#6 GM04 What is Oligopoly? Explain how price & output decisions are taken under the conditions of collusive. GM04 Managerial economics AIMA PGDM assignment solution MBA assignment solution

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6.  What is Oligopoly?  Explain how price & output decisions are taken under the conditions of collusive.

 Oligopoly

Oligopoly is that market situation in which the number of firms is small but each firm in the industry takes into consideration the reaction of the rival firms in the formulation of price policy. The number of firms in the industry may be two or more than two but not more than 20. Oligopoly differs from monopoly and monopolistic competition in this that in monopoly, there is a single seller; in monopolistic competition, there is quite a larger number of them; and in oligopoly, there are only a small number of sellers.

 

Characteristics of Oligopoly:

1.      Every seller can exercise an important influence on the price-output policies of his rivals. Every seller is so influential that his rivals cannot ignore the likely adverse effect on them of a given change in the price-output policy of any single manufacturer. The rival consciousness or the recognition on the part of the seller is because of the fact of interdependence.

2.      The demand curve under oligopoly is indeterminate because any step taken by rivals may change the demand curve. It is more elastic than under simple monopoly and not perfectly elastic as under perfect competition.

3.      It is often noticed that there is stability in price under oligopoly. This is because the oligopolist avoids experimenting with price changes. They know that if they raise the price, they will lose customers and if they lower it they will invite rivals to price war.

 

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 collusions can be classified into:

(A) Cartels- In cartels firms jointly fix the price and output through a process of agreement.

(B) Price leadership- In this form Collusive Oligopoly, one firm sets the price and others follow it. There is a price leader who is followed by the followers.

A. Cartel

The firms may agree on setting output quota, or fix prices or limit product promotion or agree not to 'poach' in each other's market. The competing firms thus from a 'cartel'. The members of firms behave as if they are a single firm.

There are two forms of cartel:

1. Cartel aiming at joint profit maximization

2. Cartel aiming at sharing of the market

Each of the form of the model is discussed below:

1. Cartel aiming at joint profitmaximization:

In this form of cartel the aim is to maximize joint industry profits. A central administrative agency decides total quantity to be produced, price, and allocation of output among each firm and distribution of profit among each firm.

In order to maximize joint profits central agency will apply marginal list rule i.e. equate industry marginal cost and industry marginal revenue curve.

 In above figure the industry demand curve DD is consisting of two firms. Marginal cost curve (MC) is obtained by the horizontal summation of MC_A and MC_B. So the MR curve and MC curve which are identical. The cartel's MR curve intersects the MC curve at point E. Profits are maximized at output OQ, where MC = MR. The cartel will set a price OP, at which OQ, output will be produced and demanded. Once the allocation is done in such a way that the marginal cost of each firm is equal, i.e. MC_A = MC_B = MR.

The total output produced by firm A and B would be determined points EA and EB respectively. Thus firm A produce OQA and firm B produce OQB level of output.

Therefore total output is the sum of individual output of A and B i.e. OQ = OQA + OQB.

It is considered that firm A is low cost firm then firm A makes profits equal to PNML while firm B makes profit PRST. The maximum joint profit is obtained by summing the individual profit of the firm.

2. Cartel aiming at sharing of the market:

In this form of cartel members firms agree not only to a common price but also agree on the quantity which they can sell in the market. If there is are only two firms in the cartel each firm will sell half of the total market demand at that price. The quotas of market share are decided by bargaining between the firms. This is graphically shown below.

 Consider two firms A and B form a cartel in industry. DD is the market demand curve and MR is the corresponding marginal revenue curve. MC curve obtained by the horizontal summation of MCA and MC_B at the equilibrium point E, where MC=MR, the cartel will achieve maximum profits. The total equilibrium output will be OQ and price OP. The total output of firm A will be OQA and of firm B will be OQB.

Thus total output in the industry will be, OQ = OQA + OQB

The total output OQ is obtained by drawing a line parallel to X- axis from point E that intersect MCA at point EA and MCB at point EB. Thus each firm sells output at monopoly price OP. This is called as market sharing cartel.

B. Price leadership

Price leadership is a form of collusion in which one firm sets the price and other firms in the market follow it. Hence it is called as price leadership.

