Oligopoly Markets

Oligopoly Markets are mainly categorized by a few firms which are large in size and the most striking feature is the hidden interdependencies they have, which creates a sense of uncertainty as the firms don't know how a competitor respond to their moves. Firms generally collude to remove uncertainties, in case of non collusion firms compete with each other.

Non-Collusive Oligopoly Models

Paul Sweezy Kinked demand curve hypothesis

• Core Assumption: Firms face an asymmetrical reaction from competitors when changing prices. If a firm raises its price, rivals will not follow (hoping to steal customers), making demand highly elastic above the current price. If a firm lowers its price, rivals will feel forced to match the cut immediately to protect their market share, making demand highly inelastic below the current price. This asymmetry creates a "kink" in the demand curve at the prevailing market price.

• Equilibrium & Rigidity: The sharp change in elasticity at the kink causes a sharp drop, or vertical discontinuity (gap), in the Marginal Revenue (MR) curve directly beneath the kink point. Because of this gap, any fluctuations in Marginal Cost (MC) that occur within this vertical range will not change the profit-maximizing level of output or price. To the left of the kink, MR > MC (providing an incentive to expand output up to the kink), and to the right, MR < MC (disincentivizing further production). Consequently, prices in an oligopoly remain remarkably rigid at the kink point, even as production costs shift.

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Cournot Model

• Core Assumption: Firms compete on quantity rather than price, and they choose their output levels simultaneously. Each firm assumes its rival's output will remain constant when making its own production decision.

• Equilibrium: The intersection of the firms' reaction functions (which map out a firm's profit-maximizing output given the competitor's output). The resulting Nash equilibrium yields an output higher than a monopoly but lower than perfect competition, with prices falling somewhere in between.

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Stackelberg Model

• Core Assumption: An extension of Cournot, but with a sequential move dynamic. One firm acts as the Leader (usually the dominant/larger firm) and chooses its quantity first. The other firm acts as the Follower and chooses its quantity after observing the leader's choice.

• Equilibrium: The Leader possesses a "first-mover advantage." Because the leader knows exactly how the follower will react to any given output level, it maximizes profit by factoring the follower's reaction curve directly into its own revenue calculations. The leader produces more, and the follower produces less, compared to the Cournot outcome.

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Bertrand Model

• Core Assumption: Firms compete strictly on price instead of quantity, producing identical (homogeneous) products. Firms choose their prices simultaneously, and consumers will always buy from the firm offering the lowest price.

• Equilibrium: This leads to the "Bertrand Paradox." Since products are identical, firms have a massive incentive to undercut each other to capture the entire market. This undercutting continues until price is driven all the way down to marginal cost ($P = MC$), meaning firms earn zero economic profit—the exact same outcome as perfect competition, even with only two firms.

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Collusive Oligopoly Models

Cartels

• Core Assumption: Firms explicitly and formally agree to cooperate rather than compete. Members openly coordinate to set a unified market price, establish strict production quotas for each firm, and divide geographic territories. By legally or secretly binding their operations together, the participating firms effectively function as a single collective monopoly to maximize joint industry profits.

• Equilibrium & Instability: The equilibrium mimics a monopoly outcome, where industry output is restricted to keep prices high. However, cartel agreements are inherently unstable due to the "cheating dilemma." Because the market price is maintained well above marginal cost ($P > MC$), individual members face a powerful economic incentive to secretly expand their output beyond their assigned quota to capture extra profits. If multiple firms cheat, market supply surges, causing the cartel price to collapse back toward competitive levels.

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Price Leadership

• Core Assumption: A form of tacit (unspoken) collusion where firms avoid formal agreements to bypass antitrust laws. Instead, one benchmark firm is established as the industry leader. When this leader adjusts its price, the remaining firms (the followers) voluntarily match the price change almost immediately, recognizing that cooperative pricing protects collective profit margins better than a price war.

• Equilibrium: Market price remains stable and predictable without explicit communication. The equilibrium depends entirely on the followers' willingness to comply. If the follower firms match the leader's price hikes, the industry enjoys high, monopoly-like profits. However, if a major rival refuses to follow a price increase, the leader is forced to rescind the hike to avoid losing substantial market share.

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Dominant firm price leadership

• Core Assumption: The price leader is the absolute largest firm in the industry, controlling a massive share of the total market. Due to its sheer scale, economies of scale, and financial resources, this dominant firm independently sets the market price to maximize its own profits. The remaining smaller, fragmented companies act as a competitive fringe.

• Equilibrium: The dominant firm calculates the residual demand curve (total market demand minus what the smaller firms can supply) and sets the price where its own $MR = MC$. The small fringe firms act as price-takers; they accept this price as given and produce where their individual marginal cost equals that price. If a small firm attempts to undercut the leader, the dominant firm can leverage its financial muscle to slash prices below the rival’s operating costs, forcing compliance or bankruptcy.

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Low cost price leadership

• Core Assumption: The price leader is not necessarily the largest firm, but the most highly efficient firm with the lowest production costs in the industry. This low-cost firm establishes a profit-maximizing price that is typically lower than what other, higher-cost firms would prefer to charge if they had the market power to choose.

• Equilibrium: The low-cost leader sets its price where its own $MR = MC$. The higher-cost firms are forced to accept this lower price point because they produce identical or highly substitutable goods. While this price maximizes the leader's profits, it severely squeezes the profit margins of the less efficient followers. The followers comply because charging a higher price would mean losing their entire market share to the leader, while charging a lower price would cause them immediate financial losses.

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Barometric firm price leadership

• Core Assumption: The firm that takes the lead is chosen because it acts as the most reliable "barometer" of changing economic conditions. It is typically an old, established firm with a proven track record of accurately interpreting market trends, such as shifts in consumer demand, fluctuating raw material costs, or new regulatory taxes.

• Equilibrium: The barometric firm does not possess the market power to coerce other firms. Instead, when it shifts its price, it signals to the rest of the industry that fundamental market forces have changed. The other firms follow the move because they trust the leader's evaluation of the market, and because it relieves them of the risk of being the first to test a new price point with consumers. If the barometric firm misjudges the market, rivals will not follow, and the leader is forced to quickly adjust its price back to the previous equilibrium.

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