Oligopoly: Understanding Market Dynamics | CFA Level I Economics

Characteristics of Oligopoly Markets

Compared to monopolistic competition, oligopoly markets have:

• Higher barriers to entry: Due to economies of scale and fewer firms.
• Varying levels of differentiation: Products can range from good substitutes to highly differentiated, affecting pricing power.
• Interdependence: Firms are interdependent, so price changes by one firm can lead to price changes by its competitors.

Similar to monopolistic competition, firms in oligopoly markets compete on price and product differentiation.

Oligopoly Pricing and Quantity Models

We’ll learn four models that explain pricing and output quantity for firms in an oligopoly market:

1. Kinked Demand Curve Model

This model assumes that:

• An increase in price will not be followed by competitors, making the demand curve more elastic above the prevailing price.
• A decrease in price will be followed by competitors, making the demand curve less elastic below the prevailing price.

This results in a kinked demand curve. The most profitable price and output combination for a firm is at the kink. A firm in an oligopoly market will maintain its price at this level unless a competitor lowers its price.

The kinked demand curve can explain why market prices are stable in most oligopoly markets. However, it cannot explain what determines the prevailing price from the outset.

2. Cournot Model

This model considers an oligopoly with only two firms competing, both with identical and constant marginal costs of production. For example, let’s set the constant marginal cost at $30 per unit for both firms.

Each firm knows the quantity supplied by the other firm in the previous period and assumes that the supply will not change in the next period.

EXAMPLE: Let’s say the market demand function is given as Q = 450 – P, and based on the Cournot model assumptions, we can solve for the equilibrium output to be 140 units for each firm. The combined output from the market is 280 units, and we can solve for the equilibrium market price, which is $170. This price-output combination is known as the Cournot equilibrium.

Under perfect competition, the market equilibrium is reached when the price (marginal revenue) equals the marginal cost. So, with a constant marginal cost of $30, this is a competitive firm’s equilibrium price, and the output quantity is 420 units.

In our next lesson, we’ll learn that a monopolist, which has full market pricing power if not regulated, will have a profit-maximizing output of 210 units at a price of $240. The Cournot equilibrium, assuming a duopoly, falls between a monopoly solution and a competitive equilibrium with many competing firms.

As the number of firms increases, the output and price equilibrium positions move toward the competitive equilibrium.

3. Nash Equilibrium Model

Developed by Nobel Prize winner John Nash, the Nash equilibrium model assumes that all firms in an oligopoly will make choices that offer a chance of a better outcome. The equilibrium is reached when no firm can improve its situation on its own.

Understanding Nash Equilibrium Through the Prisoner’s Dilemma

To grasp the concept, let’s review a classical game theory scenario called the prisoner’s dilemma.

EXAMPLE Two prisoners, A and B, are offered the following deal:

• Both remain silent: Each gets a 6-month sentence
• A confesses, B stays silent: A goes free, B gets 10 years
• B confesses, A stays silent: B goes free, A gets 10 years
• Both confess: Each gets a 2-year sentence

Nash predicts that both prisoners will break their collusion and confess, as neither can improve their situation individually. This outcome is the Nash equilibrium.

Similarly, in an oligopoly with two firms, both can collude to increase prices and earn higher profits. However, if there are no binding agreements, both firms will choose to cheat, leading to the Nash equilibrium where both firms cheat.

Cartels and Collusive Agreements

When collusive agreements are made openly and formally, the firms involved are called a cartel. An example is the OPEC oil cartel, but evidence shows that cartel members regularly cheat on their agreements.

Collusive agreements are more successful when:

• There are fewer firms
• Products are less differentiated
• Cost structures are similar
• Purchases are small and frequent
• Retaliation for cheating is certain and severe
• There’s less competition from outside the cartel

4. Dominant Firm Model

In this model, a single firm with a significantly large market share and lower cost structure determines the market price, while the rest are price takers. The dominant firm sets the market price (P-star), and price followers produce at the quantity where their marginal cost equals P-star.

The dominant firm likely reached its position due to a lower cost structure, so price followers rarely try to undercut the dominant firm, as competing based on price would be futile.

Conclusion

Understanding the Pricing and Quantity Models models helps us better analyze oligopoly markets, where interdependence among firms plays a crucial role. As we wrap up our lesson on oligopoly markets, we’ll soon move on to the world of monopoly.