OLIGOPOLY

Definition

 “Oligopoly is a market structure

characterized by a small number of firms and
a great deal of interdependence.” -Mansfield
 “An oligopoly is a market situation in which
each of a small number of interdependent,
competing producer’s influences but does not
control the market.” – Grinols
Oligopoly Market

 This is a market consisting of a few firms relatively large firms, each with a substantial share of the market
and all recognizing their interdependence. It is a common form of market structure. The products may be
identical or differentiated. The price determination and profit maximization is based on how the competitors
will respond to price or output changes.

 Characteristic Features Of An Oligopoly Market:

 Few sellers
 Lack of uniformity in the product
 Advertisement cost is included
 No monopoly competition
 Firms struggle constantly
 There is interdependency
The reason for this interdependence is the nature of the produce and the low cost of switching over to other
firm’s products. Therefore sellers continue to lure customers by various means such as advertisement and
quality perceptions.
 Experience of Group behavior
 Price rigidity
 Price leadership
 Barriers to entry
Types Of Oligopoly
 There Are Different Types Of Oligopoly:

 Pure and perfect oligopoly: if the firm produced homogeneous products it is perfect
oligopoly. If there is product differentiation then it is called as imperfect or
differentiated oligopoly.

 Open and closed oligopoly: entry is not possible. When it is closed to the new
entrants then it is closed oligopoly. On the other hand entry is accepted in open
oligopoly.

 Partial and full oligopoly: under partial oligopoly industry is dominated by one large
firm who is a price leader and others follow. In full oligopoly no price leadership.

 Syndicated and organized oligopoly: where the firms sell their products through a
centralized syndicate. On the other hand firms organize themselves into a central
association for fixing prices, output and quotas.
Types Of Oligopoly
 On the basis of agreement, oligopoly is classified as

 Collusive Oligopoly and Non-collusive Oligopoly.

 A collusive oligopoly refers to that market situation where the firms

of the industry follow a common policy of pricing. In other words,
they combine together to avoid competition among themselves
regarding the price and output of the industry.
 A non- collusive oligopoly refers to that market situation where there
is no agreement among the firms regarding the price and output of
the entire market. In other words, the firms under non-collusive
oligopoly act independently.
 Oligopoly Models
 When Oligopoly firms ignore interdependence :
 Cournot : Output
 Bertrand : Price
 When Oligopoly firms predicts the moves of Rival firms :
 Chamberlin
 P.M. Sweezy
 When firms recognise interdependence and take some
steps :
 Cartel
 Price Leadership
 Theory of Games : Observes rival firm moves and make strategies
KINKED DEMAND CURVE

 When a firm increases its price, the rival firms do not follow it by increasing
their prices in turn. This increases its market share.
 When a firm reduces its price rival firms immediately follows it by decreasing
their prices. If they do not do so, customers go to the firm which is offering at
lower price. This is the fundamental behaviour of the firms in an oligopoly
market.

 The demand curve in oligopoly has two parts.

(i) relatively elastic demand curve
(ii) relatively inelastic demand curve as shown in the graph below.
In oligopoly market firms are reluctant to change prices even if the cost of
production (or) demand changes. Price rigidity is the basis for the kinked
demand curve. Each firm faces demand curve kinked at the currently
prevailing price. At higher prices demand is highly elastic, whereas at lower
prices it is inelastic.
KINKED DEMAND CURVE

 Impact of price rise

 If a firm increases the price, then it becomes
more expensive than rivals and therefore,
consumers will switch to its rivals.
 Therefore for a price rise, there is likely to be a
significant fall in demand. Demand is, therefore,
price elastic.
 In this case, of increasing price firms will lose
revenue because the percentage fall in demand is
greater than the percentage rise in price.
KINKED DEMAND CURVE

