Question

Firms in oligopoly must constantly think in terms of how other firms in the industry will react to whatever they do. Why do they have to do this? Why is it that firms in perfect competition and in monopoly don’t have to worry about how other firms will react? (Answer ahould be: 400 - 500 words)

Answer 1

Oligopoly is market structure in which few firms operate in the market selling similar goods. It is due to this similar nature of products that there is high inter-dependence among firms. It implies lowering of price by any firm A may invite similar lowering of price by its counterparts, because there is no point in selling at higher price which can take away all his customers to the other seller.

Firms in a oligoply type of market setting have almost similar customer base due to their similar products and thus any action which can take away the customer base of one seller cannot be ignored. Moreover, due to a very few firms in the market, each firm enjoys a large share of the market and thus is in a position to effectively influence operations and profitabiltiy of other sellers. For instance, collusion of two major firms in the market can lead to a complete wash out of other smaller firms from the market. Thus, it is necessary for firms to be aware of each other's actions.

Therefore, each firm is required to carefully analyze the possible consequences of its action before actually taking any action. It is very similar to games in game theory where the player has to decide what action to take depending on the payoffs associated with them. For example, a lowering of price may induce other sellers to reduce their price as well but it may not be the same in case of price increase. This may also sometimes lead to price rigidity in the market.

This is however not the case in either monopoly or perfect competition. In case of monopoly, there is only is single seller in the market and thus it leaves no room for any competitors. Perfect Competition on the other hand is characterised by large number of sellers acting just as a price-taker and thus have no control over the prices. Prices heree are determined by the market forces of demand and supply, and they face perfectly elastic demand curve. Thus, in this case there is no point in reacting to the actions of other firms.