An oligopoly is a market structure where the total market sale is dominated by a few sellers.

As a market structure, oligopoly has the following characteristics:

1. Few firms whose decisions are interdependent: In an oligopoly, the market output and sales are dominated by a few firms, each firm decision (regarding output, pricing, etc) is mutually dependent on the decision of other firms.

2. Substantial barrier of entry: Barriers to entry also exist in oligopolies. These barriers to entry may range from legal barriers (like copyrights, and patents) to economies of scale.

3. Product may be differentiated or homogenous: This is self-explanatory. In an oligopoly, goods may be homogenous in that consumers do not see any difference between the range of goods In the market.

There is also no reason why goods in an oligopoly can not be differentiated.

Differentiated, in the sense, that buyers believe that there is a difference in the goods in the market.

An oligopoly that sells homogenous goods is called a pure oligopoly and an oligopoly that sells differentiated goods is called a differentiated oligopoly

4. Oligopolies are price makers: As with other imperfect competitive markets are price makers. This means they have some market power to raise prices above marginal costs.

Price And Output Decision Under The Two Theory Of Oligopoly

Though oligopolies are the most realistic market structure available in our world.

There is, however, no definite prediction or theory regarding the pricing and output decisions of oligopolies.

It is for this reason that there are many theories of oligopoly. But, for the scope of this blog, we will be looking at just two theories of oligopoly,  namely: cartel and kinked demand theory

Cartel theory

This theory assumes that all oligopolies in an industry will act as a monopoly.

To achieve this, they will form a cartel. A cartel is a group of firms that collude together in a bid to reduce competition in an industry.

OPEC (organization of petroleum exporting countries) is a classic example of a cartel.

By forming a cartel, oligopolists hope to reduce output and increase profit.

Figure A illustrates this. $P_1$ and $Q_1$ illustrate the case of the long-run equilibrium price and quantity without a cartel.

At this price and quantity, the price is equal to the average total cost and the firm is earning zero economic profit.

Now, think of what would happen if the firm in the industry formed a cartel. This is illustrated as $P_c$ and $Q_c$. And, this profit is shared among the members of the cartel.

Thus, we see that oligopolies have an incentive to form a cartel and collude rather than compete against each other.

Although oligopolies have an incentive to form cartels, they may not be able to do so.

This may be attributed to the following problems:

1. Problem of legalization: Due to its anti-competitive nature, it is illegal in most countries such as the USA and the EU, to form a cartel. It is, however, important to note that it is difficult to identify cartels.

2. Problem of forming cartel policy: it is one thing to agree to form a cartel, it is another story entirely to form a cartel policy. 

The obvious reason for forming a cartel is to increase joint profit. To achieve this, a fixed price and quantity are required, which means that every cartel member will have to agree on the fixed price and quantity to sell

Reaching such an agreement is not that easy. This is because of the differences in cost that could exist among different firms forming a cartel.

3. Problem of cheating: Even if a fixed price and output are established, cartel members may cheat by producing higher than the agreed output and, therefore, increase their profit. 

Another case of cheating in a cartel occurs when a firm reduces the price to gain market share.

This situation may lead to a price war, where rival firms reduce prices to increase market share.

Thus, the principal problem that the cartel face is that each member has an incentive to cheat because each member can gain a large market share by cheating on the others.

To cheat successfully, such a firm can either undercut price or expand output sold to the market.

Game theorists have developed some sort of model for this scenario, called the prisoner dilemma.

The prisoner dilemma is a paradox in decision analysis in which individuals acting in their self-interest do not produce the optimal outcome.

It can also be defined as a scenario in which individuals acting rationally according to their self-interest end up in a jointly undesirable outcome.

The prisoner dilemma shows the reason two firms may not cooperate even if it is in their best interest to do so.

To illustrate, consider the case of two firms that enter into a cartel agreement. Before agreeing, each firm will earn a profit of $\$$1000.

Then, both firms agree to increase the price and never undercut the price. If both firms hold to the agreement, each firm will get  $\$$5000.

But, if one firm holds onto the agreement and the others do not, the one that does hold onto the agreement will get $\$$500 and the one that does not hold on will get $\$$10,000.

If none of the firms holds on to the cartel agreement, then each firm gets $\$$1000. This is illustrated below.

Prisoner dilemma Oligopoly

As can be seen, Both firms A and B earn higher profits holding to the (cartel) agreement than not.

Each firm can earn even higher profits if it breaks the agreement while the other firm holds to it. 

Many economists predict that each firm will cheat on each other and therefore, end up in box 4 where they will earn the profit they did before the agreement

Thus, we predict cartels will be short-lived or relatively unstable because it is a case of a prisoner’s dilemma. 

Having looked at cartel theory, let us quickly look at the other theory of oligopoly. The kinked demand theory

Kinked demand theory

The kinked demand curve is a means of analyzing the behaviour of oligopolies that do not collude.

The underlying behavioural assumption behind the kinked demand curve is that if a firm lowers the price, a competing firm will also lower the price, but if the firm increases the price, other firms do not increase their price.

This theory, developed by American economist Paul M. Sweezy in the 1930s, can be used to explain why prices in an oligopoly are rigid before they become relatively stable over a long period.

As can be seen in the above demand curve, the kinked demand curve involves two demand curves and two marginal revenue curves.

In figure A, it is assumed that a firm is producing at price P and quantity Q.

If the firm increases its price above price P, other firms will not follow suit, and therefore, the firm sales drop (because of the high price).

The demand curve above P is highly elastic to a price increase and therefore, is indicated by $P_1$A. The firm's marginal revenue is MR. 

However, if the firm reduces its price below P, others will follow suit so as not to lose market share.

The demand curve below P is less elastic to price cut and therefore indicated by AD. The firm's marginal revenue is EF.

Therefore, there is a kink in the firm's demand curve at the current price (point A in figure B).

This kink indicates that an oligopolistic firm reacts differently to a single firm's price hikes than they do to price cuts.

So, overall, the firm demand curve includes part of $P_1$A and part of $AD$; its marginal revenue curves include part of $MR$ and $EF. 

The immediate consequence of the kinked demand curve theory is that price will be rigid at Price P even with a change in cost. 

This is because the oligopolistic firm has no incentives to increase or decrease the current price it charges as competing firms will not follow their price hike but will match price cuts.

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Criticisms Of The Kinked Demand theory

Although the kinked demand theory is useful for studying the behaviour of oligopoly that does not collude, it is not without its shortcoming.

First, it is not able to explain how the kinked came about at D.

It is only able to explain what happens after the kinked has been formed.

It does not explain how the oligopolistic firms find the kinked point on the demand curve.

Secondly, the theory can not explain the behaviour of oligopolies that collude.

The collusive behaviour of oligopolies is captured in the alternative theory of oligopoly called cartel theory which was explained earlier.

Thirdly, as George Stigler observed, "there isn't any evidence to prove that competitive oligopolies will be reluctant to match price hikes than price cuts.

This is inconsistent with the behavioural assumptions that the theory of the kinked demand suggests.

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