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UNIT 16 OLIGOPOLY

6 2 Mcaning and Clii~ractcristicsof Oligopoly

6 . 3I cc/.y's Motlcl (lii~llicdI>ciila~ld


Cnrvc)
16.3.2 Co11nlol.sModel
16.3.3 I1~1-tnlutl's
M c M
10.3.4 Stilckelhcrg's Motlcl .
6 . Collosi\.c Oligopoly
I . I Wlllrt isC-ttth~sioll?
16.4.2 I~~~ctorstlctsniii~~i~i~Coll~~~ivcOligopoly
16.4.3 C;~rtcl
16.4.4 I'riccLcadcrsliip
6 . Let Us Sum Up
I . KcyWords
16.7 Answcrs to Chcck Your Progrcss
6 . Tcnnitial Questions

16.0 OBJECTIVES
~ f t c studying
r Illis unit yon should bc nblc to:
dcfinc oligopoly and cnlist its cli;~nctcristics
describe various models of oligopoly
esplain why oligopolists try to collude anlongst tliemselvcs rather than cotnpcte
csplain tllc implications of collusion

16.1 INTRODUCTION
In units I4 and 15 you Ili~vclcanit tliiit in th~':ibsc~icc
of pcrfcct compctition wc gct impcr-
fcct colnpctitioli \vllich could takc cillicr tl~cfort11of monopoly or nloilopolislic
compctition. Utidcr monopoly markct condition tlicrc is no ronipctition at all and thcrclorc
tllc sellcr yiclds unqocslioncd polvcr to influence tlic pyicc. Undcr nio~iopolisliccol~lpctitio~~
t l ~ csourcc of impcrrcction is diffcrcntiatcd products prodrlccd by large numbcr of closc
rivals. ~ h c r tlicrcc arc largc numbcr of scllcrs. ciipacity to product difircntialion may gi\.c
cacli scllcr a liltlc powcr to influcncc l l ~ cpricc of his comniodity. Under perfcct compctition
tlic scllcr has no sr~clipowcr at ;III si~icctllcrc is rip scopc for prodr~ctdiffcrc~itiation.In
bct~vccntllcrc is il sitr~iltioli~vhicllis dirfcrc~ltfrom botll monopoly i~ndmonopolistic
compctition and \vlicrc tlicrc arc f c scllcrs
~ ciicli of thcm comni:inding ;I ~~bsti111ti;il
shiirc of
tlic markct. Tiiis situation is callcd oligopoly. Tl~osin oligopoly inipcrfcction rcsults f r o ~ i i ~
~ C \ V I I C S S Ofimls.
~

111tliis unit you will Imni llic illcalling iind clii~riictcristics.of


oligopoly. You \\.ill also lciir~i
;lb011t collusion inidcr oligopoly iind pricing ~vilhoolfoniiiil collasion.
Oligopoly
16.2 MEANING AND CHARACTERISTICS OF
OLIGOPOLY
Oligopoly is a form of market structure in which a few sellers sell differentiated or homoge-
neous products. In fact, the number of sellers depends on the size of the market: Given the
size of the market, if the number of sellers is such that each seller has command over a
sizeable proportion of the total market supply, then there exists oligopoly in Uie market.
Every seller influences and is influenced by the beliavioor of other firms and tlicrefore
producers under oligopoly are mntually dependent upon onc anothcr. Thus an oligopoly
market may be identified by (i) a relatively small number of finns. (ii) difficult enfry and (iii)
a product that is either standardised or differentiated.
The main iniplication of the above conditions is that oligopolists recognise tlieir interdepen-
dence in the market. It means that the actions of one firm will influence tlie i~ctionsof others
in thc mcuket and this interactive influence is rccognised.
The basic characteristics of oligopolistic market structure are as follows:
Competition: The charncteristic fe\-vnessof their numbcr brings oligopolists in keen
competition with one another. Let us compare oligopoly with other market structures which
you were introduced to in the previous units. As yo11know. under pcrfect compctition.
competition does not csist becausc the nr~~nber of scllers is so large that no scllcr is strong
enough to make any impact on market conditions. Undcr nionopoly therc is no cotnpetition
as there is only onc seller of the product. Under monopolistic competition. again thc number
of sellers is so large Uial tlie degree of compctition is considerably rcduced. On the contrary.
under oligopoly. the number of sellers is so.small tliat any move by one sellcr ininiedintely
affects the rival seller. As a result each fimi kccps a closc watch on tlie activities of thc rival
firms and prepares itself with a number of defensive marketing strategies.
1nterdel)endence: Competition among the oligopolists make Len1 intcrdcpendcnl in
rcspcct of decision making. If n fimi operating undcr oligopoly introduces a clinngc in the
price of its product. it will havc influence on thc price and output dccisions of otlicr f i r i s
also. Thus il charigc in llic olltprlt or pricc by onc fin11 cvokcs rcaction fro111otlicr lirnis
operati~~g in tlic market. lnterdcpendcncc in dccision-making is dlc milin characteristic of
firms operating undcr oligopoly.
Difficult Entry: In tlic long run. iln oligopolistic niarkct slnlctnrc is also chanlctcriscd by
strong barricrs to cntry orncw finns in tlic industry. Some bnrricrs lo cntry arc cco~ioniicsof
salt. pricc cuts. csistencc of cscess ciipacity ctc. Thcsc filclors prc\.cnt tlic cntn of nciv finiis
and liclp oligopoly to reoiain.

