How to Determine Price and Output under Oligopoly? | Microeconomics

The following article will guide you about how to determine price and output under oligopoly.

Generally, a firm will be in equilibrium where its marginal cost curve cuts its marginal revenue curve from its below (MC=MR) and price will be depicted by the average revenue curve or demand curve of the firm.

Price and output determination under oligopoly can be studied under the following headings:

Price and Output under Perfect Collusion:

Under oligopoly perfect collusion may be formed among different producers and sellers in two ways, namely, centralised cartel and market sharing cartel and price and output are determined accordingly.

(a) Centralised Cartel:

Under this type of collusion a centralised cartel is set up by different firms of oligopoly market structure. These firms transfer their function relating to managerial decisions and other activities to the centralised cartel to improve the volume of profit. Centralised cartel aims at maximisation of profit of all the firms. The cartel fixes price of the product, volume of output and production quota of individual firms.

Once such centralised cartel is set up under perfect collusion of oligopoly the market becomes a monopoly market. Although such situation is imaginary and unrealistic. However, the situation under centralised cartel becomes more or less the same.

We assume that under a centralised cartel there are only two firms and the cartel is well aware of the demand of the commodity at different levels of prices and marginal revenue curve of industry is drawn accordingly. The aggregate of all marginal costs of the firms is derived (∑MC). Central cartel will determine price and output to attain the maximum total output with the given average revenue (demand curve), marginal revenue and marginal cost.

The profit will be maximised by the centralised cartel when the group MR is equal to group marginal cost (∑MR=∑MC) as given in the following diagram-

In the diagram AR is the demand curve of industry and MR is the marginal revenue curve which has been drawn on the basis of AR or demand curve. ∑MC is the total marginal cost curve of the industry which is the aggregate marginal cost of two firms engaged in production in that industry. Marginal revenue curve of industry is cut by the marginal cost curve of the industry at point E where ∑MR is equal to ∑MC (∑MR=∑MC). It is the equilibrium of the industry. Price is OP and output is OQ in the industry.

The centralised cartel fixes the production quota of individual firm and it can be fixed in various ways. The simplest method is that once centralised cartel has determined the price the firms are given freedom to produce and sell it at given price.

In such a situation individual firm will produce to the point where its marginal cost is equal to its price and maximises its profit. Another method is to fix the quota of all firms on the basis of their average sales in the past. The last method is the geographical distribution of area within which the firms will sell their product and restrictions are imposed on outside area.

(b) Market Sharing Cartel:

Another form of perfect collusion is the market sharing by the firms. This type of collusion can be effective and successful when all the firms are producing homogeneous product and production costs are similar. In order to explain this type of collusion we assume that there are two firms producing on the uniform cost of production and are ready to share market on 50:50 basis.

In market sharing cartel each firm aims at maximisation of profit. The maximisation of profit will be at that point where each firm’s marginal cost is equal to its marginal revenue (MC=MR).

It can be explained with the help of the following diagram:

In the diagram, output is shown on OX-axis while price, cost and revenue on OY-axis. DD (AR) is the demand curve of industry and it has been divided into two parts. DD₁ (AR₁) is the demand curve of an individual firm and MR is its marginal revenue curve. The marginal cost curve of firms is MC and average cost is AC. The MC curve of firm cuts its marginal revenue curve (MR) from its below and the point of equilibrium is E.

The output of the firm is OQ₁ and its price is OP or LQ₁. The average cost of the firm is Q₁L₁ or OR. Hence, the firm is earning RL₁LP profit. The other firm will also produce and sell the same output because we have assumed that there are two firms only.

Hence, the output in industry will be OQ which is just double to the OQ₁ and the MC and MR will be OR₂ because the cost and revenue curves of the other firms are also similar. Under the market sharing cartel both the firms will have equal share in the industry. But the sharing may also be based on the geographical as well as on the efficiency of the firms and the share may be more.

Price and Output under Imperfect Collusion:

Under oligopoly price and output can also be determined without any collusion among the firms. The firms may decide to follow a firm in price and output determination in the long run. Such sort of policy is called price leadership under oligopoly.

