18-09-2022

Unit
6.4

Oligopoly
Pricing and Output Determination

Arjun Madan Ph D

Oligopoly

 A market structure where there are few

dominant firms selling homogenous /
differentiated products, having significant
interdependence that results in price rigidity.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 1

 18-09-2022

Characteristics
 Few dominant firms each large enough to influence market price
 Interdependence of decision making
 High barriers to entry (Technical Economies of scale, hard for new firms to
harness EoS early on)
 Artificial barriers (non price competition, collusion/merger)
 Price making power
 Non-price competition / High selling cost (advertisement)
 Products may be homogeneous or differentiated (by label, quality, branding)
 Imperfect knowledge – sellers and buyers have incompelete knowledge
about production method and pricing

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 2

Types of Oligopolies
 Perfect (Pure) / Imperfect
 Perfect: Homogenous goods
 Imperfect: Differentiated goods
 Open vs Close Oligopoly
 Open: no entry barriers
 Close: entry barriers
 Collusive Oligopoly / Non-collusive Oligopoly
 Implicit agreement (price, quota, etc.), cartelization
 Partial vs Full
 Partial : market dominated by a price leader
 Full: no price leadership
 Syndicate vs Organized
 Syndicate: high degree/level of coordination
Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 3
 18-09-2022

Oligopoly Models
 Four behavioural models of oligopoly
 Competitive Model (Price rigidity)
 Cooperative model (Collusive oligopoly)
 Formal collusion Model (Cartels)
 Informal Collusion Model: Price Leadership

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 4

Behaviour of Oligopoly firms - Price competition

 Price competition may break out at times - known as price war / predatory
pricing
 An oligopoly firm may set price deliberately low
 Undercut prices of other rival firms so as to drive competitors out and gain
larger market share
 Though firm may suffer losses in the short-run
 Due to mutual interdependence
 Other rival firms also drop price to retain customers
 Price war breaks out and erodes any supernormal profits being made

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 5

 18-09-2022

Behaviour of Oligopoly firms – Non-price competition

 With supernormal profits to be gained and the ability to create entry

barriers – oligopoly firms may engage in non-price competition to retain the
market share.
 By adopting R & D, aggressive advertainments
 Creating barriers to entry by –
 Cost reduction due to EoS – resulting in price reduction, warding off
potential new entrants.
 Gaining control over supplies of inputs, outlets or through IPRs.
 Develop new, more inelastic products.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 6

Behaviour of Oligopoly Firms – Models

 Competitive model
 This model explains price rigidity (firms may drop price to match rival
firm’s prices but do not match price increases.)
 For ex: When firm A increases its price – rivals will not follow. Consumers will
switch from firm A to its rivals – Demand will fall more than proportionately
for firm A.
 If firm A lowers its price, rivals will follow – Demand for A will increase less
than proportionately as rivals will try to match price decrease by A (leading to
price war and erosion of economic profits)

 Hence oligopoly firms seldom vary prices unless costs changes significantly.
 The kinked demand model is used to explain this behaviour

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 7

 18-09-2022

Behaviour of Oligopoly Firms

 Cooperative Model
 Collusion is a formal/informal agreement among oligopolists on what
prices to charge and divide the market.
 Reduces unpredictability of rival’s reactions to a price change.
 Can also help increase profits of the group as a whole.
 Hence, firms can cooperate and fix prices, or implements output quotas to
ensure a fair level playing field for all.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 8

Behaviour of Oligopoly Firms

 Formal Collusion Model (Cartel)
 Cartels are formed when oligopoly firms collude to act like a monopoly
to maximize profits
 Having agreed on the cartel price, members compete against each other using
non-price strategies to gain a bigger market share.
 Cartel members may agree to divide the market among themselves according
to current market share.
 An oligopolist has strong incentives to cooperate with rivals so that joint
profits can be maximized.
 They may also have an incentive to cheat secretly on any collusive
agreement in order to increase its profits at the cost of others.
 Cartels are mostly illegal.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 9

