OLIGOPOLY-MUTUAL INTERDEPENDENCE

Oligopoly is a market structure, in which a few sellers dominate the sales of a product and the entry of new sellers is difficult or impossible. The product can be either differentiated or standardized. Automobiles, cigarettes, beer and chewing gum are examples of differentiated products, whose market structures are oligopolistic. Oligopolistic markets are characterized by high market concentration.

In oligopolistic market, at least some firms can influence price by virtue of their large shares of total output produced. Sellers in oligopolistic markets know that when they or their rivals change their prices of output, the profit of all firms in the market will be affected.

The sellers are aware of their interdependence. They know that a change in one firm’s price or output will cause a reaction by competing firms. The response an individual seller expects from his rival is crucial determinant of his choices.

In this market:

1. Only a few firms supply the entire market with a product that may be standardized or differentiated.

2. At least some firms have a large market shares and thus can influence the price of product.

3. The firms in the oligopolistic market are aware of their interdependence and always consider their rivals’ reactions when selecting prices, output goals, advertising bud- gets and other business policies.

4. One more feature of the oligopoly market is the indeterminacy of the demand curve facing an oligopolistic firm. The demand curve face by an oligopolistic firm represents different quantities of output that the firm can sell at different prices. These quantities

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cannot be definitely determined because the quantities will be different depending on the different reaction patterns of the rivals. When any firm changes its own price, rivals will also change their prices and as a result the demand curve faces by an oligopolist firm loses its definiteness.

5. The oligopoly market is concerned with group behaviour. There is no generally ac- cepted theory on group behaviour. It basically depends on the behaviour of the mem- bers of the group. For example, it may happen that the members of the group may compete with one another (Non-Collusive oligopoly), or it may happen that the mem- bers come to an understanding (Collusive oligopoly) among themselves and form a general body to promote their common interests. It may also happen that there is a leader in the group and other members of the group follow the leader (Price Leader- ship), etc.

In oligopoly market, there exists interdependence among different forms. Due to this interdependence there is an uncertainty about the reaction patterns of the rivals. A wide variety of reaction patterns become possible and accordingly a large variety of models of price-output determination may be constructed. The actual solution is, therefore, indeterminate unless we specify a particular reaction pattern of the rivals.

4.5.1. Non-collusive Oligopoly

The common characteristic of non-collusive oligopoly is that they assume a certain pattern of reaction of competitors, in each period and despite the fact that the expected does not in fact materialize, the firms continue to assume that the initial assumption holds. In other words, firms are assumed never to learn from past experience which makes their behavior at least naïve.

4.5.2. Sweezy’s Model of Kinked Demand Curve

The concept of kinked demand curve was originally used to explain why, in an oligopoly market, the price which has been determined on the basis of average cost principle, would tend to remain rigid. The basic postulate of the average cost pricing is that the firm sets the price equal to average total cost which includes not only average variable cost but also a gross profit margin. The yield is a normal profit. However, the kinked demand curve, used by Paul Sweezy, explained the observed rigidity of price in an oligopoly market.

The kinked demand curve model is based on the following assumptions.

a. There are many firms in the oligopolistic industry.

b. Each produces a product which is close substitute for that of the other firm.

c. Product qualities are constant, advertising expenditures are zero.

d. Each oligopolist believes that if he lowers the price of his product, his rivals will also lower the prices of their products and that if he raises, they will maintain the prices at the existing levels.

Given these assumptions, the demand curve faced by any individual seller has a kink at the initial price-quantity combination. The kinked shape of the demand curve is based on the assumption that the rivals react differently to a rise in price or to a fall in price. It is also assumed that when an individual seller increases the price of his product other sellers will not increase their prices so that the sales of the seller increasing the price will be reduced considerably. This means that the demand curve is relatively elastic for a rise in price. On the other hand, it is assumed that when a single seller reduces the price, other sellers will also reduce the price so that the seller who reduces the price first cannot gain much for a

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fall in the price. The kinked demand curve is, therefore based on the assumption that a rise in price by one seller will not be followed by a rise in the price of the other sellers, while a fall in the price of one seller will be followed by the corresponding fall in the price by others. A kinked demand curve is shown in the following figure.

Market Structure Analysis

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Suppose that we have drawn two demand curves dd and DD. The demand curve dd is drawn on the assumption that when one seller changes his price, the other sellers do not change their prices and keep their prices unaffected. The demand curve DD is drawn on the assumptions that when one seller changes his price, the other sellers also change their price is the same direction. The demand curves dd and DD intersect at the point P.

