CHAPTER TWO: OLIGOPOLY

2.1. Introduction

Oligopoly is the fourth type of market structure. It is a form of market structure in which a few
sellers sell homogeneous or differentiated products. Oligopoly is an industry with small number of
sellers. How small is small cannot be decided in theory but only in practice. Nevertheless, in
principle, the criterion is whether firms take into account their rivals’ actions in deciding upon their
own action or not. In other words, the essence of oligopoly is recognized interdependence among
firms. Coca-Cola considers the actions and likely future responses of Pepsi when it makes its
decisions (whether concerning product design, price, advertising, or other factors).

It is difficult to fix up definite number of sellers. Any way, if each seller has command over a sizable
proportion of the total market supply then there exists oligopoly in the market. That means if one
seller increases (decreases) its supply; the market price may decrease (increase) because the supply
of this seller constitutes a significant proportion in the total market supply. The basic characteristics
of oligopolistic market structure are the following:

A) Keen (or intense) competition between firms: The number of firms is small enough that each
seller takes into account the actions of other firms in its pricing and output decisions. In other
words, each firm keeps a close watch on the activities of the rival firms and prepares itself with a
number of aggressive and defensive marketing strategies.

B) Interdependence: the nature and degree of competition makes firms interdependent in respect of
decision making.

C) Barrier to entry: in oligopoly market firms are small enough in number implies there is barrier
for new firms to enter into the market. Some common barriers to entry are economies of scale,
patent rights, and control over important inputs by existing firms.

In general, unpredictable action and reaction will make it difficult to analyze oligopoly market.
Firms may come ‘in collusion with each other’ or ‘may try to fight each other on the death.’ So

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accordingly we can classify oligopoly market structure as Non-collusive Oligopoly and Collusive
Oligopoly.

2.2. Non-collusive Oligopoly

Oligopoly firms may cooperate (collude) or may not cooperate (no-collusion) in some activities with
respect to their businesses depending on their interest and agreement. If firms do not cooperate, their
decision-making process is analyzed using the non-collusive model. Under this model, we have the
Cournot's duopoly model, the 'kinked-demand' model, Bertrand Duopoly model and Stackleberg
Duopoly model. We will look how firms arrive at equilibrium points in each model one by one.

A) The Cournot's Duopoly Model (Output Simultaneous Game)

When there are only two sellers of a product, there exists duopoly, a special case of oligopoly. Augustin
Cournot, a French economist, was the first to develop a formal duopoly model in 1838. To precede our
analysis of the model, the assumptions of the model are the following:

a) There are only two firms, A and B each owing a mineral water wells;

b) Both operate their wells at zero marginal cost of production( MC=0);

c) Both face a downward sloping straight line demand curve; and

d) Each seller acts on the assumption that its competitor will not react to its decision to change its output
and price.

C
P

D
O A X
B

Figure 2.1: Price and Output Determination under Cournot’s Duopoly

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Now, let us assume that firm A is the first to start producing and selling mineral water, X. Therefore,
the market open to A is OD, the total quantity demanded. The market demand curve for the product
is DD and its respective marginal revenue curve is firm A's marginal revenue curve (MR A ). Firm A
will sell half of the total quantity demanded OD.

MR A is twice steeper than the DD curve (please try to show how this holds true) in the imperfect
market and it bisects OD at the middle. Thus firm A will sell OX M amount of X. At point A, firm A
is maximizing its profit because at A , MR=MC=0 . When MR=0 , the elasticity of demand, e d =1. If
we assume the total quantity demanded, OD is one unit, then firm A will sell ½ (1) = ½ unit of x.

Show that in imperfect markets: MR=P 1− ( 1

ed).

Now, firm B enters into the market (next to A). The market open to B is therefore, the remaining half
(X M B) out of the total OD. Hence the demand curve of B is CD and its respective marginal revenue
curve is MR B which cuts X M D at the middle at point B. At point B profit of firm B is maximum
because MR B=MC =0. Firm B will sell quantity X M B at the Price P. Here we can observe that firm
1
B will supply X . That means
4 ()
1 1 1
= .
2 2 4

