Price and Output

determination under
Oligopoly
Prepared by
Shahrat Farsim Chowdhury
BSS, MSS
Economics
SUST
Questions to be discussed
• What is an Oligopoly?
• Types & Features of Oligopoly.
• How does the market output & price look like under oligopoly?
• Can few firms in oligopoly cooperate and behave like a monopoly?
• How to determine P & Q under different theories?
Oligopoly
The word Oligopoly is derived from two Greek words – ‘Oligi’ meaning
‘few’ and ‘Polein’ meaning ‘to sell’. An Oligopoly market situation is called
‘competition among the few’.

Oligopoly is an industry which is dominated by a few firms. In this market,

there are a few firms which sell homogeneous or differentiated products.
Also, as there are few sellers in the market, every seller influences the
behavior of the other firms and other firms influence it.
Types of Oligopoly
• Homogenous and Differentiated
Homogenous- occurs when the product is homogeneous in nature (e.g. Aluminum industry).
Differentiated- occurs when product differentiation exists (e.g. Automobile industry, banking industry).
• Open and Closed
Open – New firms can enter the market and compete with existing firms. Closed – Entry into the
market is restricted.
• Collusive and Competitive
Collusive – This occurs when few firms come to an understanding with respect to the price and output
of the products. Competitive – This occurs when there is a lack of understanding between the firms
and they invariable compete with each other.
• Partial or Full
Partial – This occurs when one large firm dominates the industry. Also, this firm is the price leader. Full
– This occurs when there is no price leadership in the market.
• Syndicated and Organized
Syndicated – The situation where the firms sell their products through a centralized syndicate.
Organized – The situation where the firms create a central association to fix prices, quotas, output,
etc.
Characteristics of Oligopoly

 Few firms dominates the market (High concentration ratio)

 Barriers to entry or exit (Patent rights, laws)
 Non-price competition(Advertising, Brand value)
 Interdependence (Price rigidity, Rival firms decision)
 Nature of the product (Differentiated or homogenous)
 No unique pattern of pricing behavior
 Indeterminateness of the dd curve
 Lack of uniformity
Firms behavior under Oligopoly

Based on the objectives of the firms, the magnitude of barriers to entry and the
nature of government regulation, there are different possible outcomes in relation
to a firm’s behavior under Oligopoly. These are:

Non
Collusive
collusive
A non-collusive oligopoly
Collusion for higher refers to a market
prices wherein the firms situation where the
cooperate with each firms compete with each
other in determining other rather than
price or output or both. cooperating.
The Cartel Theory
An organization of firms that reduces output and increases price in order to increase
joint profit. Ex- OPEC
By working together, the cartel members are able to behave like a monopolist.
Assumptions:
 Two firms with different cost curves
 Sells homogeneous product
 Buyers with perfect knowledge of the market
 Firms know industry demand

Types of cartel:
 Perfect cartel
 Market sharing cartel
 Firm: A Firm: B

Output and Cost: MCa + MCb = MCc

Price in perfect Output: OQ1 + OQ2 = OQ

cartel Price: OP
 The problem of cheating:

Firms under cartel agreement tends to cheat

and produce more output than their quota.
Which leads to more profit but in the long run
they are back to where they started.

Cartel profit= ABCPc

Super normal profit (cheating)= DEFPc

Without cartel output= OQ, price=OP

With cartel output= OQc, price= Opc
Cheating under the cartel output=Oqcc,
price= OP
Overview

Firms avoid price wars and cut throat competition.

Gains more profit at the expense of customer by charging higher

price.

Acts like a monopoly, may not survive in the long run.

Kinked demand curve theory

Kinked demand curve theory was developed

by an American Economist Paul Sweezy, to
Elastic
explain the price rigidity in oligopoly.

Each firm in an oligopoly believes the K

following two things: Inelastic

 If a firm lowers the price below the

prevailing level (P’’), then the competitors
will follow him.

 If a firm increases the price above the

prevailing level(P’), then the competitors
will not follow him.
 MR curve is discontinued
A
MR=ABC
AR=AKR
 The gap between BC shows
sharp change in MR when P is
lowered below the kink
 BC= Price Rigidity/Sticky Price
B
(i) Fear of rivals reactions
(ii) Average cost pricing policy C
(iii) Cost of changing price R
 True for short run
MR
 In long run if MC is much higher
then P and Q changes to P’ and
Q’.
 Similarly, if MC is less then P and
Q changes to p’’ and Q’’.
Overview

Firms have price setting powers but reluctant to use it.

Rivals are unlikely to match with price hike due to substitution effect
and demand curve being relatively price elastic.

Even when cost changes we see price rigidity, once firm settle on a
price there maybe a little point of changing it.
Price leadership theory

A price leadership is an informal position of a firm in oligopolistic

setting that lead to other firms in fixing the price of their
product(homogenous or heterogenous) ahead of its competitors who
closely follow the prices already announced.
It emerges spontaneously due to size efficiency, market share,
economies of scale and ability to make forecasting about market
conditions accurately.
 Types of Price leadership:
i. Price leadership by low cost firm
ii. Price leadership by dominant firm
 Price leadership by
dominant firm model
F

Assumptions:
 A large dominant firm and
number of smaller
firms(fringe firms).
 Dominant firm alone can
determine the market O O
demand curve. O
 Dominant firm is capable of OOligopoly Dominant
calculating the supply of Industry Firm
smaller curves.
Overview

It might be difficult for a price leader to correctly assess

the reaction of his followers.

The Firms enters into a non-price competition and price

competition devices are heavy advertisement sales and
promotion.
Game theory in Oligopoly
Game Theory: A mathematical technique used to analyse the
behaviour of decision makers who try to (i) Reach an optimal position
through strategic behaviour, (ii) Fully aware of the interactive nature of
the process and (iii) Anticipate the moves of the other decision makers.
Prisoners Dilemma: The prisoner's dilemma is a paradox in decision
analysis in which two individuals acting in a rational way do not
produce the optimal outcome.
Nash Equilibrium: Nash equilibrium is a concept of game theory where
the optimal outcome of a game is one where no player has an incentive
to move from his chosen strategy after considering an opponent's
choice.
 Payoff matrix:

Firm B
$ 10 (High) $ 5 (Low)

$ 10 $3 mil, $3 mil $1 mil, $4 mil

(High)
Firm A
$5 $4 mil, $1 mil $2 mil, $2 mil
(Low)

(i) Price rigidity (ii) Tendency to collude (iii) Tendency to cheat on collusive agreement
Overview

Nash equilibrium is the rational equilibrium in the long run, it is also the
dominant strategy.

Firms can focus in advertising, expanding market while the price is rigid at
Nash equilibrium

Firms are trying to form a cartel are in Prisoners dilemma, each of them can
get higher profit by breaking the agreement while the other holds to it.
Cartels are short lived.
Review

Oligopoly.

How the P and Q are determined under(i) The Cartel theory (ii) The
Kinked demand curve theory and (iii) The Price leadership theory.

How game theory explains the oligopolistic market behavior.

Any Questions?
Thank you.