OLIGOPOLY

An oligopoly is a market situation where a few firms dominate the market selling homogeneous or differentiated products interdependent with respect to pricing and output decisions.

 An industry’s concentration ratio in terms of the share in an industry total output the largest four to eight firms control determines whether an industry is an oligopoly. The high degree of concentration and the large size of firms in an oligopoly industry create serious obstacles to the entry of potential competitors. For example, British Airways and Air France operate on such routes where there are only a few close rivals. Oligopolies can arise because of economies of large  scale production, ownership or control of a key scarce resource, high-set-up and R&D costs, other entry barriers such as patents, ownership of raw materials, and mergers etc. 

Sellers do have some control on price but at the same time there is an intense rivalry, or competition in the popular sense, to increase their individual market shares. The passenger car industry in India is a good example of an oligopoly market, with only four or five manufacturers. Likewise, fertilizers, pesticides, tractors, trucks, cement, steel, life saving drugs, etc. are all examples of oligopolies in India.        

An oligopoly involves an unspecified number of buyers but only a small number of sellers. The actions of each firm in an oligopoly do affect the other sellers in the market. Price cutting by one firm will reduce the market share of other firms. Similarly, clever advertising or a new product line may increase sales at the expense of other sellers. Clearly, the responses of competitors can have a significant impact on the outcome of managerial decisions in an oligopoly market. Consequently, decision- making in an oligopoly is much more difficult than in other market situation.
The products sold in an oligopoly can be homogeneous or differentiated. If the product is homogeneous, the market is said to be pure oligopoly. If the product is differentiated, the market is a differentiated oligopoly. The automobile and television industries are examples of differentiated oligopolies. There must be some factor that prevents new firms from entering the industry. For example, a drug manufacturer might hold a patent that legally prevents other firms from producing the drug covered by the patent.

Key Features
The distinguishing characteristics of oligopoly are briefly explained below: 
Interdependence

Sellers must recognize their interdependence as they cannot act independent of each other. The action of one seller may affect another and thus cause that seller to respond in ways that will affect the first seller. For example, if Pepsi desires to enhance its market share by reducing price, it must take into consideration the chances that its close rival, such as Coca-Cola, may also reduce its price in retalliation. But oligopolists are likely to deal with this interdependence in difference ways, depending on the specific nature of the industry. In some case, most actions of competitors will be ignored. In other situations, a price war may occur in response to a seemingly innocuous price change. Many factor, such as the level of maturity of the industry, nature of the product, and ways of conducting business, can affect the way firms respond to actions of rivals. 
An oligopolist never knows exactly how his rivals will react to a price or output change that he himself makes. The number of firms being small, each seller knows his competitors in each market area and has to consider the possible reactions of his competitors to his own output and price policies. The smaller the number of firms, the higher will be interdependence between them. The reactions of rivals are generally immediate and strong and can vary in the short and long – run perspectives. A clear understanding of game theory and the Prisoner's Dilemma assists in dealing with the phenomena of interdependence.

Barriers to entry

 Oligopoly and monopoly firms usually attempt to maintain their dominance in the market either it is difficult for potential firms to enter the market or too costly to do so.   The size of the barriers, however, will differ from industry to industry. In some cases entry is relatively simple, whereas in others it is virtually impossible. Entry of new firms into oligopoly market is relatively difficult. It is neither completely free nor completely barred. The oligopolies can deliberately erect barriers to entry or can take advantage of existing natural barriers

Strategy

In oligopoly firms pricing, volume, advertising, and investment decisions involve critical strategic considerations. Therefore, strategy is extremely important to interdependent firms. These firms cannot act independently. They have to anticipate the possible response of a rival  to any specific change in their price or non-price issues. Each firm needs carefully consider how its actions are likely to affect its rivals, and how they are likely to react. Assume that due to slow-moving car sales, Ford is thinking a 10 percent reduction in price to encourage demand. It must consider carefully about how GM and Chrysler are likely to react. They might not react at all, or they might make small reduction in their price, in this case Ford could take advantage of an adequate increase in sales substantially at the cost of its competitors. Alternatively, they might make a similar cut in their prices in which case all the three companies will sell additional cars but might result in much lower profits due to the lower prices. Possibility is also there that GM and Chrysler will cut down their prices more than Ford, which might result in a price war leading to a severe reduction in profits for all competitors. Ford must carefully consider all the options. Really, for several major economic decisions including determining price, fixing production levels, engaging a major promotion campaign, or making investment in erecting new production capacity, a firm must attempt to find out precisely the most likely response of its competitors. Firms have to take strategic decisions such as compete with rivals or collude, increase or reduce price or not to indulge in price competition, or be a first mover in a new strategy or wait and watch the actions of rivals and identify ways to undermine them.