With the entry of B to the market price fall from P M to P. Firm A attempts to adjust its price and
output to the changed condition. Thus A assumes that B will not change its output X M B and price P
1 3
as B is making the maximum profit and he continues to supply . Then A has of the market
4 4
3
( ) 1
available to it that is = 1− . To maximize its profit A will supply
4 4
1 3 3
()
= of the market. Now,
2 4 8
it is B's turn to react (to move). This action and reaction will continue until both reach the
1
equilibrium point by supplying each.
3

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 Periods Firm A Firm B
I 1
2
( 1 )=
1
2
1
2( )1 1
1− =
2 4
II
(
1
2
1 1 1
1− − =
2 4 8 ) (
1
2
1 1 1
1− − − =
1
2 4 8 16 )
III 1
2 ( 1 1 1 1
1− − − − =
1
2 4 8 16 32 ) 1
2 ( 1 1 1 1
1− − − − −
1
=
1
2 4 8 16 32 64 )
. . .
. . .
We observe that the output share of Firm A declines gradually. We may re-write this expression:

1 1 1 1
[Product Share of Firm A Equilibrium]= − − − −…
2 8 32 128

[
1 1 1
¿ − + +
1
2 8 32 128
+…
]
1
The expression in parenthesis is a declining geometric progression with ratio r = . Applying the
4
a
summation formula for an infinite geometric series S= (where S=sum, a=first term of series, r=
1−r
ratio) we obtain:

1
[ Product Share of Firm A Equilibrium ] = 1 − a = 1 − 8 1 1 1
= − =
2 1−r 2 1 2 6 3
1−
4

Again we observe that the output of Firm B increasing at decreasing rate. We may re-write this
expression:

1 1
1 1 1 4 4 1
[ Product Share of firm B Equilibrium ] = + + +…= = =
4 16 64 1 3 3
1−
4 4

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 1
The supply by each firm remains in the rest of the periods. Consequently, the Cournot equilibrium
3
is stable equilibrium. The price level in the Cournot models is lower than the monopoly priced but
above the pure competitive price. In general if there are n firms in the industry each will provide
1 n
of the market, and the industry output will be clearly as more firms exist in the
( n+1 ) ( n+1 )
industry, the higher the total quantity supplied and hence the lower the price. The larger the number
of firms the closer is output and price to the competitive level.

Note: Cournot game is also called an output game as the strategies of firms are their outputs. Firms
are using their outputs as a weapon to win the tough competition among the firms.

Reaction Curve Approach

This is based on isoprofit curves of competitor. Assume there are two firms, Firm A and B. An
isoprofit curve for firm A is the locus of points defined by different levels of output of A and his
rival B which yield to A the same level of profit. The same definition works for isoprofit curve of
Firm B.

Properties of Isoprofit Curves

1) For substitutable commodities they are concave to the axis along which we measure the output of
rival firms.

2) The further the isoprofit curves lie from the axis, the lower is the profit and vice versa.

 A 1 > A2 > A 3 > A 4

 B1 >B 2> B3 > B4

3) For Firm A the highest points of successive isoprofit curves lie to the left of each other and for
Firm B is to the right.

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4) Reaction Curve of Firm A is a curve that joins the locus of points of highest profits that Firm A
can attain given the level of output of rival Firm B. The converse definition works for Firm B.

A’s Reaction
B
B Function

B’s Reaction
Function

A
A
Figure 2.1: Reaction Curves
Mathematical Derivation of Cournot’s Duopoly

Let the market demand be given by X =a – b P X for two oligopoly firms (Duopolists), where:

Market Demand=X =X 1 + X 2

X 1 =Output of Firm1

X 2 =Output of Firm2

While:

C 1=f ( X 1 )∧C 2=f ( X 2 )

The first and second order conditions of profit maximizing rule of the firms are presented as follows.

First Order Condition:

❑1=TR1−TC 1
❑2=TR2−TC 2

❑1 TR1 TC 1
= − =0 ❑2 TR2 TC 2
X1 X1 X1 = − =0
X2 X2 X2

6|Page MR 1=MC 1
MR 2=MC 2
Second Order Condition:

❑2 ❑1 ❑2 TR1 ❑2 TC 1 ❑2 ❑2 ❑2 TR 2 ❑2 TC 2
= − <0 = − <0
X 21 X 21 X 21 X 22 X 22 X 22

2 2
❑ TR 1 ❑ TC 1 2
❑ TR2 ❑ TC2
2
2
< 2 <
X1 X1 X2
2
X2
2

MR1 MC 1
< MR1 MC 1
X1 X1 <
X1 X1

Exercise: Assume that the market demand and the costs of the duopolists are given by:

2
P=100−0.5 ( X 1 + X 2 ) ; C 1=5 X 1 ; C2=0.5 X 2

A) Find the reaction functions of the two firms.