Types of Oligopoly .
Oligopoly is of two types : (a) discriniinato~oligopoly and (b) pure oligopoly.
Discriminatory Oligopoly: In tlic cnsc of discriminaton oligopoly diffcrcnt prodr~ccrsof
the product scll goods similar to onc nnothcr. Tliough tlic goods produccd by diffcrcnt
producers have sollie distinguished cl~nri~ctcristics. all of tlic~narc closc s~~bslitutcs.
From the
co~isu~iicr's
point of \~iciv.tlic diFfcrcnccs in tlic goods can bc both rcal and imaginary.
Gcncn~llydiffcrcnccs on account orsizc. sli;lpc. quality arid dcsign ctc. arc rc;il \vl~ilc
diffcrcnccs on account of trndc miirk and bc~tidname of tlic goods arc i11iilgin:ln..
Purr: Oligopoly: Ili thc cnsc purc oligopoly. all linns producc idc~tlicalprod~~cts which
aicans tliiit t l ~ producers
c do not indulge in product diffcrc~iti:~tioi~.
Tlicrcforc. cons~~nicr's
dccisions to pi~rcliasctlic good of a partici~lnrprodr~ccrarc inllucnccd by thc pricc
considerations. In otlicr words non-pricc co~npctitioncannot takc placc r~iidcrconditions of
purc oligopoly.
The :idvantage of product differc~itintionis that t h scllcr.
~ cvcn if lic is charging ;I slightly
I~igherpricc than tlic rest. can liopc to rct;li~itlic s;ilnc piirt of tlic m;lrkcl bcc:~i~schis product
is diffcrcnt to sonic cstcnt. In fiict through ad\~crliscmciitsIic 111;lyC\.CII SIICCC,:~ i n crcnling
tlic iniprcssiori that his prodt~ctis superior. Iio\vc\.cr. this liniitcd scopc also docs not csist
wlicrc product diffcrc~itiationis abscnt. 111 purc or pcrfcct oligopoly tlicrc is hardly any nccd
for ndvcrtiscment nnd for incr~rringsclling costs. All 111i1t rcmains is pricc compctition i ~ i d
T h c ~ ~ rofy Price that too ofthc fierccst posSible kind. 111sucli circi~mstanccs.if any produccr nliscs his pricc
he ciln alnlost bc surc of tlic rcaction and onc rcallvdocs not k1101v \vlicrc this war of action
and reaction utill take him. Tllns starting with an initial pricc which may bc nlcll abovc cost
of production, pure oligopoly map, because of pricc war. cnd up with a pricc nlliicli is.just
equal to average cost of production. Under thc conditions of pure oligopol~cquilibrin~n
becomes even more difficult and the market rcmains in the grip of an nnccrtainty \vhich lnay
be greater than that in other types of oligopoly.

f X E Q C V Q ~ ~ d
1) M'W-dallm
*.-rn ..Ir-.'...,
... .......- .....
.,ssa*..Ii ...,.............
r*...... i.r..r...r b......'..., ......................................

