definition of oligopoly

7/27/2019 Definition of Oligopoly

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Definition of Oligopoly:Oligopoly falls between two extreme market structures,perfectcompetition andmonopoly.Oligopolyoccurs when a few firms dominate the market for a good orservice. This implies that when there are a small number of competing firms, their marketing decisions

exhibit strong mutual interdependence. By mutual interdependence we mean that a firm's action sayof setting the price has a noticeable effect on its rival firms and they are likely to react in the someway. Each firm considers the possible reaction of rivals to its price and product developmentdecisions.

Stigler Hadsdefined oligopoly:

"Asthat market situation in which a firm bases its market policy in part onthe expected behavior of afew close rival firms".

In the words ofJackson:

"Oligopoly is an industry structure characterized by a few firms producing all or most of the output of

some good that may or may not be differentiated".

The term 'a few f i rm s'covers two to ten firms dominating the entire market for a good. If there areonly two firms in the market, the oligopoly is called Duopo ly.

The analysis ofduopo lyraises all those problems which are confronted while explaining oligopolywith more than two rival firms. Many industries including cement, steel, automobiles, mobile phones,cigrates, beverages etc.; are oligopolistic.

Oligopolies may be homogeneous or differentiated. If firms in an oligopolistic industry producestandardized products like petroleum product, aluminum, rubber products, the industry is said to beproducing under oligopolistic conditions. On the other hand, if the firms are producing goods, whichare close substitutes for each other, then differentiate oligopoly is said to prevail. Mutual

interdependence is greater when products are identical and it is lesser when goods are differentiated.

Explanation of Price and Output Determination Under Oligopoly:

There is not a single theory which satisfactorily explains the pricing and output decisionsunderduopo ly. The reasons are:

(i) The number of firms, dominating the market vary. Sometimes there are only two or three firmswhich dominate the entire market (Tight oligopoly). At another time there may be 7 to 10 firms whichcapture 80% of the market (loose oligopoly).

(ii) The goods produced under oligopoly may or may not be standardized.

(iii) The firms under oligopoly sometime cooperate with each other in the fixing of price and output ofgoods. At another time, they prefer to act independently.

(iv) There are situations also where barriers to entry are very strong in oligopoly and at another time,they are quite loose.

(v) A firm under oligopoly cannot predict with certainly the reaction of the rival firms, if it increases ordecreases the prices and output of its goods. Keeping in view the wide range of diversity of marketsituations, a number of models have been developed explaining the behavior of the oligopolistic firms.

Causes of Oligopoly:

The main reasons w hich give r ise to ol igopolyare as follows:
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(i) Economies of scale: If the productive capacity of a few firms is large and are able to capture agreater percentage of the total available demand for the product in the market, there will then be asmall number of firms in an Industry. The firms in the industry with heavy investment, using improvedtechnology and reaping economies of scale in production, sales, promotion, etc., will compete andstay in the market. The firms using outdated machinery and old techniques of production will not beable to compete with the low unit costs producing firms and eventually wipe out from the industry.

Oligopoly is, thus, promoted due to the economies of scale.

(ii) Barriers to entry: In many oligopolies, the new firms cannot enter the industry as the big firmshave ownership of patents or control over the essential raw material used in the production of anoutput. The heavy expenditure on advertising by the oligopolistic industries may also be a financialbarrier for the new firms to enter the industry.

(iii) Merger: If the few firms in the industry smell the danger of entry of new firms, they thenimmediately merge and formulate a joint policy in the pricing and production of the products.The joint action of a few big firms discourage the entry of new firms into the industry.

(iv) Mutual interdependence: As the number of firms is small in anoligopolistic industry, therefore, they keep a strict watch of the price charged by rival firms in the

industry. The firm generally avoid price war and try to create conditions of mutual interdependence.

Characteristics of Oligopoly:

The main characteris t ics of ol igop olyare as follows:

(i) Small number of firms: Oligopoly is a market structure characterized by a few firms. Thesehandful of firms dominate the industry to set prices.

{ii} Interdependence: All firms in an industry are mostly interdependent. Any action on the part ofone firm with respect to output, quality product differentiation can cause a reaction on the part of otherfirms.

(iii) Realization of profit: Oligopolists firms are often thought to realize economic profits. Wheneverthere are profits, there is incentive for entry of new firms. The existing firms then try to obstruct entryof new firms into the industry.

(iv) Strategic game: In an oligopolistic market structure, the entrepreneurs of the firms are likegenerals in a war. They attempt to predict the reactions of rival firms. It is a strategy game which theyplay.

Three Important Models of Oligopoly:Three Important Econom ic Models ofOl igopolyare as:

(1) Price and output determination under collusive oligopoly.

(2) Price and output determination under non-collusive oligopoly.

(3) Price leadership model.

(1) Price and Output Determination Under Collusive Oligopoly:

The term 'co l lus ion 'implies to 'play together'. When firms under oligopoly agree formally not tocompete with each other about price or output, it is called col lus ive ol igopoly. The firms may agreeon setting output quota, or fix prices or limit product promotion or agree not to 'poach' in each other's
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market. The completing firms thus from a 'cartel'. The members of firms behave as if they are a singlefirm.

Assumptions of Price and Output Determination Under Collusive Oligopoly:

For price output determination in a collusive oligopoly, we assume that (i) there are only three firms in

the industry and they form a cartel, (ii) the products of all the three firms are homogenous (iii) the costcurves of these firms are identical.

Under the assumptions stated above, the equilibrium of the industry under collusive oligopoly isexplained with the help of a diagram.

