Lecture: 12 Oligopoly: In case the number of firms is small and the action taken by one firm is followed by rival

firms in the market, it is then to be studied within a separate framework of monopolistic competition called Oligopoly. According to Chamberlin, if all the firms produce identical goods, they can be easily categorized and called an industry. In case, the number of firms is fairly large say 20, 40, 60 and they produce some what similar goods, it is then useful to group these firms together and call them a 'product group' of industry. We in this chapter, however, use 'product group' of 'industry' in the same sense to avoid complication. Examples of Monopolistic Competition: For example, a firm supplies branded good 'Lux Soap' in the market. There are many other firms in the market which sell similar soaps (not identical) with different brand names like Rexona, Palm Rose, etc., etc. The firm supplying 'Lux Soap' enjoys a monopoly position over the sale of its own product. It also faces competition from firms selling similar products. Same is the case with many other firms in the market like plywood manufacturing, jewellery making, wood furniture, book stores, departmental stores, repair services of all kinds, professional services of doctors, technicians, etc., etc. These firms and others which have an element of monopoly power and also face competition over the sale of product or service in the market are called monopolistically competitive firms. Characteristics of Monopolistic/Imperfect Competition: The main characteristic or features of monopolistic competition are as under: (i) A fairly large number of sellers: The number of firms in monopolistic competition is fairly large. Each firm produces or sells a close substitute for the product of other firms in the product group or industry. .Product differentiation is thus the hallmark of monopolistic competition. (ii) Differentiation in products: Under monopolistic competition, the firms sell differentiated products. Product differentiation may be real or imaginary. Real differentiation is done through differences in the materials used, design, color etc. Imaginary differences may be created through advertisement, brand name, trade marks etc. The firms producing similar products in .this imperfectly competitive world cannot raise the price of product much higher than their rivals. If they do so, they will lose much of their sale, but not all the sale. In case, they lower the price, the total sale can be increased to a certain extent. How much will the sale increase or decrease by lowering or raising the price will depend upon the product differentiation of the different firms. If the product of the various firms are very close substitutes of one another and no imaginary or real difference exists in the mind of the buyers, then a slight rise or fall in the price of the product of one firm will appreciably decrease or increase the demand for the product. If the product of one firm differs from that of other firm, (though the difference may be an imaginary one) a slight rise in the price of the product of one firm will not drive away all its customers. A few faithless buyers may be attracted by the low price of the other rival product but not all the buyers. (iii) Advertisement and propaganda: Another very important characteristic of the
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monopolistic competition is that each firm tries to create difference in its product from the other by advertising, propaganda, attractive packing, nice smile, etc., etc. When it succeeds in its object, the firm occupies almost the position of a monopolist. It is, thus, in a position to raise-the price of the product without losing its customers. (iv) Nature of demand curve: Since the existence of close substitutes limits the monopoly power, the demand curve faced by a monopolistically competitive firm is fairly elastic. The precise degree of elasticity will however, depend upon the number of firms in the group product or industry. If the number of firms is fairly large and the product of each firm is not very similar, the demand curve of a firm will be quite elastic. In case, there is close competition among the rival firms for the sale of similar products, the demand curve of a firm will be less elastic. (v) Freedom of entry and exit of firms: The entry of new firms in the monopolistically competition industry is relatively easy. There are no barriers of the new firm to enter the product group or leave the industry in the long run. (vi) Sales efforts: With heterogeneous products, the sale of the products by the firms can no longer be taken for granted sale depends upon sale efforts. (vii) Non-price competition: In monopolistic competition, the firms make every effort to win over the customers. Other than price cutting, the firms may offer after sale service, a gift scheme, discount not declared in the price list etc. Short Run Equilibrium Under Monopolistic/Imperfect Competition: Monopolistic competition refers to the market organization where there are a fairly large number of firms which sell somewhat differentiated products. A single firm in the product group (industry) has little impact on the market price. However, if it reduces price, it can expect a considerable increase in its sales. The firm may also attract buyers away from other firms by creating imaginary or real difference through advertising, branding and through many other sales promotion measures (non-price competition). If the firm raises its price, it will not lose all its customers. This is because of the fact that the product is differentiated from competing firms due to price and non-price factors. The demand curve (AR curve) of the monopolistic firm is therefore, highly elastic and is downward sloping. As regards the marginal revenue curve, it slopes downward and lies below the demand curve because price is lowered of all the units to sell more output in the market. Firm's Equilibrium Price and Output: In the short-run, the number of firms in the 'product group' remains the same. The size of the plant of each firm remains unaltered. The firm whether operating under perfect competition, or monopoly wants to maximize profits. In order to achieve this objective, it goes on producing a commodity so long as the marginal revenue is greater than marginal cost. When MR = MC, it is then in equilibrium and produces the best level of output. If a firm produces less than or more than the MR = MC output, it will then not be making maximum of profits. In the short-run, a monopolistically competitive firm may be realizing abnormal profits or suffering losses. If it is earning profits, no new firms can enter the industry in the short-run. In case, it is suffering, losses but covering full variable cost, the firm will continue operating so that the losses are minimized. If the full variable cost is not met, the firm will close down in the short-run. The short-run equilibrium with profits and short run equilibrium with losses of a monopolistically competitive firm are explained with the help of two separate diagrams as under.
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Diagram:

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In the figure (17.1), the downward sloping demand curve (AR curve) is quite elastic. The MR curve lies below-the average curve except at point N. The SMC curve which includes advertising and sales promotional costs is drawn in the usual fashion. The SMC curve cuts the MR curve from below at point Z. The firm produces and sells an output OK, as at this level of output MR = MC. The firm sells output OK at OE/KM per unit price. The total revenue of the firm is equal to the area OEMK, whereas the total cost of producing output OK is OFLK. The total profits of the firm are equal to the shaded rectangle FEML. The firm earns abnormal profits in the short run. Short Run Losses: If the demand and cost situations are not favorable in the market, a monopolistically competitive firm may incur losses in the short-run. The short-run equilibrium of the firm with losses is explained with the help of a diagram. Diagram:

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In the Figure (17.2), marginal cost (SMC) equates marginal revenue MR curve from below at point Z. The firm produces output OK and sells at OF/KT per unit-price. The total receipt of the firm is OFTK. The total cost of producing output OK is equal to OEMK. The firm suffers a net loss equal to the area FEMT on the sale of OK output. Equilibrium Price and Output in the Long Run Under Monopolistic/Imperfect Competition: Long Run Zero Economic Profits: In the long run, the firms are able to alter the scale of plant according to the changed conditions of demand for a product in the market. They can also leave or enter the industry. If the firms are earning abnormal profits in the short run, then new firm will enter the 'product group' (industry). The tendency of the new firms to enter the industry continues till the abnormal profits are competed away and the firms economic profits are zero. In case the monopolistically competitive firms realize losses in the short-run, then some of the firms will leave the industry. The exit of the firm continues till zero economic profits are restored with the operating firms. In the long-run, there are no entry barriers for the new firms. The incoming firms install latest machinery and try to differentiate their products from those of the established firms. The old firms operating with .the used machinery try to match up with the new entrants by improved variety of products in their group. They increase expenditure on advertisement and on other sales promotional measures. They employ more qualified staff for. making technical improvement in their products. Since all the firms for their existence incur additional expenditure for improving
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the quality of the products, the cost curves of all the firms move up. Due to entry of new firms in the industry and higher costs of production, the output of each competing firm is reduced. There is, therefore, a waste in the economic resources of the country. The equilibrium price and output in the long-run is explained with the help of a diagram. Diagram:

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In the figure (17.3), the higher shifted long-run marginal cost curve intersects the higher shifted marginal revenue curve at point M. The firm at this raised equilibrium point, produces the reduced level of output OK. It sells this output at price TK as at point T, LAC is a tangent to the demand or average revenue curve at its minimum point. The total revenue of the firm is equal to the area OETK. The total costs of the firm are also equal to the area OETK. The firm is earning only zero or normal economic profits. As the monopolistically competitive firm sets a price higher than that minimum average cost in the long-run, the firm therefore produces a smaller output. Since all the firms in the product group produce less at higher price, there is, therefore, an apparent waste of resources and exploitation of the consumers. The advocates of monopolistic competition are of the opinion that if consumers get differentiated products at slightly higher prices (than with no choice under perfect competition), the consumers are then not exploited. There is no wasting of resources either, as the consumer's welfare increases with the product differentiation. Price and Output Determination Under Oligopoly: Definition of Oligopoly: Oligopoly falls between two extreme market structures, perfect competition and monopoly.
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Oligopoly occurs when a few firms dominate the market for a good or service. This implies that when there are a small number of competing firms, their marketing decisions exhibit strong mutual interdependence. By mutual interdependence we mean that a firm's action say of setting the price has a noticeable effect on its rival firms and they are likely to react in the some way. Each firm considers the possible reaction of rivals to its price and product development decisions. Stigler Hads defined oligopoly: "As that market situation in which a firm bases its market policy in part on the expected behavior of a few close rival firms". In the words of Jackson: "Oligopoly is an industry structure characterized by a few firms producing all or most of the output of some good that may or may not be differentiated". The term 'a few firms' covers two to ten firms dominating the entire market for a good. If there are only two firms in the market, the oligopoly is called Duopoly. The analysis of duopoly raises all those problems which are confronted while explaining oligopoly with more than two rival firms. Many industries including cement, steel, automobiles, mobile phones, cigrates, beverages etc.; are oligopolistic. Oligopolies may be homogeneous or differentiated. If firms in an oligopolistic industry produce standardized products like petroleum product, aluminum, rubber products, the industry is said to be producing under oligopolistic conditions. On the other hand, if the firms are producing goods, which are close substitutes for each other, then differentiate oligopoly is said to prevail. Mutual interdependence is greater when products are identical and it is lesser when goods are differentiated. Explanation of Price and Output Determination Under Oligopoly: There is not a single theory which satisfactorily explains the pricing and output decisions under duopoly. The reasons are: (i) The number of firms, dominating the market vary. Sometimes there are only two or three firms which dominate the entire market (Tight oligopoly). At another time there may be 7 to 10 firms which capture 80% of the market (loose oligopoly). (ii) The goods produced under oligopoly may or may not be standardized. (iii) The firms under oligopoly sometime cooperate with each other in the fixing of price and output of goods. At another time, they prefer to act independently. (iv) There are situations also where barriers to entry are very strong in oligopoly and at another time, they are quite loose. (v) A firm under oligopoly cannot predict with certainly the reaction of the rival firms, if it increases or decreases the prices and output of its goods. Keeping in view the wide range of diversity of market situations, a number of models have been developed explaining the behavior of the oligopolistic firms. Causes of Oligopoly: The main reasons which give rise to oligopoly are as follows:
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(i) Economies of scale: If the productive capacity of a few firms is large and are able to capture a greater percentage of the total available demand for the product in the market, there will then be a small number of firms in an Industry. The firms in the industry with heavy investment, using improved technology and reaping economies of scale in production, sales, promotion, etc., will compete and stay in the market. The firms using outdated machinery and old techniques of production will not be able to compete with the low unit costs producing firms and eventually wipe out from the industry. Oligopoly is, thus, promoted due to the economies of scale. (ii) Barriers to entry: In many oligopolies, the new firms cannot enter the industry as the big firms have ownership of patents or control over the essential raw material used in the production of an output. The heavy expenditure on advertising by the oligopolistic industries may also be a financial barrier for the new firms to enter the industry. (iii) Merger: If the few firms in the industry smell the danger of entry of new firms, they then immediately merge and formulate a joint policy in the pricing and production of the products. The joint action of a few big firms discourage the entry of new firms into the industry. (iv) Mutual interdependence: As the number of firms is small in an oligopolistic industry, therefore, they keep a strict watch of the price charged by rival firms in the industry. The firm generally avoid price war and try to create conditions of mutual interdependence. Characteristics of Oligopoly: The main characteristics of oligopoly are as follows: (i) Small number of firms: Oligopoly is a market structure characterized by a few firms. These handful of firms dominate the industry to set prices. {ii} Interdependence: All firms in an industry are mostly interdependent. Any action on the part of one firm with respect to output, quality product differentiation can cause a reaction on the part of other firms. (iii) Realization of profit: Oligopolists firms are often thought to realize economic profits. Whenever there are profits, there is incentive for entry of new firms. The existing firms then try to obstruct entry of new firms into the industry. (iv) Strategic game: In an oligopolistic market structure, the entrepreneurs of the firms are like generals in a war. They attempt to predict the reactions of rival firms. It is a strategy game which they play. Three Important Models of Oligopoly: Three Important Economic Models of Oligopoly are as: (1) Price and output determination under collusive oligopoly. (2) Price and output determination under non-collusive oligopoly. (3) Price leadership model. (1) Price and Output Determination Under Collusive Oligopoly: The term 'collusion' implies to 'play together'. When firms under oligopoly agree formally not to compete with each other about price or output, it is called collusive oligopoly. The firms may agree on setting output quota, or fix prices or limit product promotion or agree not to 'poach' in
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each other's market. The completing firms thus from a 'cartel'. The members of firms behave as if they are a single firm. Assumptions of Price and Output Determination Under Collusive Oligopoly: For price output determination in a collusive oligopoly, we assume that (i) there are only three firms in the industry and they form a cartel, (ii) the products of all the three firms are homogenous (iii) the cost curves of these firms are identical. Under the assumptions stated above, the equilibrium of the industry under collusive oligopoly is explained with the help of a diagram. Diagram:

