Oligopoly: “Competition among the few”

Oligopoly is defined as a market situation where the total output of the industry is concentrated in the
hands of a few large firms, i.e., it is a market structure where competition is restricted among the few,
for e.g., the telecommunication industry is dominated by Mauritius Telecom, Emtel and Chili.

Features of firms under oligopolistic competition:

1. FEW SUPPLIERS: Each one has a relatively large market share (high market
concentration ratio).

2. PRODUCT: Goods are either perfect or close substitutes. Firms do not compete in terms
of price; they compete by differentiating their products.

3. INTERDEPENDENCE: The decision of one firm depends on the reaction of other firms
for e.g., if Emtel reduces price of mobile data services, will Mauritius Telecom also
reduce price or will maintain its constant (‘Game Theory’)
I.e., firms cannot change price independently of other firms.
This situation occurs because as there are a few firms that have a relatively large potion of
the market’s share, one firm’s action impacts other firms, i.e., a price cut by one firm
induces other firms to cut down their own prices. Therefore, leading to a price war, thus,
each firm should be cautious about the reaction from its rivals while deciding on price.
This means that oligopolistic firms will carry out ‘strategic behaviour or strategic
decision-making’ which means decision taken by one firm which is based on an
evaluation of the possible reaction by rival firms. It is behaviour that considers the action
of other firms also.

4. BARRIERS TO ENTRY & EXIT: There are strong barriers to entry and exit such as high
fixed costs.

5. IMPERFECT KNOWLEDGE: While companies in an oligopoly have perfect knowledge

of their own business operations, they do not have complete information about other
firms. Although firms are interdependent because they must consider other firms’
strategies, they are independent when choosing their own strategy. This brings uncertainty
to the market.

6. HIGH DEGREE OF UNCERTAINTY: Firms are uncertain about the reaction of rival
firm.
 Structure of Oligopoly:

Oligopoly
Non-collusive
lllllllllllllllllllll
Collusive

Kinked-Demand Game Theory

curve theory.
Tacit Collusion Cartel

Cournot Model

Collusive Oligopoly: TACIT COLLUSION AND CARTEL

Collusive Oligopoly is when the oligopolists come in formal or informal agreement with one another
to avoid competition among themselves.
Tacit collusion refers to implicit coordination among firms in the absence of explicit agreements or
communication.

Diagram and additional explanations to be added…

Cartel is a formal agreement among firms in an oligopoly to coordinate their behaviour, often
involving price fixing, output quotas (like the OPEC cartel- agreeing upon a lower production quota
so as to force price to increase), or market sharing whereby each producer agreeing to supply the
products in specific areas.

Diagram and additional explanations to be added…

Non-collusive oligopoly: KINKED DEMAND CURVE MODEL AND GAME THEORY

 In a non-collusive oligopoly, the firms tend to compete with each other, by setting their own price
and output policy, which is independent of the other firms.
Kinked demand curve model
In many oligopolist markets, it has been observed that prices tend to remain inflexible for a very long
time. Even in the face of declining costs, they tend to change infrequently. American economist Sweezy
came up with the kinked demand curve hypothesis to explain the reason behind this price rigidity under
oligopoly. It is based on the assumption that rivals match a decrease in price but do not react when the
firm increases price.

Y
From the figure, we know that:
d1
MC AC
The prevailing price level = P
P f
Kink in demand = f

The firm produces and sells output = OM

x
AC
e Also, the upper segment (d1f) of the
demand curve (d1d2) is elastic.
y d2
O X The lower segment (fd2) of the demand
M curve (d1d2) is relatively inelastic.
This difference in elasticities is due to an
assumption of the kinked demand curve
MR hypothesis.
There is a high degree of interdependence among firms because when one firm changes
price, the reaction of rivals is always considered. The kinked demand curve comprising an
elastic segment and an inelastic part is based on the assumption that when the firm
increases price, rivals do not react but when it reduces price rivals follow suit. For this
reason, both an increase and a decrease in price will result in less revenue. So, this model
explains the concept of price stickiness as an oligopoly is not free to change price
independently of others.
This legally is often characterised by price stability (especially when compared to perfect
competition)

Another reason why price can be relatively stable in oligopoly is the existence of a price-
leadership model. The leader could be the one having larger share could be the oldest one
or could even be having the best quality product. So, rivals would not take the first step
when changing price and would normally wait for a first move from the price leader.

Meanwhile the main weakness of the kinked demand curve model is that it does not
explain how price at the kink is determined. Secondly, if MC happens to cross MR
outside the gap ‘xy’, the model does not say what the new price would be.
Since there are high barriers to entry, an oligopolistic firm may continue to earn abnormal
profit in the long run as shown by the area [PfeAC] on the diagram above.

Game Theory
Game theory explained how business decisions involves uncertainties. A firm is uncertain
about the reaction of rivals. It explains how firms make decisions about the price to
charge and their level of output taking into account the responses of rival firm; their
decisions have particular implications about the level of profits earned. To explain the
game theory and price strategy of oligopoly, it is important first of all to consider the
prisoner's dilemma. An example is illustrated below:

Two prisoners A and B have been convicted for the same crime. They will be judged
tomorrow as guilty or not guilty. The judge knows that one of them is guilty but is not
sure if both are guilty. The following shows a prisoner's dilemma pay-off matrix.

Prisoner B

Confess Do not confess

Prisoner

Confess 5/5 years 10/0 years

A

Do not confess 0/10 years 7/7 years

If both prisoners were to plead guilty, they would be sentence two to five years of
imprisonment each. If prisoner A confesses the crime and prisoner B does not, then the
latter will be set free in which case prisoner A will have a maximum of 10 years of jail. If
prisoner B confesses the crime and prisoner A does not, then the latter would be set free
whereas prisoner B will be sentenced to 10 years of jail. If both prisoners do not confess
the crime, then both would be assumed to have committed the crime and would receive 7
years of jail. The dilemma for both prisoners is whether to plead guilty or not. If both
prisoners co-operate and plead guilty, they would get the same years of jail (5 years). The
problem is that no one trust each other. If prisoner A confesses the crime and prisoner B
does not, the latter would be set free and prisoner A would be sentenced for 10 years.
Same applies if B confesses and A does not.
The most obvious outcome would be that neither A nor B would confess. Indirectly, they
would deny in which case they would be sentence for seven years each.

Just like these two prisoners do not trust each other and fail to co-operate, similarly the
behaviour of two firms in an oligopolistic market would be the same. Assume two firms A
and B; they need to decide whether to cut price or not as illustrated by the game theory
matrix below:

Firm B

High Price Low Price

Firm A

High Price $4M each $6M/$2M

Low Price $2M/$6M $1M each

If both firms co-operate and charge high price, they will earn profits $4M each. If firm A
charges high price and firm B lowers the price, firm B wins consumers off from firm A in
which case firm we will have a profit of and from here only a profit of. If firm A lowers
the price and firm B does not, then the profit of firm A is likely to rise to $6M whereas
from B will earn only $2M.
However, since both firms have a sort of tacit collusion, they are likely not to trust each
other and as such charge low price ending with lower profit of $1M each. Tacit collusion
is a form of unwritten agreement between two firms to not compete with each other
through a price war.
The behaviour of oligopolies continues to be a source of concern in many countries
because although it is illegal for them to collude through a cartel, yet certain oligopolies
do practice it in a disguised way, and it is difficult to prove. It is of mutual
interdependence between them.