 18-09-2022

Behaviour of Oligopoly Firms

 Informal Collusion Model ( Price Leadership)
 Firms may tacitly (without being stated in writing) agree not to indulge in
aggressive price competition so as to gain extra profit/market share at the
expense of others.
 Price leadership occurs when price set by one firm is accepted as the market
price.
 Price leader will select price and output combination to maximise its profits.
 Dominant price leader model: followers chooses same price set by
dominant firm.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 10

The Kinked Demand Model

 Kinked demand curve – a model that seeks to explain price rigidity.
 Hall and Hitch - Paper (1939) - Price Theory and Business Behaviour
 Used the kinked demand curve - but not for determining price or output but
to prove that once the prices are determined on the basis of average cost, the
price becomes ‘sticky’.

 In the same year Paul Sweezy’s Paper – “Demand under the conditions of
Oligopoly” – tried to explain why oligopolist face kinked demand curve.
 Assumptions
 Price reductions are readily matched
 Price rise are not matched or matched only partially
 Prices will remain rigid

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 11

 18-09-2022

The Kinked Demand Model of Oligopoly

We assume that firms follow the following strategy:

My competition will not increase their

If I increase my price price and I
would lose sales.

My competition will also decrease their

If I decrease my price price and I
would gain very few if any additional sales.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 12

The Kinked Demand Model

Quantity demanded
drops by 20%
P1
If I increase my price say by
10%, no one follows and I
lose sales P0

D0
Q1 Q0
If I decrease my price by
Quantity demanded
10%, everyone follows and I P0 increases 5%
gain little or nothing at all!

P1
D0
Q0 Q1

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 13

 18-09-2022

Above P0 demand is more elastic

Above P0 MR looks like this (Blue MR Curve)
Below P0 demand is less elastic
Below P0 MR looks like this (Red MR Curve)
P0
Ignore the lower part of D0 and MR0
Ignore the upper part of D1 and MR1
Note: this Kink in demand,
translates into a gap in the
MR curve

D0
D1
Q0
MR0
MR1
Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 14

The Kinked Demand Model

 Suppose there are only two firms in the telecom industry Jio and Airtel.
 The equilibrium price is ₹600 and Jio is selling 5 lakh plans every month.
 What would happen if Jio decides to change this eq’m price?
 If Jio lowers its price, Airtel will also lower its prices. Why?
 Airtel will not want to loose its market share in case Jio decreases its price.
 Therefore, price decrease will be matched. Demand for Jio will be highly
inelastic below ₹600.
 If Jio raises its price, Airtel will keep its price at ₹600. So we can assume
that Airtel will capture much of the market share since Airtel's price remains
low.
 Demand for Jio will be highly elastic above ₹600.
Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 15
 18-09-2022

1
The Kinked Demand Model
P
1000 Jio’s Demand for Two dominant firm, Jio and Airtel, price range
Cellular Plan from ₹1000 to ₹100.
900

800
At an equilibrium price of ₹600 Jio sells about
5 lakh plans /month
700
What will happen to the demand for Jio’s plan
600
if it lowers its price ?
500
We need to predict what will Jio’s rival Airtel
400 do in response to change in price by Jio
300 If Jio lowers its price, Airtel will also lower its
200 tariffs. (Due to oligopoly behaviour)
100 Airtel would not want to lose market share in
1 2 9
case Jio decreases its price. Therefore, price
3 4 5 6 7 8 10 Q
decrease will be matched.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 16

2
The Kinked Demand Model
P The implication is that the demand for Jio will
1000 Jio’s Demand for be highly inelastic below ₹600.
Cellular Plan
900 Because Airtel will also reduce its price and Jio
800 will not gain any significant market share.
700 What will happen if Jio raises its prices?
600
How would Airtel respond to the price
increase?
500
If Jio raises its price, Airtel will keep its price
400
at ₹600.
300
Why would Airtel ignore price increase by Jio?
200
If Jio's price increases, we can assume that
100 Airtel will capture much of the market share
1 2 3 4 5 6 7 8 9 10 Q since Airtel's price remains low.
Demand for Jio will be highly elastic at price
above ₹600.
Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 17
 18-09-2022