 Impact of price cut

 If a firm cut its price, it is likely to lead to a different effect. In the

short term, if a firm cuts price it would cause a big increase in
demand and therefore would lead to a rise in revenue. The firm
would gain market share.
 However, other firms will not want to see this fall in market share
and so they will respond by also cutting price to follow the first
firm. The net effect is that if all firms cut price – the individual
firm will only see a small increase in demand.
 Because there is a ‘price war’ demand for a firm is price inelastic
– there is a smaller percentage rise in demand.
 If demand is inelastic and price falls, then revenue will fall.
 KINKED DEMAND CURVE

From the graph we can understand that OP is the given price. There is a kink at point K
on demand curve (DD). Therefore DK is the elasticity segment and KD is the inelastic
segment. There is a change in the slope of the demand curve at K. At this situation
the firm follows the prevailing price and does not make any change in it because rising
of price would contract sales as demand tends to be more elastic at this stage. It would
also fear losing buyers due to competitor’s price who have not raised their prices. On
the other hand lowering of price would imply an immediate retaliation from the rivals
on account of close interdependence of price, output movement in the oligopoly
market. Therefore the firm will not expect much rise in sale with price reduction.
 Graph – Marginal Revenue Curve In Oligopoly Market

The average revenue curve and the demand curve (DD) of an oligopoly firm has a
kink. The kinked average revenue curve implies a discontinuation in the marginal
revenues curve. It explains the phenomenon of price rigidity in oligopoly market.
Graph – Price Rigidity Under Oligopoly Market
PRICE RIGIDITY IN OLIGOPOLY

 The price output level that maximizes the profits for a firm
is derived from the equilibrium point, which lies at the
intersection of the MC and the MR curves. The price output
combination can remain optimal at the kink even though
the MC fluctuates because of the associated gap in the
MR curve. This is shown in the graph. The profit
maximizing price OP and output combination of OQ
remains unchanged as long as MC fluctuates between MC1
and MC2 that is between A and B. Hence there is price
rigidity- it means OP does not change. It is concluded that
once a general price level is reached it remains unchanged
over a period of time in oligopoly market.
Price Leadership

 Price leadership takes place when there is only

one dominant organization in the industry,
which sets the price and others follow it. It
works under the following conditions:

 When the number of organizations is small

 Entry to the industry is restricted
 Products are homogeneous
 Demand is inelastic or less elastic
Types of Price Leadership

 These three types of price leadership are explained as follows:

1. Dominant Price Leadership:

 Refers to a type of leadership in which only one organization dominates the

entire industry. Under dominant price leadership, other organizations in the
industry cannot influence prices. The dominant organization uses its power of
monopoly to maximize its profits and other organizations have to adjust their
output with the set price.

 The interests of other organizations are ignored by the dominant organization.

Therefore, dominant price leadership is sometimes termed-as partial monopoly.
Price leadership by the leading organization is most commonly seen in the
industry.

 .
Types of Price Leadership

2. Barometric Price Leadership:

 Refers to a leadership in which one organization declares the

change in prices at first and assumes that other organizations would
accept it. The organization does not dominate others and need not
to be the leader in the industry. Such type of organization is known
as barometer.

 This barometric organization only initiates a reaction to changing

market situation, which other organizations may follow it if they
find the decision in their interest. On the contrary, the leading
organization has to be accurate while forecasting demand and cost
conditions, so that the suggested price is accepted by other
organizations.
Types of Price Leadership

 Barometric price leadership takes place due to the following

reasons:

 a. Lack of capacity and desire of organizations to estimate

appropriate supply and demand conditions. This influences
organizations to follow price changes made by the barometric
organization, which has a proven ability to make correct forecasts.
 b. Rivalry among the organizations may make a leader, which can
be unacceptable by other organizations. Thus, most of the
organizations prefer barometric price leadership.


Types of Price Leadership

3. Aggressive Price Leadership:

 Implies a leadership in which one organization
establishes its supremacy by threatening the
organizations to follow its leadership. In other
words, a dominant organization establishes
leadership by following aggressive price policies
and forces other/organizations to follow the prices
set by it.
Advantages Of Price Leadership

 Advantages Of Price Leadership

 Although price leading allows one organization to drive prices across
an industry, it holds several potential advantages for other firms in
the market as well. These are some advantages of price leadership:

 Even Profitability
 If a price leader sets prices for specific products and competitors
match that price, all players enjoy high profits as long as customer
demands remain steady. This means that competitors can increase
their prices to replicate the leader’s price and still gain profits and
retain market share.


