Oligopoly Market: Concept, Types and Characteristics

1 year ago

Atiqur Rahman

22 minutes

Concept of Oligopoly

An oligopoly is an industry characterized by few dominant firms. Oligopoly is said to prevail when there are few firms in the market producing or selling a product. Oligopoly is also referred to as “competition among the few”. A special case of oligopoly is a duopoly where two firms are competing with each other.

Under an oligopoly, each firm has enough market power to prevent itself from being a price taker, but each firm is facing inter-firm rivalry which prevents it from considering the market demand curve as its own demand curve. Competition among oligopolistic firms is so severe those economists call it a ‘cut-throat competition’. Examples of oligopolistic industries include computers, soft drinks, steel, aluminium etc.

The oligopolistic market structure is different from perfect competition, monopoly and monopolistic competition in terms of strategic behaviour. The behaviour of an oligopolistic firm is strategic because it takes into account the impact of its decision on other competing firms and their reactions in response to its decision.

On the other hand, firms in perfect competition and monopolistic competition have non-strategic behaviour because before taking their price and output decisions, they do not consider any possible reaction from their competitors. The behaviour of monopolist is also non-strategic as monopolist has no competitor to compete with.

In some oligopolistic markets, some or all the firms are earning substantial profits in the long run because the entry barriers make it impossible for new firms to enter the market.

Types or Models of Oligopoly

Economists have developed a large number of models by taking different assumptions regarding the behaviour of the oligopolistic firms (that is, whether they would cooperate or compete with each other), regarding the objective they seek to achieve (that is, whether they seek to maximize profit, joint profit, sales etc.) and regarding different reaction patterns of the rival firms to price and output changes by one firm.

There are two types of models advanced by economists are as follows:

1. Collusive Models

Cartel: Profit Sharing and Market Sharing
Price Leadership

2. Non-Collusive Models

Cournot Model
Stackelberg Model
Bertrand Model
Sweezy Model or Kinked Demand Curve

Oligopoly Market Characteristics

In addition to the fewness of sellers, the following are the common characteristics of oligopolistic industries:

(1). Interdependence: There is complete interdependence among sellers in this market. Since there are few firms producing a considerable fraction of the total output of the industry, so the actions taken by one seller affect the others. By reducing or increasing the price for the whole oligopolist market, one seller can sell more or less quantity and can affect the profits of the other sellers. This also implied that in this type of market, each seller is conscious of the price moves of the other sellers and is aware of their impact on his profit. In addition to this, he also knows the action of rivals due to the influence of his price moves. Thus, there is full interdependence among the sellers in this market with respect to their price-output policies/ decisions.

(2). Advertisement: Due to the interdependence of sellers in this market, it becomes very important for each individual seller to highlight his product and tell the consumers about the different features of his product. Thus it becomes necessary for firms in an oligopolistic market to spend much on advertisements and customer services so that they can attract more market for their product and can give tough competition to their rivals.

(3). Competitions: Since under oligopoly, there are a few sellers. Thus a move by one seller immediately affects the rivals and is followed by their counter moves. Thus we can say that there exists tough competition among all the sellers in an oligopolistic market.

(4). Barriers to Entry of Firms: Due to the intense competition in an oligopolistic market, there are no barriers to entry into the market or exit from it. However, in the long run, the types of barriers to entry which have a tendency to restrain new firms from entering the industry are economies of scale, high capital requirements, exclusive patents and licenses etc. Thus, the oligopolist industry can earn long-run supernatural profits when entry is restricted/ blocked by such natural and artificial barriers.

(5). Lack of Uniformity: there exists a lack of uniformity in the size of oligopolist firms. It can be small or very large; such a situation is also known as asymmetrical, with firms of uniform size rare.

(6). Demand Curve: It is not easy to sketch the demand curve for the product of an oligopolist seller because unless the exact behaviour pattern of a producer can be curtained with certainty, his demand curve cannot be drawn accurately with definiteness. And since an oligopolist seller does not show a unique pricing pattern/behaviour, therefore, it is difficult to trace the demand curve for an oligopolist seller. However, some economists have sketched the demand curves based on certain assumptions, which are explained in the following sections.

