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BBA I Semester Managerial Economics Pricing Under Oligopoly Study Material Notes: Price Determination under oligopoly Assumptions The Model Reasons for Price stability Its Shortcomings Exercises ( Most Important Topic-wise Notes for BBA I Semester Students )
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PRICING UNDER OLIGOPOLY
Oligopoly is a market situation in which there are a few firms selling homogeneous or differentiated products. It is difficult to pinpoint the number of firms in the oligopolistic market. There may be three, four or five firms. It is also known as the competition among the few. With only a few firms in the market, the action of one firm is likely to affect the others. An oligopoly industry produces either a homogeneous product or heterogeneous products. The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated oligopoly. Pure oligopoly is found primarily among producers of such industrial products as aluminum, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among producers of such consumer goods as automobiles, cigarettes, soaps and detergents, TVs, rubber tyres, refrigerators, typewriters, etc.
PRICE DETERMINATION UNDER OLIGOPOLY
The Sweeny Model of Kinked Demand Curve (Rigid Prices)
In his article published in 1939, Prof. Sweeny’ presented the kinked demand curve analysis to explain price rigidities often observed in oligopolistic markets.
Sweeny assumes that if the oligopolistic firm lowers its price, its rivals will react by matching that price cut in order to avoid losing their customers. Thus the firm lowering the price will not be able to increase its demand much. This portion of its demand curve is relatively inelastic. On the other hand, if the oligopolistic firm increases its price, its rivals will not follow it and change their prices. Thus the quantity demanded of this firm will fall considerably. This portion of the demand curve is relatively elastic. In these two situations, the demand curve of the oligopolistic firm has a kink at the prevailing market price which explains price rigidity.
The kinked demand curve hypothesis of price rigidity is based on the following assumptions:
(1) There are few firms in the oligopolistic industry.
(2) The product produced by one firm is a close substitute for the other firms.
(3) The product is of the same quality. There is no product differentiation.
(4) There are no advertising expenditures.
(5) There is an established or prevailing market price for the product at which all the sellers are satisfied.
(6) Each seller’s attitude depends on the attitude of his rivals.
(7) Any attempt on the part of a seller to push up his sales by reducing the price of his product will be counteracted by the other sellers who will follow his move.
(8) If he raises the price, others will not follow him. Rather they will stick to the prevailing price and cater to the customers, leaving the price-raising seller.
(9) The marginal cost curve passes through the dotted portion of the marginal revenue curve so that changes in marginal cost do not affect output and price.
Pricing Under Oligopoly
Given these assumptions, the price-output relationship in the oligopolistic market is explained in Figure 1 where KPD is the kinked demand curve and OP the prevailing price in the oligopoly market for the OR product of one seller. Starting from point P, corresponding to the current price OP, any increase in price above it will considerably reduce his sales, for his rivals are not expected to follow his price increase. This is so because the KP portion of the kinked demand curve is elastic, and the corresponding portion KA of the MR curve is positive. Therefore, any price increase will not only reduce his total sale but also his total revenue and profit.
On the other hand, if the seller reduces the price of the product below OP (or P), his rivals will also reduce their prices. Though he will increase his sales, his profit would be less than before. The reason is that the PD portion of the kinked demand curve below P is less elastic and the corresponding part of the marginal revenue curve below R is negative. Thus in both the price raising and price-reducing situations, the seller will be a loser. He would stick to the prevailing market price OP, which remains rigid.
In order to study the working of the kinked demand curve, let us analyze the effect of changes in cost and demand conditions on price stability in the oligopolistic market.
Changes in Costs. In oligopoly under the kinked demand curve analysis changes in costs within a certain range do not affect the prevailing price. Suppose the cost of production falls so that the new MC curve is MC,, to the right, as in Figure 2. It cuts the MR curve in the gap AB so that the profit-maximizing output is OR which can be sold at OP price. It should be noted that with any cost reduction the new MC curve will always cut the MR curve in the gap because as costs fall the gap AB continues to widen due to two reasons:
(1) As costs fall the upper portion KP of the demand curve becomes more elastic because of the greater certainty that a price rise by one seller will not be followed by rivals and his sales would be considerably reduced. (2) With the reduction in costs the lower portion PD of the kinked curve becomes more inelastic, because of the greater certainty that a price reduction by one seller will be followed by the other rivals. Thus the angle KPD tends to be a right angle at P and the gap AB widens so that any MC curve below point A will cut the marginal revenue curve inside the gap. The net result is the same output OR at the same price OP, and larger profits for the Quantity R oligopolistic sellers.
In case the cost of production rises the marginal cost curve will shift to the left of the old curve MC as MC. So long as the higher MC curve intersects the MR curve within the gap upto point A, the price situation will be rigid. However, with the rise in costs the price is not likely to remain stable indefinitely and if the MC curve rises above point A, it will intersect the MC curve in the portion KA so that a lesser quantity is sold at a higher price. We may conclude that there may be price stability under oligopoly even when costs change so long as the MC curve cuts the MR curve in its discontinuous portion. However, chances of the existence of price rigidity are greater where there is a reduction in costs than there is a rise in costs.
