Market Structure - Oligopoly

The Term “Oligopoly” has been derived from two

Greek words.
‘Oligi’ which means few and ‘Polien’ means sellers.

Thus Oligopoly is an abridged version of

monopolistic competition . It is a competition
among few big sellers each one of them selling
either homogenous or hetrogenous products.
 Sources of Oligopoly
Factors that give rise to oligopoly are :
• Huge capital investment
• Economies of scale.
• Patent rights
• Control over certain raw materials
• Merger and takeover.
1. Few Sellers : An oligopoly market is characterized
by a few sellers and their number is limited .
Oligopoly is a special type of imperfect market. It has
a large number of buyers but a few sellers.

2. Homogeneous or Differentiated Product : The

Oligopolists produce either homogenous or
differentiated products. Products may be
differentiated by way of design , trademark or
service
3. Interdependence : The most important feature of the
Oligopoly is the interdependence in decision making of
the few firms which comprise the industry.

The reactions of the rival firms may be difficult to guess.

Hence price is indeterminate under Oligopoly.

4. High Cross Elasticities : The cross elasticity of demand

for the products of oligopoly firms is very high. Hence
there is always the fear of retaliation by rivals.
Each firm is conscious about the possible action and
reaction of competitors while making any change in
price or output
6. Competition : Competition is unique in an
oligopoly market. It is a constant struggle
against rivals.

7. Group Behaviour : Each Oligopolist closely

watches the business behaviour of other
Oligopolists in the industry and designs his
moves on the basis of some assumptions of
their behaviour .
8. Uncertainty : The interdependence of other
firms for one’s own decision creates an
atmosphere of uncertainty about price and
output

9. Price Rigidity : In an oligopoly market each

firm sticks to its own price to avoid a possible
price war. The price remains rigid because of
constant fear of retaliation from rivals.
 Various forms of oligopoly
1. Perfect and Imperfect Oligopolies : If the
product of the rival firm are homogenous
then it is Perfect Oligopoly, if the product are
differentiated it is Imperfect Oligopoly.

2. Open and Closed Oligopolies : If entry is

open to new firms it is termed as Open
Oligopoly, and if entry is strictly restricted it is
termed as Closed Oligopoly.
3. Collusive Oligopoly : If the firms under
oligopoly market combine together instead
of competing it is known as Collusive
Oligopoly. The collusive may take place in
the form of a common agreement or an
understanding between the firms.

4. Partial and Full Oligopoly : Partial

oligopoly is formed when the dominant firm
which is the price leader and all other firms
follow the price of the price leader. If no firm
acts as a price leader then it is called Full
Oligopoly.
 Oligopoly models
Economists have established a number of price-output models
for Oligopoly market, depending upon the behaviour pattern
of the members of the group.
Non collusive oligopoly-
• Cournot model
• Sweezy model

Collusive Oligopoly-
• Cartel
• Price leadership
Cournot’s duopoly model
 Duopoly meaning
Duopoly is a special case of the theory in
which there are only two sellers.
The sellers are completely independent and no
agreement exists between them.
A change in price and output of one will effect
the other and may set a chain of reaction.
Each seller takes into account the effect of his
policy on that of his rival.
 COURNOT MODEL
Developed by a french economist A Cournot
in 1838.

Took the case of two mineral water springs

situated side by side and owned by two firms A
and B.
 ASSUMPTION OF COURNOT
MODEL
Two independent sellers
Produce and sell a homogeneous product
Each seller faces a demand curve with
constant negative slope.
Cost of production is assumed to be zero
Each seller aims at obtaining maximum net
revenue or profit
 .

• MD represents the linear demand curve for

the homogeneous products of the duopolists.
Suppose producer A is operating in the
market, he views the whole market demand
curve MD facing him and corresponding to
which MR1 is the marginal revenue curve. He
will equate marginal revenue with marginal
cost to reach his equilibrium which is attained
at OQ output and will fix price equal to OP. 
 .

• Now, suppose producer B enters the market.

