Pricing under monopolistic and oligopolistic competition

Economic Analysis

Demand

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Supply

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Price

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Equilibrium

Introduction

Pricing decisions tend to be the most important decisions made by any firm in any kind of market structure. The concept of pricing has already been discussed in unit. The price is affected by the competitive structure of a market because the firm is an integral part of the market in which it operates.

We have examined the two extreme markets viz. monopoly and perfect competition in the previous unit. In this unit the focus is on monopolistic competition and oligopoly, which lie in between the two extremes and are therefore more applicable to real world situations.

Monopolistic competition normally exists when the market has many sellers selling differentiated products, for example, retail trade, whereas oligopoly is said to be a stable form of a market where a few sellers operate in the market and each firm has a certain amount of share of the market and the firms recognize their dependence on each other. The features of monopolistic and oligopoly are discussed in detail in this unit.

MONOPOLISTIC COMPETITION

Edward Chamberlin, who developed the model of monopolistic competition, observed that in a market with large number of sellers, the products of individual firms are not at all homogeneous, for example, soaps used for personal wash. Each brand has a specific characteristic, be it packaging, fragrance, look etc., though the composition remains the same. This is the reason that each brand is sold Pricing Decisions individually in the market. This shows that each brand is highly differentiated in the minds of the consumers. The effectiveness of the particular brand may be attributed to continuous usage and heavy advertising.

As defined by Joe S.Bain 'Monopolistic competition is found in the industry where there are a large number of sellers, selling differentiated but close substitute products'. Take the example of Liril and Cinthol. Both are soaps for personal care but the brands are different. Under monopolistic competition, the firm has some freedom to fix the price i.e. because of differentiation a firm will not lose all customers when it increases its price.

Monopolistic competition is said to be the combination of perfect competition as well as monopoly because it has the features of both perfect competition and monopoly. It is closer in spirit to a perfectly competitive market, but because of product differentiation, firms have some control over price. The characteristic features of monopolistic competition are as follows:

Nature of the Demand Curve

The demand curve of the monopolistic competition has the following characteristics:

Less than perfectly elastic: In monopolistic competition, no single firm dominates the industry and due to product differentiation, the product of each firm seems to be a close substitute, though not a perfect substitute for the products of the competitors. Due to this, the firm in question has high elasticity of demand.
Demand curve slopes downward: In monopolistic competition, the demand curve facing the firm slopes downward due to the varied tastes and preferences of consumers attached to the products of specific sellers. This implies that the demand curve is not perfectly elastic.

PRICE AND OUTPUT DETERMINATION IN SHORT RUN

In monopolistic competition, every firm has a certain degree of monopoly power i.e. every firm can take initiative to set a price. Here, the products are similar but not identical, therefore there can never be a unique price but the prices will be in a group reflecting the consumers' tastes and preferences for differentiated products. In this case the price of the product of the firm is determined by its cost function, demand, its objective and certain government regulations, if there are any.

As the price of a particular product of a firm reduces, it attracts customers from its rival groups (as defined by Chamberlin). Say for example, if 'Samsung' TV reduces its price by a substantial amount or offers discount, then the customers from the rival group who have loyalty for, say 'BPL', tend to move to buy 'Samsung' TV sets. As discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes downwards.

The market has many firms selling similar products, therefore the firm's output is quite small as compared to the total quantity sold in the market and so its price and output decisions go unnoticed. Therefore, every firm acts independently and for a given demand curve, marginal revenue curve and cost curves, the firm maximizes profit or minimizes loss when marginal revenue is equal to marginal cost. Producing an output of Q selling at price P maximizes the profits of the firm.

In the short run, a firm may or may not earn profits. The figure shows the firm, which is earning economic profits. The equilibrium point for the firm is at price P and quantity Q and is denoted by point A. Here, the economic profit is given as area PAQR. The difference between this and the monopoly case is that here the barriers to entry are low or weak and therefore new firms will be attracted to enter. Fresh entry will continue to enter as long as there are profits. As soon as the super normal profit is competed away by new firms, equilibrium will be attained in the market and no new firms will be attracted in the market. This is the situation corresponding to the long run and is discussed in the next section.

PRICE AND OUTPUT DETERMINATION IN LONG RUN

We have discussed the price and output determination in the short run. We now discuss price and output determination in the long run. You will notice that the long run equilibrium decision is similar to perfect competition. The core of the discussion under this head is that economic profits are eliminated in the long run, which is the only equilibrium consistent with the assumption of low barriers to entry. This occurs at an output where price is equal to the long run average cost. The difference between monopolistic competition and perfect competition is that in monopolistic competition the point of tangency is downward sloping and does not occur at minimum of the average cost curve and this is because the demand curve is downward sloping.

