from the market. A monopolist, being a single seller is in a position to decide the price and thus produces and sells the output accordingly. His demand curve is therefore definite in the form of downward sloping demand curve. An oligopoly firm being dependent on other firms for its price and output decision does not face a definite demand curve.

Non - price competition In an oligopoly market, price

remains rigid. This is due to the fear about the reaction of their rivals. An increase in price would not be responded to but any decrease will be followed by similar or at times a larger reduction in price. Such fears make a firm stick to a particular price without further changes in order to avoid a possible price war. Oligopolists, though avoid price war or competition, yet indulge in non-price competition or what is called covert cheating. Such a competition usually takes the form of secret discounts, additional facilities or any other secret benefit to the retailer or the final consumer.

OLIGOPOLY MODEL

There is no single model describing the operation of an oligopolistic market. The variety and complexity of the models is due to the fact that you can have two to 102 firms competing on the basis of price, quantity, technological innovations, marketing, advertising and reputation. Some of the better known models are the dominant firm model, the Cournot-Nash model, the Bertrand model and the kinked demand model.

Dominant firm model

In some markets there is a single firm that controls a dominant share of the market and a group of smaller firms. The dominant firm sets prices which are simply taken by the smaller firms in determining their profit maximizing levels of production. This type of market is practically a monopoly and an attached perfectly competitive market in which price is set by the dominant firm rather than the market.

Cournot-Nash model
The Cournot-Nash model is the simplest oligopoly model. The mdels assumes that there are two equally positioned firms; the firms compete on the basis of quantity rather than price and each firms makes an output decision assuming that the other firms behavior is fixed. The market demand curve is assumed to be linear and marginal costs are constant. To find the Cournot-Nash equilibrium one determines how each firm reacts to a change in the output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a point is reached where neither firm desires to change what it is doing, given how it believes the other firm will react to any change.

Bertrand model
The Bertrand model is essentially the Cournot-Nash model except the strategic variable is price rather than quantity. The model assumptions are:

There are two firms in the market. They produce a homogeneous product. They produce at a constant marginal cost. Firms choose prices PA and PB simultaneously. Firms output are perfect substitutes. Sales are split evenly if PA = PB. The only Nash equilibrium is PA = PB = MC.

Kinked demand curve under oligopoly

An oligopolist faces a downward sloping demand curve but the elasticity may depend on the reaction of rivals to changes in price and output. Assuming that firms are attempting to maintain a high level of profits and their market share it may be the case that: (a) rivals will not follow a price increase by one firm - therefore demand will be relatively elastic and a rise in price would lead to a fall in the total revenue of the firm (b) rivals are more likely to match a price fall by one firm to avoid a loss of market share. If this happens demand will be more inelastic and a fall in price will also lead to a fall in total revenue.

The kink in the demand curve at price P and output Q means that there is a discontinuity in the firm's marginal revenue curve. If we assume that the marginal cost curve in is cutting the MR curve then the firm is maximizing profits at this point.

In the bottom diagram, we see that a rise in marginal costs will not necessarily lead to higher prices providing that the new MC curve (MC2) cuts the MR curve at the same output. The kinked demand curve theory suggests that there will be price stickiness in these markets and that firms will rely more on non-price competition to boost sales, revenue and profits.

NON PRICE COMPETITION UNDER OLIGOPOLY

Non-price competition assumes increased importance in oligopolistic markets. Non-price competition involves advertising and marketing strategies to increase demand and develop brand loyalty among consumers. Businesses will use other policies to increase market share:

Better quality of service including guaranteed delivery times for consumers and low-cost servicing agreements. Longer opening hours for retailers, 24 hour telephone and online customer support. Extended Warranties on new products. Discounts on product upgrades when they become available in the market. Contractual relationships with suppliers - for example the system of tied houses for pubs and contractual agreements with franchises (exclusive distribution agreements)

Advertising spending runs in millions of pounds for many firms. Some simply apply a profit maximizing rule to their marketing strategies. A promotional campaign is profitable if the marginal benefit (or revenue) from any extra sales exceeds the cost of the advertising campaign and marginal costs of producing an increase in output. However, it is not always easy to measure accurately the incremental sales arising from a specific advertising campaign. Other businesses see advertising simply as a way of increasing sales revenue. If persuasive advertising leads to an outward shift in demand, consumers are willing to pay more for each unit consumed. This increases the potential consumer surplus that a business might extract.

