Transcript Chapter 12

Chapter 12
Oligopoly
Lecture Plan
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Introduction
Features of Oligopoly
Duopoly
Cournot’s Model
Stackelberg’s Model
Kinked Demand Curve: Price Rigidity
Collusive Oligopoly
Price Leadership
Summary
Objectives
• To examine the nature of an oligopoly market.
• To understand the indeterminate demand curve
for a firm under oligopoly
• To look into the various models of price and
output decisions under oligopoly.
• To comprehend the nuances of collusive
oligopoly, with detailed analysis of its various
forms, including cartels.
• To identify with the practice of price leadership
by an oligopolist.
Introduction
• Derived from Greek word: “oligo” (few) “polo” (to sell)
• A few dominant sellers sell differentiated or homogenous products
under continuous consciousness of rivals’ actions.
• Oligopoly looks similar to other market forms; as there can be many
sellers (like in monopolistic competition), but a few very large
sellers dominate the market.
• Products sold may be homogenous (like in perfect competition), or
differentiated (like in monopolistic competition).
• Entry is not restricted but difficult due to requirement of
investments.
• One aspect which differentiates oligopoly from all other market
forms, is the interdependence of various firms: no player can take a
decision without considering the action (or reaction) of rivals.
Features of Oligopoly
• Few Sellers: small number of large firms
compete (Automobile Industry, Oil companies)
• Product: Some industries may consist of firms
selling identical products, while in some other
industries firms may be selling differentiated
products.
• (Differentiated – Cars, motorbikes, Telivision,
Washing machine)
• (Homogeneous – Petrol, Cement, Steel,
Aluminum )
Features of Oligopoly
• Entry Barriers: No legal barriers; only economic
in nature
– Huge investment requirements
– Strong consumer loyalty for existing brands (Xerox
photocopying, Jeep (SUV), Godrej steel almirah.
– Economies of scale (HP Printers)
• Interdependent Decision making
Features of Oligopoly
• Non Price Competition: Firms are continuously watching
their rivals, each of them avoids the incidence of a price
war.
A
Market share of
A
• Two firms A & B sell a homogenous
product and sell at P1.
• Firm A lowers the price to gain
market share.
• B fears loss of its customers and
P1
retorts by lowering the price below
that of A.
B
• A further reduces the price and this
process continues.
P2
• The two firms reach P2.
• Both realize that this price war is not
helping either of them and decide to
O Market share of
end the war.
B
• Price again stabilises at P2.
Features of Oligopoly
• Price war only helps customers, not the firms.
• Instead of Price war, companies should use
other strategies such as highly aggressive
advertising, Branding, Offer Better service
packages, Forming Cartels etc.
Features of Oligopoly
• Cartels (Collusive Oligopoly) is where all the
firms openly or tactically. Agree to sell their
Products at same Price.
• Example – OPEC (Oil and Petroleum Exporting
Countries)
• Its an international Cartel in which all the
suppliers of Crude Oil have openly declared to
charge a single Price for the Product all over the
World.
Features of Oligopoly
• Indeterminate Demand Curve
Pric
e
D1
D
D
D1
O
Quant
ity
• Price and output determination is
very complex as each firm faces
two demand curves.
• Demand is not only affected by its
own price or advertisement or
quality, but is also affected by the
price of rival products, their quality,
packaging,
promotion
and
placement.
• When the firm increases the price it
faces highly elastic demand (DD)
• When it reduces the price it faces
highly inelastic demand (D1D1)
Cartels
• A cartel is a grouping of producers that work
together to protect their interests.
• Cartels are created when a few large producers
decide to co-operate with respect to aspects of
their market.
• Formation of Cartels normally involves
agreement on Price fixation, Total Industry
Output, Market share, allocation of customers,
allocation of territories, establishment of
common sales agencies, division of Profits etc.
Negative impacts of Cartels
• Higher prices - cartel members can all raise
prices together, which reduces the elasticity of
demand for any single member.
• Lack of transparency - members may agree to
hide prices or withhold information, such as the
hidden charges in credit card transactions.
• Restricted output - members may agree to
limit output onto the market, as
with OPEC and its oil quotas.
