CHAPTER TWO

2. PRICE AND OUT PUT DETERMINATION UNDER OLIGOPOLY

Introduction
Oligopoly is a market structure characterized by small number of (few) firms
selling homogeneous or heterogeneous products and there is great deal of
interdependence among them.
Reasons for the existence of oligopoly
1.There may be barrier that is very difficult to enter the industry. The barrier could be a
cost barrier or skill barrier.
2.The number of firms in an industry may decrease in response to the strategic price
decrease made by large firms drive out smaller firms.
Basic Characteristics of Oligopoly
1. Very few sellers of the product
2. Firms are mutually interdependent
3. They may have monopoly power, when they collude and charge higher prices for their
product
4. Existence of price rigidity: - by fearing price war firms mostly stick to the prevailing
market price.
5. Products can be homogenous or heterogeneous
6. Collusion is possible
7. Entry is difficult
8. Excessive expenditure on advertisement: if there is price rigidity and if firms have to
stick to the prevailing price, the only way to increase the sales is through the
advertisement or improvement of the design or quality of the product. Thus, the firm in
order to make the demand less elastic has to advertise more.
 DUOPOLY is a special case of oligopoly in which there are only two firms in the
industry. The duopoly case allows as capturing many of the important features of firms
engaging in strategic interaction without the notational complication involved in models
with a large number of firms. Also, we will limit ourselves investigation of the case in
which each firm is producing an identical product. This allows us to avoid the problems
of product differentiation and focus only on strategic interaction.
If one firm reduces its price it will attract consumers and increases its sells, leading to a
substantial loss of sales by other firms in the industry. The other firms may or may not reduce
their price, but the firm that reduces price can no longer assume other firms do not notice
his/her action. The outcome of his/her decision depends on the reaction of other firms.
Therefore, there are many solutions to oligopoly problem. This means that there is no unique
equilibrium solution like that of perfect competition, monopoly, and monopolistic
competition.
In general, oligopoly market is divided in to two. These are
I. Non collusive oligopoly
II. Collusive oligopoly

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 2.1. NON-COLLUSIVE OLIGOPOLY
This implies that firms do not enter in to collusive agreement. There are a number of non-collusive
oligopoly models that give us stable solution to the oligopoly problem that may arise.
Example
1. The Cournot’s model (1838)
2. The Stackleberg’s model (1920)
3. The Kinked demand (Sweeny’s) model (1839)
4. The Bertrand’s model (1883)
2.1.1. COURNOT’S DUOPOLY MODEL
Augustine Cournot (1838) assumed that there are only two firms each having (owning) a
mineral water well and operating at zero cost. Let one of the firms A and the other B. Both
sell their output in a market with a down wards sloping DD curve as well linear. Each firm
acts on the assumption that its competitors will not change its output and decides its own
output so as to maximize profit.

2.1.2. THE “KINKED DEMAND” MODEL: SWEEZY’S NON-COLLUSIVE STABLE

EQUILIBRIUM
The kinked demand curve as a tool of analysis of price rigidity or inflexibility was developed
by an American economist called Paul Sweezy in the year 1939.The main focus of analysis
of P. Sweezy was to explain why prices once determined remains rigid or sticky?
To illustrate his model he assumed the following:
 In many industries there may not be dominant firm
 Firms in oligopolistic market structure have strong preferences for price stability.
If their costs go down and if the demand for their products falls, they may prefer not
to lower their prices. Because of they fear unwanted price war. If their costs go up
and demand rises they may prefer not to raise their prices. Because of firms will react
asymmetrically. Then this behaviour of firms gives raise the demand curve to be
kinked.
 The kinked demand model has two limitations. These are
1. The model implies that price rigidity (stickiness) coincides with quantity
rigidity (stickiness). In reality this may not be the case. For example, in our
country the price of Coca Cola and Pepsi are rigid for the last many years but
the SS of the products has been increasing from time to time due to aggressive
promotion. In other word, the model ignores the impact of non-price
competition (advertising and sales promotion) in increasing output sold.
2. The analysis does not explain how the ongoing price gets to be stick or why
firms in oligopoly market are reluctant to deviate from this existing price to
other price that yields them higher (substantial) profits.

