Oligopoly Pricing, Keynesian Theory, and National Income Metrics

Posted on Feb 5, 2026 in Economy

Oligopoly Price Leadership Models

In an Oligopoly, firms are interdependent, meaning one firm’s pricing decision directly affects others. To avoid destructive price wars, firms often adopt a Price Leadership Model, where one firm (the “leader”) sets the price, and others (the “followers”) match it.

Types of Price Leadership

There are three primary forms of price leadership based on how the leader is established:

1. Dominant Firm Price Leadership

• Description: A single firm controls a massive share of the market (usually 60–80%), while the rest of the market consists of several small “fringe” firms.
• Mechanism: The dominant firm behaves like a monopolist; it sets the price to maximize its own profit (MR = MC).
• The Follower’s Role: Smaller firms act as “price takers.” They accept the leader’s price and produce as much as they can at that price, similar to firms in perfect competition.

2. Low-Cost Price Leadership

• Description: The firm with the lowest cost of production becomes the leader.
• Mechanism: The low-cost firm sets a price that maximizes its profit. Since its costs are low, this price is typically lower than what higher-cost firms would prefer.
• The Follower’s Role: Higher-cost firms are forced to follow this lower price to remain competitive, even if it means earning smaller profit margins.

3. Barometric Price Leadership

• Description: An experienced or respected firm—not necessarily the largest or lowest-cost—acts as a “barometer” for market conditions.
• Mechanism: This firm is the first to sense changes in demand or production costs (like a sudden rise in raw material prices). It adjusts its price, and others follow because they trust the leader’s market insight.

Critical Examination of Price Leadership

While the model explains market stability, it is subject to several critical limitations:

The Merits (Why it works)

• Eliminates Price Wars: It provides a “tacit” (unspoken) coordination that prevents firms from undercutting each other to the point of bankruptcy.
• Market Stability: It creates a predictable environment for both producers and consumers.
• Simplifies Decision-Making: Smaller firms do not need to spend resources on complex market research; they simply follow the leader.

The Demerits (Critical Challenges)

• Risk of Parallelism and Collusion: In many regions, price leadership is viewed as “implicit collusion.” If firms follow the leader to keep prices artificially high, it can attract the attention of anti-trust regulators.
• Follower Defection: The model assumes followers will always comply. However, a follower might “cheat” by offering hidden discounts or better credit terms to steal the leader’s customers.
• The “Laggard” Problem: If a barometric leader makes a mistake in reading the market, the entire industry may follow a flawed pricing strategy, leading to a collective loss.
• Entry Barriers: It can be used as a predatory tool. A dominant firm might set a price so low that it’s impossible for a new, smaller entrant to survive (Predatory Pricing).

Keynesian Theory and Effective Demand

The Keynesian Theory of Employment, introduced by John Maynard Keynes in his 1936 book The General Theory of Employment, Interest and Money, revolutionized macroeconomics by challenging the Classical belief that markets always self-correct to full employment. Keynes argued that the level of employment depends on Effective Demand, and that an economy can remain stuck in an “underemployment equilibrium” indefinitely without government intervention.

The Principle of Effective Demand

The core of Keynesian theory is that employment is determined by Effective Demand (ED), which represents the total spending in an economy. Effective demand is found at the intersection of two functions:

Aggregate Demand Function (ADF)

The total amount of money that entrepreneurs expect to receive from selling the output produced at a specific level of employment.

• Formula: $ ext{AD} = ext{C} + ext{I} + ext{G} + ( ext{X} – ext{M})$
• As employment increases, consumption increases, but at a decreasing rate (Fundamental Psychological Law of Consumption). Thus, the ADF curve rises but flattens out.

Aggregate Supply Function (ASF)

The minimum amount of money (total cost) that entrepreneurs must receive to justify employing a specific number of workers.

• The ASF curve slopes upward because higher employment leads to higher production costs.
• Once Full Employment is reached, the ASF becomes a vertical line because no more workers are available to increase output.

Equilibrium: Underemployment vs. Full Employment

Equilibrium occurs where $ ext{ADF} = ext{ASF}$. This point is called Effective Demand.

• The Keynesian Departure: Unlike Classical economists who believed equilibrium only happens at full employment, Keynes showed that equilibrium can occur at a level below full employment.
• If the demand is insufficient to employ everyone willing to work, the economy experiences “Involuntary Unemployment.”

Critical Examination (Evaluation)

While Keynesian theory saved many economies during the Great Depression, it has several strengths and weaknesses:

Major Contributions (Merits)

• Rejection of Say’s Law: Keynes successfully refuted “Supply creates its own demand,” showing that if people save more than firms invest, demand will crash.
• Focus on the Short Run: He famously said, “In the long run, we are all dead,” shifting the focus to immediate policy fixes like government spending.
• The Multiplier Effect: He explained how an initial increase in government spending leads to a much larger increase in national income.