B) Find the profit maximizing quantity and profit level of each firm.

B) The 'Kinked-Demand' Model

This model attempts to explain the phenomenon of price rigidity in oligopolistic firm. It is the best
known model to explain relatively more satisfactory the behavior of the oligopolistic firm. If an
oligopolistic firm reduces price of its product, it believes that the rival firms will follow and
neutralize the expected gain from price reduction. But if it raises its price, the firms would either
maintain their prices of even make price-cut, so that the price-raising firm would lose, at least its
market share. Therefore, the oligopoly firm would find it more desirable to maintain the prevailing
price and output.

There are three possible ways in which rival firms may react:

I) Rival firms follow the changes in price, both price hike and price cut.

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 II) Rival firms do not follow the changes in price, both price hike and price cut.

III) Rival firms follow the price cut changes but not follow price hike change.

 If rival firms react in manner (I) and (II) an oligopolistic firm taking lead in changing prices will
face two different demand curves.

dd ’=¿ Which is based on reaction (I) (Follow both hike and cut)

DD ’=¿ Which is based on reaction (II) (Do not follow both price hike and cut)

 dd ’ is less elastic than DD ’ because of the changes in d d ' in responsible to changes in price are
restrained by the counter-moves by the rival firms.

The demand curve of the oligopolist has a kink at point E reflecting the following behavioral pattern.
Now, let us look how this kink is formed at pint E.

Initially the firm is at equilibrium at point E where the expected sale is equal to the actual sale and
the price is P and the output level is X. If a firm reduces its price, all other firms also follow this
action and will reduce their price. Although, the demand in the market increases, the shares of
competitors remain unchanged. As a result, the demand curve of the firm below price level P is ED'.

P
D
C

E
P
A

O X
MR
Figure 2.3: Kinked-Demand Model

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In other round, if the firm increases price above P, other firms will not follow this action and
consequently the demand curve of the firm will be dE, implies its sales decreases due to the shift of
some of its customers to the other firms. Thus, for price increases above P, the relevant demand
curve of a firm is the section DE of the dd' curve. Finally, the demand curve of the firm will be dED'
which is a ‘'kinked demand’' curve.

Due to the kink in the demand curve of the oligopolist firm, its marginal revenue curve (MR) is
discontinuous at X which corresponds to the kink at E. The MR has two segments: Segment dA
corresponds to the upper part of the demand curve, dE while the segment from point B corresponds
to the lower part of the kinked-demand curve, ED'.

The gap or the distance between point A and point B increases or decreases depending on the
elasticities (or the slopes) of the segment dE and ED'. The greater the difference of elasticities of the
upper (dE) and lower (ED') parts of the kinked-demand curve, the wider discontinuity in the MR
curve, and hence the wider the range of AB.

Now, let us look the behavior of the equilibrium of the firm. The equilibrium of the firm is defined
by the point of the kink at point E because to the left of E, MC is less than MR and the right of E,
MC is greater than MR. Since in the range AB, MR is a straight line whatever be the MC (i.e.
whether the MC is MC 1 or MC 2 or in between MC 1 and MC 2) we have always the equality between
MR and MC (MR=MC) implying the firm is maximizing profit by producing X and charging the
price P.

Here you should note that whether the MC increases or decreases (in the range AB) price remains
the same P, i.e. price is rigid or sticky in the oligopoly market. The rigidity of price is the result of
uncertainty the firm faces from its competitors. In other words, firms do not increase price despite
the rise in costs to avoid competition of viral firms.

There is only one case in which a rise in cost will most certainly induce the firm to increase its price.
This occurs when the rise in costs is general, example imposition of tax that affects all firms equally.
Under these circumstances the firm will increase its price with the certainty that the other in the
industry will follow. Hence the point of the kink shifts upwards to the left, and equilibrium is
established at a higher price and lower output, X.