2.2. COLLUSIVE OLIGOPOLY

One way of avoiding the uncertainty that may arise from interdependence of firms in
oligopoly market is to enter in to collusive agreement (that is to adopt more strategic
cooperation). There are two main types of collusive oligopoly. These are
1. Cartels
2. Price leadership. They have been exclusively analysed by W. Fellner.

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 2.2.1. CARTELS
A cartel is a cooperation of firms whose objective is to limit (reduce) the scope of
competitive environment that arises due to mutual interdependence of firms within the
market and act as a monopoly. There are two forms of cartel. These are
a) Cartel aiming at joint profit maximization
b) Cartel aiming at sharing the market
A. CARTEL AIMING AT JOINT PROFIT MAXIMIZATION
As the name of the cartel entails, the aim of this particular form of cartel is to set prices
and outputs together so as to maximize total industry (joint) profit not profit of individual
firms. In this cartel solution the firms act together to restrict output so as no to “spoil” the
market. They recognize the effect on joint profits from producing more output in either
firm. This situation is similar to the multi plant monopoly case that seeks (wants) the
maximization of his profit.
Numerical example
Given P = 100 – 0.5Q, where Q = q1 +q2, TC1 = 5q1, and TC2 = 0.5q22 determine Q,
q1, q2, P, and joint profit.
Solution
First the central agency of the cartel computes the joint profit function as
П = П1 + П 2
= TR1 – TC1 + TR2 – TC2
= (Pq1+Pq2) – (TC1 + TC2)
= P (q1+q2) – (TC1+TC2)
= 100 – 0.5 (q1+q2) (q1+q2) – (5q1+0.5q22)
= 100q1+100q2 – 0.5q12 – 0.5q1q2 – 0.5q1q2 – 0.5q22 – 5q1 – 0.5q22
= 95q1+100q2 – 0.5q12 – q1q2 – q22
 Find the partial derivative of the profit function w.r.t q1 and q2 and equate them to
zero.
∂ П = 0 = 95 – q1 – q2 = 0 ∂ П = 100 – q1 – 2q2 = 0
∂ q1 ∂ q2
= q1+q2 = 95 -------- (1) = q1+2q2 = 100 --------- (2)
 To obtain the level of output and price that maximizes joint profit, the central agency
of the cartel solves q1 and q2 using the above two equations simultaneously as
follows
q1+q2 = 95
(q1+2q2 = 100) –1
q1+q2 = 95
-q1 – 2q2 = -100
-q2 = -5, q2 = 5. Substituting this in one of the two equations above will give
us
q1+q2 = 95
q1+ 5 = 95
q1 = 95 – 5
q1 = 90. Thus Q = q1+q2 = 90+5 = 95. Then joint profit maximizing price is
P = 100 – 0.5Q
= 100 – 0.5 (95)

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 = 100 – 47.5 = 52.5. Finally, the joint profit will be obtained by substituting
the values of q1 and q2 in the above П function or alternatively as follows
П = TR1+TR2 – TC1 – TC2
= Pq1+Pq2 – TC1 – TC2
= 52.5 (90) + 52.5 (5) – 5 (90) – 0.5 (5) 2
= 4725 + 262.5 – 450 – 12.5
= 4525 Thus, Q = 95 and P = 52.5 are the output and price levels that maximizes
joint profit.
B. CARTEL AIMING AT SHARING THE MARKET
This is the most common type of cartel. The two methods of sharing the market are
through
I. Non price competition
II. The determination of quotas