Price rigidity and non- price competition 
Oligopoly markets are characterized by rigid price. Once a price comes to prevail, it continues for years as such in spite of change in costs and demand. Firms tend to stick to the established price and limit their competitive effort to non-price competition i.e. change in the design and advertising of the product. While maintaining quoted prices constant, firms attempt to improve their position in the market through various types of concessions to the customers, free delivery, guarantee for some time, repair facilities, some kind of gifts with the product etc. A major part of the competition is in the form of product differentiation and selling activity.

Existence of Non-profit Motives

            Due to indeterminacy of the individual firm’s demand (AR) and marginal revenue curves, oligopoly firms may not aim at maximization of profits. Modern theories of oligopoly consider the following alternative objectives of the firm:

(a)    Sales maximization with profit constraint.

(b)   Fair rate of profit and long-run stability.

(c)    Limiting new entry

(d)   Maximization of the marginal utility function

(e)    Achieving “satisfactory: profits, sales etc.

(f)    Maximization of joint profits rather than individual profits.

It is impossible, therefore, to predict the effect on a firm’s sales of, say, a change in its price without firms making some assumptions about the reactions of other firms. Different assumptions will yield different predictions. For this reason there is no single generally accepted theory of oligopoly. Firms may react differently and unpredictably.

Duopoly Pricing
Augustine Curnot, a French economist, in 1883, developed a formal oligopoly model. Curnot illustrated his model with the help of following assumptions:

(a)    There are two firms that have identical products and identical costs.

(b)   Each firm owning a spring of mineral water operating at zero marginal cost.

(c)    Both firm sell their output in a market with a straight-line demand curve.

(d)   Each firm acts on the assumption that its competitor will not change in output, and decides its own output so as to maximize profit.

On the basis of his model, Curnot concluded that each seller ultimately supplies one-third of the market and both the firms charge the same price. One-third of the market remains unsupplied.

DD’ is the demand curve for mineral water and marginal revenue is depicted by MR curve. Let us assume that firm A is the first to start producing and selling mineral water. It will produce quantity OA, half of the total market demand, at price P where profits are at a maximum because at this point MC=MR=0. The elasticity of market demand at this level of output is equal to unity and the total revenue of the firm is a maximum. With zero costs, maximum revenue implies maximum profit. Selling OA output the firm earns OPCA total profit. Now firm B enters the markets. Assuming that A will keep its output fixed at OA, and hence considers that its own demand curve is CD’. Firm B decides to produce half the quantity of AD, because at this level (AB) of output (and at price P’), its revenue and profit is at a maximum. B produces half of the market that has not been supplied by A, that is, B’s output is ¼ (1/2.1/2) of the total market.

Faced with this situation firm A assumes that B will retain his quantity constant in the next period. So he will produce one-half of the market that is not supplied by B. Since B covers one-quarter of the market, A will, in the next period, produce ½(1-12) =1/2.3/4 = 3/8 of the total market.  Firm B reacts and will produce one half of the unsupplied section of the market ½ (1-3/8) =1/16

In the third period firm A will continue to assume that B will not change its quantity and thus will produce one half of the remainder of the market i.e.1/2 (1-1/16)).

This process of action-reaction continues, in successive periods. However, eventually a situation is reached in which each firm produces one-third of the total market. Any further output adjustment yields the same result. The firms reach an equilibrium position where each one supplies one-third of the market and both charge the same price.

Thus the Curnot solution is stable. Each firm supplies 1/3 of the market, at a common price that is lower than the monopoly- price, but above the pure competitive price. If there are three firms in the industry, each will produce one-quarter of the market and all of them together will supply ¾ (1/4x 3) of the entire market OD. If there are n firms in the industry each will provide 1/(n + 1) of the market, and the industry output will be n/ (n + 1) = 1(n + 1)x n . As more and more firms are assumed to exist in the industry, the higher the total quantity supplied and hence the lower the price. The large the number of firms the closer is output and price to the competitive level.

Although Cournot’s solution provides a stable equilibrium it has been criticized on the following bases:

1.  Cournot’s behavioral pattern of firms is naïve. Firms continue to make miscalculations about the competitors’ reactions. Each firm continues to assume that his rival will not change his output, but the quantity competitor starts with bring down the price to competitive level.

2.   Though the model can be extended to any number of firms, yet it is a ‘closed’ model as entry is not allowed. The number of firms that are assumed in the first period remains the same throughout the adjustment process. The model does not say how long the adjustment period will be.

3.  The assumption of zero cost of production is unrealistic. However, relaxing this assumption does not invalidate the model.