Models That Are Based On Setting Of Price

Published Date: 02 Nov 2017

Industrial Economy

Explain and compare different models of oligopoly.

Contents

The Oligopoly

Oligopoly is defined as a market form in which a market is dominated by a small number of sellers. One of the definition says: "Oligopoly is a market structure in which a few firm dominate the industry, it is an industry with a 5 firm concentration ratio of greater than 50%." [1]. Also some of the firms can affect the total price of some product in their sector of market. The equilibrium price in an oligopoly market lies between that of competition and monopoly. This small number of firms coordinates their actions to maximize joint profits. It means that firms in oligopoly are interdependent; this lead to make their decisions (price and output) depend upon how the other firms behave. They can coordinate their actions due to agreement which they arrange between them. It is not necessary, that the firms in oligopoly have an agreement, through which they coordinate their actions to maximize joint profits.

The exact definition of oligopoly is complicated, because the firms are competitive to each other, but they are also connected together. Also depends on the size of the market and in which situation the market is. Firms mutually react to changes of the prices, but also to output prices, quality of product(s) and advertisement.

Characteristic signs for oligopoly are:

relatively small quantity of producers (some of the models describe only two of firm on the market, others are more likely with small count of firm with equally authorities; and some describe oligopoly where one firm dominate market

texture of the product can be homogeneous, or heterogeneous (in this case is clear or differentiated oligopoly); as a homogeneous product is considered a oil, heterogeneous product is e.g. car industry, tobacco industry, mobile services

possibility of existence of obstruction for entering the market sector (law restrictions, cost for entry)

Nash Equilibrium

Nash equilibrium is in game theory the situation, when, none of the players (firms) can not improve his position on market by modifying his strategy. At the same time it is also a concept of solution for non-cooperative games. The concept itself is used for analysis of possible results of strategic interaction of several actors. Basic principle how to determinate Nash equilibrium is impossibility to predict the result, as long as we will view the decisions separately. All the decisions made by the player, we must considered due to the context of all possible decisions that can be made by the rest of players. Nash equilibrium was firstly used for analysis in conflict situation such as war, or in The Armament race (or Prisoner dilemma).

Models of Oligopoly

For easiest describing theory of oligopoly are used different models of oligopoly. Model of contractual oligopoly (cartel) can be apply to several firms. Depends on the fact, if there is an agreement between firms in oligopoly, we can explain the phrase of cartel. There is difference between oligopoly and cartel. Oligopoly is an economic market condition where numerous sellers have their presence in one single market. While cartel is an explicit, formal agreement between firms in an industry to fix price and production quantity, it is an already existing agreement between the firms operating on the market.

The various oligopoly models differ in the type of actions firms may use (e.g. set prices or set output), the order in which they may take actions (such as which firm sets its price first), the length of the game (one period model or many periods), and in other ways. Most of the model use for describing of oligopoly model of duopoly (there are only two firms existing on one field of the market). It allows, to monitor interactions between firms, without misrepresentation due to large count of firms on the market. It continues to better tracking of their dependence and estimate (or forecast) the future progress of these firms.

As it was mentioned above, models of duopoly are divided into two groups:

Models that are based on setting of output levels

Cournot model

Stackelberg model

Model of quantitative cartel

Models that are based on setting of price

Bertrand model

Price leader model

By using the Cournot model can be described duopoly on the basis, that one of the is firms considering the output of the second firm to be constant. The same case can be represented also by the Bertrand model with that is not considered a constant output, but constant price of the product of the second firm. The last model is Stackelberg model, which describes the situation on the market with a dominant firm and a follower. Dominant firm may not be necessarily the company with the largest market share, but it may be a company with an aggressive price strategy that second company respects and must be followed. In all three models of duopoly are beginning two companies, after entering the third company to market, is possible to extend the business model to oligopoly.

Cournout model

Cournot model belongs to the models of duopoly, which means there are only two firms in one branch of market. The prerequisities are: these two companies are producing homogeneous product, have the same cost curves and knows the market demand. It is applicable on single period – the market and the firms exist only for one period. The starting point is that, the first company expects to decide about the size of its output, that the output of the second company will be constant. It means this situation when first firm assume that the second firm will not react to the change of the output level of the first firm. If the first firm changes the output level, it also changes the price of the output (product).

The Stackelberg Model

The Stackelberg model is also known as Leader-Follower model. Stackelberg model of duopoly come out of the same prerequisites as a Cournot model, but without interaction between the firms. All the other is same – firms still produce homogeneous product and still they are competitive, but there exist asymmetry of the information. One of the firms – we can set it as a leader – knows, how the other firm will react to changes, that the leader will make in the levels of output and price. The second firm – follower – will remain passive, as it was in duopoly Cournot model. Therefore the follower consider that, the output and the price of the leader will remain constant.

The Model of Quantitative Cartel

In this model are followed the rules of the Cournots’ model; there is only change in behave of the firms. The firm replace the competition between them with mutual co-operation. The main objective is the maximizing of joint profit.