I. NON-PRICE COMPETITION (Price matching and competition)

Under this cartel members agree on a common price informally not by bargaining. This
implies that firms agree not to sell below the cartel price; but they can vary the style of
their products and their selling activities. For example
- Doctors charge the same price
- Barbers charge the same price
- Gasoline stations charge the same price
- Cinema halls charge the same price etc. These prices are not the
result of perfect competition in the market. Rather, they result from tacit agreement upon
price. Hence, sellers compete one another through advertising but not by price changes.
 Due to cost difference among manufacturing firms, this type of cartel is loose or unstable
than the complete cartel aiming at joint profit maximization. In other words, the cartel is
inherently unstable for there is a temptation to cheat by low cost firm. Hence, there is a
strong incentive to break away from the cartel and charge lower price (give price
concession to buyers). However, other members from the cartel will soon discover such a
cheating when they loose consumers.
 Another method (way) to acquire information as to whether other firms keep track of the
price is to use your customers to spy on the other firms. When firms are not sure that the
other firm is not cheating on their agreement and selling at the implicitly agreed price,
price war (instability) may develop and the cartel splits.
II. SHARING THE MARKET BY AGREEMENT ON QUOTAS
Here, cartel members agree explicitly on the common price and quantity each member
may sell in the market (national or international). The best example of this cartel is OPEC
and ICO.
 If all firms have identical cost, a monopoly solution will emerge with the market being
shared equally. That is equal quotas will be allocated. This will happen if and only if
firms have identical costs. However, if costs are different, the quotas (shares) of the
market will differ. Again, allocation of quotas on the basis of cost is unstable. Therefore,
the quotas will be decided by bargaining. During the bargaining process to decide the
quotas of members of the cartel, two main criterions are often considered. These are

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 a) Past level (historical) sells
b) The production capacity of the firm. Both criterions, however, are influenced by
the bargaining power and skills of cartel members.
 Though it is not main criterion, defining the region in which each cartel member is
allowed to sell (spheres of influence) is another criterion of sharing the market. The best
example of this kind of agreement is what the Japanese, Malaysian, and Chinese
companies producing Sony products have agreed.
 Note that cartel models of collusive oligopoly are closed models. That is they assume no
entry. However, if entry is free, the inherent instability of cartel will be intensified. This
is because new entrant firms may charge lower prices in order to secure a considerable
share of the market. Besides, if either firm are not sure the other firm keeps track on
prices and production levels, price war and eventually the dissolution of the cartel is
inevitable. A successful cartel will only be maintained if they found a means to police
members’ and new entrants’ behaviour.

2.2.2. PRICE LEADERSHIP

The collusion among the oligopolies also entails that one firm will set the market price and
others followed (adopt) it. Followers usually prefer to avoid the uncertainty that might occur
because of their competitor’s reaction for their action even if this implies departure from profit
maximizing point.
 Price leadership is more widespread than cartel. The three most common types of price
leadership are
 Price leadership by low cost firm
 Price leadership by the dominant (large) firm
 Barometric price leadership
1. Low-Cost Price Leadership
Consider a situation where there are only two firms (duopoly) that produce identical
(homogenous) products at different costs but sell their products at the same market price.
However, firms may have equal (the high cost firm also to produce the same level of output
to that of the low cost firm and sell at the same price) or unequal share.
 Therefore, the high cost firm 1 must be willing (satisfied) to accept the price decision of
the low cost firm to avoid uncertainity.
 The two together then produce output level, which is equal to q 2 + q2 = 2Q2.

2. The Dominant – Firm Price Leadership (Partial Monopoly)

 This type of duopoly assumes that there is a dominant firm, which has considerable
share of the market and smaller firms, each of them having a smaller market share.
 The dominant firm is assumed:
 To know the market demand curve
 The MC of smaller firms. Hence, firm the horizontal summation of the MC s of
smaller firms the dominant firms found the total SS by the smaller firms at
each price.

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3. Barometric price leadership
In this model, it is formally or informally agreed that all firms will follow
( exactly or approximately) the change of the price of a firm which is
considered to have a good knowledge of the prevailing conditions in the
market and can forecast better than the others the future developments in the
market. In short, the firm chosen as the leader is considered as a barometer ,
reflecting the changes in economic environment. The barometric firm may be
neither a low cost nor a large firm. Usually, it is a firm which from past
behaviour has established the reputation of a good forecaster of economic
changes. Barometric price leadership may be established for various reasons.
Firstly, rival between several large firms in an industry may make it
impossible to accept one among them as the leader. Secondly, followers avoid
the continuous recalculation of costs, as economic conditions change. Thirdly, the
barometric firm usually has proven itself as a ‘reasonably’ good forecaster of
changes in cost and demand conditions in the particular industry and the
economy as a whole, and by following it , the other firms can be ‘reasonably’
sure that they choose the correct price policy.