• Carving up a market - cartel members may
collectively agree to break up a market
into regions or territories and not compete
in each other's territory.
Duopoly
• Duopoly is that type of oligopoly in which only two players
operate (or dominate) in the market.
• Used by many economists like Cournot, Stackelberg,
Sweezy, to explain the equilibrium of oligopoly firm, as it
simplifies the analysis.
Price and Output Decisions
• No single model can explain the determination of
equilibrium price and output
– Difficult to determine the demand curve and hence the revenue
curve of the firm
– Tendency of the firm to influence market conditions by various
activities like advertisement, and fear of price war resulting in
price rigidity.
Cournot’s Model
• Augustin Cournot illustrated with an example of two firms
engaged in the production and sale of mineral water.
• Each firm owns a spring of mineral water, which is
available free from nature.
Assumptions
• Each firm maximizes profit.
• Cost of production is nil because the springs are available free
from nature, i.e. MC=0.
• Market demand is linear; hence the demand curve is a downward
sloping straight line.
• Each firm decides on its price assuming that the other firm’s
output is given (i.e. the other firm will continue to produce and sell
the same amount of output in next period).
• Firms sell their entire profit maximizing output at the price
determined by their demand curves.
Cournot’s Model
Period 1: Firm A: ½ (1) = ½
Firm B: ½ (1/2)= 1/4
Period 2: Firm A: ½ (1-1/4)= 3/8
Firm B: ½ (1-3/8) =5/16
Period 3: Firm A: ½ (1-5/16)=11/32
Firm B: ½ (1-11/32)= 21/64
Period 4: Firm A: ½ (1-21/64) = 43/128
Firm B: ½ (1-43/128)=85/256 ………
Period N: Firm A: ½ (1-1/3) =1/3
Firm B: ½ (1-1/3) = 1/3
Thus A’s output is declining progressively (with ratio=1/4), whereas B’s
output is increasing at a declining rate.
•A’s equilibrium output=1/3
•B’s equilibrium output=1/3
Cournot’s Model
Price,
Reven
ue,
Cost
P
P
B
D
A
B
A
O
D*=
Q
Q
Quant
AR
MR
M
B
A
R ity
A
B
• Firm A produces profit maximising
output (OQA) at MR=MC=0 and
sells half of the total market
demand (Half of OD*).
• Point A is the mid point of market
demand DD*.
• Firm B assumes A will continue to
produce OQA ,so considers QAD*
as the market available to it and
AD* as its demand curve. Its MR
curve will be MRB.
• B maximizes profit and produces
QAQB.
• Thus A and B together supply to
three fourths of the total market,
while
one
fourth
remains
unattended.
Stackelberg’s Model
•
•
•
•
Developed by German Economist H. V. Stackelberg
Popularly known as the Leader Follower Model.
An extension of the model of Cournot.
One of the players is sufficiently sophisticated to
recognize that the rival firm acts.
• The sophisticated firm is able to determine the reaction
curve of the rival and is also able to incorporate it in its
own profit function. Thus it acts as a monopolist.
• Naïve firm will act as follower.
Stackelberg’s Model
Output of
Firm B
RA
b
X’B
RB
Firm A’s reaction function
Firm B’s reaction function
E
a
XB
O
RA
X’A
RB
XA Output of Firm A
Cournot’s equilibrium will
be at point E.
• If firm A is the sophisticated
firm, it will try to produce that
output at which it can
maximize its profit, at point “a”.
• A will produce OXA.
• B will act as a follower of A and
will be contended with OXB.
• If firm B is the sophisticated
firm, it will be at equilibrium at
point “b”, producing OX’B.
• A will act as the follower and
accept B’s leadership and will
produce only OX’A.
Kinked Demand Curve
• Paul Sweezy (1939) introduced concept of kinked demand curve to
explain ‘price stickiness’.
• Assumptions
– If a firm decreases price, others will also do the same. So, the
firm initially faces a highly elastic demand curve.
– A price reduction will give some gains to the firm initially, but due
to similar reaction by rivals, this increase in demand will not be
sustained. And the demand curve will become Inelastic
– If a firm increases its price, others will not follow. Firm will lose
large number of its customers to rivals due to substitution effect.
