There is no definite theory of price-output determination under oligopoly. The reason being that there is interdependence in the decision-behaviour of oligopolistic firms and the uncertainty about the reaction patterns of rival firms.
The demand curve of each firm is uncertain. Due to interdependence in the behaviour of firms and uncertain reaction patterns, there can be a variety of behaviour patterns.
Different economists have made different assumptions about the aims of oligopolist firms and they assumed different behaviour patterns of firms accordingly.
Different behaviour patterns may be-(i) rivals may decide to co-operate in the pursuit of their objectives, (ii) they may fight each other to increase their market shares, and (iii) agreements may be of wide variety.
Therefore, a large variety of models about price-output determination under oligopoly have been developed by economists depending upon assumptions about the group behaviour of oligopolist firms. The different models are discussed here in the following pages.
In order to maximize profits, the firms in oligopoly market may resort to independent price policy. Every firm may estimate the reaction and calculation of its rivals and then fix its own price and output.
On the one extreme each firm may fix a monopoly price. On the other hand, if all firms are producing more or less identical products, they will fix a common or identical price for the product.
In practice, however, this may not be so because firms produce different varieties of product, have different cost of production and enjoy different share of the market.
In such a situation there maybe distrust and antagonism among rival firms. Each seller has a temptation of more profit.
Temptation of more profits and rivalry leads to independent pricing. Independent pricing under these conditions, will lead to price wars between rivals; the ultimate result maybe either price in stability and continuous wars or price stability when a satisfactory price is found.
Fight for profit cannot go on indefinitely. Thus, price war leads to price rigidity or price stability in the oligopoly market.
Under independent pricing, actual price may be fixed between extreme limit of competitive price or monopoly price.
But the general belief among economists is that independent pricing cannot last long and it is bound to lead to either price leadership by leading firm or some type of collusion between the rival firms.
Firms by experience may realize that independent pricing creates uncertainty and insecurity among rivals. Therefore, there is a constant tendency to come together.
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Pricing under collusion (Collusive oligopoly):
When competing firms make some kind of agreement about pricing and output they are said to collude. The agreements may be formal or facit.
But formal or open agreements are illegal in most countries. The agreement between oligopolist are generally tacit or secret.
When firms enter into collusive agreement, collusive oligopoly comes into existence. Collusion can be of two types:
1. Perfect collusion
2. Imperfect collusion (Price leadership)
Now we will discuss price-output determination under two types of collusion.
1. Perfect collusion:
In case of perfect collusion under oligopoly there can be centralized cartel or market sharing cartel situations.
(a) Centralized cartels:
Under centralized cartel system the price and output decisions for the whole industry as well as of every firm are taken by central Cartel Board so as to achieve maximum joint profits. Cartel board fixes the output quota of each member firm.
Total profits are distributed among the firms according to prior agreement. The total output of the industry and price are the determined in such a way that the total cost of production is minimum.
Let us suppose that there are only two firms. Supposing further the central cartel board knows the demand curve (average revenue curve) of the industry and corresponding total marginal revenue curve.
The cartel board finds out the Combined Marginal Cost (CMC) curve for the industry by horizontal summation of MC curves of the two firms.
The profit maximizing output of industry’ is determined by equating combined marginal revenue and combined marginal cost. The price-output determination is illustrated.
In AR(D) and CMR are demand curve and marginal revenue curve of the industry. EMC is combined marginal cost curve.
The industry is in equilibrium at E point where EMC cuts CMR and equilibrium output is QC. Thus equilibrium price is OR Now the question is how the output quota of each firm is determined.
Each firm will be asked to produce that much output at which MC of each firm is equal to the MC of total equilibrium output. The marginal cost of each firm will be equal.
(b) Market sharing cartel:
There can be two methods of market sharing :
(i) Non-price competition, and (ii) Market sharing by quota.
(i) Market sharing by non-price competition:
Here firms agree to sell at an agreed uniform price. But member firms are free to produce and sell that quantity at which they maximize their individual profits.
Firms are also free to change the design of their product and other method, except price, to promote sales.
If the cost of different firms in same, thin the agreed uniform price will be the monopoly price. In case there is threat of entry of new firms, low price will be fixed.