Diagram:

In this figure 17.4, the industry demand curve DD consisting of three firms is identical. So is the casewith the MR curve and MC curve which are identical. The cartel's MR curve intersects the MC curveat point L. Profits are maximized at output OQ1, where MC = MR. The cartel will set a price OP1, atwhich OQ1, output will be demanded.

Having agreed on the cartel price, the members may then complete each other using non pricecompetition to gain as big share of resulting sales OQ1 as they can.

There is another alternative also. The cartel members may agree to divide the market between them.Each member would given a quota. The sum of all the quotas must add up to Q1. In case the quotasexceeded OQ1 either the output will remain unsold at OP price or the price would fall.

(2) Price and Output Determination Under Non-Collusive Oligopoly:

It will be explain with the help of kinked Demand Curve Model.

(i) The Kinked Demand Curve Model:

The Kinked demand curvemodel was developed by Paul Sweezy (1939). According to him, thefirms under oligopoly try to avoid any activity which could lead to price wars among them. The firmsmostly make efforts to operate in non price competition for increasing their respective shares of themarket and their profit. An analytical device which is used to explain the oligopolistic price rigidity isthe Kinked Demand Curve.

This model operates on fulfilling certain condi t ionswhich, in brief, are as under:


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(a) All the firms in the industry are quite developed with or without product differentiation.

{b} All the firms are selling the goods on fairly satisfactory price in the market.

(c) If any one firm lowers the price of its product to capture a larger share of the market, the other

firms follow and reduce the price of their goods in order to retain their share of the market.

(d) If one firm raises the price of its goods, the other firms will not follow the price increase. Some ofthe customers of the price raising firm will shift to the relatively low priced firms.

Mr. Paul Sweezy used two demand curve concepts to explain the model. These are reproducedbelow:

Diagram:

In the figure 17.5. DD/ is a kinked demand curve. It is made up or two segments DB and BD/. Thedemand curve is kinked Or has a bend at point B. The kink is formed at the prevailing market pricelevel BM ($10 per unit). The segment of the demand curve above the prevailing price level ($10) is

highly elastic and the segment of the demand curve below the prevailing price level is fairly inelastic.This is explained now in brief.

Explanation:

Price increase. If an oligopolistic raises the price of his products from $10 per unit to $12 per unit, heloses a large part of the market and his sale comes down to 40 units from 120 units. There is a loss of80 units in sale as most of his customers are now purchasing goods from his competitor firms who areselling the goods at $10 per units. So an increase in price above the prevailing level-shows that thedemand curve to the left of and above point B is fairly elastic.

Price reduction. If an oligopolistic reduces the prices of its goods below the prevailing price level BM($10 per unit) for increasing his sales, his competitors will also match price changes so that theircustomers do not go away from them. Let us assume that Oligopolist has lowered the price to $4.0per unit. Its competitors in the industry match the price cut. The sale of the oligopolist with a big price


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cut of $.6.0 per unit has increased by only 40 units (160 - 120 = 40). The firm does not gain as thetotal revenue decreases with the price cut. The BD/ portion of the demand curve which lies on theright side and below point B is fairly inelastic.

Rigid Prices. The firms in the oligopolist market 'have no incentive to raise or lower the prices of thegoods. They prefer to sell the goods at the prevailing price level due to reaction function. The price

BM ($10 per unit) will, therefore, tend to remain stable or rigid, as every member of the oligopoly doesnot see any gain by lowering or raising the price of his goods.

(3) Price Leadership Model:

The firms in the oligopolistic market are not happy with price competition among themselves. They tryvarious methods to maximize joint profits. Price leadership is one of the means which provides reliefto the firms from the strains of price competition.

The firms in the oligopolistic industry (without any formal agreement) accept the price set by theleading firm in the industry and move their prices in line with the prices of the leader firm. Theacceptance of price set by the price leader firm maximizes the total profits of each firm in theoligopolistic industry.

Assumptions:

The main assump t ions of pr ice leadership mod el under ol igopolyare as under:

(a) There are two firms A and B in the market.

(b) The output produced by the two firms is homogeneous.

(c) The firm 'A being the low cost firm or a dominant firm acts as a leader firm.

(d) Both of the firms face the same demand curve.

(e) Each of the two firms has an equal share in the market. The price and output determination underprice leadership is now explained with the help of the diagram below.

Diagram:


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In this figure 1 7.6, DD/is the demand curve which is faced by each of the two firms. MR is the

marginal revenue curve of each firm. MCa is the marginal cost of firm A and MCb is the marginal costof firm B. We have assumed that the firm A is a low cost firm than firm B. As such the MCa lies belowMCb.

The leader firm using the marginalistic rule of MC = MR is in equilibrium at point E. The firm A

maximizes profits by selling output OM and setting price MP. The firm B is in equilibrium at point Fwhere MCb = MR.The firm B maximizes profits by producing ON output and selling it at NK price. Thefirm B has to compete firm A in the market, if the firm B fixes the price NK per unit, it will not be able tocompete with firm A which is selling goods at MP price per unit.

Hence, the firm B will be compelled to follow the leader firm A. The firm B will also charge MP priceper unit as set by the firm A. The firm B will also produce QM output like the firm A. Thus both thefirms will charge the same price MP and sell each of them OM output. The total output will thus betwice of OM.The firm A being the low cost firm will maximize profits by selling OM output at MP price. The profits ofthe firm B is lower than of firm A because its costs of production is higher than of firm A.

Conclusion:

After studying the pricing and output decisions under various forms of oligopoly, the main conclusiondrawn is that allocate and productive efficiency are unlikely to be achieved under them.However, Schumpeter 'sview Is that oligopolists have both the Incentive and financial and technicalresources to be more technological progressive than competitive firms.

definition of oligopoly

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