Oligopoly Pricing Models

A pure monopoly maximizes profits by producing that quantity where marginal revenue = marginal cost. However, it is much more difficult for an oligopoly to determine at what output it can maximize its profit. There are 2 major reasons for this: the interdependence of the oligopolistic firms and their diversity, especially in terms of concentration ratios. Some oligopolies have a very high concentration ratio, allowing them to act more like a monopoly, while other industries have a much lower concentration ratio, thus, making it more difficult to determine the best pricing strategy, since the number of possible responses by competitors is increased.

There have been 2 prominent characteristics of oligopolies observed over the years.

  1. In a stable economy, oligopolies' prices change much less frequently than under any other market model, such as pure competition, monopolistic competition, and even monopoly.
  2. When prices do change, the firms generally move in the same direction and by the same magnitude in their price changes, which may be the result of collusion.

There are 3 basic theories about oligopolistic pricing: kinked-demand theory, or non-collusive oligopoly, the cartel model, and the price leadership model.

Kinked-Demand Theory

Consider a firm in an oligopoly that wants to change its price. How will the other firms react? There are 2 possibilities: they can either match the price changes or ignore them. But what the other firms will actually do will probably depend on the direction of the price change. If one firm raises its price, the others probably will not follow, since that will allow them to take market share from the price changer. This makes the demand curve more elastic, since as the firm raises its price, then many of its customers will buy from the other firms, lowering the revenue of the higher-priced firm.

If the firm lowers its price, then the other firms would surely follow, to prevent any loss of market share. This part of the demand curve is much more inelastic, since all the firms are acting in concert. This creates a kink in the demand curve, where the change in demand goes from very elastic at higher prices to inelastic at lower prices. Since the marginal revenue curve depends on prices, the marginal revenue curve is also kinked. At lower prices, the marginal revenue curve drops downward creating a gap. The marginal cost curves of both scenarios will intersect the same quantity being produced by the oligopoly, represented by the vertical line in the graph; therefore, there is no change in quantity produced as prices are lowered, as long as the change in marginal cost is within the marginal revenue gap.

Graph showing how the demand and marginal revenue curves become kinked when an oligopolistic firm raises its price but the others do not follow, but if it lowers its price, then the other firms match the price decreases.
  • P1 = Product Price of the Oligopoly
  • If a firm raises its price (D1), but the others do not match the increase, then revenue will decline in spite of the price increase.
  • If the firm lowers its price (D2), then the other firms will match the decrease to avoid losing market share.
  • Because there is a kink in the demand curve, there is a gap in the marginal revenue curve (MR1 - MR2). Since firms maximize profit by producing that quantity where marginal cost = marginal revenue, the firms will not change the price of their product as long as the marginal cost is between MC1 and MC2, which explains why oligopolistic firms change prices less frequently than firms operating under other market models.

The kinked-demand curve explains why firms in an oligopoly resist changes to price. If one of them raises the price, then it will lose market share to the others. If it lowers its price, then the other firms will match the lower price, causing all the firms to earn less profit.

Critics of the kinked-demand model point out that while the model explains why oligopolies maintain pricing, it doesn't explain how its products were initially priced. Also not explained is that when the economy changes significantly, especially with high inflation, then the firms of an oligopoly do change prices often. Oligopolistic firms may even engage in a price war, where each firm charges a successfully lower price to gain market share.

Contestable Market Model

The contestable market model is an oligopolistic model based on barriers to entry and barriers to exit that determine the firm's price and output. If the barriers are high, then the oligopolist will set higher prices. On the other hand, if the barriers are low, then the oligopolist will set low prices to prevent new firms from entering the industry or to promote the exit of its competitors.

Cartel Model

Sometimes firms in an oligopoly try to form a cartel by agreeing to fix prices or to divide the market among themselves, or to restrict competition some other way. The primary characteristic of the Cartel Model is collusion among the oligopolistic firms to fix prices or restrict competition so that they can earn monopoly profits.

If the dominant firms in an oligopoly can successfully collude to fix prices, then they can be certain of each other's output, which will allow to maximize their profits by producing that quantity of output where marginal revenue = marginal cost, just as it would be for a monopoly. However, if any of the firms cheat, then a price war may ensue, lowering the profits of all firms, and maybe even causing them to operate at a loss. In most modern economies, collusion is generally against the law, however there are certain countries that engage in collusion to maximize their profits from their natural resources.

The best example of a cartel today is the Organization of Petroleum Exporting Countries, otherwise known as OPEC, which comprises 12 oil-producing nations that supply 60% of all oil traded internationally. Prices are maintained by restricting each country of the OPEC cartel to a specific production allocation. The OPEC cartel is largely responsible for the large fluctuations in gasoline prices that occurred in the United States since 1973, although recently, speculation in the commodity markets has also increased volatility.

Problems Creating and Maintaining Collusion

Collusion is often difficult to detect, because it is often based on tacit or covert agreements that are made during social interactions between the executives of the oligopolistic firms. Nonetheless, there are several obstacles to collusion.