Looking at the figure, under monopolistic competition in the long run we see that LRAC is the long run average cost curve and LRMC the long run average marginal curve. Let us take a hypothetical example of a firm in a typical monopolistic situation where it is making substantial amount of economic profits.

Here it is assumed that the other firms in the market are also making profits. This situation would then attract new firms in the market. The new firms may not sell the same products but will sell similar products. As a result, there will be an increase in the number of close substitutes available in the market and hence the demand curve would shift downwards since each existing firm would lose market share. The entry of new firms would continue as long as there are economic profits.

The demand curve will continue to shift downwards till it becomes tangent to LRAC at a given price P1 and output at Q1 as shown in the figure. At this point of equilibrium, an increase or decrease in price would lead to losses. In this case the entry of new firms would stop, as there will not be any economic profits.

Due to free entry, many firms can enter the market and there may be a condition where the demand falls below LRAC and ultimately suffers losses resulting in the exit of the firms. Therefore under the monopolistic competition free entry and exit must lead to a situation where demand becomes tangent to LRAC, the price becomes equal to average cost and no economic profit is earned. It can thus be said that in the long run the profits peter out completely.

One of the interesting features of the monopolistically competitive market is the variety available due to product differentiation. Although firms in the long run do not produce at the minimum point of their average cost curve, and thus there is excess capacity available with each firm, economists have rationalized this by attributing the higher price to the variety available. Further, consumers are willing to pay the higher price for the increased variety available in the market.

OLIGOPOLISTIC COMPETITION

We define oligopoly as the form of market organization in which there are few sellers of a homogeneous or differentiated product. If there are only two sellers, we have a duopoly. If the product is homogeneous, we have a pure oligopoly. If the product is differentiated, we have a differentiated oligopoly.

While entry into an oligopolistic industry is possible, it is not easy (as evidenced by the fact that there are only a few firms in the industry).

Oligopoly is the most prevalent form of market organization in the manufacturing sector of most nations, including India. Some oligopolistic industries in India are automobiles, primary aluminum, steel, electrical equipment, glass, breakfast cereals, cigarettes, and many others. Some of these products (such as steel and aluminum) are homogeneous, while others (such as automobiles, cigarettes, breakfast cereals, and soaps and detergents) are differentiated.

Oligopoly exists also when transportation costs limit the market area. For example, even though there are many cement producers in India, competition is limited to the few local producers in a particular area. Since there are only a few firms selling a homogeneous or differentiated product in oligopolistic markets, the action of each firm affects the other firms in the industry and vice versa.

For example, when General Motors introduced price rebates in the sale of its automobiles, Ford and Maruti immediately followed with price rebates of their own. Furthermore, since price competition can lead to ruinous price wars, oligopolists usually prefer to compete on the basis of product differentiation, advertising, and service.

These are referred to as nonprice competition. Yet, even here, if GM mounts a major advertising campaign, Ford and Maruti are likely to soon respond in kind. When Pepsi mounted a major advertising campaign in the early 1980s Coca-Cola responded with a large advertising campaign of its own in the United States.

From what has been said, it is clear that the distinguishing characteristic of oligopoly is the interdependence or rivalry among firms in the industry. This is the natural result of fewness. Since an oligopolist knows that its own actions will have a significant impact on the other oligopolists in the industry, each oligopolist must consider the possible reaction of competitors in deciding its pricing policies, the degree of product differentiation to introduce, the level of advertising to be undertaken, the amount of service to provide, etc.

Since competitors can react in many different ways (depending on the nature of the industry, the type of product, etc.) We do not have a single oligopoly model but many-each based on the particular behavioural response of competitors to the actions of the first. Because of this interdependence, managerial decision making is much more complex under oligopoly than under other forms of market structure.

Sources of Oligopoly

The sources of oligopoly are generally the same as for monopoly. That is:

Economies of scale may operate over a sufficiently large range of outputs as to leave only a few firms supplying the entire market;
Huge capital investments and specialized inputs are usually required to enter an oligopolistic industry (say, automobiles, aluminum, steel, and similar industries), and this acts as an important natural barrier to entry;
A few firms may own a patent for the exclusive right to produce a commodity or to use a particular production process;
Established firms may have a loyal following of customers based on product quality and service that new firms would find very difficult to match;
A few firms may own or control the entire supply of a raw material required in the production of the product; and
The government may give a franchise to only a few firms to operate in the market.

