In a market with only a few large firms, mutual interdependence is the reality that the actions of one firm affect the choices and actions of the other firms. Mutual interdependence is associated with oligopolistic markets—markets with barriers to entry, few competitors, and either similar or differentiated products.
In perfectly competitive and monopolistically competitive markets, where there are many competing firms, the actions of one firm have very little impact on the overall market. If one firm lowers its price, increases or decreases its output, or expands its advertising or distribution network, it will have little impact on its market because it represents only a small part of the overall output. If, on the other hand, one firm is a significant part of the overall market, its actions can affect its competitors. If one firm lowers its prices and the other firms do not match the price decrease, the one firm will increase sales, taken from the few other competitors in the market.
Mutual interdependence leads to a variety of market behaviors, including price leadership, kinked-demand curves, nonprice competition, collusion, and cartels. Using price leadership, one firm announces a price change; usually an increase in price, and the other firms match the price increase. In the United States, steel, banking, and airline prices are often changed through price leadership.
Kinked-demand curve behavior is the matching of price decreases but not price increases. This leads to two different responses to changes from the existing price. If one firm raises its price and the few other firms do not match the price increase, the firm will experience a significant decrease in sales as consumers switch to competitors’ products. If the firm lowers a price, competitors, recognizing they will lose sales if they do not lower their own price, will match the decrease. This leads to two different elasticities of demand at the current price, resulting in a kink in the demand curve.
Recognizing that competitors will match a decrease but not an increase in price frequently results in “sticky” prices. The few firms will instead compete on a basis other than price. Nonprice competition can include efforts to attract customers based on image, brands, service, warrantees, hours of operation, quality—anything but price. One of the classic studies in nonprice competition analyzed the U.S. cereal industry. Dominated by four firms (Quaker, Kellogg, Post, and General Mills), for years the industry competed based on product proliferation, constantly creating new or slightly different products, attempting to differentiate their products from competitors’ products but not competing on a basic of price.
Mutual interdependence can also lead to collusion— secret agreements to reduce competition and thereby increase profits. Collusion typically involves arrangements to divide up markets or rig prices. With only a few competitors, it is possible to agree to measures that will benefit each participant. As one sales representative once said, “We all call on the same customers and stay in the same hotels. At night we are down in the bar talking with each other, and eventually the discussion comes around to price.” Collusion is tempting but also illegal in the United States.
Cartels are open arrangements among firms to reduce output in order to raise prices. Like collusion, cartels work when there are a few mutually interdependent producers. The most famous cartels are the Organization of Petroleum Exporting Countries (OPEC) and the illegal drug cartels. Both groups operate by controlling supply.
Recognizing mutual interdependence, economists and mathematicians (including John Nash, portrayed in the film A Beautiful Mind) have developed theories about the actions and reactions of participants in a market. Game theory attempts to describe the various possible outcomes in a situation involving two or more interacting individuals when those individuals are aware of the interactive nature of their situation and plan accordingly. Games can be either cooperative or noncooperative and can be zero-sum, negative-sum, or positive-sum. Cooperative games involve participants who agree to work together; noncooperative games exist when competitors neither cooperate nor negotiate. A zero-sum game exists when the gains of one player come at the expense of other participants, while a negative-sum game is one where players as a group lose in the end, and a positive-sum game results in players as a group gaining in the end. Game theory can be used to construct a payoff matrix, measuring the outcomes, or consequences of the strategies available to participants.
See also elasticity of demand; oligopoly.