Price leadership tacit collusion

Another type of oligopolistic behaviour is price leadership. This is when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes prompted by the dominant firm. We see examples of this with the major mortgage lenders and petrol retailers where most suppliers follow the pricing strategies of leading firms. If most of the leading firms in a market are moving prices in the same direction, it can take some time for relative price differences to emerge which might cause consumers to switch their demand. Firms who market to consumers that they are never knowingly undersold or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion. Does the consumer really benefit from this? Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting or not attacking each others market Explicit collusion under oligopoly It is often observed that when a market is dominated by a few large firms, there is always the potential for businesses to seek to reduce market uncertainty and engage in some form of collusive behaviour. When this happens the existing firms decide to engage in price fixing agreements or cartels. The aim of this is to maximise joint profits and act as if the market was a pure monopoly. This behaviour is deemed illegal by the UK and European competition authorities. But it is hard to prove that a group of firms have deliberately joined together to raise prices. Price fixing

Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly. To fix prices, the producers in the market must be able to exert control over market supply. In the diagram below a producer cartel is assumed to fix the cartel price at output Qm and price Pm. The distribution of the cartel output may be allocated on the basis of an output quota system or another process of negotiation. Although the cartel as a whole is maximising profits, the individual firms output quota is unlikely to be at their profit maximising point. For any one firm, within the cartel, expanding output and selling at a price that slightly undercuts the cartel price can achieve extra profits. Unfortunately if one firm does this, it is in each firms interests to do exactly the same. If all firms break the terms of their cartel agreement, the result will be an excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement might break down.

Collusion in a market or industry is easier to achieve when:

1.

2. 3. 4.

There are only a small number of firms in the industry and barriers to entry protect the monopoly power of existing firms in the long run. Market demand is not too variable Demand is fairly inelastic with respect to price so that a higher cartel price increases the total revenue to suppliers in the market Each firms output can be easily monitored this enables the cartel more easily to control total supply and identify firms who are cheating on output quotas.

Possible break-downs of cartels Most cartel arrangements experience difficulties and tensions and some producer cartels collapse completely. Several factors can create problems within a collusive agreement between suppliers:

Enforcement problems: The cartel aims to restrict total production to maximize total profits of members. But each individual member

of the cartel finds it profitable to raise its own production. It may become difficult for the cartel to enforce its output quotas. There may be disputes about how to share out the profits. Other firms not members of the cartel may opt to take a free ride by producing close to but just under the cartel price. Falling market demand during a slowdown or recession creates excess capacity in the industry and puts pressure on individual firms to cut prices to maintain their revenue. There are good recent examples of this in international commodity markets including the collapse of the coffee export cartel and some of the problems that have faced OPEC in recent years The successful entry of non-cartel firms into the industry undermines a cartels control of the market e.g. the emergence of online retailers in the book industry in the mid 1990s The exposure of illegal price fixing by market regulators e.g. the severe fines imposed on vitamin producers by the European Commission in the autumn of 2001 and recent investigations of price-fixing by the UK Office of Fair Trading.

THE GOOD OF OLIGOPOLY

With the bad comes a little good. The two most noted goods from oligopoly are (1) by developing product innovations and (2) taking advantage of economies of scale.

Innovations: Of the four market structures, oligopoly is the

one most likely to develop the innovations that advance the level of technology, expand production capabilities, promote economic growth, and lead to higher living standards. Oligopoly has both the motive and the opportunity to pursue innovation. Motive comes from interdependent competition and opportunity arises from access to abundant resources.

Economies of Scale: Oligopoly firms are also able to take

advantage of economies of scale that reduce production costs and prices. As large firms, they can "mass produce" at low average cost. Many modern goods--including cars, computers, aircraft, and assorted household products--would be significantly more expensive if produced by a large number of small firms rather than a small number of large firms.

THE BAD OF OLIGOPOLY

Like much of life, oligopoly has both bad and good. The bads are that oligopoly: (1) tends to be inefficient in the allocation of resources and (2) promotes the concentration, and thus inequality, of income and wealth.