16.3 NON-COLLUSIVE OLIGOPOLY


We now look into the theoretical problem of oligopoly. There always exists an uncertainty in
respect of behaviour pattern of a firm under oligopoly. Due to this uncertainty which arises
out of their unpredictable action and reaction, a systematic analysis of oligopoly becomes
difficult. Under these circumstances, a wide variety of behaviour pattern may emerge. Based
on different behavioural assumptions, economists have developed a variety of models.
Which can be classified as (i) non-collusive models and (ii) collusive models of oligopoly.
Now let us present these models briefly. .
The non-collusive models of oligopoly explain the price and output determination in a
market structure in which 01i.gopolistsrecognise their interdependence.

16.3.1 Sweezy's Model (Kinked Demand Curve)


The kinked demand curve approach to the oligopoly problem was put fonvard by 'Paul M.
Swcezy, an American economist and by Hall and Hitch, Oxford economists.
It has been observcd that in many oligopolistic industries prices remain stickv or inflexible.
Many explanations have becn given of Uie pricc rigidity under oligopoly but the most
popular esplanation is the kinked demand curve theory. In explaining price and output
ilndcr oligopoly wit11 product differentiation. the kinked demand curve hypothesis has been
often used. Under differentiated oligopoly, wliell a fin11 raises its price all customers would
not leavc it because some customers arc intimately attached to it due to product differentia-
tion. Thereforc, the denxmd curvc facing a firm under differentiated oligopoly is not
perfectly elastic.
According lo the kinked demand curvc approacl~.Uie demand curve facing 'an oligopolist
has a 'kink' at the prevailing price level. Thc kink is forn~edat the prevailing price level
because the segment of the demand cunx abovc the price level is more elastic and the
segment of the demand curve below thc prcvailing price level is less elastic.
Now, let us lbok at figure 16.1. A kinked denland curve dD with a king at point K has been
shown in the figure. The prcvailing price level is QK and the firm's output level is OQ. Now
the upper segment dK of the dcmand curvc is relatively Inore elastic than thc lowpr segment
KD. This difference in elasticities is duc to the competitive reaction patteni :1ssr1111cd
by tilc Oligopoly
kinky oligopoly dc~ilandcu~c.hypothcsis .

Quantity
Figure 16.1 : Kinked Demand curve under Oligopoly

According to the kinky oligopoly demand curve theory, each oligopolist believes that if he
lowers the price below the prevailing level, his competitorswill follow him and if he raises
the price above the prevailing level, his competitors will not follow his price increase.
The above assumption may be explained in detail. In order to increase his sales if the
oligopolist reduces his price below the prevailing price lmel QK, the competitors will fear
that they will loose their customers to the former oligopolist who has cut his price. Therefore.
in order to retain their customers they will be forced quickly to match the price cut. Because
of this quick reaction from the competitors he will gain only little in sales. This means that
the demand for him is inelastic below the prevailing price, QK, showing a very little increase
in sales for a reduction in price by an oligopolist.
On the other hand, if a oligopolist raises his price above the prevailing level, there will be a
substantial reduction in his sales. As a result of a rise in his price, his customers will go to his
competitors who will welcome the new customers and gain in sales. The competitorswill
therefore have no motivation to match the price rise. Thus, the demand for him is highly
elastic above the prevailing level, QK, showing a large fall in sales if an oligopolist raises his
price.
This is how anbligopolist expects his rivals to match his price cuts quickly but does not
expect his rivals to match his price increases. Given this expected competitivereaction
pattern, each oligopolist will have a k i e d demand curve.
l'he kinked demand curve helps to e'uplain why oligopolistic prices tend to be inflexible.
Under the assumptions of the kinked dema6d.curve, a price rise would lead to a sllarp
\&ction in sales. Conversely a price ieductibn would attract few new customers. Thus, once
a price is established, it remains inflexible for estended periods of time. However, the theory
does not explain how the price has been established.

Duopoly Models
A special case of oligopoly called duopoly exists whcn there are only two sellers of a
product. Let us briefly describe some classical models of duopoly.