He thinks ED portion of the demand curve to
be the relevant demand curve facing him and
corresponding to this MR2 is his marginal
revenue curve. With MC being equal to zero,
he will produce half of QD that is QL where
MR curve intersects X-axis. This reduces the
price to P’ which leads to total profits earned
by producer B as rectangle QLKT and for
producer A it will get reduced from OPEQ to
OP’TQ.
 .

• Faced with this situation, firm A adjusts its

price and output to the changed conditions.
Assuming that B will continue to supply to ¼
of the market, A assumes ¾ of the market
available to it. To maximize its profit , A
supplies to 3/8 (1/2 x ¾) of the market. This
process goes on till both A and B have equal
i.e. 1/3 share in the market and both charge
the same price. One third of the market
remains unsupplied.
 Kinked demand curve model
(Sweezy model)
In many oligopolistic industries, prices remain sticky or inflexible
for a long time even though the economic conditions change.
Many explanations have been given for this price rigidity
under Oligopoly and the most popular explanation is the
Kinked Demand Curve Hypothesis given by an American
economist Paul Sweezy.
It is the best known model explaining relatively more
satisfactorily the behavior of oligopolistic firms.
According to the kinked demand curve
hypothesis, the demand curve facing the
Oligopolist has a ‘Kink’ at the level of the
prevailing price. The kink is formed at the
prevailing price level because the segment of
the demand curve above the prevailing price
level is highly elastic and the segment of the
demand curve below the price level is
inelastic.
• There are three ways in which rival firms may
react to change in price made by one firm :
i) The rival firms follow the price changes, both
cut and hike
ii)The rival firms do not follow the price
changes.
iii)Rival firms follow the price cuts but not the
price hikes.
The figure shows a kinked demand curve with a kink .
the prevailing price is OP and the firm produces and
sells OQ output. The upper segment of the demand
curve is relatively elastic and the lower segment is
relatively inelastic.

The differences in elasticity's is due to the particular

competitive reaction pattern assumed by kinked
demand curve hypothesis. The assumed pattern is
“Each Oligopolist believes that if he lowers the price
below the prevailing level, his competitors will follow
him and accordingly lower their prices, whereas if he
raises the price above the prevailing level, his
competitors will not follow his increase in price”
 .

 For finding out the profit maximizing price-output combination,

MR curve corresponding to kinked demand dD has been drawn.
 MR curve associated with kinked demand curve dD is always is
discontinuous
 The length of this discontinuity depends upon relative elastics of
two segments dk and kD of the demand curve.
 Between MR & dD which has a discontinuous gap HR.
 When MC curve of the oligopolistic passes through discontinuous
HR through point E oligopolist maximizing its profit at prevailing
OP price level.
 Thus it will not encourage price changes.

 When the marginal cost curve shifts upwards from MC to MC’

due to rise in cost the output remain unchanged since the new
MC’ also passes through HR
A } Price Reduction : If an oligopolist reduces the price
below the prevailing price to increase sales, the
competitors will fear that their customers would go
away from them and buy from the firm which has
made a price cut. Therefore, in order to retain it’s
customers, they will also lower the prices. Besides
the competitors quickly follow the price reduction by
an oligopolist, he will gain only very little sales.

Thus the segment of the demand curve which his

below the prevailing price OP is inelastic showing
that very little increase in sales is obtained
B } Price Increase : If an oligopolist raise the price
above the prevailing price level, there will be a
substantial reduction in sales. as a result of price
rise, its customers will withdraw from it and go to its
competitors who welcome new customers will gain
in sales. The oligopolist who raises its price will lose a
great deal and therefore, refrain from increasing
price.

The segment of the demand curve which lies above the

current price level OP is elastic following a large fall
in sales if a producer raises his price.
Each oligopolist will find himself in such a
situation that on one hand, he expects rivals
to match his price cuts very quickly and on the
other hand, he does not expect his rivals to
match his price increase .