(7). No Unique Pattern of Pricing Behaviour: Due to the rivalry arising from interdependence among the oligopolist, each seller wants to be independent and wants to earn the maximum possible profits, and in order to fulfil this motive they act and reach the price-output movements of other sellers with uncertainty for which he readies to cooperate with his rivals in order to reduce or eliminate this element of uncertainty. For this, all rivals form a kind of formal agreement with regard to their price-output changes, which in turn leads to a kind of monopoly within an oligopoly. They may also even identify one seller as a leader whose proposal all the other sellers raise or lower their prices. Hence, due to these conflicting attitudes, it is not possible to predict any unique pattern of pricing behaviour in oligopolist markets.

Demand Curve and Pricing in Oligopoly Market

Price determination under oligopoly can be done under two models:

Non-collusive Oligopoly Model of Sweezy (the Kinked Demand Curve)
Collusive Oligopoly Models related to Cartel and Price Leadership

Sweezy Model of Kinked Demand Curve (Rigid Prices)

In 1939, Professor Sweezy gave the kinked demand curve analysis in order to explain the price rigidities which are often seen in oligopolist markets. In his model, Sweezy assumes that if the oligopolist firms lower its price, their rivals will react by reducing their prices, too in order to avoid losing their customers.

Thus the firm, which has initially lowered the price in order to increase its demand, will not be able to increase its demand much because its rivals have also decreased the price of their goods which is almost a substitute for the consumers. Therefore, this portion of the demand curve of the initial firm will be relatively inelastic.

Whereas on the other hand, if an oligopolist firm increases its price, its rivals will not follow it and change their prices, and thus the quantity demanded of this firm will fall considerably, as a good number of customers may shift to the other firm which is selling the good at a lower price.

Hence, this portion of the demand curve of the initial firm will be relatively elastic. Thus, in these two situations, the demand curve of an oligopolist firm will get a kink at the prevailing market price, which in turn explains price rigidity and the gap in the marginal revenue curve means that marginal costs can fluctuate without changing equilibrium price and quantity. Thus prices tend to be rigid according to this model in an oligopolist market.

Assumptions:

There are a few firms in an oligopolistic market
Products of one firm are close substitutes for other firms
No product differentiation
No advertising expenditures
Each seller’s attitude depends on the attitude of his rivals
All the sellers are satisfied with the prevailing market price of the product
A reduction in the price by any seller (to increase his sales) will be followed by the other rivals in terms of reducing their prices as well.
An increase in the price of one seller will not be followed by the other sellers, and they will not increase their prices.
The marginal cost curve will pass through the dotted portion of the marginal revenue curve so that even if the marginal costs would change due to any reason, it will not affect the output and price.

Given these assumptions, the price-output relationship in the oligopolist market is elucidated in Figure 1, where KHD is the kinked demand curve, and OP is the prevailing market price for the OR quantity of one seller. Any increase in the price above OP will reduce his sales because his rivals will not follow this price increase.

Therefore, the KP portion of the demand curve is elastic, and the corresponding portion of KA of the MR curve is positive. Therefore, any price increase will reduce not only his total sales but also his total revenue and profits.

On the other hand, if the seller reduces the price of the product below OP then his rivals will also reduce their prices, so the HT portion of his demand curve is less elastic, and the corresponding part of the MR curve below R is negative. Therefore, this price decrease will increase his sales, but his profit would be less than before.

Thus in both the price-raising and price-reducing situations, the seller will be a loser, and hence he will stick to the prevailing market price OP for his product, which remains rigid. Moreover, the MC curve will cut the MR curve in this dotted gap which in turn means that it will give the same output and price.

So, this gap in the marginal revenue curve means that even if the marginal costs change/fluctuate, then this change in MC will not change the equilibrium price and quantity. Thus prices will remain rigid as per this model.

Collusive Oligopoly Model

In a collusive oligopoly, all firms of a particular industry join together as a single entity in order to maximize their joint profits or to share the market in a certain amount. This is also known as a cartel. There is one more type of collusion which is known as leadership, under which one firm acts as the price leader (or a dominant firm) and fixes the price for the product while other firms follow it.

1. Cartels

A cartel is an alliance of independent firms of the same industry which follows common policies related to pricing, outputs, sales, profit maximization and distribution of products. Cartels may be voluntary/ compulsory and open/ secret depending upon the policy of the government with regard to their formation.

Cartel provides a sort of incentive from uncertainty to the rival firms in which firms producing a homogeneous product form a centralized cartel board in the industry, and all individual firms give up their price-output decisions to this central board, and in return, this board decides the output quotas, price to be charged and the distribution of industry profits for all its members which further aims to maximize the joint profits of the entire oligopolist industry.