The above are not only the sources of oligopoly but also represent the barriers to other firms entering the market in the long run. If entry were not so restricted, the industry could not remain oligopolistic in the long run. A further barrier to entry is provided by limit pricing, whereby, existing firms charge a price low enough to discourage entry into the industry. By doing so, they voluntarily sacrifice short-run profits in order to maximize long-run profits.

Price Rigidity: Kinked Demand Curve

Our study of pricing and market structure has so far suggested that a firm maximizes profit by setting MR = MC. While this is also true for oligopoly firms, it needs to be supplemented by other behavioural features of firm rivalry.

This becomes necessary because the distinguishing feature of oligopolistic markets is interdependence. Because there are a few firms in the market, they also need to worry about rival firm's behaviour. One model explaining why oligopolists tend not to compete with each other on price, is the kinked demand curve model of Paul Sweezy.

In order to explain this characteristic of price rigidity i.e. prices remaining stable to a great extent, Sweezy suggested the kinked demand curve model for the oligopolists. The kink in the demand curve arises from the asymmetric behaviour of the firms. The proponents of the hypothesis believe that competitors normally follow price decreases i.e. they show the cooperative behaviour if a firm reduces the price of its products whereas they show the non-cooperative behaviour if a firm increases the price of its products.

Let us start from P1 in the Figure. If one firm reduces its price and the other firms in the market do not respond, the price cutter may substantially increase its sales. This result is depicted by the relative elastic demand curve, dd. For example, a price decrease from P1 to P2 will result in a movement along dd and increase sales from Q1 to Q2 as customers take advantage of the lower price and abandon other suppliers. If the price cut is matched by other firms, the increase in sales will be less.

Since other firms are selling at the same price, any additional sales must result from increased demand for the product. Thus the effect of price reduction is a movement down the relatively inelastic demand curve, DD, then the price reduction from P1 to P2 only increases sales to Q2.

Here we assume that P1 is the initial price of the firm operating in a non-cooperative oligopolistic market structure producing Q1 units of output. P is also the point of kink in the demand curve and is the initial price and DD is the relatively elastic demand curve above the existing price P1.

When the firm is operating in the non-cooperative oligopolistic market it results in decline in sales if it changes its price to P1. Now if the firm reduces its price below P1 say P2, the other firms operating in the market show a cooperative behaviour and follow the firm. This is shown in the figure as the curve below the existing price P1.

The true demand curve for the oligopolistic market is dD and has the kink at the existing price P1. The demand curve has two linear curves, which are joined at price P. Associated with the kinked demand curve is a marginal revenue function. Marginal Revenue for prices above the kink is given by MR1 and below the kink as MR2.

At the kink, marginal revenue has a discontinuity at AB and this depends on the elasticities of the different parts of the demand curve. Therefore, in the presence of a kinked demand curve, firm has no motive to change its price. If the firm is a profit maximizing firm where MR=MC, it would not change its price even if the cost changes. This situation occurs as long as changes in MC fall within the discontinuous range i.e. AB portion.

The firm following kinked model has a U-shaped marginal cost curve MC. The new MC curve will be MC1 or MC2 and will remain in the discontinued area and the equilibrium price remains the same at P.

Price Competition: Cartels and Collusion

Cartel Profit Maximization

We already know now that in an oligopolistic competition, the firms can compete in many ways. Some of the ways include price, advertising, product quality, etc. Many firms may not like competition because it could be mutually disadvantageous. For example, advertising. In this case many oligopolies end up selling the products at low prices or doing high advertising resulting in high costs and making lower profits than expected.

Therefore, it is possible for the firms to come to a consensus and raise the price together, increasing the output without much reduction in sales. In some countries this kind of collusive agreement is illegal e.g. USA but in some it is legal. The most extreme form of the collusive agreement is known as a cartel. A cartel is a market sharing and price fixing arrangement between groups of firms where the objective of the firm is to limit competitive forces within the market.

The forms of cartels may differ. It can be an explicit collusive agreement where the member firms come together and may reach a consensus regarding the price and market sharing or implicit cartel where the collusion is secretive in nature. Throughout the 1970s, the Organization of Petroleum Exporting Countries (OPEC) colluded to raise the price of crude oil from under $3 per barrel in 1973 to over $30 per barrel in 1980.

The world awaited the meeting of each OPEC price-setting meeting with anxiety. By the end of 1970s, some energy experts were predicting that the price of oil would rise to over $100 per barrel by the end of the century. Then suddenly the cartel seemed to collapse. Prices moved down, briefly touching $10 per barrel in early 1986 before recovering to $18 per barrel in 1987. Today the price of a barrel is about $24. OPEC is the standard example used in textbooks when explaining cartel behaviour.

