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6.
What is Oligopoly? Explain how price & output decisions are
taken under the conditions of collusive.
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.
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.
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 MCA and MCB. 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. MCA = MCB = 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.
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.
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. MCA is the marginal cost of firm A and MCB 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 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
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.
