Oligopoly: Price Rigidity and Price Leadership

Origin of Oligopoly

The word oligopoly is derived from two Greek words – ‘Oligi’ meaning ‘few’ and ‘Polein’ meaning ‘selling’. When there is limited market, in which a market is shared by a smaller number of producers or sellers.

What is Oligopoly?

Meaning of Oligopoly: – Oligopoly is a structural type of market, consisting of and dominated by a small number of firms. It can be described as a form of ‘imperfect competition’ where the actions of a firm significantly influence the other firms in the market. This is in stark contrast to monopolies, where a single firm controls the entire market.

An oligopoly is when a very few companies exert significant control over a given market. Together, these companies may control prices by colluding with each other, ultimately providing uncompetitive prices in the market. Among other detrimental effects of an oligopoly include limiting new entrants in the market and decreased innovation. Oligopolies have been found in the oil industry, railroad companies, wireless carriers, and big tech.

There is limited competition in an oligopoly market. This induces the firms to collaborate to keep hold of the market and compete with others. This interdependence is one of the main characteristics of oligopoly.

The easiest way to find out whether an industry is an oligopoly is to determine the concentration ratio of that industry. This ratio reflects the share in the total output of an industry that is controlled by the largest four to eight firms. The high level of concentration and large size of firms in an oligopoly industry create serious barriers to entry for potential competitors.

For Example: – Here, 90% of media in the U.S. is dictated by five companies—NBC Universal, Walt Disney, Time Warner, Viacom CBS, and News Corporation. Meanwhile, within big tech, two companies control smartphone operating systems: Google Android and Apple iOS.

Sellers have some control over the 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 elite market with only four or five manufacturers. Similarly, fertilizers, pesticides, tractors, trucks, cement, steel, lifesaving drugs etc. are examples of oligopoly in India.

The products sold in an oligopoly may be homogeneous or differentiated. If the product is homogeneous (same), 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 which prevents new firms from entering the industry. For example, a drug manufacturer may hold a patent that legally prevents other firms from producing a drug covered by the patent.

What are the types of Oligopolies?

There are four types of Oligopolies, as follows: –

Pure or perfect oligopoly: – If firms produce homogeneous (same) products, it is called pure or absolute oligopoly. Although the status of pure oligopoly is rare, yet, industries producing cement, steel, aluminum and chemicals tend towards pure oligopoly.
Imperfect or Differentiated Oligopoly: – If firms produce differentiated products, it is called differentiated or imperfect oligopoly. Passenger cars, cigarettes or soft drinks are examples of differentiated oligopoly. The goods produced by different firms have their own distinctive characteristics, yet they are all close substitutes of each other.
Collusive oligopoly: – Collusion is a form of oligopoly market in which some firms enter into mutual agreements to avoid competition. They form a cartel and fix the output quota and market price. The leading firm in the market is accepted by the cartel as the price leader.
Non-Collusive Oligopoly: – It is a market in which the firms act independently. In this the firms compete with each other and determine independently the price of their products. In other words, it is a market in which there are few firms in the market. Each firm pursues its own price and output policy independent of the other rival firms.

What are the features of Oligopoly?

