Oligopoly CA Foundation Notes | EduRev

Business Economics for CA Foundation

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CA Foundation : Oligopoly CA Foundation Notes | EduRev

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OLIGOPOLY
We have studied price and output determination under three market forms, namely, perfect competition, monopoly and monopolistic competition. However, in the real world economies we find that many of the industries are oligopolistic. Oligopoly is an important form of imperfect competition. Oligopoly is often described as ‘competition among the few’. Prof. Stigler defines oligopoly as that “situation in which a firm bases its market policy, in part, on the expected behaviour of a few close rivals”. In other words, when there are few (two to ten) sellers in a market selling homogeneous or differentiated products, oligopoly is said to exist. Oligopolies mostly arise due to those factors which are responsible for the emergence of monopolies. Unlike monopoly where a single firm enjoys absolute market power, under oligopoly a few firms exercise their power to keep possible competitors out.
Consider the example of cold drinks industry or automobile industry. There are a handful firms manufacturing cold drinks in India. Similarly, there are a few firms in the automobile industry in India. Airlines industry, petroleum refining, power generation and supply in most of the parts of the country, mobile telephony and Internet service providers are other examples of oligopolistic market. These industries exhibit some special features which are discussed in the following paragraphs.
Types of Oligopoly:
Pure oligopoly or perfect oligopoly occurs when the product is homogeneous in nature, e.g. Aluminium industry. This type of oligopoly tends to process raw materials or produce intermediate goods that are used as inputs by other industries. Notable examples are petroleum, steel, and aluminium. Differentiated or imperfect oligopoly occurs when goods sold is based on product differentiation, e.g. Talcum powder.
Open and closed oligopoly: In an open oligopoly market new firms can enter the market and compete with the existing firms. But, in closed oligopoly entry is restricted.
Collusive and Competitive oligopoly: When few firms of the oligopoly market come to a common understanding or act in collusion with each other either in fixing price or output or both, it is collusive oligopoly. When there is absence of such an understanding among the firms and they compete with each other, it is called competitive oligopoly.
Partial or full oligopoly: Oligopoly is partial when the industry is dominated by one large firm which is considered or looked upon as the leader of the group. The dominating firm will be the price leader. In full oligopoly, the market will be conspicuous by the absence of price leadership.
Syndicated and organized oligopoly: Syndicated oligopoly refers to that situation where the firms sell their products through a centralized syndicate. Organized oligopoly refers to the situation where the firms organize themselves into a central association for fixing prices, output, quotas, etc
Characteristics of Oligopoly Market 
The oligopolistic industry is dominated by a small number of large firms, each of which is comparatively large relative to the total size of the market. These large firms exercise considerable control over the market. An oligopoly market may have a large number of firms along with very large firms, but most of the market share will be enjoyed by the few large firms and therefore they conquer and retain market control. There are strong barriers to entry (refer barriers to entry discussed under monopoly). 
Strategic Interdependence: The most important feature of oligopoly is interdependence in decisionmaking of the few firms which comprise the industry. Since there are only few sellers, there will be intense competition among them. Under oligopoly, each seller is big enough to influence the market. A firm has to necessarily respond to its rivals’ actions, and simultaneously the rivals also respond to the firm’s actions. This is because when the number of competitors is few, any change in price, output or product by a firm will have direct effect on the fortunes of the rivals who will then retaliate by changing their own prices, output or advertising technique as the case may be. It is, therefore, clear that an oligopolistic firm must consider not only the market demand for its product, but also the reactions of other firms in the industry to any major decision it takes. An oligopoly firm that does not consider its rivals’ behaviour or incorrectly assumes them is likely to suffer a setback in its profits.