Inefficiency: First and foremost, oligopoly does not efficiently

allocate resources. Like any firm with market control, an oligopoly charges a higher price and produces less output than the efficiency benchmark of perfect competition. In fact, oligopoly tends to be the worst efficiency offender in the real world, because perfect competition does not exist, monopolistic competition inefficiency is minor, and monopoly inefficiency has the potential for being so bad that it is inevitably subject to corrective government regulation.

Concentration: Another bad is that oligopoly tends to

increase the concentration of wealth and income. This is not necessarily bad, but it can be self-reinforcing and inhibit pursuit of the microeconomic goal of equity. While the concentration of wealth is not bad unto itself, such wealth can then be used (or abused) to exert influence over the economy, the political system, and society, which might not be beneficial for society as a whole.

Examples
In industrialized economies, barriers to entry have resulted in oligopolies forming in many sectors, with unprecedented levels of competition, fueled by increasing globalization. Market shares in an oligopoly are typically determined by product development and advertising. For example, there are now only a small number of manufacturers of civil passenger aircraft, though Brazil (Embraer) and Canada (Bombardier) have participated in the small passenger aircraft market sector. Oligopolies have also arisen in heavily regulated markets such as wireless communications: in some areas only two or three providers are licensed to operate. Australia

Most media outlets are owned either by News Corporation, Time Warner, or by Fairfax Media. Grocery retailing is dominated by Coles Group and Woolworths]

Canada

Three companies (Rogers Wireless, Bell Mobility and Telus) share over 94% of Canada's wireless market

United Kingdom

Four companies (Tesco, Sainsbury's, Asda and Morrisons) share 74.4% of the grocery market Scottish & Newcastle, Molson Coors, and Inbev control two thirds of the beer brewing industry. The detergent market is dominated by two players, Unilever and Procter & Gamble

United States Many media industries today are essentially oligopolies. Six movie studios receive 90% of American film revenues. o The television industry is mostly an oligopoly of five companies: Disney/ABC, CBS Corporation, NBC Universal, Time Warner, and News Corporation. Concentration of media ownership. o Four major music companies receive 80% of recording revenues. o Four wireless providers control 89% of the cellular telephone market. o There are just six major book publishers. Healthcare insurance in the United States consists of very few insurance companies controlling major market share in most states. For example, Calfornia's insured population of 20 million is the most competitive in the nation and 44% of that market is dominated by two insurance companies, Anthem and Kaiser Permanante. Anheuser-Busch and MillerCoors control about 80% of the beer industry.
o

Worldwide

The accountancy market is controlled by Price Waterhouse Coopers, KPMG, Deloitte Touche Tohmatsu, and Ernst & Young (commonly known as the Big Four) Three leading food processing companies, Kraft Foods, PepsiCo and Nestle, together achieve a large proportion of global processed food sales. These three companies are often used as an example of "The rule of 3", which states that markets often become an oligopoly of three large firms.

Soft Drink Advertising

Game Theory
A technique often used to analyze interdependent behavior among oligopolistic firms is game theory. Game theory illustrates how the choices between two players affect the outcomes of a "game." This analysis illustrates two firms cooperating through collusion are better off than if they compete. The exhibit to the right illustrates the alternative facing two oligopolistic firms, Juice-Up and OmniCola, as they ponder the prospects of advertising their products. In the top left quadrant, if OmniCola and Juice-Up BOTH decide to advertise, then each receives $200 million in profit. However, in the lower right quadrant, if Neither OmniCola or Juice-Up decide to advertise, then each receives $250 million in profit. They receive more because they do not incur any advertising expense. Alternatively, as shown in the lower left quadrant, if OmniCola advertises but Juice-Up does not, then OmniCola receives $350 million in profit and Juice-Up receives only $100 in profit. OmniCola receives a big boost in profit because its advertising attracts customers away from Juice-Up. But, as shown in the top right quadrant, if Juice-Up advertises and OmniCola does not, then Juice-Up receives $350 million in profit and OmniCola receives only $100 in profit. Juice-Up receives a big boost in profit because its advertising attracts customers away from OmniCola. Game theory indicates that the best choice for OmniCola is to advertise, regardless of the choice made by Juice-Up. And Juice-Up faces exactly the same choice. Regardless of the decision made by OmniCola, Juice-Up is wise to advertise.