16.3.2 Cournot's Model


Augustin Cournot, a French economist, was the first to develop a fornlal duopoly model in
1838. Cournot illustrated his model by the following assumptions :
a) there are two finlls A and B
Th~wryof Price b) both operate their product at zero marginal cost
c) both face a downward sloping straight line demand curve
d) each seller acts on the assumption that his competitor will not react to his decision
to change his output and price.
Therefore, Coumot in his model assumed that each oligopolistic firm would set its output in
the belief that its rival firms output would remain constant. But his model ignores the
oligopolistic interdependence in providing a solution for the price and output under oli-
gopoly. His assumption of zero cost of production is also unrealistic.

16.3.3 Bertrand's Model


Bertrand criticised the above model and developed his model in 1883. Bertrand's model
differs from Cournot's model in respect of its behavioural assumption. While under
Coumot's model each seller assumes his rival's output to remain constant, under ~ e h d ' s
model each seller determines his price on the assumption that his rival's price remains
constant. Accordingly Bertrand's model concentrates on price competition.
Bertrand assumed that an oligopolistic firm would set its price in the belief that its rival firm
would keep its price unchanged. By assuming so, Bertrand also ignored the oligopolistic
interdependence and his model has also been criticised on the same grounds as Cournot's
model.-.

16.3.4 Stackelberg's Model


Stackelberg, a German economist, developed his leadership model of duopoly in 1930. He
assumes that one of the duopolists, for example, A will play the role of a leader and the other
say B, acts as a follower. The leader recognises that his rival seller has a definite reaction
function which the former uses into his own profit function and maximises his profits. The
model, however, dbes not explain which firm has to act a leader.

CHECK YOUR PROGRESS B


1) Defrne kinked demand m e .
......................................................................................................................

2) List the assumptions of Cournot's duopoly model.


......................................................................................................................

3) State whether the following statements are True or Raise.


i) The most popular explanation of price rigidity under oligopoly is Bertrand's Model.
ii) The demand curve facing a fm under-differentiated oligopoly is not perfectlr
elastic.
iii) Under Coumot's model each seller assumes his rival's pride to remain constant.
iv) Oligepolistic interdependence has been ignored by Bestrand's model.
v) Cournot's model concentrates on price competition.

16.4 COLLUSIVE OLIGOPOLY


Now you will be introduced to another common situation which prevails in oligopolistic
industries. Under this, different oligopolistic firms arrive at a tacit or formal agreement on a
common policy to be pursued by them.
f6.4.1' Whqf is Collusion?
ColIusion"isan agreement among f i to avoid various competitive practices, particularly
price reductions. It may involve either fo.rmal agreements or merely tacit recognition that:
competitive practices will be selfdefeatingin the long run. It is difficult to detect tacit
collusion.

16.4.2 Faciors determining Collusive Oligopoly


The oligopolistic firms, considering their interdependcncc, will cntcr into an ;igrcclncnt ;~nd
work h t h e pursuit of their common interest. Thc nlajor fi~ctbrsbclli~idcollusion arc Iistcd
below:
i) Collusion reduces the degree of competition bctween the fimls where Ihey can act
nionopolistically in their effort of profit maxiniisation.
ii) Collosion reduces the oligopolistic uncertainty sincc cartcl membck are not supposed
to act independently or against the interests of other firms.
iii) Collusion becomes a kind of banier to thc entry of new firms.

,164.3 Cartel
Cartel is a formal agrecrnent of the different oligopoly firms. Cartels are the pcrfect form of
collusion. The finnsjoin together not only to fix the price they would charge but also the
share of the market each wo~ildbe entitled to. In this agreement they aim at some kind of
joint profit masimisation. Thus under perfect cartel type of collusive oligopoly, the price
and output determination of the whole in dust^ as well as of each member firn~is dctermined
by the common administrative authority so as to achieve masimi~mjoint profit. -
The main purposc of the organisational am~ngcmcntis to assurc that thcrc is no pricc war and
. that cntry of ncw f i m ~ is
s restricted 11sfar as possiblc. Though a cartel may desire to rcstrict
the entry of other finns into thc markct. it does not I~;IVC lcgal mcans of doing so. Tllc OPEC
(Organisation of Petroleum Exporting Conntries) is ;I cartcl \vhich sccks o fis thc price of oil
and also thc sharing of thc world oil market bet\vcen tllc mcmbcr countries. Howevcr. while
agreeing on price and market sharing may be easy, policing thc iigrccliient can bc difficult.
This is becausc there is an inhercnt tcndency on the pan of thc produccrs to tr). to outwit
other producers in ways which involve infri~~gemcnt of the common arrangcmcnt. Thc main
advantage in a cartel is that the oligopolists retain individual control of thcir production
unit.
It may. however. be noted that cartels do not ncccssarily crcatc thc conditions for pricc
stability in an oligopolistic market. There is no binding on thc nlcnlbcrs undcr carlcl
agreements. Cartels do not prcvent the possibility of cntry of neu firms as there is no lcgnl
provision.
d
.

