Oligopolists are more likely to match the price-cut than a price increase by a competitor. Why?

Oligopolists are more likely to match the price-cut than a price
increase by a competitor. Why? Explain with the help of examples.


Oligopoly: Oligopoly is a situation in which only a few firms (sellers) are
competing in the market for a particular commodity. The distinguishing characteristics
of oligopoly are such that neither the theory of monopolistic competition nor the theory
of monopoly can explain the behaviour of oligopolistic firm.
These characteristics are briefly explained below:
Under oligopoly the number of competing firms being small, each firm controls an
important proportion of the total (industry) supply. Consequently, the effect of a
change in the price or output of one firm upon the sales of its rival firms is
noticeable and not insignificant. When any firm takes an action its rivals will in all
probability react to it. (i.e., retaliate). The behaviour of oligopolistic firms is
interdependent and not independent or automistic as in the case under perfect or
monopolistic competition.
The demand curve of an individual firm under oligopoly is not known and is
indeterminate because it depends upon the reaction of its rivals, which is
uncertain. Each theory of oligopoly therefore makes a specific assumption about
how rivals will (or will not) react to an individual firm’s action.
In view of the uncertainty about the reaction of rivals and interdependence of
behaviour, oligopolistic firms find its advantageous to co-ordinate their behaviour
through explicit agreement (cartel) or implicit, hidden, understanding (collusion).
Also because the number of firms is small, it is feasible for oligopolists to establish
a cartel or collusive arrangement. However, it is difficult as well as expensive to
monitor and enforce an agreement or understanding. Very few cartels last long
particularly when oligopolistic firms significantly differ in their cost conditions.
Under oligopoly, new entry is difficult. It is neither free nor barred. Hence the
condition of entry becomes an important factor determining the price or output
decisions of oligopolistic firms, and preventing or limiting entry an important
objective.
Given the indeterminacy of the individual firm’s demand and, therefore, the
marginal revenue curve, oligopolistic firms may not aim at maximization of profits.
Modern theories of oligopoly take into account the following alternative objectives
of the firm:
Sales maximization with profit constraint.
Target or "fair" rate of profit and long-run stability.
Maximization of the managerial utility function.
Limiting (preventing) new entry.
Achieving "satisfactory" profits, sales, etc. That is, the firm is a "satisficer" and not
"maximizer".
Maximization of joint (industry) profits rather than individual (firm) profits:
TWO UNIQUE ASPECTS OF OLIGOPOLY COMPETITION
In oligopoly industries, competition occurs in ways that are unique to these industries.
Two unique aspects of oligopoly competition are mutual interdependence and repeated
interaction.
MUTUAL INTERDEPENDENCE
Mutual interdependence exists when the actions of one firm has a major impact on the
other firms in the industry. For instance, if Coke decides to sell more of its product (and
to do so they reduce their prices), Pepsi will certainly notice that its sales fall. Coke's
behavior affects Pepsi: mutual interdependence exists with in the US soft drink market.
But, if a corn farmer in Kansas decides to plant another few more of corn, the sales of
other corn farmers in the US will not be affected. An individual corn farmers' output is a
very small part of US corn output; changes in output by one farmer will have no impact
on the corn market. Mutual interdependence does not exist in the corn market. Mutual
interdependence exists within an oligopoly industry because each of the oligopolists
has a sizable part of the market. As a consequence, when it changes its sales, its
prices, or its marketing strategies, this oligopoly firm will likely affect the sales of other
firms within the industry. An analogy is the following. If you are on a ocean liner that
holds 1,000 people you can stand up and jump up and down and have no effect on the
other passengers. This is because you are very, very small compared to the boat and
to the number of other passengers on the boat. But, if you are in a small rowboat with 2
other people and you stand up the other 2 people will instantly notice that the boat is
more unstable and, perhaps, threatens to capsize. They must actively shift their weight
to keep the small boat from tipping over. The 3 people in the small row boat are
mutually interdependent: what one person does can directly affect what happens to the
other people on the boat.