Such type of imperfect collusion in the form of price leadership may take two forms as given below:

(a) Price Leadership of Low Cost Firm:

Under imperfect collusion firms may agree to follow the price leadership of low cost firm. In other words, a firm of low cost production tries to maximise its profit and the same price and output policy can be followed by other firms in the industry. Under this type of price leadership we assume that there are two firms only producing the homogeneous product and they share the market and cost of production of one firm is lower than the former.

The price leadership of low cost firm can be explained with the help of the following diagram:

In the diagram output is shown on OX-axis while price, cost, and revenue are shown on OY-axis. DD is the market demand curve while DD₁ is the demand curve of the firm. AC₂ and MC₂ are average cost curve and marginal cost curve of the firm having high cost of production. Its point of equilibrium is E₂ where the price is OP₂ and the output is OQ₂.

The average cost curve (AC₁) and marginal cost curve (MC₁) are of a firm having least cost of production. Its point of equilibrium is E₁ where the price of the firm is OP₁ and output is OQ₁. The marginal revenue curve (MR) of both the firms is equal to their MC₁ and MC₂. The firm producing OQ₁ output with OP₁ price is the low cost producing firm and it will be the price leader in the market and the same price policy OP₁ will be following by other firm.

(b) Price Leadership of a Dominant Firm:

Another type of imperfect collusion under oligopoly is the price leadership by a dominant firm. This type of price determination is possible only when there is a large size firm and another firm is a small size firm in the industry. The large size firm will fix the price and the small firm will sell the output at that price.

The price leadership of a dominant firm is based on the following assumptions:

(i) There is a large size firm and others are small sized firms. There is an agreement among all these firms.

(ii) Small firms can sell their output at the price fixed by the large sized firm. Small firms are price takers.

(iii) The output is supplied by small firms at the price fixed by the dominant firm and the remaining supply of output will be produced by the large size firm.

(iv) The dominant firm will maximise its profit.

The Diagram 4 will explain the price and output determined by the dominant firm under oligopoly:

Output is shown on OX-axis, price, costs and revenue are shown on OY-axis. DD is the market demand curve of the product. ∑MC is the supply curve of small firms excluding the dominant firm.

Under it the dominant firm price leadership fixes the price. On this price all the small firms will supply the market demand and remaining demand is met by the dominant firm. We assume that the dominant firm determines the OP₁ price. On this price the total market demand is P₁L and this demand is completed by all the small firms. The supply of dominant firm on this price is zero.

If the dominant firm reduces the price which will increase the demand in the market and small firms will supply less and the dominant firm will supply a major part of market demand. On OP₂ price the market demand is P₂L₁. Out of it, P₂C is supplied by small firms and the remaining part of market demand CL₁ is supplied by the dominant firm. The demand curve of the dominant firm is P₁B.

Similarly, if the dominant firm fixes OP₃ price the market demand is P₃L₂. P₃G is the supply of small firms while the dominant firm will supply GL₂. The third point of dominant firm on the demand curve is F. Thus the various points on P₁D₁ will give the demand curve of the dominant firm and the MR_d will be its marginal revenue curve. The marginal cost (MC) curve of the firm cuts its marginal revenue curve (MR_d) at E point. At this point the dominant firm produces OM_d output and sells it at OP price. At OP price the total demand of the commodity is OM. At this price (OP) small firms will supply OM_s quantity and remaining M_SM quantity will be sold by the dominant firm. Thus, under dominant price leadership the price and output are determined.

Price and Output under Independent Pricing:

Under oligopoly market structure when there is no collusion among different sellers or firms then individual firm is free to follow an independent pricing policy. Independent pricing means each individual firm follows an independent price and output policy under oligopoly. Price war starts under the oligopoly when an independent pricing policy is followed by all the firms. Uncertainty and insecurity emerge in the market.

When an individual seller reduces the price of product the customers of his competitors will be attracted and rival firm may also reduce the price. Price war starts and spreads in the industry as a whole and each firm tries to reduce the price of its product. Many firms are forced to leave the industry because of cut-throat competition and price war.

The intensity of price war can be reduced by the experience of the industry. All the firms in the market have long run experience and they can take decision accordingly. Firms set such a price or set of prices which are accepted by all the firms from the profit point of view. Such prices are stable or rigid for a given period of time and individual firms try to adopt the policy of non-price competition (advertisement and sales promotion) in place of price competition.