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In this figure 17.4, the industry demand curve DD consisting of three firms is identical. So is the case with the MR curve and MC curve which are identical. The cartel's MR curve intersects the MC curve at point L. Profits are maximized at output OQ1, where MC = MR. The cartel will set a price OP1, at which OQ1, output will be demanded. Having agreed on the cartel price, the members may then complete each other using non price competition to gain as big share of resulting sales OQ1 as they can. There is another alternative also. The cartel members may agree to divide the market between them. Each member would given a quota. The sum of all the quotas must add up to Q 1. In case the quotas exceeded OQ1 either the output will remain unsold at OP price or the price would fall. (2) Price and Output Determination Under Non-Collusive Oligopoly: It will be explain with the help of kinked Demand Curve Model. (i) The Kinked Demand Curve Model:
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The Kinked demand curve model was developed by Paul Sweezy (1939). According to him, the firms under oligopoly try to avoid any activity which could lead to price wars among them. The firms mostly make efforts to operate in non price competition for increasing their respective shares of the market and their profit. An analytical device which is used to explain the oligopolistic price rigidity is the Kinked Demand Curve. This model operates on fulfilling certain conditions which, in brief, are as under: (a) All the firms in the industry are quite developed with or without product differentiation. {b} All the firms are selling the goods on fairly satisfactory price in the market. (c) If any one firm lowers the price of its product to capture a larger share of the market, the other firms follow and reduce the price of their goods in order to retain their share of the market. (d) If one firm raises the price of its goods, the other firms will not follow the price increase. Some of the customers of the price raising firm will shift to the relatively low priced firms. Mr. Paul Sweezy used two demand curve concepts to explain the model. These are reproduced below: Diagram:

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In the figure 17.5. DD/ is a kinked demand curve. It is made up or two segments DB and BD/.
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The demand curve is kinked Or has a bend at point B. The kink is formed at the prevailing market price level BM ($10 per unit). The segment of the demand curve above the prevailing price level ($10) is highly elastic and the segment of the demand curve below the prevailing price level is fairly inelastic. This is explained now in brief. Explanation: Price increase. If an oligopolistic raises the price of his products from $10 per unit to $12 per unit, he loses a large part of the market and his sale comes down to 40 units from 120 units. There is a loss of 80 units in sale as most of his customers are now purchasing goods from his competitor firms who are selling the goods at $10 per units. So an increase in price above the prevailing level-shows that the demand curve to the left of and above point B is fairly elastic. Price reduction. If an oligopolistic reduces the prices of its goods below the prevailing price level BM ($10 per unit) for increasing his sales, his competitors will also match price changes so that their customers do not go away from them. Let us assume that Oligopolist has lowered the price to $4.0 per unit. Its competitors in the industry match the price cut. The sale of the oligopolist with a big price cut of $.6.0 per unit has increased by only 40 units (160 - 120 = 40). The firm does not gain as the total revenue decreases with the price cut. The BD / portion of the demand curve which lies on the right side and below point B is fairly inelastic. Rigid Prices. The firms in the oligopolist market 'have no incentive to raise or lower the prices of the goods. They prefer to sell the goods at the prevailing price level due to reaction function. The price BM ($10 per unit) will, therefore, tend to remain stable or rigid, as every member of the oligopoly does not see any gain by lowering or raising the price of his goods. (3) Price Leadership Model: The firms in the oligopolistic market are not happy with price competition among themselves. They try various methods to maximize joint profits. Price leadership is one of the means which provides relief to the firms from the strains of price competition. The firms in the oligopolistic industry (without any formal agreement) accept the price set by the leading firm in the industry and move their prices in line with the prices of the leader firm. The acceptance of price set by the price leader firm maximizes the total profits of each firm in the oligopolistic industry. Assumptions: The main assumptions of price leadership model under oligopoly are as under: (a) There are two firms A and B in the market. (b) The output produced by the two firms is homogeneous. (c) The firm 'A being the low cost firm or a dominant firm acts as a leader firm. (d) Both of the firms face the same demand curve. (e) Each of the two firms has an equal share in the market. The price and output determination under price leadership is now explained with the help of the diagram below. Diagram:

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In this figure 1 7.6, DD/ is the demand curve which is faced by each of the two firms. MR is the marginal revenue curve of each firm. MCa is the marginal cost of firm A and MC b is the marginal cost of firm B. We have assumed that the firm A is a low cost firm than firm B. As such the MCa lies below MCb. The leader firm using the marginalistic rule of MC = MR is in equilibrium at point E. The firm A maximizes profits by selling output OM and setting price MP. The firm B is in equilibrium at point F where MCb = MR. The firm B maximizes profits by producing ON output and selling it at NK price. The firm B has to compete firm A in the market, if the firm B fixes the price NK per unit, it will not be able to compete with firm A which is selling goods at MP price per unit. Hence, the firm B will be compelled to follow the leader firm A. The firm B will also charge MP price per unit as set by the firm A. The firm B will also produce QM output like the firm A. Thus both the firms will charge the same price MP and sell each of them OM output. The total output will thus be twice of OM. The firm A being the low cost firm will maximize profits by selling OM output at MP price. The profits of the firm B is lower than of firm A because its costs of production is higher than of firm A. Conclusion: After studying the pricing and output decisions under various forms of oligopoly, the main conclusion drawn is that allocate and productive efficiency are unlikely to be achieved under them. However, Schumpeter's view Is that oligopolists have both the Incentive and financial and technical resources to be more technological progressive than competitive firms.
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