Key Assumptions:

(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.

 

In above figure DD1 is the demand curve which is faced by each of the two firms. MR is the marginal revenue curve of each firm. MC_A is the marginal cost of firm A and MC_B is the marginal cost of firm B. It is assumed that the firm A is a low cost firm than firm B. As such the MC_A lies below MC_B. 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 MC_B = 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

Different forms of Price leadership

(1) Price Leadership by a Low-Cost Firm:

The low-cost firm in the industry in order to maximize profits sets a lower price than the profit-maximizing price of the high-cost firms. As a result, the high-cost firms will not be able to sell their product at the higher price; these high cost firms will therefore be forced to agree to fix the low price set by the low-cost firm. The low -cost firm becomes the price leader. However, the price leader i.e., the low-cost firm has to make sure that the price which it sets must yield some amount of profits to the followers.

(2) PriceLeadership of the Dominant Firm:

In this form of leadership it is observed that there is one firm among the few firms in the industry which contributes a very huge proportion of the total production of the industry. This firm owing to its market share dominates the market for the product. This dominant firm which acquires the leadership exercises a profound influence over the market for that product. The other small firms are normally don’t have such influence on the market.

Attaining the leadership status, the dominant firm estimates its own demand curve and fixes a price which maximizes its own profits. The small firm who turns out to be the followers has no individual effects on the price of the product in the market. They therefore follow the dominant firm and accepting the price set by the price leader will adjust their output accordingly.

(3) PriceLeadership by a Barometric Firm:

As the name suggest in this form of price leadership there is a firm which is an old, matured, experienced, largest or most prestigious firm. This firm becomes the price leader and undertakes the responsibility of a guardian to protect the interests of the other firms.

The barometric price leader assesses the changes in the market conditions with regard to the change in demand, change in production cost, competition from the related products and other similar changes and accordingly takes initiatives to meet the challenges keeping in view interest and welfare of all the firms in the industry. The followers in this from follow the barometric price leadership.

(4) Price Leadership by an Exploitative Firm (Also Termed as Aggressive PriceLeadership):

In this form of price leadership there is usually a very large or dominant firm. This particular firm takes the help of aggressive price policies in order to assume the status of the Price leader. The aggressive price leader forces the other firms in the industry accept its leadership. An exploitative firm often threatens to compete with the others firms to throw them out of market if they do not follow its leadership.

 

#5 GM 04 What is meant by monopolistic competition? Is product differentiation an outcome of monopolistic competition or vice-versa? Discuss the behavior of the firm under monopolistic competition.GM 04 Managerial economics AIMA PGDM assignment solution

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GM 05 Managerial economics AIMA PGDM assignment 

5. What is meant by monopolistic competition? Is product differentiation an outcome of       monopolistic competition or vice-versa?  Discuss the behavior of thefirm under monopolistic competition.

Monopolistic competition is a market situation in which there are many sellers of a particular product but the product of each seller is in some way differentiated in the minds of consumers from the product of every other seller.

Featuresof a Monopolistic Competition

1. In Monopolistic Competition, a buyer can get a specific type of product only from one producer. In other words, there is product differentiation.
2. The firms have to incur selling expenses since there is product differentiation.
3. There is a large number of sellers with inter-dependent demand and supply conditions. Sellers are price-makers and the demand curve for the product of an individual seller is downward sloping. The demand is not perfectly elastic.
4. The firm can improve or deteriorate the quality of its products too. Improving the quality helps in increasing the demand and price of the product. On the other hand, deteriorating the quality helps reduce the average cost of production.
5.  The firms compete for inputs too. Also, they need to operate within a given technological range. Therefore, no firm can produce a better quality product at a lower average cost.
6. Firms are expected to know its demand and cost conditions. Further, they must use this knowledge to maximize its expected profit income.
7. Any firm can leave the group of firms belonging to a specific product group. Also, new firms can enter the group and produce close substitutes of the existing products in the group. This ensures that no firm incurs losses or earns super-normal profits.
8. In Monopolistic Competition, every firm must pursue the goal of profit maximization.
9. It is assumed that all firms in this market structure have identical cost and demand conditions.

