There are following three important economic models or types of oligopoly, as:
(1) Price and output determination under collusive oligopoly.
(2) Price and output determination under non-collusive oligopoly.
(3) Price leadership model.
(1) Price and Output (Profit) Determination under Collusive Oligopoly:
Definition of Collusive Oligopoly:
The term ‘collusion’ implies to ‘play together’. When firms under oligopoly agree formally not to compete with each other about price or output (profit), it is called collusive oligopoly. The firms may agree on setting output quota, or fix prices or limit product promotion or agree not to ‘poach’ in each other’s market. The completing firms thus from a ‘cartel’. The members of firms behave as if they are a single firm.
For price output determination in a collusive oligopoly, we assume that (i) there are only three firms in the industry and they form a cartel, (ii) the products of all the three firms are homogeneous and (iii) the cost curves of these firms are identical.
Under the assumptions stated above, the equilibrium of the industry under collusive oligopoly is explained with the help of a diagram.
In this figure 17.4, the industry demand curve PD consisting of three firms are identical. So is the case with the MR curve and MC curve which are identical. The cartel’s MR curve intersects the MC curve at point L. Profits are maximized at output OQ1, where MC = MR. The cartel will set a price OP1, at which OQ1, output will be demanded.
Having agreed on the cartel price, the members may then complete each other using non price competition to gain as big share of resulting sales OQ1 as they can.
There is another alternative also. The cartel members may agree to divide the market between them. Each member would given a quota. The sum of all the quotas must add up to Q1. In case the quotas exceeded OQ1 either the output will remain unsold at OP price or the price would fall.
(2) Price and Output Determination under Non-Collusive Oligopoly:
It will be explain with the help of Kinked Demand Curve Model.
The Kinked Demand Curve Model:
The kinked demand curve model was developed by Paul Sweezy (1939). According to him, the firms under oligopoly try to avoid any activity which could lead to price wars among them. The firms mostly make efforts to operate in non price competition for increasing their respective shares of the market and their profit. An analytical device which is used to explain the oligopolistic price rigidity is the Kinked Demand Curve.
This model operates on fulfilling certain conditions which, in brief, are as under:
(a) All the firms in the industry are quite developed with or without product differentiation.
(b) All the firms are selling the goods on fairly satisfactory price in the market.
(c) If any one firm lowers the price of its product to capture a larger share of the market, the other firms follow and reduce the price of their goods in order to retain their share of the market.
(d) If one firm raises the price of its goods, the other firms will not follow the price increase. Some of the customers of the price raising firm will shift to the relatively low priced firms.
Mr. Paul Sweezy used two demand curve concepts to explain the model. These are reproduced below:
In the figure 17.5 DD/ is a kinked demand curve. It is made up or two segments DB and BD/. The demand curve is kinked or has a bend at point B. The kink is formed at the prevailing market price level BM ($10 per unit). The segment of the demand curve above the prevailing price level ($10) is highly elastic and the segment of the demand curve below the prevailing price level is fairly inelastic. This is explained now in brief.
Explanation with Example:
(a) Price increase. If an oligopolistic raises the price of his products from $10 per unit to $12 per unit, he loses a large part of the market and his sale comes down to 40 units from 120 units. There is a loss of 80 units in sale as most of his customers are now purchasing goods from his competitor firms who are selling the goods at $10 per units. So an increase in price above the prevailing level-shows that the demand curve to the left of and above point B is fairly elastic.
(b) Price reduction. If an oligopolistic reduces the prices of its goods below the prevailing price level BM ($10 per unit) for increasing his sales, his competitors will also match price changes so that their customers do not go away from them. Let us assume that Oligopolist has lowered the price to $4.0 per unit. Its competitors in the industry match the price cut. The sale of the oligopolist with a big price cut of $.6.0 per unit has increased by only 40 units (160 – 120 = 40). The firm does not gain as the total revenue decreases with the price cut. The BD/ portion of the demand curve which lies on the right side and below point B is fairly inelastic.
(c) Rigid prices. The firms in the oligopolist market, have no incentive to raise or lower the prices of the goods. They prefer to sell the goods at the prevailing price level due to reaction function. The price BM ($10 per unit) will, therefore, tend to remain stable or rigid, as every member of the oligopoly does not see any gain by lowering or raising the price of his goods.
(3) Price Leadership Model:
The firms in the oligopolistic market are not happy with price competition among themselves. They try various methods to maximize joint profits. Price leadership is one of the means which provides relief to the firms from the strains of price competition.
The firms in the oligopolistic industry (without any formal agreement) accept the price set by the leading firm in the industry and move their prices in line with the prices of the leader firm. The acceptance of price set by the price leader firm maximizes the total profits of each firm in the oligopolistic industry.
The main assumptions of price leadership model under oligopoly are as under:
(a) There are two firms A and B in the market.
(b) The output produced by the two firms is homogeneous.
(c) The firm A being the low cost firm or a dominant firm acts as a leader firm.
(d) Both of the firms face the same demand curve.
(e) Each of the two firms has an equal share in the market. The price and output determination under price leadership is now explained with the help of the diagram below.
In this figure 1 7.6, DD/ is the demand curve which is faced by each of the two firms. MR is the marginal revenue curve of each firm. MCa is the marginal cost of firm A and MCb is the marginal cost of firm B. We have assumed that the firm A is a low cost firm than firm B. As such the MCa lies below MCb.
The leader firm using the marginalistic rule of MC = MR is in equilibrium at point E. The firm A maximizes profits by selling output OM and setting price MP. The firm B is in equilibrium at point F where MCb = MR. The firm B maximizes profits by producing ON output and selling it at NK price. The firm B has to compete firm A in the market, if the firm B fixes the price NK per unit, it will not be able to compete with firm A which is selling goods at MP price per unit.
Hence, the firm B will be compelled to follow the leader firm A. The firm B will also charge MP price per unit as set by the firm A. The firm B will also produce QM output like the firm A. Thus both the firms will charge the same price MP and sell each of them OM output. The total output will thus be twice of OM.
The firm A being the low cost firm will maximize profits by selling OM output at MP price. The profits of the firm B is lower than of firm A because its costs of production is higher than of firm A.
After studying the pricing and output decisions under various forms of oligopoly, the main conclusion drawn is that allocate and productive efficiency are unlikely to be achieved under them. However, Schumpeter’s view. Is that oligopolists have both the incentive and financial and technical resources to be more technological progressive than competitive firms.