Understanding Oligopoly and Trade Theory
Oligopoly
Oligopoly has been derived from Oligo + Polein, Oligo meaning few and polein means to sell. Oligopoly can thus be defined as: ‘A market structure characterized by few large sellers selling homogeneous or differentiated products, having strong barriers to entry and exit and firms recognize their mutual interdependence.
- Few Large Sellers: Oligopoly consists of just few sellers that control the whole market and hence the market share of each seller is quite large.
- Homogeneous or Differentiated Products: Oligopoly can be pure oligopoly where the sellers are selling homogeneous products like in the case of LPG cylinders or it can be impure oligopoly where sellers are selling differentiated products like in case of automobile industry. An important point to note here is that differentiation can be real (where the composition of the products is actually different) or perceived (where there is no actual difference between the products.
- Strong Barriers to Entry and Exit: New firms are not prohibited from entering the market though there are strong barriers that hinder their entry, it can be because of the cost advantage of the existing firms, economies of scale that existing firms enjoy or huge capital requirements or any such reason
- Interdependence: This is one of the most significant and distinguishing features of oligopoly firms that arises because of the fact that there are few firms and share of each firm is quite significant, thus if any firm changes its strategy with respect to price, promotion or any such variable it is bound to impact the other firms and they would retaliate Thus, each firm before bringing a change in any of its variables should consider the possible reaction of the rival firms
- Advertisement: It is one of the instruments that the oligopoly firms frequently use and it is one of the most powerful weapons that they can use against the rivals Instead of changing the prices often, firms go for this as prices are usually rigıd because of the fear that price changes can lead to a price war.
Cournot Model
The model was given by Augustin Cournot in 1838 based on only two firms that were selling homogeneous products (spring water). It is based on the following assumptions
- It is a duopoly model that is there are only two firms
- Firms do not recognize their interdependence or rivalry and act independently
- The marginal cost of production of both the firms is zero, that is MC = 0.
- Straight Linear demand curves
- Objective of the firms is profit maximization.
- Both the firms decide simultaneously how much to produce
Cournot model assumed that both the firms set their output simultaneously however Stackelberg model assumes that the firms do not take their decision simultaneously There are two firms in this model where one sets its output first and then the second firm enters. This model is based on the following assumptions
- Duopoly model- Two firms A and B
- Straight linear demand curves
- There is zero marginal cost for both the firms
- One firm is the leader that sets its output first and the second is the follower who is behaving as per Cournot assumption (assumes that the leader would keep its output constant) A firm can act as the leader because of its knowledge, experience or sophistication. There is no collusion between the firms, both the firms act independently Both the firms are selling homogeneous products.
Theory of Comparative Costs
The theory of comparative costs was discussed by the famous economist David Ricardo in his book principles of political economy and taxation. The theory is also called the theory of comparative advantage. Ricardo’s theory of comparative costs claims that trade enables countries to specialize in producing the products that they produce best. According to the theory, specialization and free trade will benefit all trading partners even those that may be absolutely less efficient producers.
- There are only two countries and they produce two goods Labour is the only factor of production and cost of production is measured in terms of labour units
- All units of labour are homogenous
- Production is subject to the law of constant returns
- Factors of production are perfectly mobile within the country but are perfectly immobile between two countries
- There is no cost of transportation
- International trade is free from all government comforts
- There is full employment in countries engaged in international trade. There is perfect competition both in the goods market and factor market