Do Prices in Oligopoly markets have to be rigid?

The theory of oligopoly is focussed on a stable market in which a few large firms dominate the supply of items and can have power over price or supply. This may be because of economies of scale or high barriers to entry. Barriers to entry can include sunk costs, legal and regulatory protections and requirements such as patents or performance rules, and resource availability.

Within such a market, the theory assumes that the Demand curve for the individual firms corresponds to their Average revenue curves. These lines are ‘kinked.’ This means that the AR is inelastic and stable below a certain price point, because customers are not purchasing below the kink based on price, and elastic above the point, because the customers are price sensitive.

Very few oligopoly models assume that the AR line is vertical below the kink, which means that there is some scope for different prices at different levels of output. Given that customers are highly inelastic, any price cuts would nevertheless result in losses as the company would gain less in new customers than it lost in existing revenue. Therefore, once the ‘kink’ in the market was identified, prices would be likely to remain at or near it, making the whole market price effectively rigid.

Oligopolies are still capable of competing, but they would do so on the basis of three constraints.

Firstly, oligopoly customers tend to remain with one company regardless of price below the kink because of convenience, some non-price factor like design, recipe, or habit, or convenience. This gives, for instance, coffee chains an incentive to develop new styles of coffee and to attract gains at the margin of the market, but in the knowledge that others will effectively copy or counter them quickly.

Secondly, oligopoly markets tend to be subject to ‘customer churn.’ This means that customers can be expected to leave one company and join others at roughly similar levels for all companies in the oligopoly. One mobile telephony company might expect to lose, for instance, five to ten per cent of its own customers per year, but to gain five to ten per cent of those who have left other large producers, and vice versa. Therefore, no company has any real incentive to alter prices to keep existing customers, though there might be some marginal gain in changing for new ones. This again means that prices are likely to be largely but not wholly rigid.

Thirdly, competition in the form of a ‘price war’ only makes sense for oligopolists if they judge that one of their members is likely to be unable to sustain a period of lower or no profits. Cutting prices drives marginal revenue down rapidly when AR is kinked, and if a company has maintained higher costs than others, it will make losses. Newspapers have in the past engaged in such behaviour in order to eliminate one title, and share the former paper’s readers with each other, thus boosting revenue. This behaviour does run the risk, however, of making all customers price-aware and causing them to demand permanently lower prices or to leave the market where an alternative exists. This is because it breaks the habitual behaviour of the customers and replaces it with price awareness, as overcomplicated price discrimination corresponding to price-gouging by eliminating consumer surplus might also do.

Oligopolists are typically aware of such dangers, and many therefore make decisions on the basis of game theory in which the second-best strategy of everyone maintaining profits by making no move on prices is a normal outcome. If one company does decide to start changing price, oligopolists using game theory must decide either to minimise their maximum loss, maximise their gain, or stay put. The ‘Nash equilibrium’ of everyone doing the second-choice thing is, most of the time, the most rational, which makes prices look rigid.

It is therefore not the case that oligopoly prices are necessarily rigid, but it benefits oligopolists if they are. This is why oligopolists are interdependent and tend to form cartels to fix prices. A cartel, in which large companies can tacitly or openly collude to keep prices at a cetain point, eliminates the need to invest in detailed analysis and game theory-based decisions about the behaviour of others.  the problem is that, in most domestic markets (but not between governments, as with OPEC) cartels are illegal, and attract the attention of regulators like the sector bodies such as Ofgem, national groups like the Financial Conduct Authority, the government of the PRC, and the US FBI, or supranational groups like the European Commission. Fines and sanctions from such groups can be intense. Some variation on prices between companies is therefore sensible when potential costs are considered.

Finally, prices are unlikely in any market to be rigid in the long run when barriers to entry can be circumvented or lapse. Technology, the time limit on patents and copyrights, and the ability of global companies to overwhelm domestically dominant firms, tends to mean that no oligopoly lasts forever even if politicians are suborned by corruption or protectionism. Therefore, prices will eventually return to an allocatively efficient point, even if there is no government intervention.