TOPIC 10 ► OLIGOPOLY MARKET

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Describe the characteristics of the oligopoly market;
2. Identify the market structure situated between a perfectly competitive market and monopoly market;
3. Explain the criteria of equilibrium in the oligopoly market; and
4. Analyse the Cournot Model and the Sweezy Model in determining the market equilibrium.

INTRODUCTION

If seen in terms of competition, market structures can be arranged in the sequence starting from the perfectly competitive market, monopolistic competition market, oligopoly market and finally the monopoly market. In the previous topics, we have discussed all types of market structure excluding the oligopoly market. The following discussion will provide an understanding about the structure of an oligopoly market.

10.1 CHARACTERISTICS OF AN OLIGOPOLY MARKET

There are three main characteristics or features in the oligopoly market as shown in Figure 10.1:

Figure 10.1: Characteristics of an oligopoly market

SELF-CHECK 10.1

What are examples of firms that have the characteristics of an oligopoly market?

Now let us look at the characteristics of an oligopoly market in detail.

10.1.1 A Small Number of Firms

Oligopoly is a market structure characterised by a few firms. This is different compared to the perfectly competitive market and the monopolistic market that consist of a large number of sellers, whereas there is only one sole seller in the monopoly market.
Due to the small number of firms, an oligopoly firm is perceived to have the power to determine price but each firm must consider the action of their competitors that is predicted to influence its decisions in determining price, output and carrying out advertising campaigns.
As a result, oligopoly firms are considered as mutually dependent since the profit of each firm not only depends on the strategies of price and sales, but also on the action of its competitors. The characteristic of mutual interdependence that exists among these firms in an oligopoly industry makes it hard to analyse the behaviour of a certain firm.

10.1.2 Homogenous Goods and Goods that can be Differentiated

In terms of goods, oligopoly firms may produce either homogenous goods or differentiated goods. Most of the goods produced such as zinc, aluminium, cement and steel are homogenous goods.
Meanwhile, consumer goods such as automobile, tyres, electronic equipments, cigarettes, breakfast cereals and sports equipments are goods that can be differentiated. For goods that can be differentiated, firms will usually conduct non-price competition such as advertising.

10.1.3 Barriers to Entry

Firms in an oligopoly market also face barriers as in the monopoly market. There are a few important barriers that influence the number of firms in the market.
The small number of firms enables each firm to make enough sales to achieve economies of scale. For new firms, they only control a small portion of market share and definitely will not be able to achieve economies of scale. This means they run production with a high average cost and eventually, they will not be able to sustain in the industry.

Figure 10.2: Barriers in an oligopoly market

10.2 EQUILIBRIUM IN AN OLIGOPOLY MARKET

In the discussions about market structures in Topic 7, 8 and 9, our main focus is to analyse how equilibrium price and outputs are determined. For instance, in the perfectly competitive market, the firm acts as takers of price which is determined by the market. Equilibrium output of the firm is achieved when price is equivalent to marginal cost. Meanwhile, in a monopoly market and monopolistic market, equilibrium price and output is achieved by fulfilling the rule of marginal revenue equivalent to marginal costs, or MR = MC.
However, the determination of equilibrium in the oligopoly market is more complicated. This is because in determining price and output, the firm has to take into account the action of its competitors. Similarly with competitors, their decisions depend on the action of other firms.
Since the firms’ decisions depend on the behaviour of their competitors, how is equilibrium price and output determined in the oligopoly market?
In the year 1951, a mathematician named John Nash had described the concept of equilibrium in an oligopoly market which is known as the Nash Equilibrium.
Nash Equilibrium is achieved when each firm executes the best action after considering the actions of its competitors. It is an important concept and will be used in the following discussion.

10.3 OLIGOPOLY MODELS

As stated above, the mutual interdependence among firms makes it difficult to analyse the behaviour of a particular firm in the oligopoly market. Therefore, there are many models regarding the theory of oligopoly that tries to explain the behaviour of oligopoly in determining price. However, for this purpose, we will only concentrate on two models, namely:

1. Cournot Model; and
2. Sweezy Model.

10.3.1 The Cournot Model

We begin our discussion by looking at the earliest model introduced by an economist named Augustin Cournot in the year 1838. Cournot presented a simple model with three basic assumptions:

1. There are only two firms in the industry. These two firms are referred to as duopoly.
2. Each firm assumes that the outputs produced by competing firms are constant.
3. Both firms wish to maximise their profit.

