3 (a) Explain why prices might fluctuate less in an oligopolistic market than in a perfectly competitive market.

Introduction

Perfectly competitive market and oligopolistic market differ in various features such as the number of sellers, the level of barriers to entry to which firms can enter the industry and the way they behave, thus affecting price stability.

Body

Prices in a perfectly competitive firm

Perfect competition (PC) is a market structure that is characterised by many buyers and sellers such that each seller supplies only a small proportion of the total market supply. As such individual sellers cannot influence price by changing the quantity supplied. Thus, they are price takers who accept the market price. Each firm then faces a perfectly elastic demand curve as seen in Figure 1a.

An example of a market that comes close to the perfectly competitive model is that of agricultural goods. In the market for wheat, each farmer produces an insignificant amount of the market supply such that any changes in his output have no impact on the market price at all. How much the farmer sells his wheat for will depend on the prevailing price of wheat in the market.

perfect competition pricing
The market for agriculture goods has low barriers to entry. Relatively low capital is required to start growing wheat. Referring to figure 1a, if the perfectly competitive firm is earning supernormal profits in the short run represented by the shaded area, the ease of entry will incentivise other firms to enter the industry and compete with the existing producers. In the long run, the entrance of more firms will result in an increase in market supply. This shifts the market supply curve rightwards from SSo to SS1 as seen in Figure 1b, causing the market price to fall from P0 to P1. Likewise, an increase in market demand from DD0 to DD1 will raise the market price from Po to P2. For the perfectly competitive firm which is a price taker, it will take the higher market price as given and also increase its output to the profit-maximizing level. Hence, in a PC market, any change in demand or supply will cause a change in the market price, thus prices tend to fluctuate.

Prices in an oligopolistic firm

Prices fluctuate less in an oligopolistic market than in a perfectly competitive market due to the varying degree of barriers to entry in the respective market.  In an oligopoly, there are high barriers to entry. The large scale of Ford Motors enables it to enjoy internal economies of scale and together with the established name and high start-up costs to purchase machineries and engage in R&D, it is hard for new firms to break into the market despite large supernormal profits being earned by oligopolistic firms in the short run. As such, the number of sellers in an oligopoly will not vary much and thus the market share and price for each oligopolistic firm does not change readily.

As an oligopoly is characterised by the dominance of few big firms, an oligopolistic firm produces a significant amount of the total market output. The seller can either influence the price or output. It can sell more by lowering price or increase price but sell less. There is high degree of mutual interdependence between firms due to the dominance of the few large firms in the industry. Any decision made by one firm will cause strong reactions from the other firms.

The auto industry is representative of an oligopoly. There are only a few large car manufacturers in the US such as Chrysler, General Motors (GM) and Ford Motors. If Ford Motors wants to increase the quantity sold, it can lower the price of its cars so that some buyers will switch from either Chrysler or General Motors.

Suppose the firm is presently charging at the equilibrium price P0, as illustrated in Figure 2. If it raises the price above P0, its rivals would not follow by raising their prices. The firm which has raised its price will suffer a more than proportionate fall in its quantity demanded because most of his customers will buy from its competitors who did not raise their prices. Therefore, the portion of the demand curve above P0 will be price elastic and total revenue would fall if the firm increases its price above P0. If it lowers its price below P0, it can expect its rivals to follow suit. The increase in output as a result of the reduction in price will be less than proportionate. Thus, the demand curve below OP0 will be price inelastic and total revenue would fall if the firm decreases its price below P0. Thus the firm has no incentive to deviate from the equilibrium price, giving rise to a kinked demand curve as seen in Figure 2 and price rigidity. Hence, prices tend to fluctuate less in oligopoly compared to PC.

oligopoly pricing

The profit maximisation oligopolistic firm will produce at the equilibrium output when MC1 intersects MR1 along the discontinuous vertical portion at E1, giving rise to the price rigidity at P0.

In addition, in the kinked demand curve model, if Ford Motors experiences an increase in the marginal cost from MC1 to MC2, the MC still cuts the MR at the discontinuity, and thus the equilibrium price remains unchanged at P­0. The kinked demand model predicts that price is rigid in an oligopolistic market. Likewise, when there is an increase in demand for an oligopolistic firm, the demand curve will shift to the right from AR1 to AR2, as shown in figure 2.  Assuming that costs remain the same at MC₁, the equilibrium price remains at OP1.

Conclusion

Hence, the above explains that due to the different features and behaviour of a perfectly competitive and an oligopolistic firm, prices might fluctuate less in an oligopolistic market than in a perfectly competitive market.


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By |2016-04-12T16:27:21+00:00October 11th, 2014|Micro: Market Structure, Uncategorized|0 Comments

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