One common obstacle is differences in demand and cost. Firms that serve different geographic markets will have varying levels of demand, and they may also have different efficiencies, resulting in different production costs. If economies of scale are steep for an industry, then smaller firms will aggressively compete on price to increase their market share, so that they can earn reasonable profits. In such cases, it will be difficult for the firms to agree on the price, because they will have different marginal cost curves. A good example is Saudi Arabia and Venezuela in the production of oil. Saudi Arabia is efficient in producing soil, whereas Venezuela, governed by an inept communist government, is highly inefficient, so it would be very difficult for Venezuela to accept a price that would be suitable for Saudi Arabia. Consequently, there is a great temptation for inefficient producers to cheat, and if they cheat, then price competition ensues.

Another factor that increases cheating is recessions. During recessions, demand declines, which shifts the firm's marginal cost and demand curve to the left. Firms often respond by reducing prices so that they can better utilize their production capacity and to try to gain market share from the other firms.

A larger number of firms in the oligopoly make it difficult both to create and maintain collusion. If there are only 2 or 3 firms in the oligopoly, then it is fairly easy to collude to set prices or to limit competition. However, if there are 6 or more firms with a smaller share of the market, then collusion becomes increasingly difficult. Indeed, the likelihood of a successful collusion decreases as the number of firms increases.

Another possible barrier to collusion is that if prices are maintained too high, then it may allow new entrants into the industry that will provide more competition, or, smaller firms that did not have much market power can cut prices and increase production to grab market share.

The other major barrier to collusion is antitrust law. Most modern economies prohibit collusion, since it is against the public interest, although there are some exceptions. A very common exception is the pricing of insurance products, since many insurance companies depend on rating companies that gather information on insurance risks and how to price them. In the United States, insurance rating information is exempted from the antitrust provisions of the United States.

Price Leadership Model

In many industries, there is a dominant firm in an oligopoly, and the other firms often follow the dominant firm in price changes, which can be viewed as a type of implicit price collusion. Hence, the dominant firm also becomes the price leader. Since most firms have been in the business for a number of years, they can observe how their competitors react to changes in the industry, allowing them to reach an understanding of how their competitors will react to any price changes. Firms in an oligopoly do not often change prices, certainly not for minor changes in costs, but they will change prices if cost changes are substantial. Indeed, if there is a general price increase in the inputs of an industry, then all firms will surely increase their prices. Increasing price of inputs, of course, helps to protect the industries from antitrust prosecutions since they have a reasonable basis for increasing the price of their products that is not related to restricting competition.

Oftentimes, the price leader will communicate the need to raise prices through press releases, trade publications, and speeches by major executives, especially when announcing quarterly earnings.

There are many times when a price leader will limit price increases to discourage the entrance of new competitors — a practice called limit pricing. This will be particularly true if the economies of scale are not that steep, since high prices can allow the entrance of new competitors who will be able to survive on a small market share.

Sometimes price leadership breaks down and price wars result. However, price wars are self-limiting, since they will often lead to losses. Eventually the firms will capitulate and return to the practice of following the price leader.

Productive and Allocative Efficiency of Oligopolies

Pure competition achieves productive efficiency by producing products at the minimum average total cost. They also achieve allocative efficiency because they produce until their marginal cost = price. However, because oligopolies produce only until marginal cost = marginal revenue, they lack both the productive and allocative efficiency of pure competition.

Because oligopolies can successfully thwart competition, they restrict output to maximize profits, producing only until marginal cost = marginal revenue. Hence, oligopolies exhibit the same inefficiencies as a monopoly. Because the marginal cost curve intersects the marginal revenue curve before it intersects the average total cost curve, oligopolies never reach an efficient scale of production efficiency, since they never operate at their minimum average total cost. Similarly, the marginal cost curve never intersects the market demand curve; therefore, oligopolies produce less product than what the market desires, so oligopolies lack allocative efficiency.

The graph below shows the long run equilibrium for monopolies, which is similar for oligopolies. Oligopolies, like monopolies and monopolistic competitors, also have excess capacity.

Diagram showing how an oligopoly sets its profit maximizing price by finding the market price that corresponds to the quantity where marginal revenue equals marginal cost, with profits equal to the price minus the average total cost times the quantity produced.
  • ATC = Average Total Cost
  • MR = Marginal Revenue
  • MC = Marginal Cost

Note that where MC rises above MR, the firm would incur greater costs than it would receive in additional revenue, which is why the firm maximizes its profit by producing only that quantity where MR = MC, and charging the corresponding price.

1 Productive Efficiency: MC = Minimum ATC

2 Allocative Efficiency: MC = Market Price

Oligopoly Profit = (Price - ATC) × Quantity

Although there are many major industries dominated by oligopolies, there are rarely prosecuted under antitrust laws. However, there are several factors that limit the pricing power of oligopolies, including foreign competition and technological advances. Before extensive world trade, oligopolies developed independently in many modern economies. As trade barriers fall, oligopolies find they must compete with oligopolies from other countries, which diminishes their pricing power. Technology can also diminish the pricing power of oligopolies by producing better products, by lowering the fixed costs of developing a product, and by opening markets to more competitors. For instance, brick-and-mortar retailers now have much more competition from the Internet.

Many of the technological advances originate in oligopolies, because they have a greater amount of money to invest in research and development (R&D). While monopolies also have money for R&D, the need to conduct research is lessened by lower or no competition. However, over time, technological advances eventually erode even a monopoly's power. Hence, oligopolies invest heavily in research and development to maintain their pricing power.