The main features of oligopoly are as follows: –

Few Firms: –
- There are some big firms under the oligopoly. The exact number of firms is not defined. Each firm produces a significant part of the total output. Severe competition exists between different firms and each firm tries to manipulate both the prices and the quantity of output in order to outperform each other. For example, the automobile market in India is an oligopoly structure as there are only a few manufacturers of automobiles.
- The number of firms is so small that the action of any one firm can affect the rival firms. Therefore, each firm keeps a close watch on the activities of the rival firms.
Interdependence: –
- Firms under oligopoly are interdependent. Interdependence means that the actions of one firm affect the actions of other firms. A firm considers the action and reaction of rival firms while determining its price and output levels. Changes in output or price by one firm react with other firms operating in the market.
- For example, the car market in India is dominated by a few firms (Maruti, Tata, Hyundai, Ford, Honda, etc.). A change in any of its vehicles (e.g., Indica) by one firm (e.g., Tata) will prompt other firms (e.g., Maruti, Hyundai, etc.) to make changes in their respective vehicles.
Non-Price Competition: –
- Firms under oligopoly are in a position to influence prices. However, they try to avoid price competition for fear of a price war. They follow the policy of price rigidity. Price rigidity refers to a situation in which the price remains constant despite changes in demand and supply conditions. Firms use other methods like advertising, better services to customers etc. to compete with each other.
- If a firm tries to lower the price, rivals will also react by lowering their prices. However, if it tries to raise the price, other companies can’t. This would result in loss of customers for the firm that intended to raise the price. Therefore, firms prefer non-price competition rather than price competition.
Barriers to Entry of Firms: –
- The main reason some firms under oligopoly are barriers, which prevent the entry of new firms into the industry. Patents, requirement of huge capital, control over critical raw materials etc. are some of the reasons which prevent new firms from entering the industry. Only those firms enter the industry which are able to overcome these barriers. As a result, firms can make unusual profits in the long run.
Role of Selling Costs: –
- Due to ‘severe competition’ and interdependence of firms, various sales promotion techniques are used to promote the sales of the product. Advertising is in full swing under oligopoly, and at times advertising can become a matter of life and death. Under oligopoly a firm depends more on non-price competition.
- Selling cost is more important under oligopoly than under monopolistic competition.
Group Behavior: –
- Under oligopoly, there is complete interdependence between different firms. Therefore, the price and output decisions of a particular firm directly affect the competing firms.
- Instead of independent pricing and production strategy, oligopoly firms prefer group decisions that will protect the interests of all firms. Group behavior means that firms behave as if they are a single firm, even though individually they maintain their independence.
Nature of the Product: –
- Firms under oligopoly can produce homogeneous or differentiated products.
- If firms produce a homogeneous product such as cement or steel, the industry is said to be a pure or perfect oligopoly.
- Second, if firms produce a differentiated product like automobiles, the industry is said to be differentiated or imperfect oligopoly.
Uncertain Demand Curve: –
- Under oligopoly, the exact behavior pattern of a producer cannot be determined with certainty. So, the demand curve faced by an elite is uncertain. Since firms are interdependent, one firm cannot ignore the reaction of rival firms. Any change in price by one firm can cause a change in prices by competing firms.

What is price rigidity?

Meaning of price rigidity under Oligopoly: – Price rigidity may occur under an oligopoly market because of the price stability accepted by the firms. Every firm in an oligopoly market is faced with a Kinked Demand Curve, the kink being at that point on the demand curve which corresponds to the prevailing common price accepted by all the firms at which they sell their output. There is thus a rigidity or stickiness about this price.

Price rigidity is found under oligopoly due to the following reasons: –

When firms under oligopoly make an agreement not to observe price war as it does not favor any of them.
When an oligopoly industry attains maturity and thinks that a price war will not benefit the industry as a whole.
The oligarch may follow a policy of price rigidity so as to discourage the entry of other firms.
All firms have experienced under the oligopoly market that when one firm lowers the price the other firms will also reduce the price.
All firms feel that they will benefit from non-price competition instead of following the policy of reduction in price.
Kinked demand curve (When the demand curve is not a straight line, but has different elasticity for high and low prices) analysis brings price stiffness under the oligopoly market.
Price rigidity is followed because under an oligopoly market the objective of profit can be achieved through maximization of sales rather than reduction in price.

The price rigidity or kinked demand curve under oligopoly can be explained with the help of the following diagram: –

In the figure above, KPD is the is the kinked-demand curve and OP₀ is the prevailing price in the oligopoly market for the OR product of one seller. Starting from point P, corresponding to the point OP₁, any increase in price above it will considerably reduce his sales as his rivals will not follow his price increase.

This is because the KP portion of the curve is elastic and the corresponding portion of the MR curve (KA) is positive. Therefore, any price increase will not just reduce the total sales but also his total revenue and profit. On the other hand, if the seller reduces the price of the product below OPQ (or P), his rivals will also reduce their prices.

