Price Determination Under Oligopoly
An Oligopoly market condition exists between two of the most extreme market conditions; i.e. perfect competition Market and Monopoly Market. An Oligopoly market is a type of market condition where there are two-three firms that dominate the market for a certain type of good or service. In this type of market condition, there are few companies, and the marketing decisions of each company affect the other. Hence, it can be said that in an oligopoly market, the marketing decisions of the competing firms are interdependent. Here, interdependence can be seen in any kind of decision, say pricing. When one company changes the price of its product or service, the effect of the change can be seen in the pricing of products and services of other companies.
Price and Output Determination Under Oligopoly
Price and Output
A determination under the Oligopoly market can be studied under two heads; One when there is a duopoly and one when there are a few firms. Here, we will discuss the price determination under Oligopoly in both the conditions:
When There is Duopoly
If in a sector there are only two companies that dominate the market, then such a condition is called duopoly. In such a market condition if, both the firms have identical products, they are likely to form a collaboration and make a joint profit. If in case the products of both the firms are a perfect substitute, then the firm with a lower cost, better goodwill and better client interaction will attract more customers. This will force the other company to lose business.
On the other hand, when the offerings of both the companies are differentiated, then each one has to keep a close watch on the other. In this kind of situation.
A firm with better quality products and the lesser price will earn abnormal profits.
When There is Oligopoly
In case there are more than two firms in a sector, and each one is considered a key player in that sector, then such a market is called oligopoly market. If all the firms produce the same products, then they will always promote collusion. This collaboration will help them earn profit jointly and would cause no harm to the other. On the other hand, if the products of all the firms are different, then they can lower or increase the price without any fear of losing a share in the market.
Theories on Price and Output Determination
No single theory can explain how the price is determined under Oligopoly. Several theories suggest various ways on how the price determination under oligopoly is done. Here we will discuss the important theories of price and output determination.
Cournot’s Model
According to Cournot, Each firm in a duopolist market thinks that instead of its action and effect on the market, The other firm will keep on producing the products. The Cournot model suggests that the most profitable pricing is when a firm’s output is two-third of its competitor’s output, and the price is also two-third.
Stackelberg Model
Under Stackelberg’s model, a leader and follower relationship is formed. The firm with good brand equity is called the leader, and the one with lower brand equity is called the follower. The leader decides the price and quality of the commodity, and then the follower observes the leader and decides the price, to maintain its market share.
Bertrand Model
Bertrand model can be explained when there exists a symmetry in the industry, i.e. there are firms which are equal in size and operations. The Bertrand model suggests that the firms set a low price until the price matches the cost of production. This is done to dominate the market.
Edgeworth Model
The Edgeworth Model suggests that each firm in a duopoly market thinks that his competitor will charge the same price, so it changes its price to make a greater profit. This thinking of the firm keeps the price war continued.
Explanation of Price and Output Determination Under Oligopoly
Under the oligopoly market, the number of firms varies.
Sometimes there are 2-3 firms, and sometimes there are 7-10 firms.
The commodities produced under the oligopoly market may or may not be homogenous.
Sometimes it so happens that firms consult each other before fixing the price of the commodities, to save each other from losses.
A firm can never be sure of its rivals' reaction to its decisions.
Determination of Price and Output In Oligopoly
There are various types of markets that exist and oligopoly is one of them. Oligopoly markets are mostly dominated by suppliers on a small scale. These are oligopoly markets that are found across the world in many sectors. Some of the oligopoly markets are competitive whereas some are not that significant. The authorities for the competition are called upon to supervise the coordinated actions as well as if there is low competition. Oligopoly markets can exist between the extreme conditions of a market which is either a perfect competition market or a monopoly market. It is the market where three are two or three firms that dominate the market for a good or service. Marketing decisions of each company and other companies affect one another thus; the oligopoly marketing decisions are interdependent in an oligopoly market. Interdependence can be any decision e.g. pricing of a particular product or service. This, in turn, will affect all the pricing of products and services of the other companies associated with a company.
Price and Output Determination in Oligopoly
There are two conditions under which the price and output determination in an oligopoly can be done. They are:
In the case of duopoly
In the case of fewer firms
In the case of duopoly, which means two companies that dominate the market in a sector and the firms have similar products. In such cases, the two firms or companies will form a collaboration with each other and have a joint profit. The firm which provides products with lower prices will attract more people and have better client associations. This can cause losses to the other company. On the other hand, if the companies have slightly different products, the firm which provides products of better quality with a low price will gain large profits.
In the case of fewer firms, each company is an essential player in that sector. Here, the collaboration will help both the companies and there won’t be a loss for either of them. When the products of the companies are different then they may increase or decrease the pricing without having the fear of losing shares in the market.
FAQs on Price and Output Determination Under Oligopoly
1. What are the defining characteristics of an oligopoly market?
An oligopoly is a market structure defined by a few key characteristics that create strategic interdependence among firms. The primary features are:
- Few Large Firms: The market is dominated by a small number of large sellers, leading to a high concentration ratio.
- Interdependence: This is the most crucial feature. The pricing and output decisions of one firm significantly impact the profits and choices of its rivals, forcing each firm to anticipate its competitors' reactions.
- Significant Barriers to Entry: High startup costs, patents, control over essential resources, or strong brand loyalty make it difficult for new companies to enter the market.
- Nature of the Product: The products offered can be either homogeneous (e.g., steel, cement) or differentiated (e.g., cars, smartphones).
- Non-Price Competition: To avoid destructive price wars, firms often compete through advertising, branding, product quality, and customer service.