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C) The Bertrand Model (Price Game)

This model assumes that firms choose price rather than output. The first piece of work in this line is
that of Joseph Bertrand. In a critique of Cournot’s book, Bertrand briefly sketched a model in which
firms make simultaneous price decisions. When firms offer identical goods and have a constant
marginal cost, there is a unique Nash Equilibrium when firms choose price and it entails both firms
pricing at marginal cost. The Bertrand model yields the surprising result that Oligopolistic behavior
generates the competitive solution! If firms’ outputs are differentiated, price competition results in
similar to those of the Cournot solution: each firm’s price lies between the competitive price and the
monopoly price. One of the most significant ways in which firms compete is trying to make their
product unique relative to the other products in the market. The reason is that the more differentiated is
one’s product; the more one is able to act like a monopolist. That is, you can set a higher price without
inducing large numbers of consumers to switch to buying your competitors’ outputs. To consider the
role of product differentiation, let us follow the suggestion of Bertrand and assume that firms make
simultaneous price decisions with constant marginal cost –though, of course, we will assume that
firms’ outputs are differentiated. This means that consumers perceive these products as being
imperfect substitutes. That is, there are consumers who are willing to buy one firm’s output even
though it is priced higher than its competitors’. It also typically means that a small change in a firm’s
price causes a small change in its demand.

D) The Stackleberg’s Duopoly Model (Output Sequential Game)

This model assumes that one oligopolist is sufficiently sophisticated. That means the sophisticated
Duopolist firm determines the reaction curve of its rival and incorporates it in its own profit function
which it then proceeds to maximize like a monopolist.

Let firm A and firm B are the two Duopolists. If firm A is the sophisticated oligopolist, it will
assume B will act on the bases of its own reaction curve. This will permit A to choose to set its own
output at the level which maximizes its own profit. This is point a , which lies on the highest possible
isoprofit curve of A, denoting the maximum profit A can attain given B’s reaction curve.

e
A’s Reaction Curv
B
Stackelberg’s equilibrium with B
the sophisticated leader

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Cournot’s Equilibrium

Stackelberg’s equilibrium with A

 B’s Reaction Curve

A
Figure 2.4: Stackleberg’s Duopoly Model

1
Exercise: Suppose the demand P=200− Q. Moreover, the total cost function of the incumbent
2
firm is given by TC 1 =30 q1 and that of the entrant firm is given byTC 2=40 q 2. Then, find
quantity and profit of each of the firms and the market price under Stackleberg’s model.

2.3. Collusive Oligopoly

Sometimes firms form collusion each other in many actions to avoid uncertainty or competition
among themselves. This collusion helps the oligopolist firms to act like a monopoly. The two main
types of collusion are cartels and price leadership.

1) Cartels

Cartels imply direct agreements among the competing oligopolists with the aim of reducing the
uncertainty arising from their mutual interdependence. Based on this objective, the general purpose
of cartels is to centralize certain managerial decisions and functions of individual firms with a view
to promoting commons benefits. There is one typical example of cartels i.e., OPEC (Oil and
Petroleum Exporting Countries). These countries (or oil producing firms) form the organization
called OPEC and this OPEC acts as decision maker and all firms are governed under it. The two
typical services of a cartel are:

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 A) Fixing price for joint maximization of firms profit and

B) Market-sharing between its members firms.

A) Cartels aiming at joint profit maximization

For the purpose of this analysis we concentrate on a homogenous or pure oligopoly, i.e., all firms
produce a homogenous products. The equilibrium analysis is similar to that of the multi-plant
monopolist. The cartel (the central agency) acting as a multi-plant monopolist, will set the profit
maximizing price defined by the intersection of the industry MR and MC curves of firms as shown
below.

For simplicity we assume that there are only two firms in the cartel, firm 1 and firm 2. Given the
market demand D in figure c the monopoly solution, which maximizes joint profits, is determined by
the intersection of MC and MR, at point e. The total output is X =X 1 + X 2 and sold at price P. Now,
once the central agency decides these variables (P and X) it allocates the production among firms 1
and firm 2 as a monopolist would do, i.e., by equating the common MR to the individual MCs’.

P P P
C C C

P P P

MR

X X X
Figure 2.5: Firm 1 Figure 2.6: Firm 2 Figure 2.7: Industry

Since all firms have the same price P, their MRs, are also the same. Therefore, at equilibrium points,
i.e., at point e, MC=MR and at point e 2 MC 2=MR . Thus firm 1 produces X 1 and B produces X 2 .
The firm with the lower cost produces a larger amount of output but the distribution of profits is
decided by the central agency of the cartel.

