Price and Output Determination Under Oligopoly

Price Determination Under Oligopoly

An Oligopoly market condition exists between two of the most extreme market conditions; i.e. perfect competition Market and Monopoly Market. An Oligopoly market is a type of market condition where there are two-three firms that dominate the market for a certain type of good or service. In this type of market condition, there are few companies, and the marketing decisions of each company affect the other. Hence, it can be said that in an oligopoly market, the marketing decisions of the competing firms are interdependent. Here, interdependence can be seen in any kind of decision, say pricing. When one company changes the price of its product or service, the effect of the change can be seen in the pricing of products and services of other companies.

Price and Output Determination Under Oligopoly

Price and Output

A determination under the Oligopoly market can be studied under two heads; One when there is a duopoly and one when there are a few firms. Here, we will discuss the price determination under Oligopoly in both the conditions:

When There is Duopoly

If in a sector there are only two companies that dominate the market, then such a condition is called duopoly. In such a market condition if, both the firms have identical products, they are likely to form a collaboration and make a joint profit. If in case the products of both the firms are a perfect substitute, then the firm with a lower cost, better goodwill and better client interaction will attract more customers. This will force the other company to lose business.

On the other hand, when the offerings of both the companies are differentiated, then each one has to keep a close watch on the other. In this kind of situation. 

A firm with better quality products and the lesser price will earn abnormal profits.

When There is Oligopoly

In case there are more than two firms in a sector, and each one is considered a key player in that sector, then such a market is called oligopoly market. If all the firms produce the same products, then they will always promote collusion. This collaboration will help them earn profit jointly and would cause no harm to the other. On the other hand, if the products of all the firms are different, then they can lower or increase the price without any fear of losing a share in the market.

Theories on Price and Output Determination

No single theory can explain how the price is determined under Oligopoly. Several theories suggest various ways on how the price determination under oligopoly is done. Here we will discuss the important theories of price and output determination.

Cournot’s Model

According to Cournot, Each firm in a duopolist market thinks that instead of its action and effect on the market, The other firm will keep on producing the products. The Cournot model suggests that the most profitable pricing is when a firm’s output is two-third of its competitor’s output, and the price is also two-third.

Stackelberg Model

Under Stackelberg’s model, a leader and follower relationship is formed. The firm with good brand equity is called the leader, and the one with lower brand equity is called the follower. The leader decides the price and quality of the commodity, and then the follower observes the leader and decides the price, to maintain its market share.

Bertrand Model

Bertrand model can be explained when there exists a symmetry in the industry, i.e. there are firms which are equal in size and operations. The Bertrand model suggests that the firms set a low price until the price matches the cost of production. This is done to dominate the market.

Edgeworth Model

The Edgeworth Model suggests that each firm in a duopoly market thinks that his competitor will charge the same price, so it changes its price to make a greater profit. This thinking of the firm keeps the price war continued.

Explanation of Price and Output Determination Under Oligopoly

  • Under the oligopoly market, the number of firms varies.

  • Sometimes there are 2-3 firms, and sometimes there are 7-10 firms.

  • The commodities produced under the oligopoly market may or may not be homogenous.  

  • Sometimes it so happens that firms consult each other before fixing the price of the commodities, to save each other from losses.

  • A firm can never be sure of its rivals' reaction to its decisions.

Determination of Price and Output In Oligopoly

There are various types of markets that exist and oligopoly is one of them. Oligopoly markets are mostly dominated by suppliers on a small scale. These are oligopoly markets that are found across the world in many sectors. Some of the oligopoly markets are competitive whereas some are not that significant. The authorities for the competition are called upon to supervise the coordinated actions as well as if there is low competition. Oligopoly markets can exist between the extreme conditions of a market which is either a perfect competition market or a monopoly market. It is the market where three are two or three firms that dominate the market for a good or service. Marketing decisions of each company and other companies affect one another thus; the oligopoly marketing decisions are interdependent in an oligopoly market. Interdependence can be any decision e.g. pricing of a particular product or service. This, in turn, will affect all the pricing of products and services of the other companies associated with a company.

Price and Output Determination in Oligopoly

There are two conditions under which the price and output determination in an oligopoly can be done. They are:

  1. In the case of duopoly

  2. In the case of fewer firms

In the case of duopoly, which means two companies that dominate the market in a sector and the firms have similar products. In such cases, the two firms or companies will form a collaboration with each other and have a joint profit. The firm which provides products with lower prices will attract more people and have better client associations. This can cause losses to the other company. On the other hand, if the companies have slightly different products, the firm which provides products of better quality with a low price will gain large profits.