If the cost of production differs, the price will be fixed by bargaining between firms keeping in view that even a high cost firm gets some profits at agreed price.
But when there is difference in cost of production then cartel is unstable because the low cost firm will have the temptation to lower price to increase its profits.
Low cost firms may even begin to give concessions to buyers secretly. Thus the cartel will break-down.
ii. Market sharing by quota:
The oligopolistic firms may agree not only to sell at a uniform price but also about the quota of output produced by each firm.
If products and costs of different firms are perfectly identical then price and output quota of each is determined in such a way that joint profits are maximum, i.e. monopoly solution will emerge.
In eases of differences in the cost of production, the quota of different firms is decided by bargaining between firms on the basis of past sales of firms or productive capacity of firms.
There can be another form of market sharing by quota. Instead of determining uniform price and quota of each firm by cartel, there may be geographical division of the market between cartel firms.
In this arrangement, the prices and output of firms may differ. However, it should be noted that all types of cartels are temporary, where the cost of production of different firms
in the oligopoly market is different. In such cases cartels collapse sooner or later.
2. Imperfect collusion:
In the absence of a formal agreement, the competing firms informally or tacitly may accept a firm as their price-leader. Economists have developed various models of price leadership.
(a) Price leadership by low cost firm:
Many a times the competing firms accept the price fixed by a low cost firm to maximize its price. However, the low cost price leader has to see that the price fixed by him should yield same profits to other firms.
For simplicity let us suppose that there are only two firms A and B. Firm A is a low cost firm and their products arc homogeneous.
Further it is assumed that both firms have equal share in the market. Determination of price under price leadership is illustrated.
In total marked demand for the product is D. Each firm’s demand curve is ‘d’ which is half of ‘D’ and each firm’s marginal revenue curve is Mr. SMC1, and SMC2 arc MC curve of A and B firms respectively.
Price leader firm A is in equilibrium at E1, point where its SMC, curve cuts the MR curve. At E1, point of equilibrium profit maximizing output for A firm is OM and it fixes OP1, price. The high cost firm B accepts OP, price fixed by A firm.
At this price each firm will produce OM quantity and 2 x OM = OQ, which is total demand at OP, price. However, the profit maximizing output and price for firm B are ON and OP2 respectively. But firm B will not set this price because at OP2 it will not be able to sell its prompt.
(b) Price Leadership by dominant firm.
Price leadership especially of the dominant firms is quite common in real life. Small firms generally follow the price leader either out of fear or of convenience.
Dominant firm may establish is leadership by adopting aggressive price policies. The dominant firm fixes the profit maximizing price for its product and other firms will fix the same price.
The small firm will consider the leader’s price as their marginal revenue and produce that output at which their marginal cost equals their marginal revenue. The small firm can fix a slightly differ price if products are differentiated.
The oligopoly situation with a dominant price leader and many small firms is sometimes referred to as partial monopoly.
The dominant firm is more than a leader but wields monopoly power, it fixes monopoly price, produces monopoly output and secure monopoly profits.
But it can escape the provisions of monopoly controls because of the presence of large number of small firms. In many cases the dominant firm may encourage the continuance of small firms since it can escape being branded as a monopolist.
The price leader, however, has to work under serious restrictions and limitations such as:
(a) His price policy may fail and he may lose his leadership if he makes a mistake in estimating the reaction of rivals.
(b) The leader may not have full knowledge of demand conditions, naturally he will have to rely on guess work.
(c) The price leader may not be sure of loyalty of the followers. The price leader may not be able to fix a higher price out of fear of new entrants.
(d) The leader may lose part of his market because of price cutting by- followers or expansion of existing small firms or the entry of powerful competitors into the market.
(e) The power of the leader depends upon the difference in cost. A high cost leader who fixed a high price may find his rival’s under-cutting him.
A low cost leader may either fix a low price to eliminate the rivals and thus naturally attract enmity or may fix higher price and get the allegiance of high cost small firms.
Most theories of oligopoly are relevant only for short period. In the long-run, industries grow or decline; economic and human resources move from one industry to another.
Besides industries come under the impact of technological changes and change in consumers’ tastes and preferences, the result is that there arc pressures working towards the reduction of cost and prices.