Given this expected competitive pattern, each

oligopolist will have a kinked demand curve
dD, with the upper segment dK being
relatively elastic and the lower segment kD
being relatively inelastic
C } Price Rigidity : An oligopolist facing a
kinked demand curve will have no incentive to
raise its price or lower it. The Oligopolist will
not gain any larger share of the market by
reducing his price below the prevailing level.
There will be a substantial reduction in sales if
he increasing the price above the prevailing
level. Each Oligopolist will adhere to the
prevailing price seeing no gain in changing it.
The prevailing price is OP at which a kink is
found in the demand curve dD . The price OP
will remain stable or rigid as every Oligopoly
firm will find no gain to lower it or increase it.
Thus rigid or sticky prices are explained
according to the kinked demand curve theory.
 .

In conclusion, we can opine that mutual

interdependence among the firms and price
rigidity are two typical features in oligopoly
market. Although the firms are rivals, they are
mutually interdependent. No firms likes to
resort to price change which will harm his
business. Hence price competition is not
significant is oligopoly market.
 Criticism of Sweezy model
1. The oligopoly model provides a theoretical explanation as
to why stable prices exist in oligopolistic industries. But it
takes prevailing prices as given and provides no justification
as to why that price level rather than some other is the
prevailing price
i.e. the kinked demand model can be viewed as incomplete.

2. Stigler had tested the kinked demand curve empirically on

several oligopolies. He found that oligopolistic rivals are just
as likely to follow price increase as price decreases
indicating little support for the kinked demand curve.
3. The kinked demand Oligopoly theory does not apply
to oligopoly cases of price leadership and price
cartels.

4. In case of pure oligopoly, the kinked demand curve

does not provide adequate explanation for price
rigidity.

5. The explanation of price stability by Sweezy’s kinked

demand curve theory applies to depression periods.
In periods of boom and inflation, when the demand
for the products increase, price is likely to rise rather
than remain stable.
 Price leadership models
Price leadership is an alternative cooperative method used to
avoid tough competition. Under this method, usually one firm
sets a price and the other firms follow. Here any firm in the
oligopolistic market can act as a price leader. The firm, which is
highly efficient, and having low cost can be a price leader or
the firm, which is dominant in the market acts as a leader.
Whatever the case may be, the firm, which sets the price,
is the price leader. We have three forms of price leadership-
a) Price leadership by low cost firm.
b) Dominant price leadership
c) Barometric price leadership.
 Barometric price leadership
• Barometric price leadership is said to occur in the market
where there is no dominant firm. The firm having a good
reputation in the market usually sets the price. This firm acts as
a barometer and sets the price to maximize the profits. It is
important to note here that the firm in question does not
have any power to force the other firms to follow its lead. The
other firms will follow only as long as they feel that the firm in
action is acting fairly. Though this method is quite ambiguous
regarding price leadership, it is legally accepted. Barometric
price leadership has been seen in the automobile sector.
Price leadership by Low-cost firm
 Dominant firm price leadership
• In dominant price leadership, the largest firm
in the industry sets the price. If the small firms
do not conform to the large firm, then the
price war may take place due to which the
small firms may not be able to survive in the
market
Price leadership by a dominant firm
 Cartel
• A cartel is an agreement between firms to
restrict output and raise price
• The cartel tries to maximise joint profit  the
‘full cartel outcome’
• Cartels aim at market sharing – loose cartel
• Joint profit is maximised by setting MR=
MC1=MC2
The market demand for all members of the
cartel is given by DD and marginal revenue
(represented by dotted line) as MR. The
cartels marginal cost curve given by MCc is the
horizontal sum of the marginal cost curves of
the member firms. In this the basic problem is
to determine the price, which maximizes
cartel profit.
 Reasons for failure of cartels
• Mistakes in the estimation of market demand
• Errors in estimating MC
• Slow process of cartel negotiation
• “ cheating” on quotas
• Stickiness of negotiated price.
• Fear of govt interference
• Fear of entry
• Lack of freedom in innovation