Question

Provide a discussion of a contemporary oligopoly, outlining its pricing decisions and reactions to price changes. (Answer should be 1.5 typed pages long)

Answer 1

Oligopoly is a market structure in which there are a few large firms in the market that compete for market share. As opposed to perfect competition, the number of firms is small and entry is restricted. A unique feature of contemporary oligopoly is interdependence of firms. Since the number of firms is small, each firm watches the actions of its rivals and reacts accordingly.

Contemporary oligopoly can take two shapes: firms either collude together and form collusive oligopoly or they do not collude. There are many cases of collusive oligopoly. These include cartels, price leadership model and mergers and acquisitions. While all of these fall under collusive oligopoly, pricing decisions made under these structures are different.

Firms form cartels and behave as a monopolist as a whole. Output and prices are fixed according to firm sizes, where output is divided between firms proportionately and hence profits are shared. Monopoly price is charged under such a collusion.

Another case of collusion is price leadership model. In such a case, a dominant firm sets price and the other firms follow suit. There are various cases of dominant firms- it could be the oldest firm in the market, or the most reputed firm, or the firm incurring lowest cost. Under this market structure, all the firms charge similar or same prices, and profits and losses depend on individual cost curves. Even when a firm is incurring losses, it does not charge a higher price under price leadership model.

Further, mergers and acquisitions also fall under collusive oligopoly. Firms often collude with each other to reap cost benefits or increase market share. Vertical integration is the case where a firm colludes with its supply chain- for example merger of a shoe company with a leather-producing company. In such a case, collusion of firms reduces the cost of production substantially.

Under horizontal integration, rival firms collude as a result of which their market share and market power increases. These firms also reap the benefits of economies of scale and share their expertise, knowledge and personnel all of which ultimately leads to lower costs. Price decisions under mergers and acquisitions are based on costs incurred by the firms. Since mergers and acquisitions often result in fall in costs, prices charged by these firms also fall.

Finally, there is non-collusive kind of oligopoly where firms behave as rivals. This is best explained by Paul Sweezy’s kinked demand curve. This model is purely based on pricing decisions made by firms and reactions of rival firms. Sweezy postulates that oligopolists face price and quantity rigidity

Under this model, the demand curve of each oligopolist faces a kink. The upper part of the demand curve is more elastic than the lower part of the curve. This is because the model is based on the assumption that firms react to price changes of its rivals, but only when a rival firm lowers its price. If any firm in an oligopoly structure lowers its price to increase its market share, all other firms will follow and hence there will be no change in the market structure. Hence, a lower price will not bring about a change in quantity demanded, and so the lower part of the demand curve is relative inelastic.

On the other hand, if one firm increases price, no other firms follow the pattern. This results in a loss of consumer base as they shift to other firms. Therefore, the upper part of the demand curve is relatively elastic. Note that because of the kink in the demand curve, the marginal revenue curve is broken at the point of the kink resulting in price and quantity rigidity.

Therefore, interdependence in oligopoly market induces firms to react in different manners and make their price decisions.