In the kinked demand curve analysis it is assumed that the rise in price will be unmatched while a fall in the price will be matched. Hence the demand curve is dPD which has a kink at the point P. Let us consider a situation where price is reduced from OP to OP . If the other sellers also reduce the price, the quantity sold by this seller will increase by QR.

But if the sellers do not reduce prices the quantity sold will increase by QS. Similarly, when the price is increased form OP to OP the quantity demanded will be reduced by PQ’ (if other sellers do not increase their prices) and the quantity demanded will be reduced by PR’ if other sellers also increase their prices. Since it is assumed that price decrease by a firm will be matched by a price reduction by rivals but an increase in the price is not matched by the rivals, the relevant demand curve has a higher price elasticity than the lower part. The position of the curve is determined by the location of OP , the price at which the oligopolist now happens to be selling his product. The price OP datum and it is not determined in the model.

is the

Consider now the implication of a kink in the demand curve faced by the seller in the market. If the demand curve is kinked, the corresponding MR curve will be discontinuous.

This is seen in the following figure. In this figure dA portion of the MR curve corresponds to the dP portion of the demand curve, while the BC portion of the MR curve corresponds to the PD portion of the demand curve. The length of the discontinuity is equal to AB. The point P on the demand curve has two elasticities of demand. If we think that P is a point on DD we get another elasticity of demand.

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The greater the difference between the two elasticities of demand, the greater will be the length of the discontinuity. This is so because, we know from the relation between the MR, price and the absolute value of the demand elasticity (e) that MR = price [1-1/e].now at that point P, both the demand curves DD and dd have the same output level. The MR will therefore be different because of the differences in the elasticities are equal at point P, the discontinuous range will disappears.

Suppose now that the MC curve of the firm passes through the discontinuous range of the MR curve, in this case, we cannot say that MR equals MC at the equilibrium point.

Equality of MR and MC is not possible. All that we can say is that MR cannot be less than MC. In this situation the price and quantity remain the same at the kink point. Even if the MC curve shifts but passes through the discontinuous range B, the price-quantity combination remains constant.

The price-quantity combination given by the point of the kink remains more or less stable in the oligopoly market. The price rise or the price fall is not profitable for a single seller because of the asymmetrical behavior of the sellers for a price rise or a price fall. The equilibrium of the firm is defined by the point of the kink because for any output level less than OM, MC is below MR, while for any output level greater than OM, MC is greater than MR. thus total profit is maximized at the kink through the profit maximizing condition (MR=MC) is not fulfilled at the kink point.

The discontinuity of A and B of the MR curve implies that there is a range within which costs may change without affecting the equilibrium price and output of the firm. This level of price and output is compatible with a wide range of costs. Thus the kink can explain why the price and output will not change despite changes in cost within the range AB.

If the demand curve is kinked, a shift in the market demand upwards or downwards, will affect the volume of output but not the level of price, so long as the MC curve passes through the discontinuous range of MR curve. In this case the demand curve shifts but the kink point lies on the horizontal straight line. As the market expands, the firm will not raise its price, although output will increase.

In conclusion it can, therefore, be said that the kinked demand analysis as a method of price-output determinations not analytically sound. But it can be accepted as a reasonable explanation for the rigidity of price and output in the oligopolistic markets.

4.5.3. Collusive Oligopoly

An important characteristic of oligopoly is collusion in which rival firms enter into an agreement in mutual interest on various accounts such as price, market share, etc. Firms either openly declare their decision of collusion, or may collude tacitly. Basic oligopoly characteristics like interdependence of firms, constant consciousness of rival’s action, fear of price war, etc., create a good opportunity for collusion. You must be wondering as to why firms would collude after all. Give it a thought; it does make sense the companies come together in order to get better control over market. When a number of producers (or sellers) enter into such an agreement formally, it is called explicit collusion; on the other hand, collusion which is not overt is known as tacit collusion. The most commonly found form of explicit collusion is known as cartels. The aim of such collusion is to reduce competition and increase profits of individual members. However governments do not encourage collusions because it creates monopoly like situation and make various laws to identity and break up cartels. This has lead to the development of tacit collusion, in which firms do not document agreements to collude.

4.5.4. Price Leadership

The agreed upon price under collusion may have been fixed on the basis of going rate or the price charged by the largest or the most sophisticated player. Such kind of price determination is known as price leadership. What is this going rate? It is price which prevails in the market and existing players as well as new entrants agree to sell their product at this price. Now the next question is that how is this price determined? You will learn about this very unique aspect of oligopoly in the following sections.