2. How is the price of a product generally determined in an oligopoly?
There is no single, universally accepted model for price and output determination in an oligopoly due to the interdependence among firms. The outcome depends entirely on how they interact:
- Collusive Oligopoly: Firms may cooperate, either formally (through a cartel) or informally (tacit collusion), to act like a single monopolist. They collectively set a high price and restrict output to maximise their joint profits.
- Non-Collusive Oligopoly: Firms compete with each other. Each firm makes its decisions by trying to predict its rivals' moves. This can lead to outcomes like price wars (where prices are driven down) or price rigidity (where prices remain stable), as explained by the kinked demand curve model.
Therefore, the final price can range from a high, monopoly-like level to a lower, more competitive level.
3. Why is strategic interdependence considered the most important feature of an oligopoly?
Strategic interdependence is considered the most crucial feature because it is the source of all unique behaviour in an oligopoly. In a market with only a few players, any action taken by one firm—like launching a new ad campaign, changing a price, or introducing a new product—directly and noticeably affects the sales and profits of its rivals. This forces all firms to operate in a constant state of action and reaction, basing their decisions not just on their own costs and demand, but also on the anticipated moves of their competitors. This strategic game is absent in a monopoly (no rivals) and insignificant in monopolistic or perfect competition (too many rivals for one firm's actions to matter).
4. What is the main difference between a collusive and a non-collusive oligopoly?
The key difference lies in the nature of interaction between the firms. In a collusive oligopoly, firms choose to cooperate instead of competing. They make joint decisions on price and output, often through a formal agreement like a cartel, to maximise their collective profits as if they were a single monopoly. In contrast, in a non-collusive oligopoly, firms act independently and compete. Each firm makes its own strategic decisions about price and output, always keeping in mind the potential reactions of its rivals. This independent decision-making can lead to intense competition and price wars.
5. How does a cartel work to determine price and output for its members?
A cartel, as a formal collusive agreement, aims to maximise the joint profits of its members by acting like a single monopolist. The process typically involves these steps:
- The cartel first estimates the total market demand curve for the product.
- It then calculates the industry's marginal revenue (MR) and marginal cost (MC) curves.
- The profit-maximising output for the entire industry is determined where the industry's MR equals its MC.
- Using the market demand curve, the cartel sets the price that corresponds to this output level.
- Finally, the cartel allocates the total production among its member firms, usually through a system of quotas.
6. What causes 'price rigidity' or sticky prices in an oligopolistic market?
Price rigidity, or the tendency for prices to remain stable despite changes in cost or demand, is a common phenomenon in non-collusive oligopolies. It is often explained by the kinked demand curve theory. The logic is that each firm assumes its rivals will react differently to a price increase versus a price decrease:
- If a firm raises its price: It expects rivals will not follow suit, hoping to capture the firm's customers. This makes the demand for its product highly elastic, leading to a significant loss in market share.
- If a firm lowers its price: It expects rivals will immediately match the price cut to protect their own market share. This makes the demand inelastic, and the firm gains very few new customers while earning less revenue on all units.
This fear of losing out from either raising or lowering prices creates a strong incentive to keep the price stable at the prevailing level.
7. Why do firms in an oligopoly often prefer non-price competition over price wars?
Firms in an oligopoly often prefer non-price competition because direct price competition, such as a price war, can be mutually destructive and lead to drastically lower profits for all involved. By competing on other factors, firms can attract customers and build market share without triggering aggressive price retaliation from rivals. Common forms of non-price competition include:
- Advertising and Branding: To build strong brand loyalty and make demand less sensitive to price.
- Product Differentiation: Offering unique features, superior quality, or innovative designs.
- Customer Service: Providing better after-sales support, warranties, or a superior customer experience.
8. How can you distinguish an oligopoly from monopolistic competition and a pure monopoly?
You can distinguish these three market structures based on the number of firms, nature of the product, and barriers to entry:
- Number of Firms: A monopoly has one firm, an oligopoly has a few dominant firms, and monopolistic competition has many firms.
- Interdependence: Strategic interdependence is the defining feature of an oligopoly. It is absent in a monopoly and insignificant in monopolistic competition.
- Barriers to Entry: Entry is blocked in a monopoly and difficult in an oligopoly, but relatively easy in monopolistic competition.
- Nature of Product: A monopoly sells a unique product, an oligopoly can have homogeneous or differentiated products, while monopolistic competition always has differentiated products.
9. What is the strategic conflict between the 'price effect' and 'output effect' for an oligopoly firm?
When an oligopoly firm considers increasing its production, it faces a strategic conflict between two opposing effects on its total revenue:
- The Output Effect: Because the selling price is higher than the marginal cost, selling one more unit at the current price will increase the firm’s profit. This creates an incentive to produce more.
- The Price Effect: To sell that extra unit, the firm often must lower its price. This lower price applies not just to the new unit but to all existing units it sells, which decreases overall revenue. This creates an incentive to produce less.
A rational oligopolist will only increase output if the positive output effect outweighs the negative price effect, a trade-off that is central to their decision-making.
10. What are some common real-world examples of oligopolies in the Indian market?
Several key sectors in the Indian economy are clear examples of oligopolies where a few large firms hold most of the market share. These include:
- Telecommunications: Dominated by players like Jio, Airtel, and Vodafone Idea (Vi).
- Automobiles: The passenger car market is controlled by firms such as Maruti Suzuki, Hyundai, and Tata Motors.
- Airlines: A small number of carriers, including IndiGo, Air India, and Vistara, handle the majority of domestic air traffic.
- Soft Drinks: Primarily a duopoly between Coca-Cola and PepsiCo.
- Cement Industry: Key players include UltraTech Cement, Ambuja Cements, and ACC.