Market Structure Continuum

The Other Three Market Structures

Oligopoly is one of four common market structures. The other three are: perfect competition monopoly, and monopolistic competition. The exhibit to the right illustrates how these four market structures form a continuum based on the relative degree of market control and the number of competitors in the market. In the middle of the market structure continuum, near the right end, is oligopoly, characterized by a few competitors and extensive market control.

Perfect Competition: To the far left of the market structure continuum is perfect competition, characterized by a large number of relatively small competitors, each with no market control. Monopoly: To the far right of the market structure continuum is monopoly, characterized by a single competitor and extensive market control. Monopoly contains a single seller of a unique product with no close substitutes. Monopolistic Competition: Also in the middle of the market structure continuum, but residing closer to perfect competition, is monopolistic competition, characterized by a large number of relatively small competitors, each with a modest degree of market control.

On the surface, oligopoly and monopolistic competition seem quite different. Oligopoly contains a few large firms that dominate a market. Monopolistic competition contains a larger number of small firms, each with some, but not a lot of market control. However, monopolistic competition and oligopoly are actually the heart and soul of the market structure continuum.

kinked demand 550 x 343 15k - gif

The Kinked Demand 350 x 259 9k - jpg

kinked demand 657 x 389 6k - gif

demand (MBB not 634 x 827 26k - 3

Kinked Demand 300 x 200 2k - gif

KinkedDemand 260 x 250 4k - gif

the Figure 6.1 315 x 235 - Kinked 7k - png 396 x 390 6k - gif

The Kinked Demand 959 x 719 11k - gif

kinked demand 290 x 286 3k - gif

Kinked Demand 296 x 279 19k - jpg

The Kinked Demand 710 x 405 42k - gif

The kink in the 550 x 334 15k - gif

the gap of the oligopolyMR Kink 224 x 167 - 320 x 232 4k - gif 19k - gif

The Kinked Demand 353 x 557 21k - jpg

the kinked demand 300 x 276 8k - gif

a Kinked demand 213 x 180 2k - gif

Demand curve. In 300 x 220 5k - jpg

Consider the demand 648 x 434 3k - gif

ECONOMIES OF SCALE AND OLIGOPOLY

It is interesting to examine how economies of scale lead to market forms such as oligopoly and monopoly, provide a reason for engaging in foreign trade, and are a factor in generating productivity gains. The existence of economies of scale in certain industries can lead to oligopolistic market structures in those industries. An oligopoly is a market form in which there are only a few sellers of similar products. Low costs of production (cost per unit or the average cost) can only be achieved if a firm is producing an output level that constitutes a substantial portion of the total available market. This, in turn, leads to a rather small number of firms in the industry, each supplying a sizable portion of the total market demand. In addition, economies of scale in production are often accompanied by economies of scale in sales promotion for the product under consideration, further strengthening the emergence of an oligopolistic structure in the industry. The automobile industry has long been considered a good example of an industry that demonstrates economies of scale in production

in the United States. According to a study by Joe Bain of the University of California, an automobile plant of a minimum efficient size can supply roughly 10 percent of the total automobile demand of the domestic market. Thus, it is not economical to have a large number of automobile firms. It is conceivable that the U.S. auto industry can possibly have about ten firms or so, and still not lose productive efficiencythat is, the industry will, even with ten firms, be able to produce at the technologically feasible minimum average cost. However, the U.S. automobile industry can simply not afford to have 50 or 100 firms due to economies of scale. The U.S. automobile industry also provides a good example of an industry that experiences economies of scale in sales promotion. Sales advertising for automobiles can be considered in a manner similar to actually producing automobiles. For an effective advertising campaign, the sales promotion must be done on a large scale. As the scale of advertising increases, the advertising cost per unit of output (advertising cost per automobile in this example) declines, at least up to a certain level of output. In addition, buyers of cars generally like to deal with a firm that has a large and dependable network of dealers. Establishing a large and dependable dealership requires a lot of money. Since dealers are also attracted to more reputable and popular brands, smaller automobile manufacturers are put at a considerable disadvantage in the battle for better dealers.

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