Pricing And output under oligopoly

Oligopoly: Meaning

Oligopoly is a market structure where there are a few sellers selling either identical products or differentiated products. If the products are identical sellers,it is the case of pure oligopoly; if the products are differentiated, it is the case of differentiated oligopoly. A single seller occupies a position of sufficient importance in the product market as changes in his price activities do have repercussions on the others in the market. The other sellers react to the market activities of the one, and their reactions, in turn, have repercussions on him. The individual seller is aware of this inter-dependence and in changing his price, output, sales promotional activity, or quality of product, he must take the reasons of others into account. Thus a few seller in oligopoly make all the difference, in the sense that each seller is producing a large and a significant portion of the market output so that its actions and reactions are of importance to the other sellers. It is very unlike a firm in perfect competition, where it is producing a small and insignificant portion of the market output and where it cannot influence the price by its own individual action.Oligopoly pricing is not as neat and precise as the theories of perfectcompetition and monopoly. It is due to the uncertainty with regard to the rival's reaction to the various kinds of activities on his part. It is also due to the fact that oligopoly covers a wide range of cases, each with its unique characteristics. Thus, the oligopoly situation cannot be generalised like the position of other market structures. As such, several models have been developed which cover a large part of the oligopoly situations in the real world.

2 . Cost, Demand and Product Differentiation

Here it is assumed that the oligopolistic firm buys its resources competitively. Its cost curves are like those of purely competitive firm and pure monopolist. In other words, the costs of a firm in oligopoly can be rising upwards.It is the demand conditions that differentiate oligopoly from other market structures. Since what one firm is able to do in the market is conditioned by ways in which other firms react to the market activities of the one. The extent of this oligopolistic uncertainty is highly variable from case to case. In certain cases the firm knows the actions and reactions and so can be certain about its demand curve while in most other cases these actions and reactions are not known and knowable and it is very diffcult to predict the demand curve under such a situation. Thus, when the firm does not prossess this knowledge, the position and the shape of the demand curve it faces, are highly conjunctural. What makes oligopolistic market structure different from others is the interdependence of demand among the firms of an industry.

3 . Pure and differentiated Oligopoly:-

When the firms in oligopoly are selling identical products, it is called pure oligopoly and when they are selling slightly differentiated products, it is called differentiated oligopoly. The distinction between differentiated oligopoly and pure oligopoly does not really matter in our analysis of pricing and output. As a practical matter, sellers in most oligopolistic industries sell differentiated products. Nevertheless, some of the fundamental principles of differentiated oligopoly, as well as pure oligopoly, are seen most clearly when we assume that pure oligopoly exists. For example, instead of a single market price, under differentiated oligopoly, a cluster of prices may occur. Televisions may range between Rs. 15580 to 25,000. The various price levels reflect consumer's vies regarding the respective qualities of the different seller's wares and the availability of different markets. The analysis is simplified if we assume that pure oligopoly exists. It does not distort the basic pricing principles seriously, by reducing a cluster of prices to single market pricefor the product.
4 . Collusion Versus Independent Action

There is a tendency among the oligopolistic firms to form a collusion although collusive arrangements are very difficult to maintain. This tendency towards collusion is indicated by the three types of incentives that exist in the oligopolistic market structure. First, the firms in oligopoly can increase their profits by decreasing the competition and acting in a more or less monopolistic fashion. Second, collusion can decrease the oligopolistic uncertainty which is so much the characteristic of oligopolies and which reduces the profits considerably by not enabling the firms to act in the monopolistic manner. In the third place, collusion among the firms alreadyin the industry will facilitate blocking of newcomers from entering into that industry. However, once the collusion comes into existence, there is also tendency on the part of a single firm breaking away from the collusion in order to enhance the profits. It is possible to classify oligopoly on the basis of the degree of collusion present in its structure. The following three forms may be distinguished :

4.1. Perfect Collusion
4.2. Imperfect Collusion
4.3. Independent Action on the part of Individual Firms

4.1. Perfect Collusion

Perfect collusion can take the shape of cartel arrangements. A cartel is a formal organisation of the producers within a given industry. Its purpose is to transfer certain management decisions and functions of individual firms to a central association in order to improve the profit positions of individual firms. Cartels are prohibited in some countries but they have existed extensively in
some countries and on an international plane. The extent of the functions transferred to the central organisation varies in different cartel situations. We will make a mention of only two representative cartel situations.The first is the Centralised Cartel ; it implies a complete cartel control over the member firms. The second is the Market Sharing Cartel meaning thereby that only fewer functions are transferred to the central association.The centralized cartel implies that decision making with regard to pricing, output sales and distribution of profits is accomplished by the central association, which markets the product, determines the prices, determines the output that each firm is to produce and divide profit among member firms. Member firms are represented in the central association, and cartels policies presumable result from exchange of ideas, negotiations and compromises. The market sharing cartel is a somewhat looser form of organisation. The firm forming the cartel agree on market shares with or without any understanding regarding prices. Member firms do their own marketing but are careful to observe the cartel agreement.

4.2. Imperfect Collusion

Very often cartels are not allowed and there is a legal ban on the formation of cartels. So formal organisation having the shape of a cartel cannot exist. Things cannot be settled in black and white. As such, informal agreements or tacit arrangements are arrived at in order to avoid the legal implications. Under such form of agreements, the firms agree to fix prices and outputs and thus escape from prosecution under the anti-trust laws. The price leadership arrangements of a number of industries—steel, automobiles, sugar and others are typical of this class. Tacit unorganised collusion can occur in
many other ways also. Gentleman's agreements of various sorts with regard to pricing, output, market sharing and other activities of the firms within the industry can be worked out on the lunch table or on some social occasions of different kinds.

