OLIGOPOLY

OLIGOPOLY
Meaning; characteristics; Cournot s model; kinked demand curve model; price leadership model; cartels; game theory treatment of oligopoly.

OLIGOPOLY Meaning
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived, by analogy with "monopoly", from the Greek (oligoi) "few" + (polein) "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others. The decisions of one firm influence, and are influenced by, the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants. Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil.

OLIGOPOLY Meaning
Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development. There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual communication between companies) for example, in some industries there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership.

OLIGOPOLY Meaning
In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater than when there are more firms in an industry if, for example, the firms were only regionally based and did not compete directly with each other. Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's structure. The study of product differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition

Characteristics
Profit maximization conditions: An oligopoly maximizes profits by producing where marginal revenue equals marginal costs. MR=MC Ability to set price: Oligopolies are price setters rather than price takers. Entry and exit: Barriers to entry are high. The most important barriers are economies of scale, patents, access to expensive and complex technology, and strategic actions by incumbent firms designed to discourage or destroy nascent firms. Additional sources of barriers to entry often result from government regulation favoring existing firms making it difficult for new firms to enter the market. Number of firms: "Few" a "handful" of sellers.[ There are so few firms that the actions of one firm can influence the actions of the other firms.[4]

Characteristics
Long run profits: Oligopolies can retain long run abnormal profits. High barriers of entry prevent sideline firms from entering market to capture excess profits. Product differentiation: Product may be homogeneous (steel) or differentiated (automobiles). Perfect knowledge: Assumptions about perfect knowledge vary but the knowledge of various economic actors can be generally described as selective. Oligopolies have perfect knowledge of their own cost and demand functions but their inter-firm information may be incomplete. Buyers have only imperfect knowledge as to price, cost and product quality.

Characteristicsis interdependence. Interdependence: The distinctive feature of an oligopoly

Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore the competing firms will be aware of a firm's market actions and will respond appropriately. It is very much like a game of chess or pool in which a player must anticipate a whole sequence of moves and countermoves in determining how to achieve his objectives. For example, an oligopoly considering a price reduction may wish to estimate the likelihood that competing firms would also lower their prices and possibly trigger a ruinous price war. (Coke v/s Pepsi) If the firm is considering a price increase, it may want to know whether other firms will also increase prices or hold existing prices constant. This high degree of interdependence and need to be aware of what the other guy is doing or might do is to be contrasted with lack of interdependence in other market structures. In a PerfectCompetition(PC) market there is zero interdependence because no firm is large enough to affect market price. All firms in a PC market are price takers, information which they robotically follow in maximizing profits. In a monopoly there are no competitors to be concerned about. In a monopolistically competitive market each firm's effects on market conditions is so negligible as to be safely ignored by competitors

Cournot s model
The Cournot-Nash model is the simplest oligopoly model. The model assumes that there are two equally positioned firms ; the firms compete on the basis of quantity rather than price and each firm makes an output decision assuming that the other firm s behavior is fixed. The market demand curve is assumed to be linear and marginal costs are constant. To find the Cournot-Nash equilibrium one determines how each firm reacts to a change in the output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a point is reached where neither firm desires to change what it is doing, given how it believes the other firm will react to any change. The equilibrium is the intersection of the two firm s reaction functions..

Cournot s model
The reaction function shows how one firm reacts to the quantity choice of the other firm. For example, assume that the firm 1 s demand function is P = (60 - Q2) - Q1 where Q2 is the quantity produced by the other firm and Q1 is the amount produced by firm 1. Assume that marginal cost is 12. Firm 1 wants to know its maximizing quantity and price. Firm 1 begins the process by following the profit maximization rule of equating marginal revenue to marginal costs.MR=MC Firm 1 s total revenue function is PQ = Q1(60 - Q2 - Q1) = 60Q1- Q1Q2 - Q12. The marginal revenue function is MR = 60 - Q2 2Q MR = MC So, 60 - Q2 - 2Q = 12 2Q = 48 - Q2 Q1 = 24 - 0.5Q2 [1.1] Q2 = 24 - 0.5Q1 [1.2] Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2.

Kinked demand curve model

According to this model, each firm faces a demand curve kinked at the existing price. In this model two assumption are: if the firm raises its price above the current existing price, competitors will not follow and the acting firm will lose market share if a firm lowers prices below the existing price then their competitors will follow to retain their market share and the firm's output will increase only marginally. If the assumptions hold then: The firm's marginal revenue curve is discontinuous, and has a gap at the kink For prices above the prevailing price the curve is relatively elastic For prices below the point the curve is relatively inelastic 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. Example Prices of Biscuits were rigid in spite of increase in price of sugar

Kinked demand curve model

The Price-Leadership Model

The price-leadership model of oligopoly assumes that there is one dominant firm in the industry that sets the price and then all the other firms in the industry behave like perfectly competitive price-taking firms. Once all the other small firms have chosen their desired quantity, the price leader will produce to meet the remaining demand at that price. As the name implies, the price leadership model consists of a leader and a bunch of followers. The leader, however, is always mindful of the demand and will set prices low enough that a satisfactory demand remains after all the followers have made production decisions. This model implies that the dominant firm is better off with larger amounts of the market share and less competition. As a result, the price leader may choose prices to minimize the participation of smaller firms. This pricing strategy is called predatory pricing. As in the other oligopoly models, an oligopoly with a dominant price leader will produce a level of output between the output that would prevail under competition and the level that a monopolist would choose in the same industry. It will also set a price between the monopoly price and the competitive price

game theory treatment of oligopoly.

A game occurs when there are two or more interacting decision-takers (players) and each decision or combination of decisions involves a particular outcome (pay-off.) The fate (or the payoff) of a player in a game depends not only on the actions of that player but also on the other players! The classic example of game theory is the Prisoners Dilemma, a situation where two prisoners are being questioned over their guilt or innocence of a crime. They have a simple choice, either to confess to the crime (thereby implicating their accomplice) and accept the consequences, or to deny all involvement and hope that their partner does likewise

game theory treatment of oligopoly.

Game theory analysis has direct relevance to our study of the behaviour of businesses in oligopolistic markets for example the decisions that firms must take over pricing of products, and also how much money to invest in research and development spending. Costly research projects represent a risk for any business but if one firm invests in R&D, can another rival firm decide not to follow? They might lose the competitive edge in the market and suffer a long term decline in market share and profitability