Monopolistic competition and Productdifferentiation

Yes, Product differentiation is an outcome of monopolistic competition or vice-versa as monopolistic competition is the market structure which combines typical features of monopoly and perfect competition. Similar to perfect competition there are many small firms in the market. Their decisions are assumed to be not interdependent. There is free entry of firms to the market with monopolistic competition. But due to product differentiation each firm behaves like a monopolist at its narrow segment of an aggregate market of close substitutes. Each firm has market power to influence the price for its product choosing the volume of output. The distinguishing feature of monopolistic competition which makes it as a blending of competition and monopoly is the differentiation of the product. This means that the products of various firms are not homogeneous but differentiated though they are closely related to each other. Product differentiation does not mean that the products of various firms are altogether different.

They are only slightly different so that they are quite similar and serve as close substitutes of each other. When there is any degree of differentiation of products, monopoly element enters the situation. And. the greater the differentiation, the greater the element of monopoly involved in the market situation.

When there are a large number of firms producing differentiated products, each one has a monopoly of its own product but is subject to the competition of close substitutes. Since each is a monopolist and yet has competitors, there is a market situation which can be aptly described as “monopolistic competition.”

With differentiation appears monopoly and as it proceeds further, the element of monopoly becomes greater. Where there is any degree of differentiation whatever, each seller has an absolute monopoly of his own product, but is subject to the competition of more or less imperfect substitutes. Since each is a monopolist and yet has competitors we may speak of them as ‘competing monopolists’ and with peculiar appropriateness, of the forces at work as those of monopolistic competition.”

Many examples of product differentiation can be taken from market such as there are various manufacturers of toothpaste which produce different brands such as Colgate. Patanjali Dant kanti, Binaca, Forhans, Pepsodent, Signals, Neem etc. Thus, the manufacturer of ‘Colgate’ has a monopoly of producing it (nobody else can produce and sell the toothpaste with the name ‘Colgate’) but it faces competition from the manufacturers of Patanjali, Forhans, Binaca, Pepsodent etc. which are close substi­tutes of Colgate. A general class of product is differentiated if a basis exists for preferring goods of one seller to those of others. Such a basis for preference may be real or fancied; it will cause differentiation of the product. When such differentiation of the product exists, even if it is slight, buyers will be paired with sellers not in a random fashion (as in perfect competition) but according to their preferences.

Monopolistic competition corresponds more to the real world economic situation than perfect competition or monopoly and product differentiation pops out to keep market monopolistic as well as competitive. Thus, it can be said that product differentiation an outcome of       monopolistic competition or vice-versa.

 Behavior of the firm under monopolisticcompetition

In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.

Unlike in perfect competition, firms that are monopolistically competitive maintain spare capacity. Models of monopolistic competition are often used to model industries. 

Firm’s behaviour in short run underMonopolistic competition

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit the firm makes is the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good.

Since monopolistically competitive firms have market power, they will produce less and charge more than a firm would under perfect competition. This causes deadweight loss for society, but, from the producer’s point of view, is desirable because it allows them to earn a profit and increase their producer surplus. Because of the possibility of large profits in the short-run and relatively low barriers of entry in comparison to perfect markets, markets with monopolistic competition are very attractive to future entrants.

 Short Run Equilibrium under Monopolistic Competition:

As seen from the chart, the firm will produce the quantity (Qs) where the marginal cost (MC) curve intersects with the marginal revenue (MR) curve. The price is set based on where the Qs falls on the average revenue (AR) curve. The profit the firm makes in the short term is represented by the grey rectangle, or the quantity produced multiplied by the difference between the price and the average cost of producing the good.

 

 

Firm’s behaviour in long run under Monopolistic competition

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.

 

While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market produce a surplus in the long run. Second, the firm is only able to break even in the long-run; it will not be able to earn an economic profit.

Long Run Equilibrium of Monopolistic Competition:

In the long run, firms in a monopolistic competitive market will produce the amount of goods where the long run marginal cost (LRMC) curve intersects marginal revenue (MR). The price is set where the quantity produced falls on the average revenue (AR) curve. The result is that in the long-term the firm will break even.