In this series of posts covering market structures, we have so far covered perfect competition and monopolistic competition. Today we will look into the third type of market structure – oligopoly and its types.
To recap, in an oligopoly there are few firms competing in the market and the firms are dependent on each other. That is, the price decision of one firm causes the other firms to review their price decision. The barriers to entry in this market are high.
There are four oligopoly models that try to explain the pricing in such a market;
Kinked demand curve model
Cournot duopoly model
Nash equilibrium model
Stackelberg dominant firm model
Kinked demand curve model believes that an increase in price by one firm is not always followed by a price increase by the other firms, but a decrease in price is always followed suit. The firms in this model believe that the demand is elastic beyond a certain price and therefore will not rise their prices above that level because doing so will cause them to lose market share as even a small increase in price beyond that level will cause a large decrease in the quantity demanded. However a decrease in price by one firm will cause others follow in the bid not to lose out on market share. That price level beyond which the demand curve is believed to be elastic is called the kink in the curve, because above it the demand curve becomes flatter. Therefore the quantity and price at which the demand curve becomes kinked is the optimal profit maximising quantity and price.
Another model of oligopoly pricing is the Cournot duopoly model. This model assumes that there are only two firms in the market (duopoly). Each firm knows the quantity supplied by the other in the last period and assumes that the other firm will supply the same quantity in the next period. By deducting this quantity from the market demand, they determine their own demand curve and the profit maximising quantity. This makes sense until both the firms choose the same quantity. At that point there is no additional profit to be gained.
The market price in this model will be less than the price in a monopoly where there is only one firm but higher than the price in a perfect competition.
The third oligopoly pricing model is the Nash equilibrium which is based on prisoner’s dilemma. In a prisoners dilemma there are two prisoners, A and B who have committed a crime together. Each is offered a deal separately. If A confesses and B remains silent, A can go free and B will get a 10 year sentence. If B confesses and A remains silent, B can go free and A gets a ten year sentence. If both remain silent they both get a 6 month sentence. If both confess each gets a 2 year sentence.
The best outcome would be both remain silent but both cannot count on each other not to cheat and confess. So the best option for each prisoner is to confess and either go free or receive a two year sentence and escape the 10 year sentence.
Similarly the Nash oligopoly model assumes that there are two firms in the market and they both have agreed to charge a high price. However each cannot count on the other not to cheat and lower the price. Profits for both are higher by keeping their agreement. However since each cannot count on the other not to lower the price, the best option is for both to cheat and lower the price and not lose market share.
The final model is the dominant firm model. In this model there is a single firm which has a large market share and therefore is the dominant firm. The dominant firm determines the price in the market and the other firms are price takers.
The other competing firms in the market maximise their profits where MC = P by supplying quantity QCF. The dominant firm maximises its profit at P by supplying quantity QDF.
A decrease in price by the other competitive firms will cause the dominant firm to decrease its price thus causing the other firms to lose market share and the dominant firm to gain further market share. Eventually in the long run the competing firms will be forced to leave the industry.
Therefore as it can be clearly seen from the four models that the actions of the firms in an oligopoly are dependent on each other, the best route for them would be to act in collusion with each other.
That’s all in this post …..Thanks for reading….in the next post we will study the fourth market structure, Monopoly, in detail…wait for the post…see ya until then…
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