The Bertrand Model

As it was mentioned, Cournot model derived a Nash equilibrium in a duopoly market, when firms produce homogeneous products and compete in output. But Bertrand derived a Nash equilibrium when firms compete in price. Output competition results in an equilibrium price below monopoly price and above marginal cost, while price competition results in the competitive solution. This means that in Bertrand’s model of oligopoly each firm chooses its quantity as the best response to the quantity chosen by other. This is also applied for chooses of its price as the best response to the price chosen by the other. This together means, that the firms set quantities sequentially – the first firm quantity is the best response to the first firm quantity. Also when the first firm sets a quantity, the second firm follows and sets the price. Also in Bertrand model apply that firms jointly set the price that maximizes industry profits. Another difference between this Bertrand and Cournot model is, that the firms don’t have any capacity regulations.

For presentation of Betrand model can be set, that first firm choose price that maximize its own profit (monopoly level price). The second firm, which step into the market assume, that first firm will not change the price level and this means the second firm price product will be lower than the price of the first firm and most of the market will go to second firm. In the next period the first firm also set lower the price level than the second one, while assuming that the second firm price will stay on the same level as before. The second firm again set lower price of the product and this cycle will continues till it reaches the marginal cost level. With this change of the funcion reply and considering of unlimited product capacity, the Betrand model comes to absolutely different situation, than in Cournot model. Both firms will get each other to the level of zero price.

The Price Leader Model in Duopoly

In this model situation in dupoly are followed prerequisites by the Betrand model, although firms are not in same positions. Assume is that first firm is the price leader and the second is follower. The first firm has an information advantage a knows the supply level of the second firm. The second firm – follower – assume the price level set by the leader as a constant and passively adapt to it.

The Cartel

As it was mentioned above, cartel is oligopoly with agreement between firms. In that case firms make agreement about setting up their output production level, or the price of their outputs will be uniform. Then the price is set up in the same high, as it would be in monopoly driven market. The main objective of the cartel is maximizing of the total profit of the specific branch. Total profit can be characterized as a difference between total revenue of whole cartel and the sum of costs from all members of the cartel. Why there can be an agreement

The Kinked Demand Curve

Due to the mutual dependence of the firms in the oligopoly, can’t be determined the demand curve that is one of the firms confronted, until we know the behaviour of the competitors. Their behaviour can differs due to reaction that are taken to the specific competitor. The competitors between them can react very sensitively or they can make no reaction – ignore the competitor. The solution, which attempt to describe this behaviour is the kinked demand curve of firm in oligopoly. In this model is supposition that the products are similar, but not same – can’t be perfect substituent to product of the others firms.

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The firms in oligopoly, faces a kinked-demand curve because of competition from other firms in the market. If the firm increases its price above the equilibrium price P, it is assumed that the other firms in the market will not follow with price increases of their own. The firms will then face the more elastic market demand curve MD1.

The firms’ market demand curve becomes more elastic at prices above P because at these higher prices consumers are more likely to switch to the lower-priced products provided by the other players in the market. Consequently, the demand for the firm's output falls off more quickly at prices above P; in other words, the demand for the firm’s output becomes more elastic.

If the firms reduce its price below P, it is assumed that its competitors will follow suit and reduce their prices as well. The firms will then face the relatively less elastic (or more inelastic) market demand curve MD2. Their market demand curve becomes less elastic at prices below P because the other players in the market have also reduced their prices. When firms follow each others pricing decisions, consumer demand for each firm’s product will become less elastic (or less sensitive) to changes in price because each of the firm is matching the price changes of its competitors.

The hypothesis of this model don’t say anything about price level – why is it on the level which is actually on – why is in the P point. This theory says only that the price will stay on the same level – when it is stabilize and why is it so. Economist argued to this a lots of doubts. The biggest one is that the fact, which is used to explain, is not a really fact. Also in some studies was found, that prices in oligopoly are not more or less stable than in any other market conditions.

The Evaluation of Oligopoly

Firms in oligopolistic industries exercise considerable market power, yielding economic inefficiency similar to monopoly. In equilibrium, the marginal social benefit (price) of their products exceeds the marginal social cost. Compared with purely or even monopolistically competitive industries, output will tend to be lower, and at higher prices to consumers. If oligopoly arises from economies of scale, however, it is possible that consumers pay lower prices than they would were the market more competitive. Some economists suggest that society gains over the long run when short-run profits reaped by oligopolistic firms are plowed back into the development and innovation of newer and better products. Furthermore, if research and development (R&D) leading to technological advances requires massive outlays, small competitive firms may be unable to finance adequate innovation. Some economists suggest that society gains over the long run when short-run profits reaped by oligopolistic firms are plowed back into the development and innovation of newer and better products. Successful collusion requires a stable environment, but unless cartels have the legal support of government, stability is unlikely. When products are significantly differentiated, or resource costs are volatile, or demands are fickle, or entry is easy, or competitors are numerous, or technology advances rapidly, or policing a cartel agreement is excessively costly, then the quiet cooperation that oligopolists would like may be replaced by strategic behavior as intense as championship chess and as hostile as war.

Literature sources:

CARLTON, D and PERLOFF, Modern Industrial Organization, New York

N. Gregory MANKIW, The Principles of Economics, The Dryden Press – Harcourt Brace College Publishers

http://www.diffen.com/difference/Cartel_vs_Oligopoly

http://www.sciencedirect.com/science/article/pii/S0165176511000619

http://www.economicshelp.org/microessays/essays/how-firms-oligopoly-compete.html