Now we will look at the explanation regarding the assumptions made. To illustrate his analysis, Cournot assumed that there are only two firms selling mineral water from two wells in the same area. Let us refer to those firms selling the bottled mineral water as Firm 1 and Firm 2. Since there are only two firms in the industry, hence it is known as duopoly.
Also assume that there are barriers for the new firms to enter the industry. This means we only consider the behaviour of the two firms present in the industry. The bottled water sold by both firms is a homogenous good and this results in the existence of only one price in the market. To facilitate analysis, both firms are assumed to have a marginal costs curve that are similar and constant.
The essence of the Cournot Model is that each firm determines its output based on the assumption that the outputs produced by its competing firms are constant. This assumption enables price and output to be determined. To understand this, let us look at how Firm 1 determines its output. This can be explained with the help of Figure 10.3.
Figure 10.3 shows the demand curve (D₁), marginal revenue curve (MR₁) and marginal cost curve (MC₁) of Firm 1. Let us say that Firm 1 assumes Firm 2 does not produce any output. This means that Firm 1 will act as though it is a monopoly firm. Therefore, the demand curve faced by Firm 1, is also the market demand curve, D₁(0).

Figure 10.3: Output determination by Firm 1

The number in bracket denotes the assumption of Firm 1 towards output that will be produced by Firm 2. In line with the demand curve, Firm 1 will face the marginal revenue curve denoted by MR₁(0).
As explained above, Firm 1 faces a constant marginal costs curve that is at MC₁. Since Firm 1 assumes that Firm 2 does not produce any output, hence Firm 1 will maximise its profit by producing at the level where marginal revenue is equivalent to marginal cost.
Referring to the diagram, the MR₁(0) curve intersects with MC at point A. This means that if the output of Firm 2 is equal to zero, Firm 1 will maximise its profit by producing 50 units of output.
Now, suppose Firm 1 assumes that Firm 2 produces 50 units of output. This means the market share owned by Firm 1 has diminished. This results in the shift of the demand curve of Firm 1 to the left as far as 50 units and this is shown by curve D₁(50).
In connection with this new demand curve, Firm 1 faces marginal revenue curve MR₁(50). To maximise profit, Firm 1 will produce 25 units of output, that is at the level where MR₁(50) = MC₁ (point B).
The process above will continue. Suppose Firm 1 assumes Firm 2 will produce 75 units of output. As explained above, the market share of Firm 1 will diminish further. The demand curve of Firm 1 will shift to the left for 75 units and now at D₁(75). Subsequently, the marginal revenue curve of the firm will also shift to MR₁(75).
Based on the belief that Firm 2 will produce 75 units of output, the decision of Firm 1 is to produce 12.5 units of output in order to maximise its profit. This level of output is produced at point C, that is, the intersection point between curve D₁(75) with MR₁(75).
Finally, suppose Firm 1 believes that Firm 2 will produce 100 units of output. This means the demand curve and marginal revenue curve faced by Firm 1 will intersect with the marginal cost curve at the vertical axis (this situation is not shown in diagram). In conclusion, if Firm 2 is expected to produce 100 units of output, then it is Firm 1 is better off not producing any output.
Reaction Curve
From the explanation above, we find that there are four combinations of output based on the action of Firm 1 in determining its output after making assumptions towards the output produced by Firm 2.

Table 10.1: Production of Firm 1 based on the Production of Firm 2

	Firm 1	Firm 2
Amount of Output Produced	50 25 12.5 0	0 50 75 100

In conclusion, it can be seen that the output that maximises profit of Firm 1 is a production table that declines based on how much output Firm 2 produces. This production table of Firm 1 is referred to as the reaction curve labelled as Q1* (Q2). The reaction curve of Firm 1 can be obtained by plotting the four combinations of output marked x. This is shown in the following Figure 10.4.