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B) Market-Sharing Cartels

As noted above the second service of the cartel is to share the market between its members. There
are two basic methods for sharing the market: non-price competition and determination of quotas.

Non - price competition agreements: firms agree on a common price, at which each of them can sell
any quantity demanded. The agreed price must be such as to allow some profits to all members. In
this type of agreement firms cannot sell at lower price but they can use different kinds of selling
activities (e.g. changing style, package, etc.). In other words by using these selling activities firms
can have a larger share of the market- called non price competition.

This form of cartel is indeed 'loose', in the sense that it is more unstable than the cartel aiming at
joint profit maximization. Because, since there are cost differences among firms, the low cost firms
will have a strong incentive to break the agreement and sell at lower price or to cheat the other
members by secret price concessions to the buyers. Then the price war and instability of the
agreement occur.

Sharing the market by agreement on quotas: if all firms have identical costs, the monopoly solution
will emerge with the market being shared equally among the firms. But if costs are different, the
quotas and shares are determined by bargaining power (or skill) of firms.

2) Price Leadership

Price leadership is another form of collusion. In this form of coordination, one firm sets the price and
the other follows it. There are various forms of price leadership. The most common types of
leadership are price leaderships by a low-cost firm and price leadership by a large (dominant)
firm.

A) The Model of the Low-Cost Price Leader

Due to economies of scale, efficiency, etc. a firm in the oligopoly market can be a low-cost firm.
Thus this firm takes the lead to charge price of the commodity and other firms will follow the action.
To look the model, let us assume there are two firms, which produce a homogenous product at

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different costs. The firms may have equal markets (figure 1) or they may have unequal markets
(figure 2) according to their agreement as shown below.

Figure1
Figure2

As you observe in the figures above, firm A is the low-cost firm and it takes a lead to charge price
and the high cost firm (i.e., firm 2) will follow this price. In figure 1 firm A, a leader, determines its
price PA that maximizes its profit at the output level (x1) where MCA= MR and firm B, the follower
takes this price PA through it does not maximize its profit by producing X 2 (at X 2 , MC B > MR B ).

Here you should note that since both firms sell the same amount at the same price, both firms have
the same demand curve d and one marginal revenue curve MR 1=MR2 in figure1 above. The market
demand curve is D. In figure1 both firms will sell the same quantity X 1 =X 2 at the same price P A .
However, firm B's profit maximizing price and output would be PB and X Be respectively. At price
P A the market demand is X =X 1 + X 2 .

In figure 2 since both firms have not equal market share their demand and marginal revenue curves
are different. Here also firm A, the leader, decides price P A according to the marginal rule MRA =
MCA, maximizes it’s Profit by selling XA, but firm B taking this price PA will sell XB, not
maximizing profit. As in figure1 firm B could maximize profit if it charged price P B. To avoid price
war firm B accepts the price set by firm A, PA.

B) Price Leadership by the Dominant Firm

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In this model it is assumed that there is a large dominant firm which supplies a large proportion of
the total market, and some smaller firms, each of them having a small market share. Thus if this
dominant firm increases or decreases price the other firms will follow it. The dominant firm sets its
price so as to maximize its profit (the point where it’s MR=MC ) but the followers may or may not
maximize their profits depending on their cost structures.

Now let us look a mathematical model how a dominant firm sets its profit maximizing price and
output. Here we represent the market demand by D and the total output that is supplied by the
smaller firms by S then the output sold by the dominant firm will be

X =D−S

Let us assume S=aP and D=b – cP

Using the above function, the dominant firm’s demand function is

X =D−S

X =b−cP – aP=b – (c + a) P ,

The inverse demand function is

(c +a) P=b−X

b−X
P=
( c+ a)

Total revenue of the dominant firm will be:

b− X
TR=PX = ∗X
(c +a)

If the cost function of the dominant firm is given asC=dx ,

It will maximize its own profit as TR – TC

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 b−X
π=TR−TC= ∗X −dx
( c+ a )

Then to determine its profit maximizing level of output the dominant firm will set the first derivative
of its profit function with respect to X must be equal to zero. After determining this level of output
the dominant firm will set at what price it will sell the product. And the small firms will follow this
decided price by the dominant firm. And this is called price leadership by a dominant firm.

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