The market demand for all members of the cartel is given by DD and marginal revenue (represented by dotted line) as MR. The cartels marginal cost curve given by MCc is the horizontal sum of the marginal cost curves of the member firms. In this the basic problem is to determine the price, which maximizes cartel profit. This is done by considering the individual members of the cartel as one firm i.e. a monopoly. In the figure this is at the point where MR= MCc, setting price = P.

The problem is regarding the allocation of output within the member firms. Normally a quota system is quite popular, whereby each firm produces a quantity such that its MC = MCc. One serious problem that arises from this analysis is that while the joint profits of the cartel as a whole are maximised, each individual member of the cartel has an incentive to cheat on its quota. This is because the price for the product is greater than the members marginal cost of production. This implies that an individual member can increase its profit by increasing production. What would happen if all members did the same?

The market sharing arrangement will breakdown and the cartel would collapse. Here lies the inherent instability of cartel type arrangement and can be summarized as follows: There is an incentive for the cartel as a whole to restrict output and raise price, thereby achieving the joint profit maximizing result, but there is an incentive on the part of the members to increase individual profit. If this kind of situation occurs, it leads to break-up of the cartel.

The Prisoner's Dilemma

The difficulty with sustaining collusion is often demonstrated by a classic strategic game known as the prisoner's dilemma. The story is something like this: Two KGB officers spotted an orchestra conductor examining the score of Tchaikovsky's Violin Concerto. Thinking the notation was a secret code, the officers arrested the conductor as a spy. On the second day of interrogation, a KGB officer walked in and smugly proclaimed, "OK, you can start talking. We have caught Tchaikovsky".

More seriously, suppose the KGB has actually arrested someone named Tchaikovsky and the conductor separately. If either the conductor or Tchaikovsky falsely confesses while the other does not, the confessor earns the gratitude of the KGB and only one year in prison, but the other receives 25 years in prison. If both confess each will be sentenced to 10 years in prison; and if neither confesses each receives 3 years in prison.

Now consider the outcome. The conductor knows that if Tchaikovsky confesses, he gets either 25 years by holding out or 10 years by confessing. If Tchaikovsky holds out, the conductor gets either 3 years by holding out or only one year confessing. Either way, it is better for the conductor to confess.

Tchaikovsky, in a separate cell, engages in the same sort of thinking and also decides to confess. The conductor and Tchaikovsky would have had three-years rather than 10-year jail sentences if they had not falsely confessed, but the scenario was such that, individually, false confession was rational. Pursuit of their own self interests made each worse off.

This situation is the standard prisoner's dilemma and is represented in the above matrix. This first payoff in each cell refers to Tchaikovsky's, and the second is the conductors. Examination of the payoffs shows that the joint profit maximizing strategy for both is (Cooperate-Cooperate). The assumption in this game is that both the parties decided their strategies independently.

This scenario is easily transferred to the pricing decision of a company. Consider two companies setting prices. If both companies would only keep prices high, they will jointly maximise profits. If one company lowers price, it gains customers and it is thus in its interests to do so. Once one company has cheated and lowered price, the other company must follow suit. Both companies have lowered their profits by lowering price.

Clearly, companies repeatedly interact with one another, unlike Tchaikovsky and the conductor. With repeated interaction, collusion can be sustained. Robert Axelrod, a well-known political scientist, claims a "tit-for-tat" strategy is the best way to achieve co-operation. A tit-for-tat strategy always co-operates in the first period and then mimics the strategy of its rival in each subsequent period. Axelrod likes the tit-for-tat strategy because it is nice, retaliatory, forgiving and clear.

A fascinating example of tit-for-tat in action occurred during the trench warfare of the First World War. Front-line soldiers in the trenches often refrained from shooting to kill, provided the opposing soldiers did likewise. This restraint was often in direct violation of high command orders.

Price Leadership

Price leadership is an alternative cooperative method used to avoid tough competition. Under this method, usually one firm sets a price and the other firms follow. It is quite popular in industries like cigarette industry. Here any firm in the oligopolistic market can act as a price leader. The firm, which is highly efficient, and having low cost can be a price leader or the firm, which is dominant in the market acts as a leader. Whatever the case may be, the firm, which sets the price, is the price leader. We have two forms of price leadership:

Dominant Price Leadership

In dominant price leadership, the largest firm in the industry sets the price. If the small firms do not conform to the large firm, then the price war may take place due to which the small firms may not be able to survive in the market. It is more or less like a monopoly market structure. This can be seen in the airlines industry in India where the dominant firm Indian Airlines (IA) sets prices and the others Jet and Sahara follow the price changes of IA.

