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Oligopolistic pricing

The behavior of firms in oligopolistic markets is competitive. In the struggle for profit and increasing its market share, price control, advertising, and the establishment of output are used. The small number of competitors in the conditions of oligopoly forces firms to reckon with each other's reaction to their decisions.

To consider the issue of oligopolistic pricing, the following features of the oligopolistic market are important:

1. Only a few firms supply the entire market. The product they supply can be either standardized or differentiated.

2. At least some firms in the oligopolistic industry have large market shares. Consequently, some firms in the market have the ability to influence the price of a product by varying its availability in the market.

3. Firms in the industry are aware of their interdependence. Sellers always reckon with the reaction of their competitors when they set prices, benchmarks for sales volumes, the size of advertising expenses or take other business measures.

Conscious rivalry between firms gives rise to oligopolistic price wars. The pricing policy of any company in the market depends on the market demand for its products and on how the company imagines the reaction of competitors to its pricing policy. Each company, seeking to maximize profits, assumes that its competitors will choose a certain price for this product and will adhere to their decision, and if the company reduces its prices, then competitors will not lower their prices in response.

Table 11.

Product differentiation and competition (price, non-price) in the production of paracetamol



Suppose that there are only two sellers of goods T on the market, each seller produces T at constant average production costs of 10 rubles. and other sellers of goods T do not have the opportunity to enter the market (Fig. 7). Each seller sets a price of 20 rubles per unit of goods T and, therefore, both receive a profit of 10 rubles per unit. At this price, the quantity of goods T, for which there is demand, is 100,000 units per month, that is, two sellers sell at this price 50,000 units of T per month, making a profit of 500,000 rubles. every. Initially, sellers split the market in half and make economic profit. Since each seller believes that a competitor will not respond to his price reduction, each of them is tempted to increase monthly sales by cutting prices. By lowering the price below the price of its competitor, each seller plans to capture a large market share and increase his profit. If one seller lowered the price to 19 rubles, then the quantity for which there is demand would increase. Despite the fact that the profit per unit of goods T will be only 9 rubles, the total profit will increase due to an increase in sales. Then the second company reacts by lowering the price of the goods T. The price war continues until the price drops to the level of average costs. In equilibrium, both sellers charge the same price, the total market output is the same as would be the case with perfect competition.

Fig. 7.

The consequences of the oligopolistic price war



Equilibrium exists when no company can no longer benefit from lower prices. This happens when the price is equal to average costs, and economic profits are equal to zero and a further reduction in price will lead to losses.

Price wars are usually short-lived, as oligopolistic firms cooperate to set prices and divide markets in order to avoid the prospect of price wars and their adverse effects on profits.

Consider the main features of oligopolistic pricing:

• oligopolistic prices change less frequently than prices under conditions of perfect competition, monopolistic competition, or even in some cases of pure monopoly;

• prices in an oligopoly tend to be “tough”, inflexible;

• in the event of a change in price by one producer, it is likely that other manufacturers will also change prices;

• oligopolistic pricing behavior implies the existence of incentives and concerted actions in setting or changing prices.

There are four main models of oligopolistic pricing:

I.
An oligopoly not based on conspiracy. This model considers an oligopoly consisting of three firms, each of which controls a third of the market. One of the firms starting from a certain current

prices, reduces it and increases market share and output. A further level of price and output will depend on the reaction of two other firms. If they follow the first firm, they will prevent it from gaining a significant advantage. As a result of these actions, there will be a slight increase in sales in the industry as a whole due to other industries. If the company raises the price, then competitors most likely will not follow it and will show a firm intention to seize the market share lost by the first company. If competitors follow the price increase, then in the case of elastic demand, this may lead to a general loss of industry sales in favor of others.

II. Based on conspiracy. Firms involved in collusion tend to maximize total profits, that is, their behavior is close to that of a pure monopolist. However the difference

in demand and costs, the presence of more than 3 to 4 firms, price discrimination, potential entry into the industry of a potential competitor, sudden downturns in business activity, antitrust laws hinder secret collusion. These obstacles contributed to the decline of the very prosperous OPEC cartel - in the 80s.

III. Price leadership. In this case, there is no formal secret agreement. The largest and most efficiently operating company is undertaking price changes, and all others are following it.

The behavior of the price leader is due to the following circumstances. First, the price will be changed only when the conditions for the formation of costs and demand change significantly throughout the industry (increase in the price of material or fuel and energy resources, increase or decrease in taxes, etc.). Secondly, the price may change in order to preserve the existing oligopolistic structure of the industry and to prevent potential competitors from entering the industry. This situation arises if the barrier to entry

in the industry is the effect of scale of production. If the price in the industry is very high, then even a relatively small and inefficient company can enter the industry and even expand its activities. Therefore, the price leader will reduce the price and, accordingly, profit. Thirdly, the notification of the need to change the price always takes place publicly through the media, which has a psychological effect on competitors and allows them to reach agreement.

IV. "Costs plus." In this case, the price is based on the costs per unit of product and a premium is added to them to establish the final price. The mark-up represents the target profit, and unit costs are calculated at the standard estimated capacity utilization. For example, General Motors has used this pricing method for 40 years. The model forms a standard price, which is used as a base for making price decisions. Moreover, price decisions are based on a conspiracy or set by the firm - the price leader. An ideal situation may be when several manufacturers have approximately the same level of costs. In this case, the standard price and its changes will fluctuate within small limits.
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