In the case of fewer firms, each company is an essential player in that sector. Here, the collaboration will help both the companies and there won’t be a loss for either of them. When the products of the companies are different then they may increase or decrease the pricing without having the fear of losing shares in the market.

FAQs on Price and Output Determination Under Oligopoly

1. What are the Characteristics of Oligopoly Market?

The characteristics of Oligopoly Market are as follows:

The oligopoly market consists of a few firms, and these firms dominate the market. All firms in the industry in an oligopoly market are interdependent as one firm’s action affects the decision of the other. In an oligopoly market, the firms earn the most profit, and they try to restrict the entry of any new player into the industry to save their market share. The firms and the owners of the firm in an oligopoly market always try to predict the decisions of their rivals. This helps them to form policies to tackle any kind of change that can cause harm to them. 

2. What are the Causes of Oligopoly?

Numerous reasons cause an oligopoly market condition. Here we have mentioned some of the reasons, and they are;

When the production capacity of a few firms is large, and they invest heavily in production. They implement new ways of production and have advanced machinery. They produce the products at a lower cost and dominate the market. 

On the other hand, the firms which are small and have outdated machinery are thrown out of the industry. This creates an oligopoly market. The second reason is that the entry of new players in an oligopoly market is barred by the dominating firms to retain their share in the market.

3. What are the Stackelberg model and Bertrand Model?

The Stackelberg model mainly describes how a leader and follower relationship is maintained and formed. The firms which have good brand equity are called the leader whereas the firm whose brand has lower equity is called the follower. The leader is the one who decides the pricing and quality of the product and this is followed by the follower to maintain the market share of its company.

The Bertrand model is when two industries are equal in size and an operation i.e. there is ‘symmetry’ in the companies. The firm sets a low price for a product which matches the production cost. This helps in maintaining dominance in the market.

4. What are the key aspects related to oligopoly?

The main points which are associated with oligopoly are as follows:

  • Few large firms: There are large firms that are low in number and there is huge competition.

  • Entry barrier: Barriers include patents, licenses and control over raw materials which prevent the entry of new firms.

  • Non-price competition: The use of methods like advertisement, warranties etc. ensures that there is a lesser competition of prices in the market. This helps the firm influence their product demands and get their brands largely recognised.

  • Interdependence: There is interdependence between the firms which means a change in discussion (pricing change) will influence the other competing firms as they will also affect the output of these firms.

  • Product nature: The products sold by different companies can either be the same or different.

  • Pricing behaviour is not unique: In oligopoly markets, the firms or companies act independently and earn profits as well as cooperate with the competing company or firm to remove any uncertainty.

5. Can we understand the outcomes related to a firm’s behaviour?

When we know the objectives of a firm, entry barriers and government regulation, we can understand the outcomes of the firm. These can be stable prices, pricing wars and collusion for higher prices. The market can be either collusive or non-collusive which can be explained as – collusive oligopoly is a condition in the market where the firms cooperate with each other to decide a price or output or both. Whereas, a non-collusive oligopoly is a situation in a market where the firms do not cooperate with each other and instead compete with one another.

6. What is price rigidity?

Firms can change their pricings but there cannot be an increase in demand just because the firm changes it. Thus, the firms stick to the original price given to the product over time which causes a situation called price rigidity in an oligopoly. Conlisk et al. in 1984 developed a model which showed that the prices of long-lasting goods remain the same for a larger period of time, drop for a short period and then return to their original price. Tirole(1988) explained that prices are rigid as there are incentives for the firms or companies to sustain prices at higher amounts through implicit agreements.

7. What is the difference between monopoly and oligopoly?

Monopoly and oligopoly are the structures of a market when there is not a perfect competition. Monopoly can be defined as the market condition when a single firm or company produces products that have no alternatives, on the other hand, in oligopoly a small number of large firms produces similar or slightly different goods. In both the market conditions, there are entry barriers that prevent other new firms from competing with them. Monopoly can occur in a particular region but oligopoly occurs in larger geographical areas. There are antitrust laws that prevent firms from the restraint of trade and transacting mergers which causes a decrease in competition.