REPEATED INTERACTION
Often the oligopolists within an industry have been competing with one another for a
long time. For instance, Pepsi and Coke have competed within the same market for
decades. Ford, GM, and Chrysler have faced one another in the US auto market for a
very long time. Oligopolists in other markets might have competed with one another for
a much shorter period of time, perhaps only a few years. But, in each of these cases,
the oligopolists within these industries have experience with the others within the
industry. For instance, whenever Pepsi decides to lower the price of its products it
knows how Coke responded in the past to previous reductions in price by Pepsi.
Perhaps Coke matches a Pepsi price reduction 10 out of the past 12 times Pepsi
reduced its prices. In this case, Pepsi likely anticipates that when it lowers its prices
this time, the odds are that Coke will respond in kind. Coke, on its part, also remembers
what happened in its past competitive interactions with Pepsi. Coke and Pepsi
remember, and take into account, what happened in the past when they design their
current competitive strategies. The situation is characterizes as "repeated interaction."
OLIGOPOLISTS ARE MORE LIKELY TO MATCH THE PRICE-CUT THAN A PRICE
INCREASE BY A COMPETITOR - KINKED DEMAND CURVE
The kinked demand curve has features common to most oligopoly markets. The kinked
demand curve analysis does not deal with price and output determination. Rather, it
seeks to establish that once a price quantity combination is determined, an oligopoly
firm does not find it profitable to change its price even if there is a considerable change
in cost of production. The logic behind this proportion is as follows. An oligopoly firm
believes that if it reduces the price of its products, rival firms would follow and
neutralize the expected gain from price reduction. But, if it raises its prices, rival firms
would either maintain their prices or may even cut their prices down. In either case, the
price raising firm stands to lose, at least a part of its market share. This behavioural
assumption is made by all the firms with respect to others. The oligopoly firms,
therefore, find it more desirable to maintain their price and output at the existing level.
Examples
In the cigarette business, as in many other American industries, we have what is known
as an oligopoly, where a few large firms dominate the market and by various more or
less legal means contrive to keep the prices for all brands uniform. Demand for
cigarettes in general is thought to be highly inelastic, meaning that people will buy
about the same number no what the price is; but demand for individual brands is highly
elastic--people are fickle, and will readily switch to another brand if it's priced
significantly lower. What this means is that if one manufacturer cuts his prices, he'll sell
a lot more cigarettes, but mainly at the expense of his competitors. Knowing this, the
competitors would immediately have to drop their own prices, and the upshot is that
everybody ends up selling about as many cigarettes as before, only at a lower profit
margin. For this reason the manufacturers try to avoid price competition if at all
possible.
Let’s take another example of Dell computers and Gateway. If either firm changes
prices, they generally expect the worse. If Dell increases prices, Gateway does nothing
and Dell gets hurt. If Dell reduces prices, Gateway responds by imposing their own
price cut and the ensuing price war likely hurts Dell. Why would Gateway do this?
Simply because these actions best help Gateway protect or increase its profit. If Dell
increases their prices and Gateway does not, then Gateway will experience a boost in
demand (Gateway computers and Dell computers are substitute products). As Dell
computers are now higher priced, more consumers will buy from Gateway (although
Gateway kept the same price as before). This can only help Gateway's sales, revenue,
and profits. It is rational, then, for Gateway to keep their prices the same when Dell
raises their prices. If Dell reduces their prices and Gateway does not, then Gateway will
find they lose many sales to the (now) lower-priced competitor, Dell. In this situation,
Gateway might find it is best to respond with their own price reduction in order to help
maintain their sales, revenues, and profits. It is likely rational for Gateway to reduce
prices when Dell reduces prices. As is clear, competition within this industry can be
very nasty as firms attempt to take advantage of other firms (if these other firms raise
their prices) or firms act to protect themselves by matching price reductions.