Advantages Of Price Leadership
 Minimize Price Wars
 Among the advantages of price leadership, reducing price wars is a
significant one. A market having organizations of the same size is bound
to witness price clashes as competitors look to increase their respective
market shares. An organization can choose to enter into an implicit or
explicit agreement with its competitors to solidify its market share or
match the leader’s price to avoid losing it.

 Improve Quality
 Once an organization establishes itself as a price leader, it can use the
additional profits to add features to its products, improve designs or
reinvent the product altogether. An organization can provide a good
product at a cheap rate or charge premium rates for premium products,
but they have to use their resources to research and develop improved
products in order to create demand.
Drawbacks of Price Leadership

 Drawbacks.

 It’s a reason for unfair competition, as big organizations

can lower prices by using operating synergies to levels
that become unsustainable for smaller businesses.

 Even if a small firm matches the price to retain its share, it

can lose profits in the long run and exit the market
eventually. Similarly, when a price leader increases their
product prices other organizations follow suit. This causes
customer dissatisfaction and businesses can incur
significant losses.
Examples

Reliance JIO
 Reliance JIO is a popular price leadership example from recent
years. They launched the network by offering free calls and
internet to its users. In an age where people rationed their data
usage, JIO offered unlimited data daily. People didn’t have to worry
about call rates and durations as JIO offered unlimited free calls
and text messages across any network in the country.

 This move compelled other telecom giants to rethink their pricing

and modify it accordingly. Once JIO gained a significant customer
base, they changed the pricing of its packages, which were not free
anymore but reasonably priced. The newer pricing forced other
networks to change their pricing again to match JIO’s rates to
retain their remaining market shares.
Examples

 Indigo Airline
 At a time when people had to pay hefty amounts to avail of good airline services,
Indigo emerged as a low-cost provider with standard services, becoming a price
leadership example for other businesses. Indian airlines offered premium services, but
their rates were high. Other smaller airline operators charged much less but offered
poor air services. Indigo used the barometric model to identify the rise in demand for
airway services and a balance between fares and facilities. They offered good services
at rates higher than the smaller operators but much lower than the premium ones. This
forced other services to adjust their prices and service qualities to suit people’s
demands and retain market shares.

 Price leadership is often used by strong organizations to show their presence and
dominance in a market. In most cases, smaller organizations find it beneficial to follow
a price leader and avoid incurring losses due to price wars. Ambitious organizations can
choose to rely on advanced techniques to set the trend and identify inevitable industry
changes. Managers must learn financial analysis and avoid mistakes that make price
leadership a means to monopolize the market and charge high rates from customers
instead of using it purely as a business strategy.
Price-Output Determination under
Price Leadership

 Price leadership takes place when there is only one

dominant organization in the industry, which sets the
price and others follow it. Different economists have
developed different models for determining price and
output in price leadership
Price-Output Determination under Price Leadership
COLLUSIVE OLIGOPOLY

 When a few large firms dominate a market

there is always the potential for businesses
to seek to reduce uncertainty and engage in
some form of collusive behaviour
 When this happens the existing firms engage
in price fixing cartels.
 A cartel is a formal agreement among firms
on price and output.
CARTEL

 A cartel is a formal agreement among firms. Cartels usually

occur where there are small number of sellers and the
product is usually homogenous

 Formation of cartels 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.
 A combination of these
TYPES OF CARTELS

 Centralised Cartel :

 In this particular case the aim of the cartel is the maximisation of

the industry (joint) profit. In this type of arrangement, the
product is essentially homogenous or pure oligopoly, that is, an
oligopoly where all firms produce a homogeneous product.

