‘Oligopoly is an industry structure characterized by a few firms producing all, or most, of the output of some good that may or may not be differentiated.book’ An oligopoly lies somewhere in between a monopoly (only one seller) and competition (many sellers). Firms are said to exhibit ‘strong mutual interdependence,’ meaning that an action by one firm is likely to have a substantial effect on the others. An example of this interdependence can be shown if firm A takes the action of lowering the price of its good. If other firms keep the same price as they had previously, they will lose sales to firm A. If they react by lowering their price to the same as that of firm A, they will avoid losing sales but will lose profit per sale equivalent to the fall in price that has occurred. To complicate things further, all other firms also have the option of cutting price below that of the firm A’s original cut. In oligopoly firms make their decisions on ‘some guess, or conjecture, about its competitors’ responses.’ Firms act on the predictions that they make but, due the complexities of the decisions that they face, firms often make the wrong choices. This guesswork leads to a complicated market. As a result, a number of models have been suggested, each attempting to explain the behavior of firms in oligopolistic competition. Important features of an oligopoly that need to be considered are firstly, whether the product is homogenous or differentiated, acting as a key determinant on level of advertising. Secondly, the influence on pricing behavior that arises through the presence of barriers to entry.
Augustin Cournot introduced one of the earliest models in 1838. He considered a ‘duopoly,’ an industry with two firms. These two firms produce homogenous products, allowing only one price, determined by the ‘combined output of the two firms in conjunction with the market demand curve for the product,book’ to prevail. For simplification purposes, it is assumed that both firms have constant and equal long-run marginal cost curves, and that there is a linear market demand curve. The Cournot model is based on the key element that ‘each firm determines its output based on the assumption that any other firms will not change their outputs.book’ Through this method we can determine market price and output.
According to the Cournot model, if Firm A produces nothing (and will continue to produce nothing), Firm B will behave as a monopolist. It will therefore profit-maximise, producing at output level Qm (48 units) where MC is equal to MR on the graph below. Notably this is half of output under competition. If, on the other hand, Firm A produces 32 units, Firm B will now only be able to produce at 32 units less than the total quantity demanded. This can be demonstrated by the rightward shift of Firm B’s vertical axis by 32 units, making its origin now Qu and its demand curve BD. With demand curve BD, Firm B has a new marginal revenue curve in MR(32). The market now produces 64 units of output and Firm B operates where MR(32) equals MC. We can now see that Firm B’s output is totally dependent upon Firm A’s. Firm B will always produce half the difference between Firm A’s output and the output at which MC intersects D. This idea is reversible as, using the Cournot assumption, Firm A will determine its output depending on Firm B’s output.
The problem now is establishing where the market equilibrium will be. This happens when neither firm has any incentive to change its output which is when firms A and B produce 32 units of output. They have the same marginal cost curve and, as they are both profit maximizing, there is no incentive to change from 32 units of output if the other company is also producing at 32 units of output.