"In oligopoly markets price and output decisions are indeterminate." Explain and discuss.

P

                        Elastic demand above SP

SP

                                        Inelastic demand below SP

                                                

                                                D        

                                                           Q

                Figure 1.0: Kinked Demand Curve

This is illustrated in Figure 1.0 Kinked Demand Curve (Page 2) where: P is the Price, SP is the Stable Price, D is the Demand and Q is the Quantity. Oligopolists are price makers. Above the "kink" in the demand curve, demand is relatively elastic (flat). An increase in price would not be copied by competitors, and consumers would shift to the cheaper product, causing a large decrease in QD from a given increase in price. The segment of the demand curve below the "kink" is relatively inelastic (steep). A decrease in price would be copied by competitors and each firm keeps its original market share, implying a small decrease in QD from a given decrease in price. The price established at the "kink" changes very infrequently. A price cut would have little effect on sales, because competing firms would follow and cut their prices also. This would mean the demand curve in this area would be very inelastic. Hence we end up with a kinked demand curve where there is a tendency for prices to be quite stable as none of the firms in the industry have much incentive to change prices.

 

The price leader model shows how a firm with sufficient market power can decide on a price change which its competitors will tend to follow.

P                                

                    i              a                MC                

                                         t               

PL                                               AR D market

                                        AR D leader        

                              MR leader

                       QL                         QT                        Q

Figure 2.0 A Price leader maximizing profits

In Figure 2.0 A Price leader maximizing profits, the price leader chooses to produce QL at a price of PL: at the point i on its demand curve (where MC = MR). Other firms follow that price. The total demand is then QT. Often, all the competitors will be facing similar changes in costs and all follow the lead given by the price leader. Therefore price leadership is a strategy in which a dominant firm sets the price for an industry and the other firms follow in cases of both price increases and decreases. Additionally this is an informal process that assumes firms do not collude. The price leader will be the dominant firm in the industry and perhaps also the largest.

A Cartel is a group of firms formally agreeing to control the price and output of a product. They agree to limit output in order to keep prices higher then they would be if there was perfect competition. The well known example is OPEC which at times in the past has restricted output so that world oil prices would rise. This is different from a standard cartel because governments are involved. Firms which collaborate in this way, replace competition with cooperation in order to reap monopoly profits.

P1                                        Industry MC

                                                Industry D = MR

                                 Industry MR

                                        

                       Q1                                Q                

Figure 3.0: Profit-maximizing Cartel

In Figure 3.0 the cartel’s MC curve is the horizontal sum of the curves of its members. The profits are maximized at Q1 where MC=MR. The cartel may agree to a minimum price or limit their range of products, output or non-price competition. However, if one firm “cheats” it would increase its output above the agreed level and increases profits.

John Vickers, Director General, Office of Fair Trading said of cartels:

"Cartels take money off their customers by rigging markets against them. The OFT will not hesitate to use its powers to unearth, stop and punish cartels. Firms that operate a cartel can now be fined up to 10% of their UK turnover for up to three years." – (Vickers, J oft.gov.uk/:2004) Director General, Office of Fair Trading.

In most developed countries competition policy makes cartels illegal. By restricting competition they lower output and increase prices. Additionally a cartel is hard to maintain because the high prices act as an incentive for more firms to enter the industry.

Finally the fourth model used in market prices and output decisions is the non-price competition model. This involves competitive activity other than reducing the price. Oligopolies often compete through non-price methods such as advertising and product differentiation. This firms use non-price competition because it reduces the risk of lower profits associated with price competition. Additionally changes in price would be easy for competitors to match, while it is more difficult to compete with clever or important product improvement. Branding is a particularly visible form of non-price competition.

Conclusion

The key point to make regarding markets price and output decisions are that there is no single theory of oligopoly (equivalent to that of perfect competition or monopoly) that exists because the behaviour of oligopolistic firms are determined by the strategic reaction and behaviour of their rivals and these reactions will differ according to the market situation. Therefore the markets price and output decisions are indeterminate. We have four basic models or theories to explain why these decisions are made, the kinked demand curve, price leadership, cartels and finally non-price competition. A firm in an oligopoly market situation may use one of the above theories to strategize for its rivals. Economists use game theory to examine the best strategy a firm can adopt for each assumption about its rivals’ behaviour.

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