– Thus an oligopoly firm faces a highly elastic demand in case of
price fall and highly elastic demand in case of price rise.
– The Marginal Cost curve always intersects the MR curve at
that region where MR discontinues
• A firm has no option but to stick to its current price.
• At current price a kink is developed in the demand curve
Kinked Demand Curve
(price and output determination)
Price,
Revenue, D1
Cost
K
MC1
P
MC2
A
S
T
O
B
Q
D2
Quantity
• D1K = highly elastic MR
portion of the
demand curve (AR) when rival
firms do not react to price rise
• KD2 = less elastic portion, when
rival firms react with a price
reduction.
• Kink is at point K.
• Discontinuity in AR (D1KD2)
creates discontinuity in the MR
curve.
• At the kink (K), MR is constant
between point A and B.
• Producer will produce OQ,
whether it is operating on MC1 or
MC2, since the profit maximizing
conditions are being fulfilled at
points S as well as T.
• If MC fluctuates between A and
B, the firm will neither change its
output nor its price.
• It will change its output and price
only if MC moves above A or
below B.
Collusive Oligopoly
• Rival firms enter into an agreement in mutual interest on
various accounts such as price, market share, etc.
• Explicit collusion: When a number of producers (or sellers)
enter into a formal agreement.
• Tacit collusion: A collusion which is not formally declared.
• Cartel
• A formal (explicit) agreement among firms on price and output.
• Occurs where there are a small number of sellers with
homogeneous product.
• Normally involves agreement on price fixation, total industry
output, market share, allocation of customers, allocation of
territories, establishment of common sales agencies, division of
profits, or any combination of these.
• Immidiate impact is a hike in price and a reduction in supply.
• Two types:
• centralized cartels
• market sharing cartels.
Centralized Cartels
Price,
Cost,
Revenue
MCB
∑MC
MCA
P
MR
O
QB QA Q
AR=D
Quantity
• Assuming the case of a cartel with
two firms facing same MR and AR
• MCA = Firm A’s marginal cost
• MCB = Firm B’s marginal cost
• ∑MC = industry marginal cost
• OQ = profit maximizing output
because (MR=∑MC).
• OQA = A’ output
• OQB = B’s output
• OQ=OQA + OQB; OQA > OQ B
• OP = price at which both firms can
sell their output. Price will be
determined by summation of all
firms’ costs and demand.
• In a cartel an individual firm is just
a price taker.
Market Sharing Cartels
Price,
Cost,
Revenue
MC
AC
PA
PB
ARA
MRA
ARB
MRB
O
Q B QA
Quantity
• Firms
decide to divide the
market share among them and
fix the price independently.
• All firms have the same cost
functions because they are
producing
a
homogenous
product but have different
demand functions.
• Due to different demand
functions, at equilibrium total
output = OQA+ OQB, where
OQA> OQB.
• The quantity of output produced
and sold would depend upon
the terms of agreement among
the firms in the cartel.
Factors Influencing Cartels
• Number of firms in the industry: Lower the number of firms in the
industry, the easier to monitor the behaviour of other members.
• Nature of product: Formed in markets with homogenous goods rather
than differentiated goods, to arrive at common price. But if goods are
homogeneous, an individual firm may gain larger market share by
cheating, i.e. by lowering the price.
• Cost structure: Similar cost structures make it easier to coordinate.
• Characteristics of sales: Low frequency of sales coupled with huge
amounts of output in each of these sales make cartels less
sustainable, because in such cases firms would like to undercut the
price in order to gain greater market share.
– with large number of firms and small size of the market some firms
may deviate from the cartel price and thus cheat other members.
Informal and Tacit Collusion
• Formed when firms do not declare a cartel, but informally
agree to charge the same price and compete on non
price aspects.
• Sometimes this agreement invloves division of the
market among the players in such a way that they may
charge a price that would maximize their profit.
• It is as damaging to consumers as formal cartels,
because it makes an oligopoly act like a monopoly (in a
limited sense) and deprives consumers of the benefits of
competition.