Critical Limitations (Demerits)

• The Problem of Stagflation: In the 1970s, many economies faced high inflation and high unemployment simultaneously—a scenario Keynesian theory could not explain or solve.
• Ignoring the Long Run: By focusing only on the short run, the theory ignores the long-term consequences of massive government debt and inflation.
• Over-emphasis on Demand: The theory assumes that supply will always respond if demand is high. It ignores “supply-side” shocks, such as a sudden rise in oil prices or a technological collapse.

National Income Aggregates and Measurement

National Income is the total value of all final goods and services produced by the residents of a country in a given period, usually one financial year. It represents the sum total of all factor incomes (wages, rent, interest, and profit) earned by the “normal residents” of a nation, whether they are working within the country or abroad. In technical terms, National Income is specifically referred to as Net National Product at Factor Cost ($ ext{NNP}_{ ext{FC}}$).

Core Concepts of National Income

To understand National Income fully, we must navigate several related aggregates. These concepts are built using three fundamental adjustments:

Adjustment Types

• Gross vs. Net: $ ext{Net} = ext{Gross} – ext{Depreciation}$ (Wear and tear of machinery)
• Domestic vs. National: $ ext{National} = ext{Domestic} + ext{NFIA}$ (Net Factor Income from Abroad)
• Market Price vs. Factor Cost: $ ext{Factor Cost} = ext{Market Price} – ext{Net Indirect Taxes (NIT)}$

1. Gross Domestic Product ($ ext{GDP}_{ ext{MP}}$)

$ ext{GDP}$ is the market value of all final goods and services produced within the domestic territory of a country in a year. It focuses on where the production happens, not who does it.

2. Net Domestic Product ($ ext{NDP}_{ ext{MP}}$)

$ ext{NDP}$ is the “clean” version of $ ext{GDP}$, accounting for capital used up during production.

• Formula: $ ext{NDP} = ext{GDP} – ext{Depreciation}$

3. Gross National Product ($ ext{GNP}_{ ext{MP}}$)

$ ext{GNP}$ measures the total value of goods and services produced by the normal residents of a country, regardless of their location.

• Formula: $ ext{GNP} = ext{GDP} + ext{NFIA}$
• Example: An Indian doctor working in the USA, their income is part of India’s $ ext{GNP}$ but USA’s $ ext{GDP}$.

4. Net National Product ($ ext{NNP}$)

When we subtract depreciation from $ ext{GNP}$, we get $ ext{NNP}$.

• $ ext{NNP}_{ ext{MP}}$: Net National Product at market prices.
• $ ext{NNP}_{ ext{FC}}$ (National Income): This is the most accurate measure of a nation’s wealth. It subtracts indirect taxes (which inflate prices) and adds back subsidies (which lower prices) to find the actual cost of production.

Other Important Income Measures

Beyond the standard aggregates, economists use specific measures to understand household welfare:

• Personal Income (PI): The total income actually received by individuals. It excludes corporate taxes and undistributed profits but includes Transfer Payments (like pensions) for which no productive service was rendered.
• Disposable Personal Income (DPI): The money actually available for households to spend or save. Formula: $ ext{DPI} = ext{Personal Income} – ext{Direct Taxes (Income Tax)}$
• Per Capita Income: The average income earned per person in a country. Formula: $ ext{Total National Income} / ext{Total Population}$

Why These Concepts Matter

Understanding the difference between these is crucial for policy. For example:

• $ ext{GDP}$ tells us how much activity is happening in our factories (the “Engine”).

Inflation: Causes and Rate Classifications

Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Economists generally classify inflation in two ways: by its cause (what started it) and by its speed (how fast it is rising).

Types Based on Causes

This classification looks at the underlying economic forces that push or pull prices upward.

Demand-Pull Inflation

This occurs when the total demand for goods and services in an economy exceeds the available supply. Economists often describe this as “too much money chasing too few goods.”

• Cause: High consumer spending, increased government expenditure, or an expansion in the money supply.
• Result: As demand outpaces production capacity, businesses raise prices to ration their stock.

Cost-Push Inflation

This occurs when the costs of production increase for companies, forcing them to raise prices to maintain their profit margins.

• Cause: A sudden rise in the price of raw materials (like oil), an increase in wages (wage-push), or higher taxes.
• Result: The “supply shock” reduces the total amount of goods produced, pushing the general price level up.

Built-in (Wage-Price Spiral)

This is a circular type of inflation linked to expectations. As prices rise, workers demand higher wages to keep up with the cost of living. To afford these higher wages, businesses raise prices further, creating a continuous loop.

Types Based on Speed (Rate of Increase)

This classification measures how rapidly the price level is changing annually.

Other Specific Types

• Stagflation: A rare and difficult situation where the economy faces stagnant growth (high unemployment) and high Inflation at the same time.
• Deflation: The opposite of inflation—a sustained decrease in the general price level.
• Core Inflation: A measure of inflation that excludes volatile items like food and energy to show the long-term trend in the price level.