Prices Under an Oligopoly

Prices Under an Oligopoly

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Prices Under an Oligopoly

Oligopoly is a market structure, which has some distinctive qualities that separate it from the others. Most notably they are that oligopoly has barriers of entry and is made of only a few companies, which supply the majority of the market and are interdependent. In other market structures price of the product and other decisions are often based on technical information such as marginal cost or demand (when you are a monopoly) but what makes oligopoly unique from all other market structures is that companies cannot base their decisions solely on technical information they must be aware of and react to their competitors.

Oligopoly is also a distinctive market structure because price is not usually used as a competitive tool. There are exceptions of oligopolies that engage in price wars, for example AMD and Intel, semiconductor producers, both use fierce price lowering tactics because when one of them decreases their price of a product the other has nothing else to do but follow in order not to loose a big market share. Intel and AMD price wars are beneficial to the consumers but not to the companies which each year miss their target revenues and get lower profits. Relatively stable prices under oligopoly, which are called sticky prices or rigid prices, is a strong feature of this market structure and this essay will try to explain why such prices exist.

This essay will analyze situations when companies do not coordinate their actions (Non-collusive behavior) and when they do, implicitly (tacit collusion) and explicitly (formal collusion).

I. Non-collusive behavior

Non-collusive behavior is when companies do not coordinate their actions but still react to their competitors. In 1939 Robert Hall and Charles Hitch in UK and Paul Sweezy in USA individually presented a kinked demand curve, which demonstrates a reason why oligopolies do not what to change prices. The kinked demand curve (fig. 1) graph is hypothetical because companies will try to restrain from changing their prices. If a company raises its price, represented in the graph by the demand curve AA then their competitors presumably will not follow them and the first company looses customers. If a company decides to lower its price, represented by BB their competitors will have no choice but to also decrease their prices which would not be beneficial for every company in the market. The demand curve for a company is fused from AA and BB demand curves and has a kink at point P, though it is not exactly clear where the kink occurs exactly.

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Also in this graph marginal revenue curve MRa - MRb has a discontinuity at the quantity point of the kink. Marginal cost curve crosses marginal revenue curve somewhere at a discontinuity between points QR, though this does not mean that a kink occurs at a point when MR=MC.

Fig. 1 Kinked demand curve. R.L. Hall and C.J. Hitch, “Price Theory and Business Behavior,” Oxford Economic Papers, no. 2 (May 1939): 17

Kinked demand curve is one of the reasons why oligopolies keep their prices more stable though it is not a sole reason. One of the other explanations might be so called menu costs, the price of changing the cost of a product, e.g. reprinting menus at a restaurant, changing price labels at supermarkets, etc. One of the most famous examples of sticky prices was the Coca-Cola Company, which priced its bottle of Coca-Cola at five cents for more than 70 years, from 1886 to 1959. The rigid price was mostly because their vending machines could not accept any other coins, and the price to replace them would be too great (menu cost), also that the next available coin at the time was ten cents, so changing the price would be increasing it by 100%. Another factor for price stability is the number of companies in the market, the fewer there are the more stable the prices.

A good insight on how prices are set and varied might be provided by analysis of the game theory. Game theory is an oversimplified market simulation where there are usually only few companies and they have only few choices of action. Strategies they choose might provide information about price formation in oligopolies. Lets say we have a duopoly (company A and company B), and they can sell product for either $2 or $1.80.

Price
/
Millions in revenue |A
$1.8 |A
$2.0 | |B $1.8 |5 each |A 2, B 12 | |B $2.0 |A 12, B 2 |10 each | |

Each company has to decide which price to set, a company can be pessimistic and use a maxi-min strategy, that is discover worst of the possible outcomes and choose the best of them, so for company A it would be $5 million if both lowered their prices and $2 million if it keeps the same, so using maxi-min strategy company should choose to lower its price. If a company is optimistic it might use a mini-max strategy, that is the worst of the best outcomes, the best outcomes for a company would be $10 million and $12 million so a company would keep its price at $2.00 and hope that its competitor would do the same. So only under oligopolies strategies are so influenced by what other companies are doing. A dominant strategy is when a company has a set of actions that thinks is the best regardless of what other firms are doing. Nash equilibrium is what a company will do if it does not have a dominant strategy; choose a best possible outcome while evaluating their competitors’ actions.

So companies in oligopoly markets will try to avoid price wars, though they will still compete, just in different ways. Some companies might provide distinctive services such as free product delivery. Probably most successful way of competing is product differentiation or branding, in markets that do not offer homogenous products companies must prove to customers that their product is different from everybody else’s, this makes the product less sensitive about the price changes.

