Oligopoly

Few Firms in the Industry

Strategic Decision MakingThe number of firms in an industry play a role in determining whether firms explicitly take other firms’ actions into account.A monopolistically competitive firm does not take into account rival firms’ responses to its decisions.In oligopoly each firm takes account of a rival’s expected response to a decision.

Oligopoly: Competition has a face and a name.

Oligopoly is an intermediate market structure between PC and Monopoly.Firms might compete (non-cooperative oligopoly) or cooperate (cooperative oligopoly) Whereas firms in an oligopoly are price makers, their control over the price is determined by the level of coordination among them.There are often significant barriers to entry and exit.

OligopolyThe distinguishing characteristic of an oligopoly is that there are a few mutually interdependent firms that produce either identical products (homogeneous oligopoly) or heterogeneous products (differentiated oligopoly).Mutual interdependence means that each firm must take into account the expected reaction of other firms.

CharacteristicsFew firms each large enough to influence market priceProducts may be differentiated or homogeneousThe behavior of each firm depends on the behavior of the othersEntry/exit barriers exist.

Examples of OligopoliesTennis Balls: Wilson, Penn, Dunlop and Spalding.Cars: GM, Ford, DaimlerChryslerCereal: Quaker, Ralston Food, Kellogg, Post and General Mills.Airlines: American and Delta with US Airways, Northwest and TWA struggling along.Aircraft: Boeing (McDonnell Douglas) and Lockheed MartinGrocery stores(Ralphs, Trader Joe’s)

OPECThe Most Famous OligopolyThe Most Famous Oligopoly

The Organization of Petroleum Exporting Countries: Africa (Algeria, Libya and Nigeria) Asia (Indonesia)Middle East (Iran, Iraq, Kuwait, Qatar, Saudi Arabia and the United Arab Emirates)Latin America (Venezuela).

Models of Oligopoly Behavior

No single general model of oligopoly behavior exists. Three models of oligopoly behavior are: The cartel (Collusion) model

The group behaves as ONE (monopoly)

The contestable market model.The group behaves as PC market.

The Kinked Demand Model (for the special oligopoly case of Duopoly)

The Cartel ModelA cartel is a combination of firms acting as a single firm.In the cartel model, an oligopoly sets price as a monopoly.If the cartel can limit the entry of other firms, they can increase their profits.Restrict output to maximize profit

For this they must assign output quotas to member firms

Implicit Price Collusion

Formal collusion is illegal in the U.S. while informal collusion is inevitable.Implicit price collusion exists when multiple firms make the same pricing decisions even though they have not consulted with one another. Sometimes the largest or most dominant firm takes the lead in setting prices and the others follow.

Illegal but done …Explicit Price Collusion

OPEC

Implicit Price Collusion: Firms just happen to charge the same price but did not meet to discuss it.

Airlines, Car Manufacturers.

The Collusion ModelSuppose there are only two firmsProducing identical productsFace identical demandHave identical cost structures

The Sum of the Firms’ Demand = Market

Demand

Market Demand

One Firm’sDemand

1000 2000

P0

Each Firm’s Demand = Half Market

Demand

The Sum of the Firms’ Demands = Market

Demand

Market Demanddeach firm

mreach firm

The Sum of the MR lines for both firms = deach firm

dA+ dB = Market Demand

MR

Collusion: The two firms agree to behave as One

Monopolist

MR D

MCPo

Qo

Together these two firms will sell Qo each firm selling half.

Oligopoly Collusion Solution is Inefficient

MRD

MCPo

Qo Qpc

Ppc

The efficient solution is the perfectly competitive Price and Output combination (Ppc, Qpc)

Oligopolies restrict output and charge higher

prices (Po, Q o)

Enforcement of Cartel agreements is difficult

Antitrust Laws make collusive agreements illegalThere is a strong incentive to cheat.

The Incentive to Cheat the

Agreement

Q P TR tr MR0 120 0 010 110 1100 550 11020 100 2000 1000 9030 90 2700 1350 7040 80 3200 1600 5050 70 3500 1750 3060 60 3600 1800 1070 50 3500 1750 -1080 40 3200 1600 -3090 30 2700 1350 -50100 20 2000 1000 -70110 10 1100 550 -90120 0 0 0 -110

Assume: MC = 10

Profit Maximizing Output for Cartel at: MC = MR

Each firm should produce 30 units

Total sold = 60 unitsPrice =$60

Each firm’s Total Revenue = $3600/2 = 1,800

To maximize Profit, both firms will cheat.

