Explain why oligopolistic firms are affected by both interdependence and uncertainty when selling their product. An oligopoly is a market structure in which it is dominated by a small number of firms who have a high concentration ratio of the market and so have the ability to collectively exert control over supply and market prices. An oligopoly firm would face uncertainty, if they were taking part in collusive acts. Collusion is an agreement between two or more firms, sometimes illegal and therefore secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair advantage. As collusion is illegal, there can be no legally binding documents, this means that there is no certainty that the firms also taking part in the agreements, will be honest, they could go back on their word, or they could undercut the other firms even more.
The kinked demand curve assumes a business might face a dual demand curve for its product based on the likely reactions of other firms in the market to a change in price or another variable. The common assumption of the theory is that firms in an oligopoly are looking to protect and maintain their market share and that rivals are unlikely the match another’s price increase but may match with a price fall. The business would then lose market share and expect to see a fall in its total revenue.
If a business reduces price but other firms follow suit, the price change is much smaller and demand would be inelastic in respect of the price change. Cutting prices when demand is inelastic also leads to a fall in total revenue with little or no effect on market share. The kinked demand curve model therefore makes a prediction that a business might reach a profit-maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.
The kinked demand curve model predicts periods of price stability under an oligopoly with businesses focusing on non-price competition as a means of reinforcing their market position and increasing their supernormal profits. This theory shows interdependence, whereas game theory helps to illustrate uncertainty within an oligopolistic market. Game theory is mainly concerned with predicting the outcome of games of strategy in which the participants have incomplete information about the others’ intentions.
The theory seeks to analyse strategic behaviour between firms it can be applied to price competition or non price competition such as whether to raise or lower prices or engage in research and development or not as a result they may lose their competitive edge or market share. In the long run the dominant theory, in the case of research and development, would be to go ahead with it. If they do not and the other firm does then their profits will fall and lose out on market share.
Overall the best way to explain how oligopolistic firms can be affected by interdependence and uncertainty is the prisoner’s dilemma as it can help to explain the breakdown of fixing price agreements between producers which can lead to the outbreak of price wars among suppliers, the breakdown of other joint ventures between producers and also the collapse of free trade agreements between countries when one or more countries decide that protectionist strategies are in their own best interest.