Importance of advertising and selling costs: A direct effect of interdependence of oligopolists is that the firms have to employ various aggressive and defensive marketing weapons to gain greater share in the market or to maintain their share. For this, firms have to incur a good deal of costs on advertising and other measures of sales promotion. Therefore, there is great importance for advertising and selling costs in an oligopoly market. It is to be noted that firms in such type of market avoid price cutting and try to compete on nonprice basis because if they start undercutting one another, a type of price-war will emerge which will drive a few of them out of the market as customers will try to buy from the seller selling at the cheapest price.
Group behaviour : The theory of oligopoly is a theory of group behaviour, not of mass or individual behaviour and to assume profit maximising behaviour on the oligopolists’ part may not be very valid. There is no generally accepted theory of group behaviour. The firms may agree to pull together as a group in promotion of their common interest. The group may or may not have a leader. If there is a firm which acts as a leader, it has to get others to follow it. These are some of the concerns of the theory of group behaviour. But one thing is certain. Each oligopolist closely watches the business behaviour of the other oligopolists in the industry and designs his moves on the basis of some assumptions of how they behave or are likely to behave.
Price and output decisions in an oligopolistic market
Oligopoly, in fact, describes the operation of a number of large corporations in the world. The operations of these markets are characterized by strategic behaviour of a small number of rival firms. As mentioned above, the extent of power as well as profits depends to a great extent on how rival firms react to each other’s decisions. If the behaviour is less competitive, that is, if the rival firms behave in a cooperative manner, firms will enjoy market power and can charge prices above marginal cost.
An oligopolistic firm has to behave strategically when it makes a decision about its price. It has to consider whether rival firms will keep their prices and quantities constant, when it makes changes in its price and/or quantity. When an oligopolistic firm changes its price, its rival firms will retaliate or react and change their prices which in turn would aect the demand of the former firm. Therefore, an oligopolistic firm cannot have sure and determinate demand curve, since the demand curve keeps shifting as the rivals change their prices in reaction to the price changes made by it. Now when an oligopolist does not know his demand curve, what price and output he will fix cannot be ascertained by economic analysis. However, economists have established a number of price-output models for oligopoly market depending upon the behaviour pattern of other firms in the market. Different oligopoly settings give rise to different optimal strategies and diverse outcomes. Important oligopoly models are:
(i) It is assumed by some economists that oligopolistic firms ignore their interdependence and make their decisions independently. When interdependence is ignored, the demand curve becomes definite and the equilibrium output is found out by equating marginal cost and marginal revenue.
(ii) Some economists assume that an oligopolist is able to predict the reaction pattern of his competitors and on the basis of his prediction; he makes decisions relating to price and quantity. In Cournot model, the firms’ control variable is output in contrast to price. They do not collude. In Stackelberg’s model, the leader commits to an output before all other firms. The rest of the firms are followers and they choose their outputs so as to maximize profits, given the leader’s output. According to Bertrand model, price is the control variable for firms and each firm independently sets its price in order to maximize profits. (iii) The third approach is that oligopolists enter into agreement and try to pursue their common interests. They jointly act as a monopoly organization and fix their prices in such a manner that their joint profits are maximized. They will then share the profits, market or output among them as agreed. Entering into collusion or forming a cartel is generally considered illegal because it restricts trade and creates situations which are close to monopoly. However, in reality, we find a number of cartels operating in the world economy who collude formally or in a tacit manner. Organisation of Petroleum Exporting Countries (OPEC) is the best example of such type of agreement among oligopolists.
Price Leadership 