Q P Firm A Firm B can sell TR for Firm B

0 120 3010 110 3020 100 3030 90 3040 80 30 10 80050 70 30 20 140060 60 30 30 180070 50 30 40 200080 40 30 50 200090 30 30 60 1800100 20 30 70 1400110 10 30 80 800120 0 30 90 0

If one firm sells 30 and the other

“cheats” selling 40, total units for sale = 70 and the price will

then drop to $50

Total revenues for the cheating firm

would be 50 x 40 = 2,000

Total revenues for the cheated firm would be

50 x 30 = 1,500

Each firm can increase profits by

cheating the

agreement.

Both firms will bring 40 units for sale

Total Sold = 80 unitsPrice = $40

Firm’s Total Revenue = $3200/2=1,600

Prices are more stable in oligopoly than in any other

market structureWhen prices are stable we say prices are “sticky” – difficult to move-.Informal collusion is an important reason why prices are sticky in oligopoly.Another is the kinked demand explanation.

The Kinked Demand ModelDeveloped to explain why prices in oligopoly markets tend to be sticky.

We observed that changes in costs were only rarely met by changes in oligopoly pricesWe also observed that when prices did change, they were large in magnitude.

Kinked Demand Model of Oligopoly

A firm realizes that its price drops are more likely to be matched by rivals than its price increases

The Kinked Demand Model of Oligopoly

We assume that firms follow the following strategy:

If I increase my priceMy competition will not increase their price and Iwould lose sales.

If I decrease my priceMy competition will also decrease their price and Iwould gain very few if any additional sales.

The Kinked Demand ModelIf I increase my pricesay by 10%, no one follows and I lose sales

If I decrease my priceby 10%, everyone follows and I gain little or nothing at all!

Quantity demanded

drops by 20%

Quantity demanded

increases 5%

Q0

P1D0

Q1

P0

P0

D0

Q0Q1

P1

Demand is more elastic above P0

Demand is less elastic below P0

P0

D0

Q0 MR0MR1

D1

Above P0 demand is more elasticAbove P0 MR looks like thisBelow P0 demand is less elastic

Below P0 MR looks like this

Ignore the lower part of D0 and MR0

Ignore the upper part of D1 and MR1

Note: this Kink in demand, translates

into a gap in the MR line

The Kinked Demand Model

For prices above the current price

P0

D

Demand is more elastic

For prices below the current price

Q0

MR

MR

Marginal Revenue is flatter

Demand is less elastic

Marginal Revenue is steeper

Why are prices sticky under oligopoly?

D

Q0MR

MR = MC

MC0

MC1

MC2

MR = MC0

P0

MR = MC1

P1 =

P2

Q1

If Costs increase within the MR gap…

Price does not change

Price changes only when MC shifts out

of the MR gap

1.Oligopolist A cuts price in an attempt to enlarge his share of the market. His competitors retaliate with identical price cuts. In this case, oligopolist A will move from point A to which point? ________2.Oligopolist A cuts price in an attempt to enlarge his share of the market. His competitors fail to retaliate with price cuts. In this case, oligopolist A will move from point A to which point? ________3.Demand curve CAD represents a market in which oligopolists will match the price changes of rivals and demand curve EAB represents a market in which oligopolists will ignore the price changes of rivals. According to the kinked demand model, the relevant demand curve will be: ________4.According to economic theory, the kink in the demand curve will occur at point _____

The Contestable Market Model

A contestable market is defined as one into which there are no barriers to entry or exit.

Entry is free and exit is costless.In this case we predict that even in a market with only one firm, that firm will make zero profits, just as in a perfectly competitive market. WHY?

Why is “free entry” relevant?The threat that other firms will enter is sufficient to deter the single firm from making profits which would attract entry

Threat of entry is enough to deter the firm from raising prices above the ATC.

This is true even if even with high fixed costs of entry as long as these costs are recoverable (say airplanes, cars, buildings, etc which can be resold).

If the single firm set price to make a positive profit, a firm has little to lose by entering because it can always recover its investment.

Barriers to ExitWhen “barriers to exit” exist, exiting the industry is not costless because there are ‘sunk costs’This is the case to enter, a firm would have to purchase assets with no alternative use

A nuclear power plant

Or the firm must incur costs that are unavoidable once they have been committed at a particular moment in time

The money that the telecoms spent to win mobile phone licenses at auction in 2000.

