Lecture:

Oligopoly
(a)The term ‘Oligopoly’ is coined from two Greek words ‘Oligo meaning ‘a few’ and ‘Polly means ‘to
sell’.Oligopoly is a market structure with a small number of firms, none of which can keep the others
from having significant influence. The concentration ratio measures the market share of the largest
firms. A monopoly is one firm, duopoly is two firms and oligopoly is two or more firms. There is no
precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the
actions of one firm significantly influence the others.

(b)With few sellers, each oligopolist is likely to be aware of the actions of the others. According to game
theory, the decisions of one firm therefore influence and are influenced by decisions of other firms.
Strategic planning by oligopolists needs to take into account the likely responses of the other market.
Entry barriers include high investment requirements, strong consumer loyalty for existing brands and
economics of scale.
(c)Steel,Cement,Automobiles heavy capital investment industry.

Example of Oligopoly:

In India, markets for automobiles, cement, steel, aluminium, etc, are the examples of oligopolistic
market. In all these markets, there are few firms for each particular product.

Collusive oligopoly : price determination under cartel

(i)In order to avoid uncertainty arising out of interdependence and to avoid price wars and cut throat
competition, firms working under oligopolistic conditions often enter into agreement regarding a
uniform price-output policy to be pursued by them.

(ii)The agreement may be either formal (open) or tacit (secret). But since formal or open agreements to
form monopolies are illegal in most countries, agreements reached between oligopolists are generally
tacit or secret. When the firms enter into such collusive agreements formally or secretly, collusive
oligopoly prevails.

(i)Collusion
There are three main factors which bring collusion between the oligopolistic firms
Collusion reduces the degree of competition between the firms and helps them act monopolistically in
their effort of profit maximisation
Collusion reduces the oligopolistic uncertainty surrounding the market since cartel members are not
supposed to act independently and in the manner that is determined to the interest of other firms
Collusion forms a kind of barrier to the entry of new firms.

But collusions are of two main types:

(a) Cartels and

(b) Price leadership.

(A) Cartels:

A cartel is an association of independent firms within the same industry. The cartel follows common
policies relating to prices, outputs, sales and profit maximisation and distribution of products. Cartels
may be voluntary or compulsory and open or secret depending upon the policy of the govern ment with
regard to their formation. Thus cartels have many forms and use many devices in order to follow varied
common policies depending upon the type of the cartel. We discuss below the two most common types
of cartels: (1) Joint profit maximisation or perfect cartel; and (2) market-sharing cartel.

1. Joint Profit Maximisation Cartel:

The uncertainty to be found in an oligopolistic market provides an incentive to rival firms to form a
perfect cartel. Perfect cartel is an extreme form of perfect collusion. In this, firms producing a
homogeneous product form a centralised cartel board in the industry. The individual firms surrender
their price-output decisions to this central board.

The board determines output quotas for its members, the price to be charged and the distribution of
industry profits. Since the central board manipulates prices, outputs, sales and distribution of profits, it
acts like a single monopoly whose main aim is to maximise the joint profits of the oligopolistic industry.

Assumptions:

The analysis of joint profit maximisation cartel is based on the following assumptions:

1. Only two firms A and В are assumed in the oligopolistic industry that forms the cartel.

2. Each firm produces and sells a homogeneous product that is a perfect substitute for each other.

3. The number of buyers is large.

4. The market demand curve for the product is given and is known to the cartel.

5. The cost curves of the firms are different but are known to the cartel.

6. The price of the product determines the policy of the cartel.

7. The cartel aims at joint profit maximisation.

Joint Profit Maximisation Solution:

Given these assumptions, and given the market demand curve and its corresponding MR curve, joint
profits will be maximised when the industry MR equals the industry MC. Figure 4 illustrates this situation
where D is the market (or cartel) demand curve and MR is its corresponding marginal revenue curve. The
aggregate marginal cost curve of the industry ΣMС is drawn by the lateral summation of the MC curves
of firms A and В, so that ΣMС = MCa + MCb. The cartel solution that maximises joint profit is determined
at point E where the ШС curve intersects the industry MR curve.
First of all, the cartel will estimate the demand curve of the industry’s product. As the demand curve
facing a cartel will be the aggregate demand curve of the consumers of the product, it will be sloping
downward as is shown by the curve DD in Fig. 29.1(c) Marginal revenue curve MR showing the addition
to cartel’s revenue for successive additions to its output and sales will lie below the demand curve DD.

Cartel’s marginal cost curve (MCc) will be given by the horizontal addition of the marginal cost curves of
the two firms. This has been done in Fig. 29.1(c) where MCc curve has been obtained by adding
horizontally marginal cost curves MCa and MCb of firms A and B respectively.
It should be noted that cartel’s marginal cost curve MCc, obtained as it is by horizontal addition of
marginal cost curves of the two firms, will indicate the minimum possible total cost of producing each
industry output on it; each industry output being distributed among the two firms in such a way that
their marginal costs are equal
Now, the cartel will maximise its profits by fixing the industry’s output at the level at which MR and MC
curves of the cartel intersect each other. It will be seen in Fig. 29.1 (c) that MR and MC curves cut each
other at point R or output OQ. It will also be seen from the demand curve DD that the output OQ will
determine price equal to QL or OP.