Changes in Demand. We now explain price rigidity where there is a change in demand with the help of Figure 3, D, is the original demand curve, MR, is its corresponding marginal revenue curve and MC is the marginal cost curve. Suppose there is decrease in demand shown by D, curve and MR, is its marginal revenue curve. When demand decreases, a price-reduction move by one seller will be followed by other rivals. This will make LD,, the lower portion of the new demand curve, more inelastic than the lower portion HD, of the old demand curve. This will tend to make the angle at L approach a right angle. As a result, the gap EF in MR, curve is likely to be wider than the gap AB of the MR, curve. The marginal cost curve will, therefore, intersect the lower marginal revenue curve MR, inside the gap EF, thus India Eating a stable price for the oligopolistic industry. Since the level of the kinks H and L of the two Quantity demand curves remains the same, the same price OP is maintained after the decrease in demand. But the output level falls from 0 to 0 .. This case can be reversed to show increase in demand by taking D, and MR, as the original demand and marginal revenue curves and D, and MR, as the higher demand and marginal revenue curves respectively. The price OP is maintained but the output rises from 09, to 00. So long as the MC curve continues to intersect the MR curve in the discontinuous portion, there will be price rigidity.
The whole analysis of the kinked demand curve points out that price rigidity in oligopolistic markets is likely to prevail if there is a price reduction move on the part of all sellers. Changes in costs and demand also lead to price stability under normal conditions so long as the MC curve intersects the MR curve in its discontinuous portion. But price increase rather than price rigidity may be found in response to rising cost or increased demand.
Pricing Under Oligopoly
Reasons for Price Stability
There are a number of reasons for price rigidity in certain oligopoly markets.
(1) Individual sellers in an oligopolistic industry might have learnt through experience the futility of price wars and thus prefer price stability.
(2) They may be content with the current prices, outputs and profits and avoid any involvement in unnecessary insecurity and uncertainty.
(3) They may also prefer to stick to the present price level to prevent new firms from entering the industry.
(4) The sellers may intensify their sales promotion efforts at the current price instead of reducing it. They may view non-price competition better than price rivalry
(5) After spending a lot of money on advertising his product, a seller may not like to raise its price to deprive himself of the fruits of his hard labour. Naturally, he would stick to the going price of the product.
(6) Ifa stable price has been set through agreement or collusion, no seller would like to disturb it, for fear of unleashing a price war and thus engulfing himself into an era of uncertainty and insecurity.
(7) It is the kinked demand curve analysis which is responsible for price rigidity in oligopolistic markets.
But the theory of kinked demand curve in oligopoly pricing is not without shortcomings.
(1) Even if we accept all its assumptions it is not likely that the gap in the marginal revenue curve will be wide enough for the marginal cost curve to pass through it. It may be shortened even under conditions of fall in demand or costs thereby making price unstable.
(2) One of its major shortcomings, according to Prof. Stigler, is that the theory does not explain why prices that have once changed should settle down, again acquire stability, and gradually produce a new kink.” For instance in Figure 2, the kink occurs at P because OP is the prevailing price. But the theory does not explain the forces that established the initial price OP,
(3) Price stability may be illusory because it is not based on the actual market behavior. Sales do not always occur at list prices. There are often deviations from posted prices because of trade-ins, allowance and secret price concessions. The oligopolistic seller outwardly keep the price stable but he may reduce the quality or quantity of the product. Thus price stability becomes illusory.
(4) Moreover, it is not possible to statistically compile actual sales prices in the case that may reflect stable prices for them. It is therefore, doubtful that price stability actually exists in oligopoly. out that the kinked demand curve analysis holds during the short
(5) Critics point out that the kinked demand run, when the knowledge about the reactions of rivals are low. But it is difficult to guess correctly the rivals’ reactions in the long run. Thus the theory is not applicable in the long run.
(6) According to some economists, the kinked demand curve analysis applies to an oligopolistic industry in its initial stages or to that industry in which new and previously unknown rivals enter the market.
(7) The kinked demand curve analysis is based on two assumptions: first, other firms will follow a price cut and, second, they will not follow a price rise. But in an inflationary period the rise in price is not confined only to one firm but is industry-wide. So all firms having similar costs will follow one another in raising price.
(8) The kinked demand curve analysis is applicable only under depression. For in an inflationary period when demand increases, the oligopolistic firm will raise price and other firms will also follow it. In such a situation, the demand curve of the oligopolist will have inverted kink.
(9) Stigler further points out that cases in oligopoly industries where the number of sellers is either very small or somewhat large, the kinked demand curve is not likely to be there.
1 Explain the equilibrium of a firm under oligopoly.
2. What is an oligopoly? Give reasons for price rigidity under oligopoly.
Pricing Under Oligopoly
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