3
The Kinked Demand Model
P Let’s derive the demand cure for Jio and see
1000 Jio’s Demand for
Cellular Plan how it will change if Jio lowers its price and if
900 it raises its price.
800 If Jio lowers its price to ₹400, the increase in
700 demand will be very small because Airtel will
lower its price too.
600
The D increase to only 6 lakh. This means the
500
demand is highly inelastic below ₹600.
400
If Jio increases its price to say ₹700, the D will
300 fall from 5 lakh to 1 lakh. this means the
200 demand is highly elastic above ₹600.
100 If we draw the D curve based on these
D
1 2 9
assumptions we end up with what is called a
3 4 5 6 7 8 10 Q
kinked demand curve.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 18

4
The Kinked Demand Model
P At any price other than ₹600, demand curve
1000 Jio’s Demand for
Cellular Plan will slope steeply below ₹600. Demand will
900 be inelastic, however, demand will be
800 relatively elastic above ₹600.

700 Price decreases will be matched but price

increases will be ignored in order to capture
600
customers who will switch.
500
So based on our assumptions, we can predict
400 how Jio and Airtel will determine their prices.
300 We assume that Airtel has very little incentive
200 to lower its price.
100 Let’s see how revenue will be affected if
D
1 2 9
either firms decide to lower the price.
3 4 5 6 7 8 10 Q

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 19

 18-09-2022

5
The Kinked Demand Model
P The yellow shaded area represents the total
1000 Jio’s Demand for
Cellular Plan revenue at ₹600 price.
900
Jio must decide whether or not lowering its
800 price will improve its total revenue.
700
If Jio were to lower its price to ₹400 the D
600 grows only by 1 lakh units.
500 This means Jio’s TR will be actually smaller,
400
represented by the green rectangle.

300 Total Revenue It would not be in the interest of Jio to lower

Total Revenue its price since the TR is going to fall. TC will
200
increase, and its profits will be less.
100
D
1 2 3 4 5 6 7 8 9 10 Q

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 20

6
The Kinked Demand Model
P Jio’s Demand for What about price increase ? Will Jio benefit by
1000
Cellular Plan rising its price?
900
Clearly, that will not be the case. Increasing
800 the P from ₹600 to ₹700, will once again cause
700 TR to fall.
600 The blue rectangle represents Jio’s TR at a
price of ₹700.
500

400
Jio’s TR will decrease whether it lowers its
price or increases its price.
300
Thus, we can see that there is a tendency of
200
price in the oligopolistic market to remain
100 sticky, at the eq’m levels.
D
1 2 3 4 5 6 7 8 9 10 Q Oligopolist have no incentive to raise or lower
their prices.

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 21

 18-09-2022

8
The Kinked Demand Model
P Jio’s Demand for Now to complete our graph, we need to add
1000
Cellular Plan MR curve.
900
The MR curve will have two different
800 segments – one that accompanies the elastic
700 range of the demand curve and the other
corresponding to the inelastic range of D
600
curve.
500
This results in a vertical gap in the MR curve
400 since there is no MR curve corresponding to
300 the inelastic portion of the MR curve at the
kink.
200
This is generally called as the MR gap,
100
D represented by the vertical red curve in the
1 2 3 4 5 6 7 8 9 10 Q MR curve.

MR

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 22

7
The Kinked Demand Model
P The implication of the vertical range of MR is
1000 Jio’s Demand for that even if the firm’s cost were to increase
Cellular Plan significantly in the short-run, the profit
900
maximization quantity will not change.
800
MC2 Even if there is an increase in MC to MC2 the
700
eq’m (MC=MR) Q and P does not vary from
600 MC1 5 lakh units and ₹600 price.
500

400

300

200

100
D
1 2 3 4 5 6 7 8 9 10 Q

MR

Business Economics (Micro) – Market Analysis – Oligopoly Arjun Madan Ph D 23