II. Collusive behavior

Tacit collusion

Companies in oligopoly market structure might engage in tacit collusion that is when they do not have any explicit agreements but mostly will know how other companies will respond to certain price changes from earlier behavior. Examples of tacit collusion:

Dominant price leadership - when one company sets a price and most of other will change their prices accordingly.

Barometric company price leadership - when one firm acts as a kind of barometer indicating to other firms the mood of the market.

Collusion pricing - it is an informal cartel. Companies introduce prices almost coincidingly.

Tacit collusion means that prices in the market will still be stickier because companies will still coordinate them to an extent.

b) Formal collusion

Some companies explicitly meet and plan to artificially change market equilibrium. One of the best examples of that is OPEC, Organization of the Petroleum Exporting Countries; it was formed in 1960 as a cartel, a form of formal collusion. OPEC countries export around 40% of world’s oil. With oil prices rising cartel’s members are thriving, still there are inherent problems with cartels. When the demand is high due to quotas agreed every company would want to produce and sell more than their quota, especially if the product is homogenous (no difference between products of companies). It is difficult for companies to detect wrongdoing by other members but a good rule is checking whether one of them is doing a better business than it should statistically. After detection there might come retaliation, a heavy advertising campaign, a price war, maybe even a collapse of the cartel. So the company that starts to disobey the rules must really calculate the probable gain and see if it outweighs the benefits of staying in the cartel. Another problem with cartels is the so-called “free riders”. OPEC has the biggest market power in the world, but there are many other countries that produce oil and benefit from the high demand without participating in the organization, Mexico is the sixth oil exporter in the world and due to high oil prices enjoys a very profitable situation. There were members of OPEC that not always followed the quotas imposed on them, but for now the organization seems to be performing well. OPEC embodies most of the problems that face cartels: often members want to deviate from their agreements with others; there are free riders who enjoy the benefits of the cartel without participating in one, still without a cartel prices would be lower and less stable.

The diagram (fig 2.) illustrates a cartel agreement. Equilibrium in a perfect market structure would be at Pe Qe, but lets say a company could produce at Q1, though in a cartel companies might agree to produce no more than Q* thus making the supply curve SVS’ and forcing the customer to buy at a price higher than p*.
[pic]
Fig. 2. Operations of cartels seeking a maximum price at p*. Economics for Business and Management, Griffiths and Wall, 1st edition, Pearson Education Limited 2005.

A good illustration of how a cartel works is a prisoner’s dilemma. Let’s assume that two people (suspect A and B) are arrested for armed robbery, both of them are interrogated separately and given same conditions: if you testify against your partner you will get 2 year in prison and your partner gets 10 or vice versa. If you do not testify and your partner does not you both get 1 year for carrying illegal weapons, and if you both testify against each other both spend 5 years in prison.

Years in prison |A
Testify |A
Does not testify | |B Testify |A - 5; B-5 |A - 10; B - 2 | |B Does not testify |A - 2; B - 10 |A - 1; B - 1 | |

Prisoner’s dilemma has no point if you have no prior agreements before the arrest, because you have no guarantee that the other person will be silent, the same as in cartels, if there is no agreement nobody will hold to it. So using maxi-min strategy worst outcomes for suspect A would be 10 or 5 years in prison so he or she would almost certainly testify. Cartels face a similar reason that is why they often collapse, companies have a strong incentive to cheat, but cartels play the game many times. So prisoners as well as cartels usually do not as long as it is profitable and they know that the next time they play there might be retribution.

One strategy might be used whether in tacit or explicit collusion is called limit pricing - a form of collusion when incumbent company or companies keep a price at a certain level that a new entrant would not even cover its total variable cost and therefore move out of the market. This keeps the price more stable than it would if the number of companies increased in the market

To conclude, oligopoly is a unique market structure because of the interdependence of the companies and sticky prices. Kinked demand curve is an explanation why the prices do not go up or down extremely and why companies must find other ways to compete, like branding. Companies will accommodate their prices while observing their competitors or just coordinate their behavior explicitly. Still companies are not suited to work together and cooperation might not last. As a Japanese proverb goes: none of us is as smart as all of us. Though eventually some company is.

BIBLIOGRAPHY

EIA: International Energy Annual (2000-2004), International Petroleum Monthly (2005-2006).

Griffiths, A., Wall, S., (2005), Economics for business and management, 5th ed. Financial Times Prentice Hall.

McBride, E., (2007), The world in 2008, “OPEC rules again. The oil cartel is riding high, at least for now”.

Phlips, L., (1988), The economics of imperfect information, Cambridge; New York: Cambridge University Press.

Reid, G., (1981), The kinked demand curve analysis of oligopoly: theory and evidence. Edinburgh University Press.
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