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Monopolistic Competition and Oligopoly
(Part D)
by
Charles Lamson
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Oligopoly
An oligopoly is an industry dominated by a few firms that, by virtue of their individual sizes, are large enough to influence the market price.
An industry that has a relatively small number of firms that dominate the market is called a concentrated industry. Oligopolies are concentrated industries. The complex interdependence that usually exists among firms in these industries makes oligopoly difficult to analyze. The behavior of any one firm depends on the reactions it expects of all the others in the industry. Because individual firms make so many decisions---how much output to produce, what price to charge, how much to advertise, whether and when to introduce new product lines, and so forth---industrial strategies are usually complex and difficult to generalize about. Oligopoly Models Because many different types of oligopolies exist, a number of different oligopoly models have been developed. The following provides a sample of the alternative approaches to the behavior (or conduct) of oligopolistic firms. As you will see, all kinds of oligopoly have one thing in common: The behavior of any given oligopolistic firm depends on the behavior of the other firms in the industry comprising the oligopoly.  The Collusion Model In parts 60 and 63 of this analysis, we examined what happens when a perfectly competitive industry falls under the control of a single profit-maximizing firm. In the analysis, we assumed neither technological nor cost advantages to having one firm instead of many. We saw that many competing firms act independently, they produce more, charge a lower price, and earn less profit than they would have if they acted as a single unit. If these firms get together and agree to cut production and increase price---that is, if firms can agree not to price compete they will have a bigger total profit pie to carve. When a group of profit-maximizing oligopolists colludes on price and output, the result is exactly the same as it would be if a monopolist controlled the entire industry. The colluding oligopoly will face market demand and produce only up to the point at which marginal revenue and marginal cost are equal (MR = MC), and price will be set above marginal cost. Review "Collusion and Monopoly Compared" in part 60 of this analysis if you are not sure why. A group of firms that gets together and makes price and output decisions jointly is called a cartel. Perhaps the most famous example of a cartel today is the Organization of Petroleum Exporting Countries (OPEC). As early as 1970, the OPEC cartel began to cut petroleum production. Its decisions in this matter led to a 400 percent increase in the price of crude oil on world markets during 1973 and 1974. OPEC controls a smaller portion of world production today (Case & Fair, p. 291). Price-fixing is not controlled internationally, but it is illegal in the United States. Nonetheless, the incentive to fix prices can be irresistible, and industries are caught in the act from time to time. One famous case in the 1950s involved explicit agreement among a number of electrical equipment manufacturers. In that case, 12 people from five companies met secretly on a number of occasions and agreed to set prices and split up contracts and profits. The scheme involved rotating the winning bids among the firms. Ultimately the scheme was exposed, and the participants were tried, convicted, and sent to jail (p. 291).  For a cartel to work, a number of conditions must be present. First, demand for the cartels product must be inelastic. If many substitutes are readily available, the cartel's price increases may become self-defeating as buyers switch to substitutes. Second, the members of the cartel must play by the rules. If a cartel is holding up prices by restricting output, there is a big incentive for members to cheat by increasing output. Breaking ranks can mean very large profits. Collusion occurs when price and quantity fixing agreements are explicit. Tacit collusion occurs when firms end up fixing price without a specific agreement, or when such agreements are implicit. A small number of firms with market power may fall into the practice of setting similar prices or following the lead of one firm without ever meeting or setting down formal agreements. The Cournot Model Perhaps the oldest model of oligopoly behavior was put forward by Augustin Cournot almost 150 years ago. The Cournot model is based on three assumptions: (1) there are just two firms in an industry---a duopoly; (2) each firm takes the output of the other as given; and (3) both firms maximize profits. The story begins with a new firm producing nothing and the existing firm producing everything. The existing firm takes the market demand curve as its own, acting like a monopolist. When the new firm starts operating, it assumes that the existing firm will continue to produce the same level of output and charge the same price as before. The market demand of the new firm is market demand less the amount that the existing firm is currently selling. In essence, the new firm assumes that its demand curve is everything on the market demand curve below the price charged by the older firm. When the new firm starts operation, the existing firm discovers that its demand has eroded because some output is now sold by the new firm. The old firm now assumes that the new firm's output will remain constant, subtract the new firm's demand from market demand, and produces a new, lower level of output. However, that throws the ball back to the new firm, which now finds that the competition is producing less.  These adjustments get smaller and smaller, with the new firm raising output in small steps and the older firm lowering output in small steps until the two firms split the market and charge the same price. Like the collusion model, the Cournot model of oligopoly results in a quantity of output somewhere between output that would prevail if the market were perfectly competitive and output that would be set by a monopoly. Although the Cournot model illustrates the interdependence of decisions in oligopoly, its assumptions about strategic reactions are quite naive. The two firms in the model react only after the fact and never anticipate the competition's moves. The Kinked Demand Curve Model Another common model of oligopolistic behavior assumes that firms believe that rivals will follow if they cut prices but not if they raise prices. This kinked demand curve model assumes that the elasticity of demand in response to an increase in price is different from the elasticity of demand in response to a price cut. The result is a "kink" in the demand for a single firm's product.    Notice that this model predicts that price in oligopolistic industries is likely to be more stable than cost. In Figure 5, the marginal cost curve can shift up or down by a substantial amount before it becomes advantageous for the firm to change price at all. A number of attempts have been made to test whether oligopolistic prices are indeed more stable than costs. While the results do not support the hypothesis of stable prices, the evidence is far from conclusive. The kinked demand curve model has been criticized because (1) it fails to explain why price is at P* to begin with, and (2) the assumption that competing firms will follow price cuts but not price increases is overly simple---real-world oligopolistic pricing strategies are much more complex. The Price-Leadership Model In another form of oligopoly, one firm dominates an industry and all the smaller firms follow the leader's pricing policy---hence price leadership. If the dominant firm knows the smaller firms will follow its lead, it will derive its own demand curve simply by subtracting from total market demand the amount of demand that the smaller firms will satisfy at each potential price.  The price-leadership model assumes (1) that the industry is made up of one large firm and a number of smaller, competitive firms; (2) that the dominant firm maximizes profit subject to the constraint of market demand and subject to the behavior of the smaller competitive firms; (3) that the dominant firm allows the smaller firms to sell all they want at the price the leader has set. The difference between the quantity demanded in the market and the amount supplied by the smaller firms is the amount that the dominant firm will produce. The result has the quantity demanded in the market split between the smaller firms and the dominant firm. The result is based entirely on the dominant firm's market power. The only constraint facing a monopoly firm, you will recall, is the behavior of the demanders---that is, the market demand curve. In this case, however, the presence of smaller firms acts to constrain the dominant firm's power. If we were to assume that the smaller firms were out of the way, the dominant firm would face the market demand curve on its own. This means the dominant firm has a clear incentive to push the smaller firms out of the industry. One way is to lower the price until all of the smaller firms go out of business and then raise the price once the market has been monopolized. The practice of a large, powerful firm driving smaller firms out of the market by temporarily selling at an artificially low price is called predatory pricing. Such behavior, common during the nineteenth century in the United States, became illegal with the passage of antimonopoly legislation around the turn of the century. As in the other oligopoly models, an oligopoly with a dominant price leader will produce the level of output between the output that would prevail under perfect competition and the output that a monopolist would choose in the same industry. It will also set a price between the monopoly price and the perfectly competitive price. Some competition is usually more efficient than none at all.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 290-294* end |
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