Price Leadership
• Dominant Firm: a leader in terms of market share, or
presence in all segments, or just the pioneer in the
particular product category.
– May be either a benevolent firm or an exploitative firm.
• Benevolent leader
– Allows other firms to enter by fixing a price at which
small firms may also sell.
• so that it does not have to face allegations of
monopoly creation;
• Earns sufficient margin at this price and still retains
market leadership
Price Leadership
• Exploitative leader: fixes a price at which small
inefficient players may not survive and thus it gains large
share of the market.
– At times results in monopoly type conditions
• Barometric Firm: has better industry intelligence and
can preempt and interpret its external environment in a
more effective manner than others.
– No single player is so large to emerge as a leader,
but there may be a firm which has a better
understanding of the markets.
– Acts like a barometer for the market.
Suppose there are two fast food outlets in Jalandhar. Experience tells
that they have tried to engage in price war to win more customers but
have not gained substantially in terms of profits. Can these outlets
collude to increase profits? Defend your answer with justification.
What is the role of non-price strategies in oligopoly?
Compare the charastistics of Perfect competition with monopolistic
competition?
What is Product differ nation?
Which of the following companies can be identified in a perfect
competition, Monopoly, monopolistic competition, oligoply?
• Domino’s
Google Search engine
• Wheat
Haveli
• Maruti Suzuki
Indian Raliways
Summary
• Oligopoly is a market with a few sellers, differentiated or
homogenous product, interdependent decision making by firms,
non price competition and indeterminate demand curve.
• Duopoly is a special case of oligopoly, in which only two players
operate (or dominate) in the market. All the characteristics of
duopoly are same as those of oligopoly.
• Difficulty in determining the demand curve, tendency to influence
market conditions and fear of price war resulting in price rigidity are
some of the reasons which pose a major constraint in developing a
model to explain oligopoly.
Summary
• In Sweezy’s kinked demand curve model firms avoid a situation like
price war; therefore they stick to the current price. Thus the oligopoly
price remains rigid.
• The kink in demand curve signifies that the demand curve has two
different degrees of price elasticity.
• Under collusion rival firms enter into an agreement in mutual interest
on various accounts such price, market share, etc. Collusion may be
open or tacit. The most commonly found form of explicit collusion is
known as cartels.
• A centralized cartel is an arrangement by all the members, with the
objective of determining a price which maximizes joint profits. In
market sharing cartel members decide to divide the market share
among them and fix the price independently.
• A dominant firm is a leader in terms of market share, or presence in
all segments, or just being the pioneer in the particular product
category. A leader can be benevolent or exploitative.
• A barometric firm has better industry intelligence and can preempt
and interpret its external environment in an effective manner.
Cartels in the cement Industry
• India ranks second in the world in cement production. The cement
industry is highly fragmented as its faces tremendous pressure on
price realization. The demand for cement is price –elastic. Any
imbalance in the demand and supply leads to a disproportionate
increase in the price. Based on the season, the price is determined
by the supply. When the cement manufacturers increase their
capacities, the enhanced capacity leads to excess supply. As the
supply is more than demand, cement prices fall and demand picks
up, leading to an increase in price.
• Since cement production is highly capital-intensive, profit margins
are low. The declining profit margins have prompted cement
companies to form cartels. For example, five big players in the
industry cut production by 10% and managed to increase profit by
50%.
There are two important factors affecting cement production, namely,
sales tax benefits, and the direct cost incurred in production. Sales tax
incentive varies from state to state. Tamil Nadu offers sales tax
exemption for seven years and the payment can be deferred up to 14th
year. Gujarat offers exemption from sales tax for seven years. Based
on the cost structure and the freight and packing charges, the firm
arrives at its profit or loss. The price and supply of cement in a
particular state is fixed by local cartel. Profit margin depends upon
incentives, direct costs, and decisions of the cartel. The cartel decides
the floor price and the sales volume for individual members in a region.
Normally, cement cartels do not last into the long run; cartelization is
more of a short-run phenomenon.
• What are the reasons for the formation of cartels in the cement
industry?
•
Why cartels do exists only in the short run?
• What if cartels were not illegal?