16.4.4 Price Leaderspip


Recognised interdependqce often causes oligopolistic finns to rccognise the futility of cut-
throat price competition pnd the profitabilitl.of n~i~lual
restraint or tacit collusion.
I
Thus tacit colliision is mutual self restraint. a parallcl rcluctancc to compctc on pricc
grounded on individual understanding. If succcssf~~l..facit collusion has its rewards - Iligh
prices and profits. perhaps nearly as high as a n~osopolist's.An imporl;~ntcsi~rnplcof tacit
agreement, in oligopolistic industries is found in wllat is called pricc Icndcrship. Pricc
leadcrslrip is an impcrfcct form of colliision bct\vccn oligopoly finns.
I
Undcr price Icadcrship. prices set by a lcading fina arc imitarcd by thc otllcr finns in tllc
markct simply by self interest, not by fonnal agrccmcnt. Ho\vc~.cr.ir may bc noccd Illat
sometimes pricc leadership rcsulls from a formal ~llcctirlg:~ndiigrcc!ncnt bctwccn the
competing finns in \vhich thcy choose i1 Icadcr and agrcc to follo\v llinl in setting price.
Price lc~dcrsllipis possiblc under bolh prodiict Iroalogcncity and product diffcrcntiation.
There ;ire three types of pricc Icadcrships:
i) Price lc~dcrshipby a dominant finll:
Theory of Price ii) Price leadership by a low-cost firm; and
iii) Barometric price leadership
Let us have a look at each of the above.
Under price leadership by a dominant firm, one of the few f m s in the industry may be
producing a very large proportion of the total production and may therefore dominate the
market of the product. This dominant firm has a great influence over the market of the .
product, while other firms are small and are incapable of making any impact on the market.
.As a result the dominant firm estimates its own demand curve and fixes a price, which
'maximises its own profits. Having no individual effect on the price, the small firms follow
the dominant fm,accept the price set by him and adjust their output accordingly.
The second kind of price leadership is by a small fm with a low cost of production. Inspite
of its controlling only a small part of the market, a small fm manages to keep its cost of
production low. The advantage of such a firm is that it can charge a lower price without
being a loser. The larger firms may accept the small firm as the price leader because they
may already be in a tight position due to their high cost.
Finally, under barometric price leadership, an old, experienced or most respected firm
assumes the role of a leaderlcustodian who protects the interests of all. The price leader may
not necessarily be the largest firm of the industry. The barometric firm assesses the change in
the market conditions with regard to demand, cost of production, competition from the
related production etc. and announces price changes which are best from the viewpoint of all
the firms in the indtstry. It is thus obvious that other f m follow him willingly.
However, there are certain limitations in maintaining the price leadership. They are: i) the
success of price leadership of a firm depends upon the accuracy of his estimates about the
reaction of his followers. ii) when a price leader fixes a higher price, there is a strong ten-
dency among the followers to make secret price cuts in order to increase their market shares.
iii) there is a tendency on the part of the rivals to indulge in non-pride competition to
increase their sales and thereby their share of market. The rival firms try to increase their
market share by going for improvement in the quality of their product, more attractive
advertising or changing the brand name. As a result, the price leader has also to adopt similar
devices to prevent the fall in its sales. Thus the price leader may not be able to maintain his
leadership for a long time.

CHECK YOUR PROGRESS C


1) What do you mean by collusion? .
.......,.,..,,..,.*..: ..............................................................................................

2) What is a cartel?
.........................
c..r d‘....;.X.r.i... ,...,.
iiiiiiiii .i...u .,.... i;‘.~i~.,iii,..~ii~~..~+ii.~~ii.,....i*...' ............

