Oligopoly

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

• Discontinuity in AR (D1KD2) creates

Price, discontinuity in the MR curve.
Revenue, D1
Cost MC1
• At the kink (K), MR is constant between
K
P point A and B.
MC2
• Producer will produce OQ, whether it is
A operating on MC1 or MC2, since the
S
B profit maximizing conditions are being
T D2 fulfilled at points S as well as T.
• If MC fluctuates between A and B, the
O Q Quantity firm will neither change its output nor
MR
• D1K = highly elastic portion of the its price.
demand curve (AR) when rival firms do • It will change its output and price only if
not react to price rise MC moves above A or below B.
• KD2 = less elastic portion, when rival
firms react with a price reduction.
• Kink is at point K.
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.
• Immediate impact is a hike in price and a reduction in supply.
• Example: Organization of Petroleum Exporting Countries (OPEC)
• Two types:
 centralized cartels
 market sharing cartels.
Factors Influencing Cartels
 Number of firms in the industry: Lower the number of firms in the
industry, the easier to monitor the behavior 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.
 Stability in the Industry
 High barriers to Entry

 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.
 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 enter 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
Price Leadership
 Exploitative leader: fixes a price at which small inefficient
players may not survive and thus it gains large share of the market.
 At times results in monopoly type conditions
 Barometric Firm: has better industry intelligence and can
preempt and interpret its external environment in a more
effective manner than others.
 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.
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.
Cartels in the cement Industry

 India ranks second in the world in cement production. The cement industry is
highly fragmented as it faces tremendous pressure on price realization. The
demand for cement is price –elastic. Any imbalance in the demand and supply
leads to a disproportionate increase in the price. Based on the season, the price
is determined by the supply. When the cement manufacturers increase their
capacities, the enhanced capacity leads to excess supply. As the supply is more
than demand, cement prices fall and demand picks up, leading to an increase in
price.
 Since cement production is highly capital-intensive, profit margins are low. The
declining profit margins have prompted cement companies to form cartels. For
example, five big players in the industry cut production by 10% and managed to
increase profit by 50%.
 There are two important factors affecting cement production, namely, sales tax
benefits, and the direct cost incurred in production. Sales tax incentive varies
from state to state. Tamil Nadu offers sales tax exemption for seven years and
the payment can be deferred up to 14th year. Gujarat offers exemption from
sales tax for seven years. Based on the cost structure and the freight and packing
charges, the firm arrives at its profit or loss. The price and supply of cement in a
particular state is fixed by local cartel. Profit margin depends upon incentives,
direct costs, and decisions of the cartel. The cartel decides the floor price and
the sales volume for individual members in a region. Normally, cement cartels
do not last into the long run; cartelization is more of a short-run phenomenon.
 What are the reasons for the formation of cartels in the
cement industry?

 Why cartels do exists only in the short run?

 Suppose there are two fast food outlets in Jalandhar.
Experience tells that they have tried to engage in price
war to win more customers but have not gained
substantially in terms of profits. Can these outlets
collude to increase profits? Defend your answer with
justification.