Model Answer
0 min readIntroduction
Oligopoly, a market structure dominated by a few large firms, is a common feature of modern economies. Within this structure, a ‘dominant firm’ often emerges – a firm with a significant market share that influences the pricing and output decisions of smaller ‘fringe’ firms. This arrangement frequently leads to price leadership, where the dominant firm sets the price, and the fringe firms accept it. This phenomenon is particularly relevant in industries like automobiles, steel, and telecommunications. Understanding how a dominant firm acts as a price leader is crucial for analyzing market dynamics and formulating appropriate policy interventions.
Understanding the Market Structure
An oligopoly is a market structure characterized by a small number of firms, high barriers to entry, and interdependence among firms. A dominant firm within an oligopoly possesses a substantial market share, typically exceeding 40-50%, allowing it to significantly influence market outcomes. The remaining firms, known as the competitive fringe, are smaller and individually have limited market power.
The Price Leadership Mechanism
The dominant firm acts as a price leader due to its ability to influence market price. This happens in the following steps:
- Demand and Residual Demand: The dominant firm faces the total market demand curve. However, it recognizes that if it raises its price, the fringe firms will capture some of its market share. Therefore, the dominant firm considers the residual demand curve – the demand it faces after accounting for the output of the fringe firms at any given price.
- Fringe Firm Response: The fringe firms react to the dominant firm’s price by adjusting their output. They typically operate at a level where their marginal cost (MC) equals the market price set by the dominant firm.
- Dominant Firm’s Profit Maximization: The dominant firm maximizes its profit by setting its output where its marginal revenue (MR) equals its marginal cost (MC), taking into account the residual demand curve. This involves understanding how the fringe firms’ output will change in response to its price decisions.
- Price Setting: The dominant firm sets a price that maximizes its profit, and the fringe firms accept this price. They adjust their output to maximize their own profits at the given price.
Mathematical Representation
Let:
- Q = Total market quantity
- Qd = Quantity supplied by the dominant firm
- Qf = Quantity supplied by the fringe firms
- P = Market price
- D = Market demand curve (P = a - bQ)
- MRd = Marginal revenue of the dominant firm
- MCd = Marginal cost of the dominant firm
The residual demand curve faced by the dominant firm is:
P = a - b(Qd + Qf)
The dominant firm maximizes profit by setting MRd = MCd, solving for Qd, and then substituting Qd and Qf into the market demand curve to find the market price P.
Graphical Illustration
Imagine a graph with price on the Y-axis and quantity on the X-axis. The market demand curve (D) slopes downwards. The fringe firms’ supply curve is horizontal at their marginal cost. The dominant firm’s residual demand curve is derived by subtracting the fringe firms’ supply from the market demand. The dominant firm’s profit-maximizing output is where its MR curve intersects its MC curve. The corresponding price on the residual demand curve is the market price.
Examples of Price Leadership
US Steel Industry (Historically): In the early 20th century, US Steel held a dominant market share and acted as a price leader, with other steel companies following its price changes. Microsoft in the Operating System Market: For many years, Microsoft’s dominance in operating systems allowed it to effectively set the standard and influence pricing in the software market. Indian Cement Industry: Historically, a few large players like ACC and Ambuja Cement have often influenced pricing trends in the Indian cement market.
Limitations and Challenges
The price leadership model assumes that the fringe firms are small and have no individual influence on price. However, if the fringe firms collude or if one fringe firm becomes significantly larger, the dominant firm’s control can be weakened. Furthermore, the model doesn’t fully account for dynamic competition, innovation, or the potential for new entrants.
Conclusion
In conclusion, the dominant firm model provides a useful framework for understanding price leadership in oligopolistic markets. The dominant firm leverages its market share to influence pricing decisions, considering the response of the competitive fringe. While this model offers valuable insights, it’s important to acknowledge its limitations and the potential for changes in market dynamics. The effectiveness of price leadership depends on factors like the size and behavior of the fringe firms, the barriers to entry, and the degree of product differentiation.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.