Cartels are often formed in industries where there are a few firms, all of which are similar in size. A group of firms that explicitly agree (collude) to coordinate their activities is called a cartel. Most cartels have only a subset of producers. If the participating producers stick to the cartel’s agreements, the cartel will have high market power and earn monopoly profits especially when the demand for the product is inelastic. But it is possible that there is a dominant or a large firm surrounded by a large number of small firms. If these firms are numerous or too unreliable, the large firm has to decide how to set its price, taking into account the behaviour of these fringe firms. One strategy is to adopt a ‘live and let live philosophy’. Specifically, the dominant firm accepts the presence of fringe firms and sets the price to maximize its profit, taking into account the fringe firms’ behaviour. This is called price-leadership by dominant firm. Another type of price leadership is by a low cost firm. Here, the price leader sets the price in such a manner that it allows some profits to the followers also. Then there could be barometric price leadership under which an old, experienced, largest or most respected firm acts as a leader and assesses the market conditions with regard to the demand, cost, competition etc. and makes changes in price which are best from the view point of all the firms in the industry. Whatever price is charged by the price leader is generally accepted by the follower firms. Thus we find that fixing of price under oligopoly is very tricky affair and involves a number of assumptions regarding the behaviour of the oligopolistic group.
Kinked Demand Curve
It has been observed that in many oligopolistic industries prices remain sticky or inexible for a long time. They tend to change infrequently, even in the face of declining costs. Many explanations have been given for this price rigidity under oligopoly and the most popular explanation is the kinked demand curve hypothesis given by an American economist Paul A. Sweezy. Hence this is called Sweezy’s Model.
The demand curve facing an oligopolist, according to the kinked demand curve hypothesis, has a ‘kink’ at the level of the prevailing price. It is because the segment of the demand curve above the prevailing price level is highly elastic and the segment of the demand curve below the prevailing price level is inelastic. A kinked demand curve dD with a kink at point P is shown in Fig. 32.
Oligopoly CA Foundation Notes | EduRev
Fig. 32: Kinked Demand Curve under oligopoly 
The prevailing price level is MP and the firm produces and sells output OM. Now the upper segment dP of the demand curve dD is relatively elastic and the lower segment PD is relatively inelastic. This difference in elasticities is due to the particular competitive reaction pattern assumed by the kinked demand curve hypothesis. This assumed pattern is :
Each oligopolist believes that if it lowers the price below the prevailing level its competitors will follow him and will accordingly lower prices, whereas if it raises the price above the prevailing level, its competitors will not follow its increase in price.
This is because when an oligopolistic firm lowers the price of its product, its competitors will feel that if they do not follow the price cut, their customers will run away and buy from the firm which has lowered the price. Thus, in order to maintain their customers they will also lower their prices. The lower portion of the demand curve PD is price inelastic showing that very little increase in sales can be obtained by a reduction in price by an oligopolist. On the other hand, if a firm increases the price of its product, there will a substantial reduction in its sales because as a result of the rise in its price, its customers will withdraw from it and go to its competitors which will welcome the new customers and will gain in sales. These happy competitors will have therefore no motivation to match the price rise. The oligopolist who raises its price will lose a great deal and will therefore refrain from increasing price. This behaviour of the oligopolists explains the elastic upper portion of the demand curve (dP) showing a large fall in sales if a producer raises his price. Briefly put, the effect of a price cut on the quantity demanded of the product of an oligopolistic firm depends upon whether its rivals retaliate by cutting their prices. Similarly, the effect of a price increase on the quantity demanded of the oligopolistic firm’s product depends upon whether its rivals respond by raising their prices as well.
Each oligopolist will, thus, adhere to the prevailing price seeing no gain in changing it and a kink will be formed at the prevailing price. Thus, rigid or sticky prices are explained by the kinked demand curve theory. Oligopolistic firms often have a strong desire for price stability. Although costs or demand change, oligopolistic firms are reluctant to modify the price set by it.
Other important market forms 
Other important market forms are:
Duopoly, a subset of oligopoly, is a market situation in which there are only two firms in the market.
Monopsony is a market characterized by a single buyer of a product. or service and is mostly applicable to factor markets in which a single firm is the only buyer of a factor. Oligopsony is a market characterized by a small number of large buyers and is mostly relevant to factor markets.
Bilateral monopoly is a market structure in which there is only a single buyer and a single seller i.e. it is a combination of monopoly market and a monopsony market.

