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Theories of oligopoly

A central aim of market theory is to formulate predictions about firms' price and output decisions in different situations, and, under such market forms as perfect competition and monopoly, economists can be fairly certain about likely outcomes: in the case of the former, price is set in the market through the free interaction of demand and supply, and individual firms passively take this price and equate marginal cost with marginal revenue to determine the best output; in the case of the latter, the firm will still equate MC with MR, but can restrict output and raise price in so doing.

However, under oligopoly no such certainty exists - where the number of firms in the industry is small and much interdependence exists between these firms, there will be a whole variety of ways in which individual oligopolists may respond to rivals' price and output decisions. Consequently, several different models of oligopoly have been developed, underpinned by different analytical approaches and assumptions about the nature of oligopolistic, reactive market behaviour.

Unfortunately, therefore, for students of economics, there is no single, general and all-embracing theory of oligopoly to explain the nature of the business world around us! Particular theories of price and output determination under oligopoly should therefore be seen as illustrative of what might happen under certain sets of assumptions about the reactions of rival oligopolists.

The various models of oligopoly can be classified under two main headings: non-collusive or competitive oligopoly and collusive oligopoly. We shall consider each in turn:

Non-collusive or competitive oligopoly

In this case, each firm will embark upon a particular strategy without colluding with its rivals, although there will of course still exist a state of interdependence, as possible reactions of rivals will have to be considered.

There are three broad approaches that might be adopted by firms in a situation of competitive oligopoly:

  • Observe the behaviour of rival firms but make no attempt to predict their possible strategies on the basis that they will not develop counter strategies. This was the essence of the earliest model of oligopoly developed by Cournot as far back as 1838: each firm acts independently on the assumption that its decision will not provoke any response from rivals; this is not generally accepted nowadays as providing a useful framework in which to analyse contemporary oligopoly behaviour.
  • Make the assumption that a given strategy will provoke a response from competitor firms, and assess the nature of the response using past experience. This is the basis of the kinked demand curve model, described below, in which it is assumed that any price cut by one oligopolist will induce all others to do likewise, whilst a similar price increase would not be matched.
  • Formulate a strategy and try to anticipate how rivals are most likely to react, and be prepared with suitable counter measures.

This is the basis of game theory in which competition under oligopoly is seen as being similar to a game of chess in which every potential move must be regarded as a strategy, and possible reactive moves by opponents and subsequent counter-moves must all be carefully considered. The application of the theory of games to economics was first introduced in 1944 by J. von Neuman and O. Morgenstern. Games theory involves the study of optimal strategies to maximise payoffs, taking into account the risks involved in estimating reactions of opponents, and also the conditions under which there is a unique solution, such that an optimum strategy for two opponents is feasible and not inconsistent. A zero-sum game is one in which one player's gain is another's loss, and a non-zero-sum game is one in which a decision adopted by one player may be to the benefit of all.

In this discussion of non-collusive oligopoly, we shall focus our attention on the second of the three broad approaches identified above.

The kinked demand curve theory

This theory of oligopoly was first developed in 1939 by Paul Sweezy in the U.S.A, and by R. Hall and C. Hitch in the U.K, to explain why oligopolistic markets would be characterised by relatively rigid prices, even when costs increase.

As mentioned previously, the kinked demand curve model makes the assumption of an asymmetrical reaction to a change in price by one firm: a decrease in price by one firm will cause a similar reduction of price by other firms eager to protect their market share, whilst a price increase by one firm will not be matched and its market share will be eroded. This is shown in Figure 1 below.

Figure 1 Kinked demand curve

Price is initially set at OP1, at the kink of the demand curve, and the oligopolist sells an output of OQ1. If the firm tries to reduce price to OP2 in order to sell more, other firms would match this reduction so that sales would increase only slightly, or more technically, by a less than proportionate amount, to OQ2. The demand curve would be inelastic and the reduction in price would not represent a sound strategy as total sales revenue, and probably profit levels, would both fall; clearly the area OP1 x OQ1, representing initial revenue, is greater than OP2 x OQ2, the producer's revenue after the reduction in price. The alternative ploy of raising price to OP3 would also be unsound as none of the other oligopolists would follow suit, and a large or more than proportionate fall in demand would follow.