Exiting the industry requires that the firm lose its investment

The Contestable Market Model

In the contestable market model, an oligopoly with no barriers to entry or exit sets a competitive price (= ATC) in order to eliminate any incentive for new firms to enter the market.The threat from outside competition limits oligopolies from acting as a cartel (setting monopoly prices).

The newcomer may not want to cooperate with the other firms.

Comparing the Contestable Market and

Cartel ModelsThe stronger the ability of Oligopolists to collude and prevent entry, the closer the oligopoly price would be to monopoly pricing.The weaker the ability to collude is, the more competitive the oligopoly price is.Most Oligopoly markets lie between these two extremes.

Profit Maximization under Oligopoly

Much is uncertain: there is NO Single model to predict output and price under oligopoly…An oligopoly's plan is a contingency or strategic plan:

As in chess: A firm plans a strategy based on what it believes the opponent will do in response to price moves.

Strategic interactions have a variety of potential outcomes rather than a single outcome.

Strategic Pricing and Oligopoly

Both the cartel and contestable market models use strategic pricing decisions where firms set their price based on the expected reactions of other firms.

Price WarsPrice wars are the result of strategic pricing decisions gone wild.A predatory pricing strategy involves temporarily pushing the price down in order to drive a competitor out of business.

Game Theory and Strategic Decision MakingMost oligopolistic strategic decision making is carried out with explicit or implicit use of game theory.Game theory is the application of economic principles to interdependent situations.

Prisoner’s DilemmaTwo suspects are arrested. The police have

insufficient evidence for a conviction so they put the prisoners in separate rooms to prevent them from talking to each other. They are offered the following deal:

If you confess you go free and your partner receives a 10-year sentence.

If neither confess, both get six months in jail for a minor charge.

If both confess, each receives a five-year sentence. How should the prisoners act?

Prisoner’s DilemmaPrisoner B Stays Silent

Prisoner B confess

Prisoner A Stays Silent

Each serves 6 months

Prisoner A: 10 yearsPrisoner B: goes free

Prisoner A Confess

Prisoner A: goes freePrisoner B: 10 years

Each serves 5 years

"No matter what he does, I personally am better off confessing than staying silent. Therefore, for my own sake, I should confess."

Prisoner’s Dilemma and a Duopoly Example

All possible courses of action are represented in a table called

A payoff matrix: a table that contains the outcomes of a strategic game under various circumstances.

Using Game Theory to Determine Oligopoly Outcome

Q P TR tr MR0 120 0 010 110 1100 550 11020 100 2000 1000 9030 90 2700 1350 7040 80 3200 1600 5050 70 3500 1750 3060 60 3600 1800 1070 50 3500 1750 -1080 40 3200 1600 -3090 30 2700 1350 -50100 20 2000 1000 -70110 10 1100 550 -90120 0 0 0 -110

To set up the oligopoly decision as a game you need to:

Define the possible actions for each firm:Abide by the quota agreement (Q=30) orCheat the agreement (Q =40)

Determine the payoffs to each firm for each choice action:

Revenues = 1,800 for both firms if they cooperateRevenue Cheating Firm = 2,000Revenue Cheated Firm = 1,800

Payoff Matrix

A’s Profit = 1,600(40 x $40 = 1,600)B’s Profit = 1,600

A’s Profit = 1,500(30 x $50 = 1,500)B’s Profit = 2,000(40 x $50 = 2,000)

Cheat (Produce 40 units)

A’s Profit = 2,000(40 x $50 = 2,000)B’s Profit = 1,500(30 x $50 = 1,500)

A’s Profit = 1,800(30 x $60 = 1,800)B’s Profit = 1,800

Produce 30 units

Cheat ( Produce 40 units)

Produce 30 units

Firm A’s Strategies

Fir

m B

’s S

trat

egie

s

If both firms sell 30 units, total Quantity =

60 and price = $60

If both firms sell 40 units, total Quantity = 80 and price = $40

If A sells 40, and B sells 30, total

Quantity = 70 and price = $50

If A sells 30, and B sells 40, total Quantity = 70 and price = $50

P = 60P = 50P = 50P = 40

Most Likely Outcome:

A’s Profit = 1,600B’s Profit = 1,600

A’s Profit = 1,500B’s Profit = 2,000

Cheat

A’s Profit = 2,000B’s Profit = 1,500

A’s Profit = 1,800B’s Profit = 1,800

Produce 30 units

CheatProduce 30 units

A’s Strategies

B’s

Str

ateg

ies

If B Sells 30 Units as agreed…A’s best strategy is the one that brings the largest payoff.