 Firms appoint a central agency, to which they delegate the

authority to decide not only the total quantity and the price at
which it must be sold so as to attain maximum group profits, but
also the allocation of production among the members of the
cartel, and the distribution of the maximum joint profit among
the participating members.
CENTRALISED CARTEL – JOINT PROFIT
MAXIMISATION
CENTRALISED CARTEL – JOINT PROFIT MAXIMISATION
EXPLANATION OF THE GRAPH
 Figure shows the situation where D is the market (or cartel) demand curve and MR is
its corresponding marginal revenue curve. The aggregate marginal cost curve of the
industry ΣMC is drawn by the lateral summation of the MC curves of firms A and B, so
the ΣMC = MCa + MCb,.
 The cartel solution-that maximizes joint profit is determined at point E where the Σ
MC curve intersects the industry MR curve. Consequently, the total output is OQ
which will be sold at OP = (QF) price. As under monopoly, the cartel board will
allocatethe industry output by equating the industry MR to the marginal cost of each
firm. The share of each firm in the industry output is obtained by drawing a straight
line from E0 to the vertical axis which passes through the curves MC b, and MCa of firms
B and A at points Eb, and Ea respectively.
 Thus the share of firm A is OQa and that of firm B is OQb which equal the total output
OQ (= OQb + OQA). The price OP and the output OQ distributed between A and B
firms in the ratio of OQa: OQb, is the monopoly solution.
 Firm A with the lower costs sells a larger output OQ b than the firm B with higher costs
so that OQa > OQb,. But this does not mean that A will be getting more profit than B.
The joint maximum profit is the sum of RSTP and ABCP earned by A and B
respectively. It will be pooled into a fund and distributed by the cartel board according
to the agreement arrived at by the two firms at the time of the formation of the cartel.
PROBLEMS OF A CARTEL

 It is difficult to make an accurate estimate of the market demand curve.

 The estimation of the market MC curve may be inaccurate because of the supply of wrong data
about their MC by individual firms to the cartel.
 The formation of a cartel is a slow process which takes a long time for the agreement to arrive at
by firms especially if their number is very large.
 The larger the number of firms in a cartel, the less is its chances of survival for long because of the
distrust. The cartel will, therefore, break down.
 In theory, the cartel-members agree on joint profit maximisation. But in practice, the seldom
agree on profit distribution.
 The price of the product fixed by the cartel cannot be changed even if the market conditions
require it to be changed. This is because it takes a long time for the members to arrive at an agreed
price.
 Unless all member firms in the cartel are strongly committed to cooperation, outside
disturbances, such as a sharp fall in demand, may lead to the breakdown of the cartel.
 Some high-cost uneconomic firms may refuse to shut down or leave the cartel despite the cartel
board’s request.
MARKET SHARING CARTELS

This form of collusion is more common in practice because it is more popular. The
firms agree to share the market, but keep a considerable degree of freedom
concerning the style of their output, their selling activities and other decisions.
There are two basic methods for sharing the market non-price competition and
determination of quotas.
 Non-price competition agreements:
 In this form of ‘loose’ cartel the member firms agree on a common price, at which
each of them can sell any quantity demanded. The price is set by bargaining, with
the low-cost firms pressing for a lower price and the high-cost firms for a high price.
The agreed price must be such as to allow some profits to all members.
The firms agree not to sell at a price below the cartel price, but they are free to vary
the style of their product and/or their selling activities. In other words, the firms
compete on a non-price basis. By keeping their freedom regarding the quality and
appearance of their product, as well as advertising and other selling policies, each
firm hopes that it can attain a higher share of the market.
MARKET SHARING CARTELS

Sharing of the market by agreement on quotas:

 The second type of market-sharing cartel is the agreement reached
between the oligopolistic firms regarding quota of output to be
produced and sold by each of them at the agreed price. If all firms
are producing homogeneous product and have same costs, the
monopoly solution (that is, the maximisation of joint profits) will
emerge with the market being equally shared by them.
 However, when costs of member-firms are different, the different
quotas for various firms will be fixed and therefore their market
shares will differ. The quotas and market shares in case of cost
differences are decided through bargaining between the firms.
During the bargaining process, two criteria are usually adopted to
fix the quotas of the firms.