Short Response Question pg. 125 – Oligopoly

Explain why prices tend to be quite stable in a non-collusive oligopoly.

Oligopoly is where a few firms dominate an industry. The industry is made up of quite a few firms or not very many, as long as a large percentage of the industry’s output is shared by just a small number of firms. Collusion is the process of when firms in an oligopolistic market cooperate to decide on the price that they are going to cell their product for (together they act as a monopoly). Non-collusive oligopoly occurs when the firms in an oligopoly do not collude, meaning they do not decide on a price together. This means that each oligopolistic firm needs to be very aware of the reactions of other firms when making pricing decisions. The prices in a non-collusive oligopoly tend to be quite stable for various reasons. First of all, firms are afraid to raise prices above the current market price, because the other firms would keep their price, meaning that most consumers will stop buying from the firm that is charging the higher price, and purchase their products from the other firms which sell very similar products, but for a lower price. So, if firms in a non-collusive oligopoly raise their price, they will lose trade, sales, and most likely profit. On the other hand, firms are also not able to lower their prices below the current market price, because then other firms would follow, and maybe go as far as selling their products at an even lower price. This would create a price war where each firm would try to sell their product at the lowest price, to increase the quantity demanded for that firm, but this would harm all the firms involved since they would all be gaining losses. This can be illustrated by a graph. Above the market price, the demand is relatively elastic, since a small increase in price would lead to a large fall in quantity demanded. Below the market price, the demand curve is less elastic, since a decrease in price is unlikely to lead to a noticeable increase in quantity demanded. All in all, the prices tend to be quite stable in a non-collusive oligopoly because a slight increase in price would lead to a large fall in quantity demanded, since the demand is relatively elastic, and a decrease in price would not lead to an increase in quantity demanded, so it would not lead to great profits.