SUMMARY 
The features of various types of market form are summarised in the table given below: 
Classification of Market Forms 
Form of Market StructureNumber of FirmsNature of productPrice Elasticity of Demand of a firmDegree of Control over price
(a) Perfect competition
Large number of firms 

Homogeneous 
Innite
None 
(b) Monopoly OneUnique product without close substituteSmallVery Considerable
(c) Imperfect CompetitionLarge number of firms Differentiated products Largesome
ii) OligopolyFew FirmsHomogeneous or dierentiated product smallsome

Perfect Competition:
  • A market is said to be perfectly competitive if it has large number of buyers and sellers, homogeneous product, free entry and exit, perfect mobility of factors of production, perfect knowledge about the market conditions, insignificant transaction costs, no government interference and absence of collusion.
  • A firm is in equilibrium when it’s MC = MR and MC curve cuts the MR curve from below.
  • In the short run, firms may be earning normal profits, supernormal profits or making losses at the equilibrium price.
  • In the long-run all the supernormal profits or losses get wiped away with entry or exit of the firms from the industry and all firms earn only normal profit. 
  • in the long run, in perfect competition, the market mechanism leads to an optimal allocation of resources.

Monopoly 

  • Monopoly is an extreme form of imperfect competition with a single seller of a product which has no close substitute.
  • Since the monopolist firm is the only producer of a particular product, its demand curve is identical with the market demand curve for the product.
  • Since a monopoly firm has market power it has the ability to charge a price above marginal cost and earns a positive economic profit.
  • The fundamental cause of monopoly is barriers to entry; in effect other firms cannot enter the market.
  • In the long-run, the supernormal profit will be continued because entry is restricted.
  • One of the important features of monopoly is price discrimination, i.e. charging different prices for the same product from different buyers.
  • Price charged will be higher in the market where the demand is less elastic and lower in the market where the demand is more elastic.
  • Under the first degree price discrimination, the monopolist separates the market into each individual consumer and charges them the price they are willing and able to pay and thereby extract the entire consumer surplus. 
  • Under the second degree price discrimination different prices are charged for different quantities of sold.
    Under the third degree price discrimination, price varies by attributes such as location or by customer segment. 
  • In the absence of competition, the monopolist need not produce at the optimal level.
  • Since monopolies are exploitative and generate undesirable outcomes in the economy, a number of steps are taken by governments to regulate and to prevent the formation of monopolies.
  • In real life, pure monopolies are not common because monopolies are either regulated or prohibited altogether.

Imperfect Competition 

  • Imperfect competition is an important category wherein the individual firm exercises control over the price to a smaller or larger degree depending upon the degree of imperfection present. 

Monopolistic Competition

  • It refers to the market situation in which many producers produce goods which are close substitutes of one another.
  • The essential feature of monopolistic competition is the existence of large number of firms, product differentiation, non price competition, high selling costs and freedom of entry and exit of firms.
  • In monopolistic competition, the features of monopoly and perfect competition are partially present.
  • Demand curve is highly elastic and a firm enjoys some control over the price.
  • Firms in monopolistic competition are not of optimum size and there exists excess capacity with each firm.

Oligopolistic Competition

  • Oligopoly is also referred to as ‘competition among the few’ as a few big firms produce and compete in this market.
  • There are different types of oligopoly like pure and differentiated oligopoly, open and closed oligopoly, collusive and competitive oligopoly, partial and full oligopoly and syndicated and organized oligopoly.
  • The main characteristics of oligopoly are strategic interdependence, importance of advertising and selling costs and group behaviour. Different oligopoly settings give rise to different optimal strategies and diverse outcomes.
  • Price-leadership can be by dominant firm, a low cost firm or it can be barometric price leadership.
  • A group of firms that explicitly agree (collude) to coordinate their activities is called a cartel.
  • Paul A. Sweezy propounded the kinked demand curve model of oligopoly. The price will be kept unchanged for a long time due to fear of retaliation and price tend to be sticky and inflexible.
  • Other important market forms are : Duopoly, Monopsony, Oligopsony and Bilateral monopoly. 

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