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BUSINESS

ECONOMICS
ASSIGNMENT - 1

NAME: JANVI KAPOOR


ROLL NO: 405 BBA (B & I) 1st semester 1st shift
PRICING UNDER OLIGOPOLY
The term, 'OLIGOPOLY', is derived from two greek words. 'Oligoi'
meaning few and 'Pollen' meaning to sell. Oligopoly is an imperfect
market where there are a few sellers in the market, producing either
identical products or producing products which are close but not
perfect substitutes of each other.
Oligopoly differs from monopoly and also from perfect competition
and monopolistic competition in many respects like the number of
firms, the number of firms , the nature of the product etc. Oligopoly
is also known as Limited Competition, Incomplete Monopoly,
Multiple Monopoly etc. It is also called 'Theory of Games'.
Oligopoly is competition among the few. There is great deal of
interdependence among them. Each oligopolist formulates its
policies regarding price or output influences the sales and profits of
competitors. Because of their interdependence Oligopolists face a
situation in which the optimal decision of one firm depends on what
other firms decide to do, and in which there is opportunity for both
conflict and cooperation. The special case of a market dominated by
two firms is called a ‘Duopoly’.

The following are some of the salient features of


oligopoly:

 A few sellers
Oligopoly is a market structure in which a small number of rival firms
dominate the industry. It is under oligopoly that rivalry among firms
takes its most direct and active form. The products sold by oligopolistic
firms can either be homogeneous or differentiated . In general, the
number of firms vary from 5 to 10. The hall-mark of an oligopolistic
industry is that there are only few firms in the market. The numbers of
buyers in oligopoly will be quite large.

 Lack of uniformity
Another feature of Oligopoly is lack of uniformity in the size of firm.
Some firms may be very large and others may be small. For example, the
share of Maruti Udyog is 70 percent in small car segment of the
Automobile industry. While the share of Ceilo or Tata is comparatively
much less.

 Homogenous or differentiated product


Firms in Oligopolistic industry may produce either homogeneous or
differentiated products. If the firms produce a homogeneous product
like cement and tea, the industry is called a pure or perfect oligopoly. If
the firms produce a differentiated or imperfect oligopoly.

 Advertisement
Advertising and selling costs have a strategic importance for oligopoly
firms . In this context, Prof. Baumol rightly remarks that ,”It is only
under oligopoly that advertising comes fully into its own.”

 Elements of monopoly
Under oligopoly, there are only few firms in the market. The existence of
product differentiation creates ‘brand loyalty’ on the part of the
consumers which is the basic source of monopoly power. Moreover,
through collusion, the existing firms can raise the price and earn some
monopoly income.

 Constant struggle or keen competition


Competition is of a unique type in the oligopolistic market. Competition
here implies struggle of rivals against rivals.

 Interdependence
The cross elasticity of demand for the oligopoly product is high.
Therefore the sellers are aware of their independence with their rivals.
Each firm in the industry is presumed to recognise the fact that a change
in its price or output will cause a reaction by the competing firms.

 Existence of price rigidity


In an oligopolistic market each firm sticks to its own price. If a firm tries
to reduce the price , the rivals will also retaliate by reducing their prices.
So it will not produce any advantage. Likewise if a firm tries to raise the
price, other firms will not do so . In this situation, the firm which
intended to raise the price will lose its customers. So there is price
rigidity in an oligopolistic market.

 Uncertainty
In oligopoly, due to interdependence of firms on each other, no certain
prediction about the behaviour of different firms can be made . It is
difficult to calculate the consequence of current economic changes on
the basis of facts already in existence. So uncertainly prevails in
oligopolistic market.

