Price Output Decisions Under Oligopoly

Demand curves relate quantity demanded to price, holding constant the effect of all other variables. One variable that is typically assumed to remain fixed is the price charged by competing firms. In oligopoly, however, if one firm changes its price, other firms react by changing their prices. The demand curve for the initial firm shifts position so that instead of moving along a single demand curve as it changes price, the firm moves to an entirely new demand curve.

The phenomenon of shifting demand curves is illustrated in Figure 11.3(a). Firm A is initially producing units of output and selling them at a price of Pr Demand curve D1 applies here, assuming that prices charged by other firms remain fixed. Under this assumption, a price cut from Pj to P2 would increase demand to Q2. Assume, however, that only a few firms operate in the market and that each has a fairly large share of total sales. If one firm cuts its price and obtains a substantial increase in volume, other firms lose a large part of their business. Furthermore, they know exactly why their sales have fallen and react by cutting their own prices. This action shifts firm A down to the second demand curve, D2, reducing its demand at P2 from Q2 to Q3 units. The new curve is just as unstable as the old one, so knowledge of its shape is useless to firm A; if it tries to move along D2, competitors will react, forcing the company to yet another demand curve.

Shifting demand curves presents no real difficulty in making price/output decisions if each firm knows how rivals will react to price changes. The reactions would just be built into the price/demand relation, and a new demand curve could be constructed to include interactions among firms. Curve D3 in Figure 11.3(b) represents such a reaction-based demand curve; it shows how price reductions affect quantity demanded after competitive reactions have been taken into account. The problem with this approach is that different interfirm behavior leads to different pricing decision rules.

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