In Figure 2, given the market demand curve and its corresponding MR curve, joint profits will be maximized when the industry MR equals the industry MC. The following figure illustrates this situation where D is the market or cartel demand curve, MR is its corresponding marginal revenue curve, and MC is drawn by the lateral summation of the MC curves of firms A & B so that MC = MCa+MCb.

The cartel solution, which maximizes joint profit, is determined at point E where MC intersects MR, and thus the total output is OQ, to be sold at OP prices. Now the cartel board will allocate the 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 E to the vertical axis, which passes through the curves MCb and MCa of firms B & A at points Eb and Ea, respectively. Thus the share of firm A is OQa, and that of firm B is OQb which equals the total output OQ.

Here we can see that firm A has a lower cost of production, and thus it is selling a larger output as compared to firm B, 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 & B respectively.

Thus this type of perfect collusion by oligopolist firms in the form of cartels not only avoids price wars among rivals but also maximizes the joint profits of all firms, which is generally more than the total profits earned by them if they were to act independently.

However, another type of perfect collusion in an oligopolist market relates to market sharing by the member firms of the cartel. Under this, the firms enter into a market sharing agreement, either through a non-price competition or through a quota system, to form a cartel but keep a considerable degree of freedom concerning the style of their output, their selling activities and other decisions.

Under the non-price competition cartel, the low-cost firms insist on a low price and the high-cost firms on a high price, but in the end, they agree upon a common price below which they will not sell their product.

In such case, the firms compete with one another on a non-price basis by varying the colour, design, shape, packing etc, of their product and having their own different advertisement and other selling activities thus, this type of cartel allow them to earn some individual profit.

However, this type of cartel is unstable because if one low-cost firm cheats the other firmly by charging a lower price than the common price, then it will attract the customers of other member firms, too and earn larger profits. And when the other firm comes to know about it, then it will leave the cartel, and a price war will then start in the industry.

Under market sharing by quota agreement, all firms in an oligopolist industry enter into collusion and charge an agreed uniform price for sharing the market equally among them so that each firm would earn and get its profit on its sale.

In Figure 3, D is the market demand curve, and D/MR is its corresponding MR curve ∑MC is the aggregate MC curve of the industry which intersects the D/MR curve at point E, which determines OP price and OQ quantity for the industry. This is also known as the monopoly solution in the market-sharing cartel.

However, this industry output can also be shared equally between the two firms. For this, we assume that the D/MR is the demand curve of each firm, and mr is its corresponding MR curve. AC & MC are their identical costs curve where the MC curve intersects the mr curve at point e so that the profit maximization output of each firm is Oq. So that 2*Oq=OQ, it is equally shared by the 2 firms as per the quota agreement between them. Thus each sells Oq output at the same price OP and earns RP per unit profit, where the total profit earned by each firm is RP*Oq and by both is RP*2*Oq or RP*OQ.

2. Price Leadership

Price leadership is imperfect collusion among the oligopolist firms in an industry when all firms follow the lead of one big firm. This is of three types:

i) The Low-Cost Price Leadership Model:

In the low-cost leadership model, an oligopolist firm having low cost than the other firms sets the lower price, which the other firms have to follow. Thus the low-cost firm becomes the price leader. The main assumption of this model is that the cost of all the firms is different, but they all have identical demands and MR curves.

As illustrated in the following Figure 4, D is the industry demand curve, D/MR is its corresponding MR curve which is the demand curve for both the curves, and mr is their marginal revenue curve. Here the cost curves of the low-cost firm A are ACa and MCa, and of the high-cost firm B are ACb & MCb.

Now if the two firms act independently, then the high-cost firm B would charge OP price per unit and sell OQb quantity as determined by point B where its MCb curve cuts the mr curve. Similarly, the cost curve A will charge OP1 price unit and sell OQa quantity as determined by point A where its MCa curve cuts the mr curve.

Now since there is a formal agreement between the 2 firms, therefore, the high-cost curve B has no choice but to follow the price leader firm A. Therefore, it will sell OQa quantity at a lower price OP1, even though it will not be earning maximum profits.

On the other hand, price leader A will earn much higher profits at OP1 price by selling OQa quantity. Since both A & B sell the same quantity OQa, the total market demand OQ is equally divided between the 2 firms but if firm B sticks to OP price, then its sales will be zero because the product is homogeneous, and all its customers will shift to firm A because it is selling the same product at a much lower price.

ii) The Dominant Firm Price Leadership Model:

Under this model, there is one large dominant firm and a number of small firms in the industry, where the dominant firm fixes the price for the entire industry and the small firms sell as many products as they like and the remaining market is filled by the dominant firm itself. In this case, the dominant firm will select the price which will give it more profits.