 Existence of Non-profit motive


A firm under oligopoly may not always aim to maximise its profit . It
may have other motives like sales maximisation , risk minimisation,
output maximisation ,security maximisation etc. In the absence of the
motive of profit maximisation it becomes difficult to determine
equilibrium level of output and price .
Reasons for the emergence of Oligopoly:
 Large capital
 Economies of sale
 Entrepreneurship
 Mergers
 Patent rights
 Essential factors

PRICE RIGIDITY

SWEEZY’S KINKY DEMAND CURVE MODEL

Non-collusive models of oligopoly explain the price and output


determination in an oligopolistic market. Sweezy’s Kinked Demand
Curve models is regarded as most important model of this category.
Several decades ago, economists believed that they had noticed
something quite significant about oligopolies. For relatively long
periods of times , prices in these industries seemed to remain more
or less fixed. This observed “stuckiness” of oligopolistic prices gave
rise to the theory of the “Kinked Demand Curve” s theory that tries
not to explain how prices are determined, but as to why they do not
change.
A well known theory formulated to explain the price-rigidity in
oligopolistic market was developed by American economist of
Harward University Paul M. Sweezy in 1938.
Assumptions
The Kinky Demand Curve is based on the following assumptions:
1) If one firm decreases its price other firms will also reduce their
prices.
2) If one firm increases its price other firms will not follow price
increase.
3) There is an established prevailing price
4) The marginal cost curve will pass through the dotted portion of
the marginal revenue curve. Price rigidity means that the changes in
cost and demand conditions may not affect price level . There are
many explanations for the price rigidity in oligopoly. The two main
models are discussed as under :
1) Paul Sweezy’s Kinky Demand Model
2) Hall and Hitch version of Kinky Demand Analysis

1.Paul Sweezy’s Kinky Demand Model


This model was given by Paul Sweezy, an American economist. In
order to expand kinky demand model two types of demand curves
are used:
A) perceived demand curve or subjective demand curve
B) proportional demand curve or market share demand curve

A) Perceived demand curve


In this , price changes of firm are not followed by its rival firms . This
demand curve is more elastic
B) Proportional Demand curve
In this all firms in a group change the prices, in the same direction
by the same amount. This demand curve is less elastic.

This can be shown with the help of the following diagram , dd is


subjective demand curve of every producer which is drawn on this
assumption that if one producer changes the price , other will not
follow.
DD is a curve which is drawn on the assumption that if one firm
changes price, other must follow. Hence, dd is more elastic and DD is
less elastic. If the firms reduces price from P, others will also do so.
Hence actual increase in demand is smaller , thus KD portion of
demand curve is less elastic. If the firm raises price above OP , other
will not follow . Hence fall in demand is much larger so dK portion of
demand curve is relatively more elastic. Hence the relevant demand
curve is dKD. There is kink in demand curve at point K.

Discontinuity in MR curve
Because of difference in elasticities of two demand curves, demand
curve in oligopoly becomes kinky and the MR curve corresponding
to this kinked demand curve becomes discontinuous.
The length of discontinuity depends upon the relative elasticities as
two segments i.e. dK and KD portions of demand curve. The greater
the difference in elasticities of two demand curves , the larger would
be the discontinuity in MR curve. In the diagram, the discontinuity is
shown by m1 m2.

Explanation of Price Rigidity


According to Paul Sweezy, Hall and Hitch the demand curve in
oligopoly is not continuous rather there is a kink in the demand
curve. They explain price rigidity only and does not explain how the
price and output will be determined.
The price and output determination under Kinky demand is
shown in the above diagram. At point E, MC=MR where MC is cutting
MR in the discontinuous portion. The equilibrium output is OQ and
price is OP. So long as MC cuts MR in the discontinuous portion,
equilibrium price and output would remain unaffected
Following Factors are Responsible for Price Rigidity in
Oligopoly:
(a) Oligopoly faces a declining demand curve and hence the firm
prefers to increase its sales rather than price change.
(b) Since behaviour of different firms is uncertain, they prefer to
keep the price fixed, so to earn reasonable profit.
(c) Security motive in oligopoly is more important than profit
maximisation . The price rigidity has been explained, on the basis of
two types of changes:
1. Changes in cost conditions.
2. Changes in demand conditions.

