An important case of imperfect competition is that of oligopoly. While monopolistic competition is more frequently found than pure competition in modern industry, however, it is not the typical market form. Oligopoly is the typical market form, many of the markets being oligopolistic.
A large proportion of output in a modern industrial economy is accounted for by industries where all or most of the output is produced by a small number of large firms.
Here, competition is much less impersonal than in monopolistic competition because the number of producers is fewer. If any firm cuts its price, the other firms will know who the price cutter was.
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Each firm, therefore, has to watch closely what its competitors are doing because any action by one of the competitors is likely to have direct repercussions on the firm itself. Each firm represents a large part of a total market.
It is for this reason oligopolists are unlikely to indulge in price-cutting or raising prices ahead of their competitors; they recognise that they have a common interest in maintaining prices, as retaliation is bound to follow a price cut; they also know that if they attempt to increase prices individually, their competitors may not follow suit.
Under monopolistic competition, since there are so many firms in the group or industry, an increase in the market share of one, will not be so clearly at the expense of any one of them.
But under oligopoly, any substantial change in the market share of one firm, whether achieved by lower prices, better products or more advertising, will have significant effects on the market share at the expense of any one of them.
Since competition is so direct where there is a small number of a producer in the competing group, each has to keep a careful watch on the others.
At the same time, each firm has to be prepared to look for devices of limiting the effects of competition, perhaps by agreeing to rule out some of the most damaging types of competitive action.
When there is such competition among the few, we have oligopoly. Oligopoly means a few sellers and it is related to the term oligarchy which implies a small group of rulers. So an oligopoly is a smaller number of producers.
In the oligopoly market, the product of rival firms might be either homogeneous or heterogeneous.
If the product is standardised, the market is called homogeneous oligopoly and if differentiated, heterogeneous oligopoly. A special type of oligopoly is duopoly which has only two sellers.
The price-quantity combination and profit of an oligopolist depends upon the actions of all members of his market.
He has control over his own output level or over price, if his product is differentiated, but he has no direct control over other variables which affect his profits.
The profits of each seller are the result of the interaction of the decisions of all the members in the market. There is no generally accepted behaviour pattern for oligopolists as there are for perfect competitors and monopolists.
There are many different solutions for oligopolists, each of which is based upon a particular set of assumptions. Some of the interesting solutions will be discussed in this section.
The theory of pure competition, the theory of pure monopoly and the theory of monopolistic competition all come to clear conclusions about equilibrium prices and outputs.
Each of the theories is built with demand curves, cost curves and the profit-maximising assumption. Each of the theories yields equilibrium that is determinate. However, some theories of oligopoly give indeterminate results.
Assume an oligopolisitc market which has just three sellers, A, B, and C, and their products are close substitutes.
We can imagine as demand curve by assuming that B and C do not change price for their products.
If B and C kept prices unchanged, then as demand curve can be drawn which will show the different quantities he can sell at different prices.
But when A alters his prices causing B and C to change their prices, the result will be different. Changes in B’s price and C’s price immediately shift as demand curve either to the right or to the left.
The same argument applies to the demand curves of B and C. These three demand curves are interdependent so much so that it makes little sense to try to think of them separately.