If B Cheats and sells 40 units….A’s best strategy is the one that brings the largest payoff.

If A Cheats and sells 40 units,

B’s best strategy is the one that brings the

largest payoff.

The best strategy for both firms is to cheat under both scenarios: if the other firm cheats as well as if the other firm

abides by the agreement

Both Cheat

Best strategy

If A Sells 30 Units as agreed…

B’s best strategy is the one that brings the largest payoff.

Best strategy

Determining Industry Structure

Economists use one of two methods to measure industry structure:

The concentration ratio.The Herfindahl index.

Concentration Ratio

Is the value of sales by the top firms of an industry stated as a percentage of total industry sales.The most commonly used concentration ratio is the four-firm concentration ratio.The higher the ratio, the closer to an oligopolistic or monopolistic type of market structure.

The Herfindahl IndexAn index of market concentration calculated by adding the squared value of the individual market shares of all firms in the industry.The Herfindahl index gives higher weights (than those given by the concentration ratio) to the largest firms in the industry because it squares market shares.

The Herfindahl Index

The Herfindahl Index is used as a rule of thumb by the Justice Department to determine whether a merger be allowed to take place.

If the index is less than 1,000, the industry is considered competitive thus allowing the merger to take place.

An ExampleFirm

Market Share

A 50%

B 25%

C 5%

D 4%

E 4%

F 4%

G 4%

H 4%

The weight assigned to the

largest firm is four times that of the next largest firm

Four Firm Concentration Ratio: 84.

50 + 25 + 5 + 4 =HHI :3,230

502 + 252 + 52 + 5(42) =2,500 + 625 + 25 + 5(16)

The HHI index reflects more accurately the true distribution of

power in the industry.

The weight assigned to the largest firm is twice that of the next

largest firm

Herfindahl-Hirschman Index (HHI)

Largest index for a monopoly:

Market share =100% HHI: 1002= 10,000

For an industry with 2 firms:Market share = 100%/2=50% each

HHI: 2(502)=5,000For a competitive industry with 10,000 firms:

Market share =100%/10,000=0.01%

HHI: 10,000(0.012)= 1

The More Concentrated the Industry,

The larger the Herfindahl-Hirschman Index (HHI)

Concentration Ratios and the Herfindahl Index

Percentage of 1992

Value of Shipments

3,00076 %Medicinal Chemicals

2,67684 %Cars

2,25385 %Breakfast Cereal

?93 %Cigarettes

31528 %Men/Boy Shirts

29324 %Ice Cream

HHILargest 4Industry

Questions to Prepare1. Define the following terms and provide an example.

a. monopolistic competitionb. oligopolyc. carteld. oligopolistic interdependencee. excess capacityf. price leadershipg. kinked demand curveh. contestable market

2. What is the value of the HHI index and the four firm concentration ratio when there are  

a. 20,000 firms all with equal market shares b. Ten firms all with equal market shares c. 2 firms with equal market share and d. One firm?

3. In what way is monopolistic competition more like competition, and in what way is it more like monopoly?

4. Explain how short-run and long-run equilibrium in monopolistic competition differ. Use graphs to illustrate your answer. Be sure that your graphs are completely and correctly labeled.

5. Here is an excerpt form an editorial praising capitalism in The Economist: "It is competition that delivers choice, holds prices down, encourages invention and service, and (through all these things) delivers economic growth." To what type of competition does the writer refer? Is it the sort of competition that economists study? Explain..

B Cheats

B Does not cheat

A Does not cheat A Cheats

B +$200,000 B 0

A 0

A +$200,000

B $75,000

A $75,000

A – $75,000

B – $75,000

Determine the competitive solution for this duopoly

1. What is the value of the HHI index and the four firm concentration ratio when there are  

a. 20,000 firms all with equal market shares b. Ten firms all with equal market shares c. 2 firms with equal market share and d. One firm?

2.Explain how short-run and long-run equilibrium in monopolistic competition differ. Use graphs to illustrate your answer. Be sure that your graphs are completely and correctly labeled.

3. Find price, output and profit/loss for this MC producer. Explain in detail what would happen in the long run.

© 2000 Claudia Garcia - Szekely62