However, when each firm sells its product at a price set by the dominant firm, then its demand curve is perfectly elastic at that price, and its marginal revenue curve coincides with the horizontal demand curve, and the firm will produce that output where its MR=MC.

Moreover, the MC curves of all the small firms combined laterally to establish their aggregate supply curve, where all these firms behave competitively while the dominant firm behaves passively by fixing the price and allowing the small firms to sell all they wish at that price.

Figure 5 explains the case of price leadership by the dominant firm, where DD1 is the market demand curve, and SMC1 is the aggregate supply curve of all the small firms. By subtracting SMC1 from DD1 at each price, we get the demand curve faced by the dominant firm, PNMBD1, which can be drawn as follows.

Suppose the dominant firm sets the price OP; then it allows the small firms to meet the entire market demand by supplying PS1 quantity, but the dominant firm will supply nothing at this price OP. Therefore, point P is the starting point of its demand curve.

Now take a price OP1 < OP, then at this, the small firms would supply P1C (or OQs) output, where their SMC1 curve cuts their horizontal demand curve P1R at point C. since the total quantity demanded at OP1 is OQ, and the small firms supply P1C quantity. So, CR quantity would be supplied by the dominant firm.

Now by taking P1N=CR on the horizontal line P1qR, the dominant firm supply becomes P1N (=OQd). Since the small firms will not supply anything at prices below OP2 (because their SMC1 curve exceeds this price), the dominant firm’s demand curve coincides with the horizontal line P2B over the range MD and then with the market demand curve over the segment BD1 and the dominant firm’s demand curve will be PNMBD1.

In addition to this, the dominant firm will maximize its profit at that output where its marginal cost curve MCd cuts its MRd at point E, at which the dominant firm sells OQd output at Op1 price. The small firms will sell OQs output at this price for SMC1, where the marginal cost curve of the small firms equals the horizontal price line P1R at C. Thus, the total output of the industry will be OQ=OQd+OQs.

However, if OP2 price is set by the dominant firm, then the small firms would sell P2A and the dominant firm AB. In case of a price below OP2, small firms will sell zero, and the dominant firms will meet the entire industry demand. Hence this analysis shows that the price quantity solution is stable because the small firms behave passively as price takers.

iii) The Barometric Price Leadership Model:

Under this, there is no leader firm as such but one firm among the oligopolist firm with the wisest management, which announces the price change first, which is followed by other firms in the industry.

Here the barometric price leader may not be the dominant firm with the lowest cost or even the largest firm in the industry. It is a firm which acts like a barometer in forecasting changes in cost and demand conditions in the industry and economic conditions in the economy as a whole.

Oligopoly Market Player’s Decision

As has been discussed in the previous sections, the players’ decision in an oligopolistic market structure depends upon the other existing firms in the market. There exists complete interdependence of price and output decisions of each firm due to the existence of a few firms in an oligopoly market. It has been discussed and shown in the previous section that each move by one firm is followed by the counter moves of the other firms (rivals).

According to the kinked demand curve model, the oligopoly market players’ decision is based on the other players’ decision in such a way that a decrease in the price has been followed by all the other players by reducing their prices of products also, but an increase in the price by one seller does not lead to an increase in the price of the other sellers’ product.

In the collusive oligopoly model, all firms form a sort of tacit agreement under which they all charge a common price and sell individual quantities so as to maximize the joint profits of all firms.

However, firms can also follow a common price and can form a sort of agreement under which they decide each player’s market share either through a non-price competition cartel or by quota agreement.

Moreover, according to the price leadership model, each player’s decision is based on the decision of the dominant or price leader firm. According to a price leader firm, the low-cost firm decides the price at which all other firms sell their products and as per the dominant firm, a dominant or big-size firm decides the price for the other firms, which is followed by all the players of the oligopolist market.

Hence, in an oligopoly market structure, each player’s decision is dependent on the decision of the other players though in a different way according to different models, as has been discussed above, but the main characteristic is that their decisions are mutually interdependent and influence the decisions of all other market participants and thus the entire oligopoly market.

Oligopoly Market: Concept, Types and Characteristics

Concept of Oligopoly

Types or Models of Oligopoly

Oligopoly Market Characteristics

Demand Curve and Pricing in Oligopoly Market