Price and output determination under Oligopoly

A diversity of specific market situations works against the development of a single, generalized explanation of how an oligopoly determines price and output.

Pure monopoly, monopolistic competition and perfect competition, all refer to rather clear-cut market arrangements; oligopoly docs not.

“Oligopoly is an industry structure characterized by a small number of firms producing all or most of the output of some good that may or may not be differentiated”.

Price and Output Determination Under Oligopoly

• Cournot’s Model
• Stackelberg Model
• Bertrand Model
• Edgeworth Model
• Collusive Oligopoly

Cournot’s Model

As per Cournot’s model, each duopolist thinks that regardless of his actions and the effect upon the market of the product the other will go on producing the same commodity.

Cournot model says if the output of a firm is two- thirds of the competitive output and the price is two–third, this is most profitable i.e., monopoly price.

Stackelberg Model

The producer under a duopoly structure integrates the decision level of his rival. It then integrates in its own profit function and thereby maximizes profit. Thus, Leader-follower relation emerges.

Bertrand Model

According to this model, producers try to set lower the price until the price is equal to the cost of production.

Edgeworth Model

Each duopolist thinks that his rival will continue to charge the same price as he is just doing irrespective of what price he decided to set. No determinate equilibrium will exist under duopoly.

Collusive Oligopoly

According to this model, firms form a cartel. Firms jointly fix the price and output with a view to maximizing joint profit. For example, OPEC countries form a cartel.

Explanation of Price and Output Determination Under Oligopoly

We cannot explain the pricing and output decisions under duopoly a single theory. It will not be satisfactory. The reasons are:

(i) The number of firms may vary which is dominating the market. Sometimes there may be only two or three firms that dominate the entire market (Tight oligopoly). At another time there are 7 to 10 firms that capture 80% of the market (loose oligopoly).

(ii) The goods produced may or may not be standardized under oligopoly.

(iii) Sometimes the firms under oligopoly cooperate with each other in the fixing of price and output of goods. At another time, they choose to act independently.

(iv) Sometimes barriers to entry are very strong in oligopoly and at another time, they are quite loose.

(v) Sometimes A firm under oligopoly cannot certainly predict with the reaction of the rival firms if any changes occur in the prices and output of its goods. Considering the wide range of diversity of market situations, a number of models have been developed which explain the behavior of the oligopolistic firms.

• Price Determination in Non-Collusive Oligopoly:

In this case, each firm follows an independent price and output policy on the basis of its judgment about the reactions of his rivals. If the firms are producing homogeneous products, price war may occur. Each firm has to fix the price at the competitive level. On the contrary, in case of differentiated oligopoly, due to product differentiation, each firm has some monopoly control over the market and therefore charge near monopoly price.

Thus, the actual price may fall between the two limits:

(i) The Upper Limit of Monopoly Price and,

(ii) The Linear limit of Competitive Price.

Practically, there is every possibility to determine the exact price within these limits. However, there may be the following possibilities:

(i) There may be complete price instability in the market which results in price war.

(ii) The price may settle down at intermediate level due to the working of the market forces.

(iii) The firm may accept the prevailing price and adjust itself according to prevailing price.

So long as the firm earns adequate profits at the prevailing price, it may not try to change it. Any effort to change it may create uncertainties in the market. A firm will stick to that price to avoid uncertainties. Thus, the price tends to be rigid where oligopolist takes independent action.

• Equilibrium under Collusion:

The modern economists are of the view that independent price determination cannot exist for long in oligopoly. It leads to uncertainty and insecurity and to overcome them there is a tendency among oligopolists to act collectively by tacit collusion. In addition, the firms can gain the economics of production. All the firms in oligopoly tend to enlarge their size and lower their costs of production per unit and capture maximum share of the market.

Collusive oligopoly is a situation in which firms in a particular industry decide to join together as a single unit for the purpose of maximising their joint profits and to negotiate among themselves so as to share the market.