Having decided the total output OQ to be produced, the cartel will allot output quota to be produced by
each firm so that the marginal cost of each firm is the same. This can be known by drawing a horizontal
straight line from point R towards the Y-axis.
It will be seen from the figure that when firm A produces OQ1 and firm B produces OQ1 the marginal
costs of the two firms are equal. The output quota of firm A will be OQ1 and of firm B will be OQ1. It is
worth noting that the total output OQ will be equal to the sum of OQ1 and OQ2.

Criticisms of the Model:One main drawback of the cartel model is that the threat to revert to Cournot
behaviour for- ever is not really strong or very realistic. One firm certainly may believe that the other
firm will punish it for deviating, but this is unlikely to happen period after period or forever. A more
realistic model would consider shorter periods of retaliation. Some models of game theoretic literature,
called models of repeated games, illustrate some of the possible patterns of behaviour.

2) Market -Sharing Cartels:

(I)The formation of perfect cartels, as described above, has been quite rare in the real world even where
their formation is not illegal. In a perfect cartel not only the price but also the output to be produced by
each member of a cartel is decided by a central management authority and profits made in all of them
are pooled together and distributed among the members according to the terms of a prior agreement.

(II)Non-price competition :the non price competition agreements are usually associated with loose
cartels. Firms fix a uniform price and each firm is allowed to sell as much as it can at a cartel price . The
only requirement is that firms are not allowed to reduce the price below cartel price .The cartel price is
bargain price .While low cost firms press for a low price ,the high cost firms press for a higher price . But
the cartel price is so fixed by mutual consent that all the members are able to make some profits . But
the firms are allowed to compete with one another in the market On a price level basis . That is , they
are allowed to change the style of their product , innovate new design and to promote their sales
without reducing their price below the level of cartel price . However, as the rivals gradually loose their
customers, the cheating by the low-cost firms will be ultimately discovered and consequently open price
war may commence and cartel breaks down.

Market-Sharing by Output Quota:

The second method of market sharing is a quota system .The market-sharing cartel is the agreement
reached between the oligopolistic firms regarding quota of output to be produced and sold by each of
them at the agreed price. If all firms are producing homogeneous product and have same costs, the
monopoly solution (that is, the maximisation of joint profits) will emerge with the market being equally
shared by them.
However, when costs of member-firms are different, the different quotas for various firms will be fixed
and therefore their market shares will differ. The quotas and market shares in case of cost differences
are decided through bargaining between the firms. During the bargaining process, two criteria are
usually adopted to fix the quotas of the firms.
The second common basis for the quota system and market sharing is the division of market region-
wise, that is, the geographical division of the market between the cartel firms. In this arrangement, price
and also style of the product of cartel firms may vary.

(b)Assumptions:
1. Only two firms can enter into market-sharing agreement on the basis of the quota system.
2. Each firm produces and sells a homogeneous product.
3. The number of buyers is large.
4. The market demand curve for the product is given and known to the cartel.
5. Each firm has its own demand curve having the same elasticity as that of the market demand curve.
6. Both firms share the market equally.
7. Cost curves of the two firms are identical.
8. There is no threat of entry by new firms.
9. Each sells the product at the agreed uniform price.
Let us assume that the d/MR is the demand curve of each firm and mr is its corresponding MR curve. AC
and MC are their identical cost curves. The MC curve intersects the mr curve at point e so that the profit
maximization output of cache firm is Oq. Since the total output of the industry is OQ which is equal to 2
x Oq = (OQ = 20q), it is equally shared by the two firms as per the quota agreement. Thus cache sells Oq
output at the same price qB (= OP) and earns RP per unit profit. The total profit earned by each firm is RP
x Oq and by both is RP x 20q or RP x OQ.

In practice, there are more than two firms in an oligopolistic industry which do not share the market
equally. Moreover, their cost curves are also not identical. In case their cost curves differ, their market
shares will also differ. Each firm will charge an independent price in accordance with its own MC and MR
curves.

They may not sell the same quantity at the agreed common price. They may be charging a price slightly
above or below the profit maximisation price depending upon its cost conditions. But cache will try to be
nearest the profit maximisation price. This will lead to the breaking up of the market sharing agreement.

Cartels do not necessarily create the conditions for price stability in an oligopolistic market . Most cartels
are loose . Generally, cartel agreements are not binding on the members . Cartels do not prevent the
possibility of entry of new firms . On the other hand , by ensuring monopoly profits , cartels in fact
create conditions which attract new firms to industry. They create the conditions for instability in price
and output .