4) State whether the following statements are T ~ l or


eFah
i) It is difft&t to detect tacit collusion.
. ii) Collusion restricts the entry gf new firms

iii) Oligapolist9 loose individual mntroi of their pmduction unit unda a Cartel
iv) Met I a i a h i p is an uampls:o f d t agreema.
V) M c e-1 b a aafad mm of cellus@ buwmolilppalv firms

16.5 LET-US SUM UP


Oligopoly is an important fornl of imperfect compctition. No individual firni undcr oli-
gopoly can be sure-yf tl~e,dem~and curve it faces though the demand curve of thc industry is
. known. This uncertainty is due to oli~opolistsbcing so much interdependent rathcr than
independent. It is difficult to determine the reaction of other oligopolists to a change in the
price of the product by one oligopolist. It is d i ~ cto Ulis incapability to detcrnline the reaction
of other finns that makcs the demand curve of a firnl under oligopoly indetcnninatc.
Unlike a monopolist or a competitor, an oligopolist cannot detern~inethe product price that
will deliver masimu~nprofit simply by estimating denland and cost conditions. An
oligopolist must also predict how rival firmswill react to his price adjustments. Since each
oligopolist confronts the same complex problem, .it is impossible to determine the precise
price and output policy that will emerge in oligopolistic industries.
As mentioned above, there is no single determinate solution to price-output fisation under;
oligopoly. Various ecclnomists' have developed a large number of models by adopting
different assumptions regarding the behaviour of oligopolistic firms, the objective they seek
to achieve, and the different reaction patterns of rival firms to price and output changes by
one firm.
The kinked demand curve helps to explain why oligopolistic prices tend to be inflesible.
However, it only csplains why an oligopoly pricc has been determined would remain rigid.
But it does not esplain how the prevailing pricc has been determined.
Oligopolists tv not to have a price competition and thcrefore they often prefer to collude
rather thancompete. Collusion can be formal or informal. In fonnal collusion, thcy fis up
one price which all of them should charge. This price is determined in such a way that therc
will bcJoint profit maximisation. When collusion is infornlal, price is determined by a price
leader. A pricc l ~ i d ecould
r be both a large finn or a small firm depending i~ponthe criterion
thc oligopolists likc to apply to the choicc of their Icader. Price leadcrship models attelnpt to
explain the firms behaviour of changing prices in step rvith each othcr.

16.6 KEY WORDS


Cartel: A fonnal agreeluenl111which price of Ule commodilg and sharing of the markcts are
comnlonly decided but the organisational control of a firm is in its own hands.
Collusion: Agreement anlong oligopolistic finns to avoid compctition amongst Ihcn~scl\~cs.
Formal Collusion: A collusion which is based on a formal agreement.
Informal Collusion: A collusion behind which therc is a broad understanding amongst thc
participants but no formal agreement.
Interdependence: The situation in which a seller does not fccl frec to take br~sincssdpcisions
withalt duly considering the reactions of his rivals.
KinKetl Dcn~irntlCunrc: A sellcr facing a demand curve ill which incrcasc in pricc abovc tlic
prevailing pricc levcl makes his denland morc elastic but decreasc in pricc below thc
prevailing pricc levcl rnakes his dcmand inelastic.
Olign1)oly: When the number of sellers is so small U~ateach one of them inflr~cnccthc
market price. quality and output powerfully.
Price Leirtlershil): When'oligopolists decidc that the market price be set by somc particular
fm and they follow that firm to chargethe same price.
Theory of Price
16.7 ANSWERS TO CHECK YOUR PROGRESS '

A) 2) i) False ii) T n ~ eiii) Tnle iv) Falsc v) False


9) 3) i) False ii) True iii) False iv) Tnie v) False
C) 4) i) T n ~ eii) True iii) False iv) Tnie v) False

16.8 TERMINAL QUESTIONS


1) What is interdependence in an oligopolistic market'? What kind of problems does it
create in determining price and output under oligopoly'?
2) What isfoint profit maximisation? Hdw is it sought to be achieved under olig&oly?
3) A kinked demand curve may help to understand why oligopoly price tends to be rigid
bur it docs 1101 csplain how the price has been determined. Comment.
4) Esplain lllc conccpt of price leadership. Does acceptance ofprice leadership solve all
problc~iisof oligopoly equilibrium'? .

Notc: These questions help you to understand the unit better. Try to write
answers for them. But do not send your answers to the University. These are
for your practice'only.