Oligopoly

OLIGOPOLY (mar ket power base d on produ ct different iat ion an d/or the firm’ s do minan ce of the mar ket )

FEA TURES       

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Few sellers of a product Unspecified number of buyers Interdependence among firms Market entry and exit difficult Pure oligopoly - Homogeneous product Differentiated oligopoly - Differentiated product Non-price competition very important among firms selling differentiated products Duopoly - Two sellers

SOU RCES O F OLIGOP OLY      

Economies of scale Large capital investment required Patented production processes Brand loyalty Control of a raw material or resource Government franchise

COLLUSIVE OLIGOPOLY

COLLUSIVE OLIGOPOLY 

Cooperation among firms to restrict competition in order to increase profits

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Firms cooperate with each other in taking joint decisions to keep their bargaining position stronger against the consumers

CAR TELS 

Cartel: explicit agreement among firms (on price, O/P, market sharing etc)

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2 types of cartels: (a) Centralized Cartel  All decisions (price, O/P, sales, distribution of profits) taken by central association of all firms (b) Market-Sharing Cartel  Firms agree on market shares (geographical area), with or without any understanding on prices

CENT RALI ZED CAR TEL

WEAKNES S 

Firms can ask for an equitable distribution of profits.

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Firm may withdraw from the cartel

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Cartel members have a strong incentive to cheat by selling more.

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Monopoly profits may attract other firms.

EX CER CISE If 2 firms constitute duopoly industry & their profit function are: ∏ 1 = 12 X1 – X12 – 2X22 – 10 ∏ 2 = 16 X2 – 2X22 – 4X1 – 2 What will be firm’s profits & O/P if they set O/P level by collusion i.e. to maximize their joint profits?

ANSW ER 

X1 = 4

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X2 = 2

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∏1 = 14

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∏2 = 6

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∏= 20

NON COLLUSIVE OLIGOPOLY

NON COLLUSIVE OLIGOPOLY 

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Firms act independently & each firm is closely watched by other Price & O/P decisions are taken keeping in view the reaction of other firms in industry 3 models:

Sweezy kinked demand model  Price leadership  Prisoners’ dilemma 

KINK ED D EMAND C URV E MODEL  

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Proposed by Paul Sweezy If an oligopolist raises price, other firms will not follow, so demand will be elastic If an oligopolist lowers price, other firms will follow, so demand will be inelastic Implication is that demand curve will be kinked, MR will have a discontinuity, and oligopolists will not change price when marginal cost changes

KINK ED D EMAND C URV E MODEL 

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Original price and quantity at point A  If reduce price & competitors match price cut then move along more inelastic demand segment  If increase price & competitors do not follow then move along the more elastic segment It leads to kinked demand curve

Competitors do not match price increases Competitors match price cuts

KINK ED D EMAND C URV E MODEL 

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In order to maximize profits, apply MR=MC rule.  The MR curve for the kinked demand curve is discontinuous at the kink. This leads the firm to charge the same price even if costs change

KINK ED D EMAND C URV E MODEL

CRITICISM 

No evidence that price increase is not matched

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Unable to tell the price at which the kink will occur

PRIC E LEAD ERSH IP 

Price Leader 

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Largest, dominant, or lowest cost firm in the industry Demand curve is defined as the market demand curve less supply by the followers

Followers 

Take market price as given and behave as perfect competitors

PRIC E LEAD ERSH IP MC f

Price

MC leader

P

P leader

Total Demand MR leader Demand Leader

0

Q leader

Q total

Quantity

OLI GO POL Y GA ME T HEOR Y AND P RICING BEHA VIOR 

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Game theory can be used to explain and predict behavior when there is mutual interdependence. Game theory is concerned with “how individuals make decisions when they are aware that their actions affect each other and when each individual takes this into account.” (Bierman and Fernandez, 1998)

PRISONERS’

D ILEMMA

Two suspects are arrested for armed robbery. They are immediately separated. If convicted, they will get a term of 10 years in prison. However, the evidence is not sufficient to convict them of more than the crime of possessing stolen goods, which carries a sentence of only 1 year. The suspects are told the following: If you confess and your accomplice does not, you will go free. If you do not confess and your accomplice does, you will get 10 years in prison. If you both confess, you will both get 5 years in prison. What will each suspect do?

PRISONERS’

D ILEMMA

Payoff Matrix

Confess Individual A Don't Confess

Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

PRISONERS’

D ILEMMA

Dominant Strategy Both Individuals Confess

Confess Individual A Don't Confess

Individual B Confess Don't Confess (5, 5) (0, 10) (10, 0) (1, 1)

PRISONERS’

D ILEMMA

Application: Price Competition

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)

PRISONERS’

D ILEMMA

Application: Price Competition Dominant Strategy: Low Price

Firm A

Low Price High Price

Firm B Low Price High Price (2, 2) (5, 1) (1, 5) (3, 3)