Oligopolistic markets

To understand what the question is asking, a definition of an oligopolistic market is required before I will attempt to answer. An oligopolistic market is characterized by few firms and many buyers, there are a sufficiently small number of firms for interdependence to exist, meaning that each firms prospects depend on rivals as well as their own policies. This interdependence can lead to attempts at communication, coordination and collusion. All decisions made are strategic and rivals responses will have been taken into account.

Each time a firm in an oligopolistic market adjusts either price or quantity, any revenue gain is at the expense of its competitors. The competitors whose profit margins are affected are likely to respond by altering their own price or quantity. From this we can understand why there is an incentive for firms to collude. There are four important oligopoly models, the Cournot-Nash model, the Stackelberg model, the Bertrand model and the dominant firm price leadership model, each built upon different assumptions and result in different equilibrium outputs.

I am going to examine each in turn, a discussion which mirrors that in Waldman and Jenson1. * Cournot-Nash Model – considers a duopoly market with identical firms, facing identical costs and no product differentiation. Each firm believes that its competitor will always maintain its current output i. e. they assume that rivals will not react to changes they implement. Equilibrium is reached where each firm's output is the best response to its rival's output and where both firm's output maintenance assumptions concerning the other are correct.

It is a game of imperfect information because it is a simultaneous move game. This model has been used in the airline industry between American Airways and United Airlines. * Stackelberg Model – this model considers what would happen if the Cournot model is viewed as a two stage sequential game where the leader moves first and assumes that the follower will respond to the leaders quality decision by producing on its reaction function. So the leader will select a point on the followers reaction function that maximizes the leaders profits.

This model was used in the US coffee roasting industry in the 1970's * Bertrand Model – Firms take their competitor's prices, rather than quantities, as fixed. With the absence of product differentiation price equals marginal cost (MC). This model is driven by the assumption that one of the firms can capture the entire market if it charges a lower price than its competitor. At MC neither firm has an incentive to reduce price. American Airlines has a policy of pricing close to MC on routes where it has competition, this shows us the models viability in the real world.

* Dominant firm price leadership model – occur if one firm controls a large percentage of the industry's output compared with several considerably smaller 'fringe' firms that supply the rest of the market demand. The dominant firm sets the industry price, and the fringe acts as price takers. If the fringe earns positive economic profits it is likely to expand and the dominant firm's market share will decline over time. The major weakness of this model is that the dominant firm is passive, this model has been seen several times in recent years, but especially with Xerox in the low volume segment of the copier industry.

For an oligopolistic market to remain so, there must be a reason for competitors to stay out, this could be due to firms not earning supernormal profits or due to high entry barriers. Positive profits will induce entry, which, will have the effect of increasing supply and decreasing price; this is detrimental for all firms in an industry. To prevent this firms will want to erect entry barriers. Bain2 defines entry barriers as "the extent to which in the long run, established firms can elevate their selling prices above the minimum average costs of production and distribution without inducing potential entrants to enter the industry".

Baumol and Willig cite "anything that requires an expenditure by a new entrant into an industry, but that imposes no equivalent cost upon an incumbent. " If firms in oligopolistic markets persue their own interests and do not cooperate, joint output is greater than the monopoly quantity but less that the competitive industry quantity. Market price will be lower than in a monopoly. Tacit collusion is "unorganized and unstated attempts by informally coordinated oligopolies to practice joint actions".

An example of this would be price leadership where the dominant firm sets the price or initiates changes and the other firms follow that lead, a good example being Brooke Bond, which has 43% of the UK tea market. However as the number of firms in an oligopoly increases the cost of coordinating behaviour also increases. If barriers to entry are low and new firms enter the market it is possible they will destroy the coordination mechanisms in place. We can compare firms operating without a formal agreement with the aim to sustain a joint monopoly equilibrium to a cartel, which is a type of formalized collusion.

A cartel would usually involve the establishment of a central body to sets prices and output for all of its member firms, which tends to be the whole industry. A good example of this is the OPEC cartel, which, in the 1970's through to the 80's succeeded in hiking up the price of oil. Profit maximization for a cartel as a whole is not always consistent with profit maximization for each individual member. Self interest can make it difficult to maintain a cooperative outcome. However the strong incentive for collusion is to reduce production, raise prices and ultimately increase profits.

Firms that care about the future profits of the industry will cooperate rather than cheat on the agreement to achieve a one-time gain. The incentive to cheat on an agreement is clearly profit, but cheating can be a destabilizing force. A member can make more profit for itself by cheating on the cartel, by increasing its own output or by lowering price. The cheater is considered a free rider, exploiting the restraint of the other firms. If too many firms cheat, the cartel collapses.

To prevent cheating punishment must be enforced (there is simply not enough time to undertake a discussion of this point). If the number of sellers in a market increases, the market moves towards being a competitive market and price will approach MC and quantity will approach the socially efficient level. Another way of looking at this is the more concentrated the market and the higher the entry barriers, the easier it is for a non-collusive equilibrium to be maintained, as firms only need be concerned with current rivals actions.