Here, the demand curve would be elastic and the change in price would again cause total revenue to fall - OP3 x OQ3 is smaller than OP x OQ. The logical conclusion from this analysis would therefore be that oligopolists would benefit from keeping prices stable so long as all could enjoy reasonable profits at the established price.

The kinked demand curve theory also has other implications. A normal demand curve becomes less elastic as price falls, but the oligopolist's demand curve becomes less elastic suddenly at the kink. Mathematically, this causes the MR curve to suddenly change to a different position, as can be seen in Figure 2, so that a discontinuity exists along the vertical line YZ above output OQ1.

Figure 2 The oligopolist's absorption of a rise in costs

This implies that the MC curve can increase or decrease between this discontiuity, without necessitating a change in the profit maximising output OQ1 or price OP1 - the oligopolist will absorb the higher costs. According to normal demand and supply analysis, an increase in costs would cause a fall in output and an increase in price. An example of cost absorption in practice is when the price of crude oil rises and petrol companies wish to increase price, but do not as no company wants to be the first to do so.

Criticisms of the kinked demand curve theory

  • The theory assumes that oligoplists perceive a kink at the current market price i.e. at point X, but it does not explain how or why the original price was chosen. As a theory, it is therefore incomplete as it does not deal with price determination.
  • Price stickiness or rigidity in oligopolistic markets might, in practice, be more apparent than real; for example, in the market for new cars, published catalogue prices may remain constant over relatively long periods, but the common practices of offering discounts, and items such as free insurance, cash- back deals and interest -free credit all amount to ways of reducing price. In fact, the theory takes no account of the various forms of non-price competition which characterise most oligopolistic markets.
  • There is little empirical evidence from firms operating in oligopolistic markets to substantiate the kinked demand curve hypothesis that a change in price by one firm will always evoke a predictable and uniform response from its rivals. In practice, a very wide range of possible reactions is probable.
  • Any perceived stability in prices in oligopolistic markets may not be due to the existence of a kinked demand curve, but may occur for other reasons such as the administrative expense and inconvenience of altering prices too regularly.

Cut-price competition (predatory pricing)

Although oligopolistic markets tend to be characterised by relative price stability in the longer term, occasionally short bursts of price warfare break out. This typically occurs when the dominant players attempt to defend and/or raise their market shares because the total level of demand in the market is insufficient to enable all to achieve their intended level of sales, and overcapacity results. The price cutting has the effect of reducing the profits of all the combatants in the short run, with consumers gaining the temporary benefit of lower prices.

However, the likely outcome is that the weakest firms, i.e. those with the highest costs, will be driven into bankruptcy, with a new era of relative price stability eventually emerging. If too many casualties are caused, consumers are likely to face greater monopoly power and possibly higher prices. There have been numerous examples of price wars in recent years with the most notable battles occurring on the petrol forecourts and in the retail grocery and travel businesses.

Collusive oligopoly

A central feature of competitive or non-collusive oligopoly is the existence of uncertainty amongst the interdependent firms. Although these firms may utilise informed guesswork and calculation to cope with such uncertainty, they can never be entirely sure as to how their competitors will react to any given marketing strategy. Thus instead of living with uncertainty, firms may adopt a policy of reducing, or even eliminating, it by some form of central co-ordination, co-operation or collusion. Such collusion may occur where firms attempt to maximise their joint profits, by reaching agreement on their price, output and other policies, or where firms seek to prevent the entry of new firms into the industry so as to protect their longer run profits.

In the next section we consider the forms that such collusion may take. Click on the right arrow at the top or bottom of the page to have a look at this section.