4.3. Independent Action

Many a time, collusive agreements are not arrived at instead firms of an industry go it alone. There are two possible outcomes of such independent action. First the firms acting despondently often do  not know the reactions of other firms to its own price formation. It very often invokes retaliatory action which results into price wars. Second, in some industries independent action may be consistent with industry's stability over time. Firms may have learnt by experience what the reactions of rivals will be to actions on their part and may voluntarily avoid any activity that will rock the boat. It is just possible that the management of each firm is well satisfied with present prices, outputs and profits and is content to let things continue as they are rather than change and start a chain reaction in the shape of price war. Such a situation is described as Price Stability.We shall take now these models one by one.

5 . Collusive oligopoly Models:

5.1. Perfectly Organised Collusive Oligopoly Models

Let us first take up the two cases of perfectly organised collusive oligopoly for the purpose of determining price and output. The analysis assumes short run where the individual firms do not have the time to change their plant size nor is it possible for new firms to enter the industry.
(i) The Completely Centralized Cartel : It refers to collusion in its most complete form. Its purpose is the joint or monopolistic maximization of industry profits by several firms of the industry. Ideal or complete monopolistic price and output determination by the cartel will rarely be achieved in real world, although it may be approached in some instances. In a completely centralised cartel, individual firms in an industry surrender the powers to make price and output decisions to a central association. Quotas to be produced are determined by the association and so is the distribution of industry's profits. Policies adopted are to be those which will contribute most to total industry profits. To simplify the analysis, let us take two firms in an industry producing identical products. These two firms join and form a central association to which they delegate the authority to decide not only the total quantity and the price at which it must be sold so as to attain maximum group profits, but also the allocation of production among the cartel members and the distribution of the maximum joint profits among the participating members. The authority of the central association is complete clearly the central association will have access to the cost figures of the individual firms and for the purposes of the present model we unrealistically assume that the association can have its market demand curve and the corresponding MR curve. From the horizontal summation of the MC curves of the individual firms, the market MC curve is derived. The firm acting as a multi-plant monopolist, will set the price as defined by the intersection of the industry MR and the MC curves.

The Centralised Cartel

The cost structures of the individual firm are shown in the fig. 1-A and 1-B. From the horizontal summation of the MC curves we obtain the market MC curve. This is implied by the profit maximization goal of the cartel; each level of the industry output should be produced at the least possible cost. This if we add the output of A and B that can be produced at the same MC, clearly the resulting total is the output that can be produced at this common, lowest cost. Given the demand curve DD in fig. 1-C; the monopoly solution which maximises joint profits is determined by the intersection of MR and MC at the point i.e. E. The total output is X and it will be sold at price P. Now the central association allocates the production among firm A and firm B as a monopolist will
do, that is by equating the MR with the individual MCs. Thus, firm A will produce X1 and firm B will produce X2. Note that the firm with lower costs produces a large amount of output. However this does not mean that it will also take a larger share of the attained joint profit. The total industry profit is the sum of the profits from the output of the two firms denoted by the shaded areas of figures 1-A and 1-B. The distribution of profits is decided by the central association of the cartel.

(ii) The Model of Market-Sharing Cartel :

This form of collusion is more common in practice because it is more popular. The firms agree to share the market, but keep a considerable degree of freedom concerning the style of their output, their selling activities and other decisions. We illustrate the market-sharing cartel with the determination of quotas. This method of sharing the market is the agreement on quotas, that is, agreement on the quantity that each member may sell at the agreed prices. If all firms have identical costs the monopoly solution will emerge with the market being shared equally by the member firms. For example, if there are only two firms with identical costs, each firm will sell at the monopoly price one-half of the total quantity demanded in the market at that price. Suppose establish the rule of a single price in the product market.

Market-Sharing Cartel :

Identical Cost Conditions with two firms : In the figure 2, the industry demand curve for the product is DD. Each firm faces demand curve dd for its own output. Each has a short run average cost curve and a short run marginal cost curve represented by SAC and SMC respectively. The marginal revenue curve faced by each firm is MR. Profit maximizing output for each firm will be X, at which SMC is equal to MR. Each firm will want to charge price p. Together the firms will produce an industry output of X that will fill the market at price p. Such will be the case since dd lies halfway between the market demand curve and the price axis.

Another popular method of sharing the market is the definition of a region in which each firm is allowed to sell. In this case of geographical sharing of the markets, the price as well as the style of the product may differ. There are many examples of regional market-sharing cartels, some operating at international level. However, even a regional split of the market is inherently unstable. The regional agreements are often violated in practice, either by mistake or intentionally, by the low-cost firms who have always the incentive to expand their output by selling at a lower price openly defined or by secret price concessions or by reaching adjacent markets through advertising.It should be obvious that the cartel models of collusive oligopoly are ‘closed’ models. If entry is free, the inherent instability of cartels is intensified, the behaviour of the entrant is not predictable with certainty. It is not certain that the new firm will join the cartel. On the contrary, if the profits of the cartel members are lucrative and attract new firms in the industry, the newcomer has a strong incentive not to join the cartel, because in this way its demand curve will be more elastic, and by charging a slightly lower price than at the cartel, it can secure a considerable share in the market on the assumption that the cartel members will stick to their agreements. Cartels being aware of the dangers of entry, will either charge a low price so as to make entry unattractive or may threaten a price war on the newcomer. If entry occurs and the cartel carries out its threat of price war, the newcomer may still survive, depending on his cost advantage, and his financial strength in withstanding possible losses during the initial period of his establishment, until he reaches the size which will allow him to reap the full scale economies that he has over those enjoyed by the existing firms.