Barometric Price Leadership

Barometric price leadership is said to be the simpler of the two. This normally occurs in the market where there is no dominant firm. The firm having a good reputation in the market usually sets the price. This firm acts as a barometer and sets the price to maximize the profits. Here it is important to note that the firm in question does not have any power to force the other firms to follow its lead. The other firms will follow only as long as they feel that the firm in action is acting fairly. Though this method is quite ambiguous regarding price leadership, it is legally accepted. These two forms are an integral part of different types of cooperative oligopoly. Barometric price leadership has been seen in the automobile sector.

ILLUSTRATION: Reestablishing Price Discipline in the Steel Industry

Until the 1960s, U.S. Steel was the leader in setting prices in the steel industry. However, in 1962, a price increase announced by U.S. Steel provoked so much criticism from customers and elected officials, especially President John F. Kennedy, that the firm became less willing to act as the price leader. As a result, the industry evolved from dominant firm to barometric price leadership. This new form involved one firm testing the waters by announcing a price change and then U.S. Steel either confirming or rejecting the change by its reaction.

In 1968, U.S. Steel found that its market share was declining. They responded by secretly cutting prices to large customers. This action was soon detected by Bethlehem Steel, which cut its posted price of steel from $113.50 to $88.50 per ton. Within three weeks, all of the other major producers, U.S. Steel included, matched Bethlehem's new price.

The lower industry price was not profitable for the industry members. Consequently, U.S. Steel signaled its desire to end the price war by posting a higher price. Bethlehem waited nine days and responded with a slightly lower price than that of U.S. Steel. U.S. Steel was once again willing to play by industry rules. Bethlehem announced a price increase to $125 per ton.

All of the other major producers quickly followed suit, and industry discipline was restored. Note that the price of $125 per ton was higher than the original price of $113.50.

Source: Peterson and Lewis, 2002. Managerial Economics. Pearson Education Asia.

CONCENTRATION RATIOS, HERFINDAHL INDEX AND CONTESTABLE MARKETS

The degree by which an industry is dominated by a few large firms is measured by Concentration ratios. These give the percentage of total industry sales of 4, 8, or 12 largest firms in the industry. An industry in which the four-firm concentration ratio is close to 100 is clearly oligopolistic, and industries where this ratio is higher than 50 or 60 percent are also likely to be oligopolistic.

The four-firm concentration ratio for most manufacturing industries in the United States is between 20 and 80 percent. Another method of estimating the degree of concentration in an industry is the Herfindahl index (H). This is given by the sum of the squared values of the market shares of all the firms in the industry. The higher the Herfindahl index, the greater is the degree of concentration in the industry.

For example, if there is only one firm in the industry so that its market share is 100%, H=100²=10,000. If there are two firms in an industry, one with a 90 percent share of the market and the other with a 10 percent share, H = 90² + 10² = 8,200. If each firm had a 50 percent share of the market, H = 50² + 50² = 5,000. With four equal-sized firms in the industry, H = 2,500. With 100 equal-sized firms in the (perfectly competitive) industry, H = 100.

This points to the advantage of the Herfindahl index over the concentration ratios discussed above. Specifically the Herfindahl index uses information on all the firms in the industry - not just the share of the market by the largest 4, 8, 12 firms in the market.

Furthermore, by squaring the market share of each firm, the Herfindahl index appropriately gives a much larger weight to larger than to smaller firms in the industry. The Herfindahl index has become of great practical importance since 1982 when the Justice Department in the US announced new guidelines for evaluating proposed mergers based on this index.

In fact, according to the theory of Contestable markets developed during the 1980s, even if an industry has a single firm (monopoly) or only a few firms (oligopoly), it would still operate as if it were perfectly competitive if entry is "absolutely free" (i.e. if other firms can enter the industry and face exactly the same costs as existing firms) and if exit is "entirely costless" (i.e., if there are no sunk costs so that the firm can exit the industry without facing any loss of capital).

An example of this might be an airline that establishes a service between two cities already served by other airlines if the new entrant faces the same costs as existing airlines and could subsequently leave the market by simply reassigning its planes to other routes without incurring any loss of capital. When entry is absolutely free and exit is entirely costless, the market is contestable. Firms will then operate as if they were perfectly competitive and sell at a price which only covers their average costs (so that they earn zero economic profit) even if there is only one firm or a few of them in the market.