The complex case of firms in an oligopoly

In an oligopoly the way in which firms compete is uncertain. Despite there has been a deep researching in this field of the literature it keeps being complex to analyse it.

Broadly speaking, it entails the firms’ target, market’s dynamics and product’s differentiation strategies. Since the oligopolistic theory arose (Bertrand, 1883), it has been evolved with the kinked curve, and complemented by a number of researchers (Anderson, 1984; Bhaskar, 1988; Maskin and Tirole, 1988). Oligopolistic theory suggests a stochastic asymmetry in expected rivals’ responses which is the main factor that sets it as an uncertain theory in Academia and sometimes it was the cause for it to have been discredited by academics (Stigler, 1978; Friedman, 1983). Also this stochastic asymmetry in rivals’ reaction caused the traditional theory modification since it was formulated.

In its traditional formulation the oligopolistic demand curve (Sweezy, 1939; Hall and Hitch, 1939) is kinked at PQ in the kinked demand curve showed below and each firm’s demand curve depends on how competitors react. In this market firms are always trying to develop their products to get their own comparative advantage. By making their product special and genuine they can attract a bigger portion of customers, albeit this fact of differentiate products does not entail a pure strategy equilibria. Following Edgeworth’s first statements, prices will never reach an equilibrium in an oligopoly. For substitutive products he thought a price equilibria didn’t take place in pure strategies and for complementary products he reviewed the concept of Nash equilibrium.

The kinked demand curve


In order to set a basic explanation on how this theory works, let X denote a firm in an oligopolistic market. As Begg et al. (2014) discuss, supposing X rises the price, if rivals don’t follow it, the firm will lose a portion of its customers who will buy from the other competitors. Consequently, the firm’s demand curve is elastic above PQ at prices above the current price P. However, if X believes that cutting prices will be followed by its competitors, market shares are unchanged. If firms cut the prices, it will entail extra sales rises due to the industry as a whole will move down the market demand curve.

At point PQ it is shown the kinked demand for these firms, reflecting the effects of a price change. At the output Q, X reaches the inelastic part of its kinked demand curve and marginal revenue is much lower. As from this point demand is less elastic, further output increases require much lower prices to sell this extra output. At Q, X will maximise its profits, but only through following a suitable strategy which fits with the response of its competitors.

Subsequently, regarding to X’s production decisions, it could be considered here the Prisoner’s Dilemma game (Flood and Dresher, 1950). If X, followed by its rivals, increase production the price will be low and each one will make lower profit. Firms can attemp a group strategy in order to establish a collusive monopoly by reducing their production activity, achieving prices increase due to the scant industry output. X can reach to its maximum profit by having the highest output while the others reduce their production in order to get an equilibrium point which let to keep the price at the same level. Nevertheless, as it was held above, X decides prices depending the price it expects its rival to set. If X sets a price above its marginal cost, its competitors automatically will take advantage from it by cutting the prices below it in order to increase their market share. Since firms could anticipate this, it will never set such a price and this will lead until, in Nash equilibrium, firms set prices at marginal cost and split the market between them, forgetting any incentive to getting better market share (Nash, 1950).

The weakness of this theory is that these rivals’ responses are ad hoc and arbitrary as they are not derived from any form of maximising behaviour, and it has been found to be cyclically sensitive so that increases in price were more probable to be followed in booms or inflationary periods while decreases in price were more probable to be followed in recessions or depressions (Bhaskar, Machin and Reid, 1991). The difficult sustainability of the oligopolistic theory has supposed a suitable opportunity for researchers to develop it and makes this theory more rigid since it was formulated, as it was achieved by several contributions despite not reaching to its highest peak. As Vives (1993) stated, Edgeworth’s review of oligopoly theory has been focused on indeterminacy, price dynamics, role of numbers and substitutability of products and Nash equilibrium. Thanks to Edgeworth, the researching on strategic competition has advanced further instead the remaining indeterminacy region in outcomes that has kept reluctant. Thanks to Vives’ further contribution, we know now that pricing is determinate from a static equilibrium approach. Equilibria in pure strategies exist an it has an order structure, non-equilibrium approach is limited and equilibrium outcomes have stability conditions involving oligopoly.

Enrique Muñoz-Salido
Enrique Muñoz-Salido
Enrique works in the tech industry, computer software, in the City, London. His interests lie at crossroads of human behavior and software. Enrique is an Oxford Masters graduate, Talentia scholarship.