1. Changes in Cost Conditions


In oligopoly changes in cost does not bring any change in price. It
means if cost of production increases or cost of production falls,
price will remain the same. In the diagram, it is shown that there is a
kink in the demand curve at point K . m1m2 is the length of
discontinuous portion of MR. Now if MC passes through the
discontinuous portion , then equilibrium output would be OQ and
price would be OP. The equilibrium point would be at point E. If MC
shifts downward to MC2 or it shifts upward to MC1 ; equilibrium
price and output would remain the same because the MC is cutting
MR within the discontinuous portion . However , if MC shifts upward
in such a way that it cuts MR outside the discontinuous portion i.e. at
point E3 , in this case price will increase to OP1 and output will fall
to OQ1.

2. Changes in Cost Conditions


The demand of a product in oligopoly may change i.e. may increase
or decrease but the price may not change. It is shown below in the
diagram .
In the diagram, when demand curve id dD , the equilibrium point is
E , where MC cuts MR in discontinuous portion . The output is OQ
and the price is OP . when demand increases so curve shifts to the
right to d’D’ ,MC again cuts MR in the discontinuous portion at E1 .
New equilibrium point E1 , equilibrium output is OQ1 but
equilibrium price would remain the same i.e. OP. It is thus evident
that changes in demand do not bring about any change in price.

2. Hall and Hitch version of Kinky Demand


Analysis
Hall and Hitch had used empirical approach. They had interviewed
38 entrepreneurs on price policy and concluded that a business firm
under oligopoly attempts to charge a price that covers average cost.
Thus , the oligopolist firms sets a price that covers average cost
where its demand curve has a kink as shown in the diagram . In the
diagram equilibrium price is OP and equilibrium price is OQ . This
price covers average cost at the point kink K .
However , the following two exceptions have been
pointed out:
1) In case of large decrease in demand oligopolistic firms decide
to cut down its price in order to maintain its output and other
firms will also be under pressure to decrease their prices.
2) If the change in factor prices or technology covers shifts in
average cost curves of all the firms by an equal amount. It is
likely that full cost price would be revised but the amount of
change in price would be more or less the same as the change
in wage and raw material cost.

Criticisms of Kinky Demand Curve


Analysis

1) It cannot explain price and output


determination
Kinky demand curve analysis does not explain how the
price and output are determined. It simply explains that
once the price has been determined , it would remain
rigid.
2) Not applicable to other cases of oligopoly
Kinky demand theory cannot be applied to oligopoly
cases of price leadership and collusion because in these
cases there is no kink in the demand curve which is due to
the concerted behaviour of various firms in regard to the
price changes.
3) Not applicable to oligopoly with product
differentiation
Kinky demand model of price rigidity is not applicable to
the case of oligopoly with product differentiation. In
oligopoly having product differentiation there exists
different prices for different brands.
4) Sweezy’s kinky demand approach applies only
to depression period but not to boom or
inflation period
In depression demand falls but according to this theory,
price will remain stable. But in boom or inflation where
demand is increasing the price is likely to rise rather than
remaining stable as shown in diagram in which the upper
portion of demand curve is less elastic whereas the lower
portion demand is more elastic . In this case, there is not
one price rather there can be 3 prices i.e. the firm may
increase the price from OP to OP1 in boom or it can
decrease the price to OP2 if higher output is to be sold .
5) Wrong assumptions
The theory of kinked demand curve is based on the
assumption that other will follow price decrease but not
price increase . This assumption of kinked demand theory
could not be proved empirically. Oligopoly prices are not
as rigid particularly in an upward direction. In the period
of inflation when the demand for the product is high and
increasing , the price is likely to rise rather than
remaining stable .
6) Ignores non price competition
The price rigidity theory does not take into consideration
non price competition. The oligopolist firm may charge
the prevailing price but allow several concessions to the
customers . it makes the real price flexible even if money
price remains rigid. In fact, the Sweezy model ignores
credit facilities , concessions and other promotional
facilities given to the customers.