Figure 10.4: Reaction curve and Cournot equilibrium

The analysis above describes how Firm 1 determines its output after predicting the output level produced by Firm 2. For Firm 2, it will also react like Firm 1 when determining its output level.
If the same analysis is used on Firm 2, we will be able to form the reaction curve of Firm 2. The reaction curve of Firm 2 is labelled as Q₂* (Q₁) as shown in Figure 10.4.
The question now is, what is the amount of output produced by each firm? The reaction curve of each firm describes the quantity that needs to be produced by firms after taking into consideration the output produced by its competitor. This means that each firm determines their output by referring to its reaction curve.
Therefore, the level of equilibrium output is achieved when the reaction curves intersects. The point of intersection is referred to as the Cournot Equilibrium. At this level of equilibrium, each firm has made accurate assumptions regarding how much output is being produced by its competitor. Then, the firm will determine the level of output that can maximise its profit based on the information obtained.
Cournot equilibrium is an example of Nash equilibrium. We know that Nash equilibrium is achieved when every firm has done their best after taking into consideration their competitors’ action. Thus, when a Nash equilibrium exists, none of the firms will alter its behaviour.
The conclusion obtained from the Cournot equilibrium is that each firm will produce the amount of output that will maximise its profit after considering the amount of output produced by its competitor.

10.3.2 Sweezy Model

In the Cournot Model, we have seen how the duopoly mutually considers the output produced by its competitor in order to determine its own output. We find that the behaviour of duopoly is influenced by the output level. What if the firm alters its price level? What will be done by its competing firm and how will it affect other firms?
We will look at an oligopoly model that discusses a simple idea, that is, if a firm reduces their price, the firm believes that this act will be followed by its competitors. On the other hand, if the firm increases the price, this will not be followed by its competitors. The model is known as the Sweezy Model or the kinked demand curve model.
This model assumes that part of the demand curve that shows the reaction towards price decrease differs from the part of the demand curve that shows the reaction towards price increase. Pertaining to that, this model is also able to explain the price strategy of an oligopoly firm.
Now we will try to understand the kinked demand curve model by referring to Figure 10.5.

Figure 10.5: Kinked demand curve model of oligopoly

Figure 10.5 illustrates how a kinked demand curve of a firm is formed. The curve DD denotes the demand curve of an oligopoly firm when one firm alters its price and this action is not followed by the competing firm. Meanwhile, curve D’D’ denotes the demand curve of an oligopoly firm when one firm alters its price and this action is followed by the competing firm.
Suppose the firm begins at point e where the firm produces q units of output and imposes a price of p. If the firm reduces its price, the demand quantity will increase. From the explanation above, we know that the firm’s action in reducing price will be followed by other firms. This is because competing firms do not want to face loss in sales and market share. This means the firm will face the demand curve D’D’. Therefore, if price decreases lower than p, the firm will face a demand curve marked eD’.
On the other hand, if the firm decides to increase price, it is assumed that other firms will not follow the decision. This causes the firm to face loss in terms of sales and market share. Thus, the firm will face demand curve DD if it decides to increase price. Therefore, if price increases higher than p, the firm will face a demand curve marked De.
In conclusion, because the reaction of the competing firm is different towards the firm’s decision either to increase or reduce price, the firm faces a kinked demand curve, that is DeD’.

ACTIVITY 10.1

In your own words, compare the Cournot Model and the Sweezy Model.

SUMMARY

• The three main characteristics of an oligopoly market are a small number of firms; homogenous or differentiated goods; and barriers to entry.
• In order to maximise profit, a firm must produce at the level where marginal cost is equivalent to marginal revenue. However, in an oligopoly market, the firm not only has to fulfil this condition, but must also consider the action of its competitors when determining the price and output that maximises its profit.
• Two out of the many models that tries to explain the behaviour of competitors that influences the decision of the firm in determining the equilibrium price and output are the Cournot Model and the Sweezy Model. Your understanding towards these two models will help you understand the behaviour of the firm in real situations.