Understanding Oligopoly: Features, Models, and Strategies

1. Chapter 12 Oligopoly

2. Lecture Plan • Introduction • Features of Oligopoly • Duopoly • Cournot’s Model • Stackelberg’s Model • Kinked Demand Curve: Price Rigidity • Collusive Oligopoly • Price Leadership • Summary

3. 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.

4. 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.

5. 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 )

6. 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

7. P2 Features of Oligopoly • Non Price Competition: Firms are continuously watching their rivals, each of them avoids the incidence of a price war. • 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 retorts by lowering the price below that of A. • A further reduces the price and this process continues. • The two firms reach P2. • Both realize that this price war is not helping either of them and decide to end the war. • Price again stabilises at P2. P1 A B O Market share of A Market share of B

8. 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.

9. 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.

10. D1 D D D1 Features of Oligopoly • Indeterminate Demand Curve • 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) Price O Quantity

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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

17. B PB QB QA MRA MRB Cournot’s Model • 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. Price, Revenue, Cost D A PA D*=AR O Quantity

18. 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.

19. RA Output of Firm B RB Firm A’s reaction function Firm B’s reaction function RB RA O Output of Firm A Stackelberg’s Model • 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. b X’B E a XB XA X’A Cournot’s equilibrium will be at point E.

20. 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 • The demand curve is more elastic above the kink and less elastic below the kink.

21. MC1 Price, Revenue, Cost MC2 O Quantity MR Kinked Demand Curve(price and output determination) • 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. D1 K P A S D2 T B Q • D1K = highly elastic 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.

22. 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.

23. ∑MC MCA Price, Cost, Revenue MCB P AR=D MR O QB QA Quantity Q Centralized Cartels • 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.

24. MC AC PA PB ARA MRA ARB MRB QB QA Market Sharing Cartels • 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. Price, Cost, Revenue O Quantity

25. 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.

26. 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.

27. 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

28. 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.

29. 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

30. 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.

31. 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.

32. 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%.

33. 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.

34. 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?