Price and Output under Oligopoly

• Economic theory analyses price and output determination under perfect competition, monopoly, and monopolistic competition, but many real-world industries are characterised by oligopoly, making it an important form of imperfect competition.

• Oligopoly exists when there are few firms or sellers producing or selling a product; it refers to a market with two or more, but not many, producers or sellers.

• Because only a small number of firms operate in the market, oligopoly is often described as “competition among the few.”

• The simplest form of oligopoly is duopoly, which exists when there are only two producers or sellers of a product.

• Analysis of duopoly is important because it contains the basic problems and issues that also arise in explaining oligopoly with more than two firms.

• Although no precise boundary exists between “few” and “many” sellers, an oligopolistic market is generally considered to exist when the number of sellers ranges from two to ten.

• Oligopoly can be classified on the basis of the nature of products sold:

  • Pure oligopoly (oligopoly without product differentiation) exists when the products of the few sellers are homogeneous.

  • Differentiated oligopoly (oligopoly with product differentiation) exists when the products of the few firms are differentiated, yet remain close substitutes for one another.

Characteristics of Oligopoly

In oligopoly some special characteristics are found which are not present in other market structures. We discuss some of these characteristics below:

Interdependence:

• The most important characteristic of oligopoly is the interdependence of decision-making among the few firms that constitute the industry.

• Because the number of competitors is small, any change in price, output, product design, or other business decisions by one firm directly affects the fortunes and market position of rival firms.

• As a result, rival firms are likely to retaliate or respond by altering their own prices, outputs, or products in reaction to the actions of the initiating firm.

• An oligopolistic firm must therefore consider not only the market demand for the industry’s product but also the likely reactions of competing firms before making any decision.

• Since competitors may respond in more than one possible way, the outcome of any action taken by a firm depends on the specific reaction pattern adopted by rival firms.

• Owing to this strategic interdependence and uncertainty regarding rivals’ responses, it is necessary to make assumptions about competitors’ reactions before arriving at a definite and determinate explanation of price and output determination under oligopoly.

Importance of advertising and selling costs:

• A direct consequence of the interdependence among oligopolistic firms is that firms must employ various aggressive and defensive marketing strategies to increase their market share or prevent its decline.

• To achieve this objective, firms incur substantial expenditure on advertising and other sales promotion measures, making advertising and selling costs highly significant under oligopoly.

• As noted by William J. Baumol, advertising reaches its greatest importance under oligopoly; it is under oligopoly that advertising “comes fully into its own.”

• The importance of advertising differs across market structures:

  • Under perfect competition, advertising by an individual firm is largely unnecessary because it can sell any quantity of its product at the prevailing market price.

  • Under monopoly, competitive advertising is generally unnecessary because the monopolist is the sole seller of the product; however, advertising may be used to inform consumers about a new model or to attract potential consumers who have not yet used the product.

  • Under monopolistic competition, advertising is important because of product differentiation, but its role is less significant than under oligopoly.

  • Under oligopoly, advertising can become a critical competitive weapon, as a firm that fails to match the advertising expenditure of its rivals risks losing customers to competing products.

• Competition under oligopoly extends beyond price and includes rivalry through advertising expenditure, product quality, pricing decisions, and output changes, indicating the presence of strong competitive forces despite the small number of firms.

• Because oligopolistic firms continuously struggle to outperform rivals through multiple strategic tools, the existence of competition in oligopoly cannot be denied.

• From the oligopolist’s perspective, genuine competition is not the passive equilibrium of perfect competition, where no firm is powerful enough to disturb the market situation; rather, competition is viewed as a continuous struggle among rivals, a condition most clearly observed under oligopoly and, to a lesser extent, under monopolistic competition.

Group Behaviour:

• Another important feature of oligopoly is that the determination of price and output requires an analysis of group behaviour, since decisions are made in a setting where a few firms are closely interdependent.

• In the theories of perfect competition, monopoly, and monopolistic competition, economists face little difficulty in making assumptions about behaviour:

  • Under perfect competition and monopolistic competition (with a large number of firms), firms are assumed to maximise profits.

  • This assumption yields satisfactory results because a large number of firms are involved and there is no significant interdependence among them.

  • Under monopoly, where a single seller exists, assuming profit-maximising behaviour is also considered appropriate.

• The theory of oligopoly differs fundamentally because it deals with group behaviour rather than mass behaviour or individual behaviour.

• In an oligopolistic market, only a few firms exist and they are highly interdependent, making the simple assumption of profit maximisation by an individual producer insufficient for explaining market outcomes.

• Given the existing state of economic and social science, there is no universally accepted theory of group behaviour, creating a major difficulty in analysing oligopoly.

• Several key questions arise in understanding group behaviour under oligopoly:

  • Will firms cooperate to promote their common interests or compete to advance their individual interests?

  • Does the group have a leader?

  • If a leader exists, how does that leader induce other firms to follow its decisions?

• Answering these questions regarding cooperation, rivalry, leadership, and coordination among interdependent firms is essential for a satisfactory theory of oligopoly.

Indeterminateness of demand curve facing an oligopolist:

• Indeterminateness of the demand curve is a key feature of oligopoly. The demand curve shows the quantity of a product a firm can sell at different prices, but unlike other market structures, the demand curve facing an oligopolist is not definite or stable because of rivals’ reactions.

• Under perfect competition, an individual firm faces a given and definite demand curve because:

  • It is one among a very large number of firms producing an identical product.

  • It cannot influence market price through its own actions.

  • It accepts the prevailing market price and therefore faces a perfectly elastic demand curve at that price.

• Under monopoly, the demand curve is also given and definite because:

  • The monopolist’s product has only remote substitutes.

  • The monopolist can safely ignore the effects of its price changes on distant rivals.

  • Its demand curve depends primarily on consumer demand for its own product.

• Under monopolistic competition, the demand curve of a firm can still be treated as definite because:

  • There are many firms producing close substitute products.

  • A price change by one firm has only a negligible effect on each of its numerous rivals.

  • The firm can reasonably assume that rivals’ prices will remain unchanged when it changes its own price.

  • Its demand curve is therefore determined by buyers’ preferences for its product.

• The situation is fundamentally different under oligopoly because firms are interdependent:

  • Each firm recognizes that its actions affect rivals and that rivals are likely to react.

  • A firm cannot assume that competitors will keep their prices unchanged when it changes its own price.

  • Rival firms may alter their prices in response to the firm’s pricing decisions.

• Because of this mutual dependence and strategic reaction, the demand curve facing an oligopolistic firm becomes indefinite and indeterminate:

  • The demand curve continuously shifts as rivals adjust their prices.

  • The quantity a firm can sell at any price depends not only on consumer demand but also on competitors’ reactions.

  • Unlike perfect competition, monopoly, and monopolistic competition, a stable and uniquely determined demand curve cannot be specified for an oligopolistic firm.