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6.8 Behaviour of Firms in Oligopoly

Oligopoly
•If the market of a particular commodity consists of more than one seller but the number of sellers is few, the market structure is termed oligopoly.
•The special case of oligopoly where there are exactly two sellers is termed duopoly.
•In analysing this market structure, we assume that the product sold by the two firms is homogeneous and there is no substitute for the product, produced by any other firm.
 
Highlights of Oligopoly
•Oligopoly is a market structure with a small number of firms, none of which can keep the others from having significant influence.
•The concentration ratio measures the market share of the largest firms.
•A monopoly is one firm, duopoly is two firms and oligopoly is two or more firms.
•There is no precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the actions of one firm significantly influence the others.
 
Interaction of firms
•As there are a few firms, each firm is relatively large when compared to the size of the market.
•Each firm is in a position to affect the total supply in the market, and thus influence the market price.
•For example, if the two firms in a duopoly are equal in size, and one of them decides to double its output, the total supply in the market will increase substantially, causing the price to fall.
•This fall in price affects the profits of other firms in the industry.
•Other firms will respond to such a move in order to protect their own profits, by taking fresh decisions regarding how much to produce.
•Therefore the level of output in the industry, the level of prices, as well as the profits, are outcomes of how firms are interacting with each other.
 
Collusion
•The firms could decide to ‘collude’ with each other to maximize collective profits.
•In this case, the firms form a ‘cartel’ that acts as a monopoly.
•The quantity supplied collectively by the industry and the price charged are the same as a single monopolist would have done.
 
Competition
•Oligopoly firms could decide to compete with each other.
•For example, a firm may lower its price a little below the other firms, in order to attract away their customers.
•Obviously, the other firms would retaliate by doing the same.
•So the market price keeps falling as long as firms keep undercutting each others’ prices.
•If the process continues to its logical conclusion, the price will have fallen till the marginal cost.
•No firm will supply at a lower price than the marginal cost else they would make losses.
 
Real life behaviour of oligopoly firms
•In practice, cooperation of the kind that is needed to ensure a monopoly outcome is often difficult to achieve in the real world.
•On the other hand, firms are likely to realize that competing fiercely by continuously under-cutting prices is harmful to their own profits.
•So, the oligopolistic equilibrium is likely to lie somewhere between the two extremes of monopoly and perfect competition.
 
Conclusion
•In oligopoly, a small number of firms collude, either explicitly or tacitly, to restrict output and/or fix prices, in order to achieve above normal market returns.
•Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution, of oligopolies.
•The major difficulty that oligopolies face is the prisoner's dilemma that each member faces, which encourages each member to cheat.
•Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to limit competition.
 
Prisoner's Dilemma
•The prisoner's dilemma is a paradox in decision analysis in which two individuals acting in their own self-interests do not produce the optimal outcome.
•The prisoner’s dilemma presents a situation where two parties, separated and unable to communicate, must each choose between co-operating with the other or not. The highest reward for each party occurs when both parties choose to co-operate. 
•The typical prisoner's dilemma is set up in such a way that both parties choose to protect themselves at the expense of the other participant.
•As a result, both participants find themselves in a worse state than if they had cooperated with each other in the decision-making process. 
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