However, even if his sales increase, his profits would be less than before. This is because the PD portion of the curve below P is less elastic and the corresponding part of the marginal revenue curve below R is negative. Therefore, in both price-raising and price-reducing situations, the seller is the loser. He will stick to the prevailing market price OP₀ which remains rigid.

What is price leadership?

Meaning of price leadership: – Price leadership occurs when a leading firm in a given industry is able to exert enough influence in the sector that it can effectively determine the price of goods or services for the entire market. This type of firm is sometimes referred to as the price leader. In some situations, organizations under oligopoly do not engage in collusion.

There are many organizations in the oligopoly market, but one of them is the dominant organization, called Price Leader.

Value leadership occurs when there is only one major organization in the industry that sets the value and others follow. Sometimes, an agreement may be developed between organizations to assign a leadership role to one of them. The dominant organization is regarded as a value leader for various reasons, such as the large size of the organization, large economies of scale, and advanced technology. Price leadership is supposed to stabilize price and maintain price discipline.

Firms achieve effective price leadership, if they works in the following circumstances: –

When the number of organizations are less.
Restricted entry in industry.
Products are homogeneous.
Demand is inelastic or less elastic.
Organizations have similar cost curves

What are the types of Price Leadership?

There are three types of Price Leadership: –

Dominant Price Leadership: – It refers to a type of leadership in which only one organization dominates the entire industry. Under key price leadership, other organizations in the industry cannot influence prices. The dominant organization uses the power of its monopoly to maximize its profits and other organizations have to adjust their output with the fixed price.
Barometric Price Leadership: – It refers to a leadership in which one organization first announces a change in prices and believes other organizations will accept it. The organization does not dominate others and is not required to be a leader in the industry. This type of organization is known as a barometer. This barometric organization only initiates the reaction to the changing market situation, which other organizations can follow if they find a decision in their own interest.
Aggressive Price Leadership: – A leadership refers to one in which an organization establishes its dominance by threatening organizations to follow its leadership. In other words, a leading organization establishes leadership by following aggressive pricing policies and forces other/organizations to follow the prices set by it.

Here, we would discuss a simple model for determining price and output in price leadership, which is shown in figure: –

Suppose there are two organizations, A and B producing similar products where the production cost of organization A is less than that of organization B. Hence, consumers are indifferent between these two organizations because of similar products. This implies that both organizations will face the same demand curve, which further represents equal market share.

In Figure, DD is the demand curve of both the organizations and MR is their marginal revenue. MCA and MCB are the marginal cost curves of organizations A and B respectively. As stated earlier, the cost of production of organization A is less than that of B, thus, MCA is drawn below MCB.

Let us first begin the discussion of price leadership with the case of Organization A. Organization A’s profits will be maximized at the point where MR intersects MCA. At this point, the output price level of organization A will be OQ with OP. On the other hand, organization B’s profit will be maximized at the point where MR intersects MCb with output OQ1 and price OP1.

In such a case, organization B is priced higher than organization A. However, both the organizations have to charge the same price as the products are homogeneous. In this case, Organization A is the value leader and Organization B is the follower.

Thus, organization A will fix the price to organization B. Both the organizations will follow the same output, OQ and price OP. However, profit earned by organization B is less than that of A because it has to produce at OP price which is less than its profit maximization price OP1. In addition, organization B also has a higher cost of production leading to lower profits at the expense of OP1.

What are the drawbacks of Price Leadership?

Price leadership suffers from various shortcomings, as follows: –

The value makes it difficult for the leader to evaluate the reactions of the followers.
Leads to malpractices, such as charging low prices by rival organizations in the form of discounts, money back guarantees, free services after delivery and easy installment facility. The prices charged by rival organizations are comparatively less than the prices set by the price leader.
Non-price competition by rival organizations in the form of aggressive promotional strategies.
The price increase affects new organizations to enter the industry. These new organizations may not follow the industry leader.
Problems arise when there is a difference in the cost of price leaders and value followers. In case, if the price leader has lower cost of production, he will fix the lower price. This will cause a loss for a price follower if his cost of production exceeds the price leader.